Sa1 Pu 14 PDF

SA1: CMP Upgrade 2013/14 Page 1
Subject SA1
CMP Upgrade 2013/14
CMP Upgrade
This CMP Upgrade lists all significant changes to the Core Reading and the ActEd
material since last year so that you can manually amend your 2013 study material to
make it suitable for study for the 2014 exams. It includes replacement pages and
additional pages where appropriate. Alternatively, you can buy a full replacement set of
up-to-date Course Notes at a significantly reduced price if you have previously bought
the full price Course Notes in this subject. Please see our 2014 Student Brochure for
more details.
This CMP Upgrade contains:
all major changes to the Syllabus objectives and Core Reading.
key changes to the ActEd Course Notes, Series X Assignments and Question
and Answer Bank that will make them suitable for study for the 2014 exams.
The Actuarial Education Company IFE: 2014 Examinations

Page 2 SA1: CMP Upgrade 2013/14
1 Changes to the Syllabus objectives and Core Reading
1.1 Syllabus objectives
There have been a number of changes to the syllabus objectives in Subject SA1.
Objective (a) has been amended to read:
(a) Define the principal terms used in health and care in the UK.
Objective (c) has been amended to read:
(c) Describe the general business environment for health and care insurers in the
UK, in terms of:
products and distribution, including the roles of the State and employers
underwriting approaches, including genetic testing
use of counterparties
external influences demographic, medical, economic, political and
social.
Objective (f) has been amended to read:
(f) Understand how to design and price health and care insurance products to be
sold by UK insurers, including:
policy conditions
capital requirements and return on capital
marketability, competition and distribution
management of the risks
underwriting
reinsurance
investment policy
the renewal process and options
regulatory requirements.
IFE: 2014 Examinations The Actuarial Education Company

1.2 Core Reading
Throughout the Core Reading, all references to the UK Actuarial Profession have been
amended to refer to the Institute and Faculty of Actuaries.
This section contains all non-trivial changes to the Core Reading.
Chapter 1
Page 11
The following paper has been added to the Product design section:
Long-term care a review of global funding models

Elliott, Golds, Sissons, Wilson Institute and Faculty of Actuaries (2012).
http://www.actuaries.org.uk/research-and-resources/documents/long-term-care-
%E2%80%93-review-global-funding-models
Page 13
The following paper has been added to the Valuation and evaluation section:
Demystifying the risk margin: theory, practice and regulation.

Brown SIAS (2012).
The title of the other Core Reading paper in the Valuation and evaluation section has
been amended to read:
ERM for health insurance from an actuarial perspective.
Chapter 2
Page 6
The first sentence of Section 1.2 has been amended to read:
Income protection (IP) insurance, which has also been known as Permanent
Health Insurance (PHI) or disability insurance (DI), has been around for over 100
years.

Page 12
The third paragraph of Core Reading has been amended to read:
It should also be noted that the severity of the means test income restriction,
which limits the personal expense allowance to less than 25 per week
(April 2013) reduces the dignity of older people, as it leaves no personal income
to spend on themselves or their family.
Pages 13-14
A new paragraph of Core Reading has been inserted before the last paragraph on page
13. It reads:
In early 2013, the UK government announced an intention to adopt the principles

recommended by Dilnot, but with a higher maximum contribution cost of 72,000
and a means test asset threshold of 123,000. These changes are planned to be
implemented in 2016.
The final paragraph of Core Reading in Section 1.4 has been deleted:
At the time of writing (April 2012), none of the Dilnot recommendations have
been enacted into legislation.
Replacement pages are attached.
Page 16
Section 1.6 is now a new section on Microinsurance. Replacement pages are attached.
The material previously in Section 1.6 now forms Section 1.7.
Pages 26
The following sentence has been added to the start of the third paragraph on this page:
The degree of anti-selection must be costed as well as controlled.
The final sentence in the third paragraph and the whole of the fourth paragraph have
been deleted.

Page 27
The final paragraph of Core Reading on this page has been amended to read:
In order to be able to price the potential for such claims, the insurer will need to
assess the prevalence of moral hazard within the population experience relative
to that within the insured portfolio.
Page 28
The first sentence on this page has been amended to read:
Fraudulent features of insurance (deliberate non-disclosure, falsifying the nature

or extent of the claim) are sometimes attributed to moral hazard, but should be
treated as a separate aspect.
Chapter 3
Page 2
The section headed Changes to Incapacity Benefit has been deleted.
Page 7
The following sentence has been added below the first paragraph in Section 1.6:
Employment and Support Allowance (ESA) is the main form of State disability
benefit.
Pages 13-16
There have been a number of changes to the Core Reading in this section. Replacement
pages are attached.

Chapter 4
Page 3
The final sentence of the second paragraph has been amended to read:
A broker will generally assist on acquiring the best of breed (ie the most
appropriate product available, weighing up cost against benefits provided and
conditions imposed) for each component.
Page 11
Section 2.4, Accuracy of costing, has been deleted.
Chapter 5
Page 2
The final sentence of the third paragraph of Core Reading in Section 1.2 has been
amended to read:
This is largely the result of the low investment return environment and
competition from other savings providers.
Page 6
The first sentence of the second paragraph of Core Reading on this page has been
amended to read:
There are those who prefer the monthly cost of a PMI premium to ensure prompt
treatment, at their convenience and in comfortable surroundings.
Page 9
The third and fourth bullet points on this page have been amended to read:
the underperformance and lack of transparency of with-profit funds

the large and high profile fines imposed by the financial services
regulator, eg for mis-selling, compliance breaches and poor
administration to the detriment of customers

Pages 11-12
There have been a number of changes to the Core Reading in Sections 1.5 and 1.6.
Page 14
The final sentence in the first paragraph of Section 2.2 has been deleted.
The final paragraph on this page has been amended to read:
The Retail Distribution Review (RDR) has replaced commission with explicit
charges for investment products, as well as other measures such as minimum
standards of professionalism for advisers. Whilst consulting on the possible
advantages and disadvantages of this approach in the protection (and therefore
health and care) market, the regulator has to date stopped short of implementing
it.
Page 20
The Core Reading under the heading Definitions not made clear at outset has been
amended to read:
I have had a heart attack. My doctor says that I have had a heart attack. So why
cant I claim? The fact that only particular heart attacks (very severe ones) are
covered may not have been drawn to the attention of the policyholder sufficiently
clearly at outset. Is this another case for the courts to decide on the balance
between promise, expectation and contract wording? Who decides on the
definition of a severe heart attack?
It should be noted that the ABI definitions clarify what is covered under such
policies and hence address this issue to some extent (see Chapter 24).
Page 22
The Core Reading below the example has been amended to read:
However, the applicant may emerge from the sales process believing that he has
bought cover that is sufficient to meet all his private medical needs.
Pages 23-24
There have been a number of small Core Reading changes on these pages. Replacement
pages are attached.

Page 27 -31
There have been a number of changes to the Core Reading on these pages.
Chapter 6
Page 18
A new paragraph of Core Reading has been added to Section 3.3. It has been inserted
before the final sentence of the second paragraph in this section and incorporates this
sentence:
Most UK PMI insurers require customers to obtain authorisation prior to

treatment so that eligibility can be confirmed and any shortfall in the amount that
the insurer would pay relative to the actual likely cost is highlighted where
known. However, due to the high volume of potential providers of treatment in
the UK private medical market, it is not feasible to pre-agree all medical staff and
hospital charges before treatment.
Page 20
The third bullet point has been deleted from Section 4.1.
Page 21
The following bullet point has been added immediately above Question 6.15:
it can result in an increase in PMI claims as people live longer but

possibly with poor health.
The section headed Retiring younger has been deleted.
Page 22
The following text has been added to the end of Section 4.1:
Fertility rates have, however, stabilised in the UK since around 1980 and have
shown some increases over the past ten years, perhaps due to relatively higher
fertility rates amongst immigrants.

Page 24
The final sentence in the first paragraph under the heading PMI has been amended to
read:
This increases both costs (since the insurance is written on an indemnity basis)
and frequency (as new treatments are covered, often in addition to existing
treatments).
Chapter 7
Page 2
The final sentence of the first paragraph has been amended to read:
The actuary not only has to consider the policy wording in the context of the
current environment, but also the possible effects of external influences and
changes.
Page 9
The final sentence in the first paragraph under the heading Expiry age or term has
been amended to read:
Contracts written under long-term business regulations must have a minimum

(potential) term of not shorter than five years.
Pages 11-14
There have been a number of changes to the Core Reading on pages 11 and 13.
Chapter 8
Page 15
In the first bullet point in Section 2.5, the reference to the FSA Returns has been
amended to refer to the supervisory returns.

Page 24
The assumptions for the inflation of the various cashflow components claims,
premiums, ordinary expenses and expenses incurred in administering claims
should be set consistently. It cannot be assumed that the components will all
have the same rate of inflation.
Page 25
The paragraph under the heading Claims inflation: non-indemnity benefits has been
amended to read:
Inflation on claims and premiums will be a function of the product design, eg if

the payout is a capital sum then there is no inflation to take into account;
similarly if premiums are level.
Pages 31-34
There have been a number of small changes on these pages, mainly updating references
to the FSA. Replacement pages are attached.
Page 39
The section headed Monitoring lapses / non-renewal rates has been deleted.
Chapter 9
There have been a number of changes to the Core Reading in this chapter. A
replacement chapter is attached.
Chapter 11
There have been a number of changes to the Core Reading in this chapter, particularly
due to the removal of all references to the FSA. A replacement chapter is attached.

Chapter 12
Page 1
The first two sentences of Core Reading have been amended to read:
All information included in Chapters 12 and 13 is current as at the time of writing

(April 2013). However, since Solvency II remains under development during 2013
and potentially also 2014, some of the details may have been amended or
replaced by the time of the examination.
Page 2
The bullet point list has been amended to read:
increase the level of harmonisation of solvency regulation across Europe

protect policyholders
introduce Europe-wide capital requirements that are more sensitive (than
the minimum Solvency I requirements) to the levels of risk being
undertaken
provide appropriate incentives for good risk management.
Pages 3-4
There are a number of Core Reading changes on these pages, particularly related to the
timescales for implementation. Replacement pages are attached.
Page 12
Initial applicants were Bermuda, Switzerland and Japan (reinsurance only), but
this list has since been extended to include several others eg Australia, Hong
Kong and South Africa.

Chapter 13
Page 6
The final paragraph has been amended to read:
It is also noted that the method used to determine the discount rate needs to be
consistent between different currencies, including those without an active
government bond or swap market or where the market is not active for as long a
duration as the liabilities.
Pages 7-8
There have been a number of changes on these pages. Replacement pages are attached.
Page 22
The first paragraph has been deleted and replaced by the following text:
The overall capital requirements resulting from the use of an internal model will
generally differ from the outcome of the standard formula calculation, and may
be either higher or lower depending on how the firms tailored risk profile
compares against the assumptions underlying the standard formula.
Pages 23-24
Chapter 14
Page 2
The reference to the FSA in the first paragraph has been changed to say regulatory.
Page 5
The first paragraph of Core Reading has been amended to read:
Membership of the FOS is compulsory for all regulated UK financial services

companies.

Page 6
The final sentence has been amended to read:
Annual levy limits are specified in the regulatory Handbooks.
Pages 8-11
There have been a number of changes to the Core Reading on these pages, including
updating references to the FSA. Replacement pages are attached.
Pages 15-19
Page 32
The reference to the FSA in the fourth point has been changed to refer to say
supervisory.
Chapter 15
There have been a number of changes to the Core Reading in this chapter. A
replacement chapter is attached.
Chapter 16
Page 14
The actuary is then faced with a difficult situation; inadequate servicing of the
business, increases in claims outstanding and losses to the company.
Page 19
A new section on Microinsurance has been added as Section 3.11. Replacement pages
are attached.

Page 20
There have been a number of changes to the Core Reading on this page. A replacement
page is attached.
Page 23
All references to the FSA Returns in Section 4.5 have been amended to refer to the
Supervisory Returns (including in the section title).
Page 26
The following sentence has been added to the end of the first paragraph in Section 5.1:
The concept is of most relevance to long term insurance business.
The third bullet point under the Reasons for calculating embedded values has been
deleted.
Page 28
The fourth paragraph in Section 5.2 has been amended to read:
The (determination of) bonus to staff and salespeople could warrant a realistic or
perhaps slightly prudent basis.
The next paragraph in this section has been retained, and the subsequent three
paragraphs have been deleted.
Chapter 17
Page 7
Under Section 3.1, the heading Proportional reinsurance and the first sentence below
it have been deleted.
The third paragraph in Section 3.1 has been amended to read:
Under proportional reinsurance, the solvency requirements for a particular line

of business are normally reduced in line with the proportion ceded, though this
may be subject to an upper limit. This upper limit can materially affect the pace
of development if the limit is low in relation to the direct insurers requirements.

The heading Lapse Risk on this page has been deleted.
Page 8
Section 3.2 has been re-titled Free assets. The sub-heading Surplus relief and
embedded value financing has been deleted.
The first sentence in Section 3.2 has been amended to read:
Occasionally, where the reinsurer agrees that a block of renewing business

should produce regular profits in the future, capital can be found for the insurer
to improve its free asset position by reinsuring this portfolio of profitable
existing business.
The following sentence has been added before Question 17.5:
This type of arrangement is generally known as surplus relief or embedded

value financing.
Page 11
The first sentence in the second paragraph of Section 4.4 has been amended to reads:
Reinsurers will generally offer staff training.
Page 13
The first paragraph in Section 4.7 has been amended to read:
Claims control is another essential component of the management process to

establish and maintain profitability. Reinsurers can assist in the provision of
claims management (eg initial assessment of claims) and of training in claims
handling and monitoring of experience.
Page 14
The first paragraph in Section 4.9 has been amended to read:
The robustness of policy wording and product design is an important element of

risk management. Shortfalls or defects can result in claims arising that were not
intended to be within the scope of the contract. Regular reviews of claims
experience need to be undertaken to highlight such defects and thus incorporate
the solution into the next policy draft. Reinsurers can assist with such reviews.

Page 17
The first sentence of the third paragraph on this page has been deleted. This paragraph
now reads:
However, there may be problems with the confidentiality of information as it

moves from site to site.
The final paragraph on this page has been deleted.
Page 18
The first sentence of Section 5.2 has been amended to read:
Solvency capital requirements may be different for reinsurers and direct insurers
resulting in differences in capital cost.
Page 20
The bullet point list has been amended to read:
one or other may wish to build volume in a particular class of health and
care business, or
one or other may wish to gain experience in the writing of a class or in a
new territory, or
an insurer may wish to develop a product in order to be able to offer it to a
specific client or distribution channel, or
the presence of a reinsurance treaty may be a requirement of the regulator
(if the insurer is a new company).
Chapter 18
Page 5
The final two sentences before Question 18.8 have been amended to read:
Not all of the inflationary forces will totally mirror the UKs most widely quoted
inflation indices, the Retail Prices Index (RPI) and the Consumer Prices Index
(CPI), or average earnings indices. However they will have some relevance to
the claims in particular classes of insurance.

Page 6
The first bullet point in Section 1.8 has been amended to read:
relative security of payment due to their UK government guarantee, and
Page 7-8
There have been a number of changes on this page including changing:

free reserves to free assets
required solvency margin to minimum solvency capital requirements
stocks to securities.
Page 9
Section 3.2 has been re-titled Index-linked securities and now reads:
Similar comments apply for index-linked securities, except that the payments
should be increased by an estimate of changes in the index, eg the RPI for
index-linked gilts.
Page 12
Section 4.1 has been re-titled Fixed-interest securities.
Under the Capital values heading, references to stocks have been amended to
bonds.
Page 16
The third and fourth paragraphs in Section 5 have been amended to read:
If the model is also required to incorporate an assessment of the likely level of

solvency at each period in the future, then it must be extended to include
estimates of the regulatory asset values and the value of the liabilities. A
comparison can then be made of the actual level of solvency with that
acceptable to the regulatory authorities.
It is also likely that an insurer will place further, more stringent, class specific
solvency capital requirements on itself.

Page 17
The first paragraph in Section 6 has been amended to read:
The examiners will expect candidates to be able to discuss, in relation to specific

classes of business and free assets, the suitability of the main types of asset
held by a health and care insurer, namely:
ordinary shares and preference shares
gilt-edged and other fixed-interest securities
index-linked securities
direct property investments
cash and other money-market investments
overseas investments.
In Section 6.1, the tenth bullet point has been amended to read:
size of the free assets
Chapter 19
Page 3
The fourth bullet point and the final two bullet points have been amended as follows:
by region / location
by group size (for group business)
by industry (for group business).
The following bullet has been added between the fourth and fifth points:
by occupation
Page 8
The third paragraph has been amended to read:
A broad-brush approach to the analysis might be to consider the overall loss

ratio (claims incurred expressed as a percentage of premium).

Page 10
The first sentence of the paragraph under the heading Pre-funded contracts has been
amended to read:
In theory pre-funded contracts should be investigated in a similar manner to

contracts discussed in medical expenses, above.
Page 11
The analysis will compare actual deaths with expected deaths as per the
impaired life mortality information used in the pricing.
Page 12
Here the average size of benefit payout, subdivided into as many categories as
there are separate incidence rates, will be researched.
The following has been added before the heading Critical illness and income
protection:
For health cash plans, monitoring of the experience by claim amount needs to be
undertaken, for example to determine whether policies with higher (or lower)
payback percentages experience different incidence rates from the overall
average.
Page 13
The final paragraph of Section 2.4 has been amended to read:
If the benefit design indemnifies the claimant for certain aspects of his / her long-
term care costs up to stated benefit limits, the insurers experience is subject to
volatility (although this is capped). The analysis of claims by amount is thus
crucial in the assessment of the profitability of the business, in reserve setting
for ongoing claims and in the reassessment of the current premium basis.

Page 24
The penultimate sentence of the final paragraph has been amended to read:
The analysis of experience here will indicate also the degree to which increasing
costs are mirrored by national indices (eg RPI or average earnings) or whether
these have to be adjusted.
Page 27
The first bullet point list has been amended to read:
The movements normally monitored are in respect of:

new business
lapses
deaths (whether or not leading to a claim)
disability claims
endorsements
mid-term cancellations.
The first sentence of the final paragraph in Section 7.1 has been amended to read:
The movements give an important early warning on adverse changes that might
indicate the need to review premium rates and/or reserves for certain risk
groups.
Page 29
The first sub-heading on this page has been amended to read Lapses (short-term
business).
The first sentence of this section has been amended to read:
Lapses from a particular period, by definition, can stem only from those short-
term policies actually invited for renewal in that period.

Page 30
The second sentence of the penultimate paragraph on this page has been amended to
read:
Normally, the best solution for short-term business will be to relate new
business incepting in a particular month to the corresponding number of
renewals invited in that month (ie the same base as used to measure lapses).
Chapter 20
Page 4
The fourth bullet point has been amended to read:
actual vs expected mortality / critical illness incidence
The sentence after the bullet point list has been amended to read:
Note that LTCI may be grouped with mortality / critical illness incidence if a lump
sum benefit is payable.
Page 12
The sub-heading has been amended to read Mortality / critical illness incidence.
Page 14
The sub-heading has been amended to read Withdrawals / lapses.
The definitions of formula terms have been amended as follows:

V0W = reserve at beginning of year for withdrawals / lapses
PW = valuation premiums received (net of expected renewal

expenses) for withdrawals / lapses
EDS W = the contribution from withdrawals / lapses to the

expected death / disability strain
Page 21
The third and fourth paragraphs on this page have been deleted.

Chapter 21
Page 6
The second sentence of the final paragraph has been amended to read:
Thus the second circumstance in Section Error! Reference source not found. above
will not apply to guaranteed contracts (if premiums are to be increased), but the
first may be acceptable legally.
Chapter 22
Page 3
The sub-heading The regulator (FSA) has been amended to read The regulator.
On the remainder of this page the references to the FSA have been amended to the PRA.
Page 6
In the fifth paragraph, the first sentence has been amended to read:
It may not always be possible to achieve surplus from each and every policy.
Chapter 23
Page 28-29
There have been a number of changes to the Core Reading on these pages, updating the
OECD data to 2012 figures. Replacement pages are attached.
Chapter 24
Pages 1-10

Chapter 25
Pages 3-4
The fifth, sixth and seventh bullet points from the list have been deleted.
Chapter 26
The following definitions have been changed as follows:
Age-at-entry pricing
This phrase relates to the practice in some PMI markets of calculating premiums
with allowance for the increasing probability of claim as the age of the
policyholder increases over the prospective period of cover (often to age 65).
Therefore such policyholders are not subject to the age-related increases that
affect PMI products with standard pricing.
However, the insurer usually retains the right to increase premiums

subsequently to allow for medical inflation or medical inflation in excess of
levels assumed in the original calculation. The PMI contracts would still be
written on an annual renewal basis.
Change of occupation (UK)
This has now largely been dropped in the UK.
However, where such a requirement is in place, the ABI Statement of Best

Practice says that the insurer should bring to the policyholders attention his or
her duty to notify any change of occupation whenever it periodically writes to the
policyholder for other purposes (eg when there is a need to review premium
rates or to increase premiums or benefits).
Claim escalation rates (UK)
In the UK, escalation rates for claims fall into three specific categories:
benefits increase in line with a price index (typically Retail Price Index
(RPI) or Consumer Price Index (CPI))
benefits increase in line with the national average earnings index
the policyholder is offered a choice of set percentage increases.

Increases may be subject to a maximum or minimum rate. The majority of

escalating policies today in the UK link to an index and benefits increase both
prior to and during claim payment.
Pre-existing conditions (PEC) exclusion
Under the terms of such an exclusion, cover is not provided in respect of any of
the conditions listed in the policy that the life insured has already suffered,
ie where the condition pre-existed at the commencement of cover. It is also
usual to exclude cover for any condition where the life insured has previously
suffered from another medical condition that gives a materially greater risk of
that condition occurring.
PEC exclusions can be used in PMI, CI and IP contracts.
The following minor changes have also been made:
Acute illnesses has been split into Acute illnesses and Acute illnesses (UK) as
follows:
Acute illnesses
Illnesses or conditions of a non-degenerative nature where a cure is a

reasonable prospect. This should be contrasted with Chronic illnesses.
Acute illnesses (UK)
In the UK, PMI generally only covers surgery and other treatment for illnesses
deemed acute.
Anti-selection
People will be more likely to take out insurance contracts when they believe their
risk to be higher than the insurance company has allowed for in the premium,
ie the benefits are worth more than the premiums payable. This is known as
anti-selection.
An example in critical illness cover may be where an individual begins to suffer

pains in the chest. He takes out a policy without mentioning the chest pains and
then goes to the doctor to see if the pains are due to heart disease. If they are,
then there is a greater likelihood of a claim for benefit.
Anti-selection is also recognised in the tendency for sick or sub-standard lives

legitimately to renew policies or take up options providing additional cover
without evidence of health.

Claim notification period
In order to improve claims handling procedures, many companies require that

claimants notify them of potential claims at an early stage. The notification
requirements of companies generally fall into two broad categories:
The insured is required to notify the company a set time after the
incapacity begins, irrespective of the deferred period.
The insured is required to notify the company at a set time before the end
of the deferred period.
The purpose of this period is twofold: to ensure that valid claims are ready to be
paid at the end of the deferred period and for the purposes of early intervention
from a claims management perspective.
Continuation option
A continuation option describes a benefit under an insurance policy whereby the

insured can choose, without having to provide evidence of health, to continue
the cover provided by the policy under circumstances where it has otherwise
ceased. Such circumstances might apply where the individual has left his place
of work and is thus no longer covered by an employer-sponsored scheme or
where an individual policy has expired. The terms under which the option is
effected are those applicable to a healthy life for the age at the date when the
option arises.
Creditor insurance
This is a form of cover that is taken out to protect a loan or mortgage. It may
consist solely of life insurance that will repay the outstanding loan if the
borrower dies before it is repaid. Often cover is extended to pay off the loan
following a total and permanent disability and, more recently, critical illness.
Creditor insurance can also be taken out to cover repayments during temporary
disability or unemployment.
Day case admissions
This term relates to the increasing practice of treating the more straightforward
operations in hospital surgical units on the day of admission, occupying a bed
but being discharged on the same day (ie no overnight stay).
Deferred period
This is a term most often encountered in IP insurance, meaning the period of

incapacity before any benefit is paid.

Definition of incapacity (UK)
In the UK, the ABI Statement of Best Practice includes Guidance Notes on the
definition of incapacity (own occupation and any occupation) under IP policies.
Direct salesforce
An insurance company that employs the services of salespeople to sell only

their products directly to the customer is said to operate a direct salesforce.
Exclusions
The final bullet point (AIDS / HIV) has been deleted.
Insurance intermediaries
Insurance intermediaries are independent of any particular financial services

company (contrasted with a member of a direct salesforce). They select and
recommend the products that they consider to be most appropriate for the
customer using various criteria. They are known in some territories as brokers
or financial advisers.
Insurance premium tax (IPT) (UK)
Insurance premiums are exempt from VAT in the UK, but most general insurance
premiums are subject to an insurance premium tax (IPT), currently (May 2013) at
the rate of 6%.
Key Features document (UK)
This is a legislative requirement for regulated plans that aims to give a short
and punchy synopsis of the product which is easy to read and capable of being
understood by the investor. It sets out the required information such as aims
and purposes of the policy, nature of the policyholders commitment, a
description of the risk factors and illustrative projections.
Limited benefits / budget plans
A number of IP providers offer policies under which, in the event of a claim,

benefit payments are restricted to a certain number of years. These policies are
sometimes referred to as budget plans because they are cheaper than contracts
that provide benefit to the terminal age.

No claims discount (NCD)
Under PMI, the insured, not having claimed in a policy year (or other specified
period), will pay a lower premium than would have arisen if a claim had been
made. An NCD system is used as an own-experience proxy for more accurate
risk segmentation.
Pregnancy clause (UK)
The pregnancy clause is an IP policy term covered by the ABI Statement of Best
Practice in the UK. The Statement of Best Practice recommends that insurers
should:
(a) Cover claims arising from complications of pregnancy diagnosed by a
doctor, or a consultant who specialises in obstetrics.
(b) Cover such complications from the date on which they become
incapacitating, ie without any extension of the standard deferred period.
Actual practice varies, with the most common approach being that disability
attributable to pregnancy or complications thereof is not covered unless the
condition continues for more than 13 weeks after the termination of the
pregnancy. The deferred period is then deemed to commence.
Proportionate benefits (UK)
The final paragraph of this definition has been deleted.
Rider benefits
These are extra benefits that can be added to a basic policy either at
commencement of the cover or sometimes at defined policy anniversaries of the
contract. These benefits would be underwritten at outset and would normally
affect premium rates and possibly initial underwriting requirements. For
marketing reasons, some riders are provided for the policyholder at no
additional charge.
Solvency II (UK)
Solvency II is an updated set of regulatory requirements for insurance firms in

the EU, based on a three pillar approach, which is planned to replace the current
Solvency I regime at some future date (at the time of writing, the implementation
date is not yet clear). The aim of EU solvency rules is to ensure that insurance
undertakings are financially sound and can withstand adverse events, in order to
protect policyholders and the stability of the financial system as a whole.

Switch
In the context of PMI, switch applies to the process whereby an existing

policyholder, individual or group, changes insurer on renewal, possibly without
further underwriting or with simplified underwriting ie a declaration of good
health.
Technical Actuarial Standards (TAS) (UK)
Technical Actuarial Standards are professional standards issued by the

Financial Reporting Council, which cover both generic and specific areas of
actuarial work. Each TAS is mandatory for all members of the Institute and
Faculty of Actuaries when undertaking work that is within the scope of that TAS.
Treating customers fairly (TCF) (UK)
The regulatory concept of Treating Customers Fairly (TCF) is enshrined within

UK regulation: a firm must pay due regard to the interests of its customers and
treat them fairly. It is clear that the responsibility for satisfying the TCF
requirements rests with the Board and senior management of an insurance
company.
Senior management is expected to incorporate its approach to treating

customers fairly into the firms corporate strategy, and to support delivery of the
strategy with an appropriate framework of controls.
The following definitions have been deleted:
AIDS exclusion (UK)

Board for Actuarial Standards (BAS) (UK)
The following (UK-specific) definitions have been added:
Financial Conduct Authority (FCA) (UK)
The FCA is the UK regulator responsible for regulation of conduct in financial

markets (and the infrastructure that supports those markets) and the prudential
regulation of financial services companies that do not fall under the scope of the
PRA (eg insurance brokers and smaller investment firms).
Financial Reporting Council (FRC) (UK)
The FRC has responsibility for the regulation of the Institute and Faculty of
Actuaries, including setting technical actuarial standards.

Prudential Regulation Authority (PRA) (UK)
The PRA is a subsidiary of the Bank of England and is the UK regulator

responsible for the prudential regulation of all deposit-taking institutions,
insurance providers and large investment firms.

2 Changes to the ActEd Course Notes

Chapter 1
Page 15
The section on the Financial Services Authority has been replaced with details of the
Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA).
The relevant websites are:
PRA - www.bankofengland.co.uk/pra
FSC - www.fca.gov.uk
Page 16
The website for Cover magazine has been updated to read:
Cover magazine www.covermagazine.co.uk
Chapter 2
Pages 13-14
There have been a number of changes to the material on these pages. Replacement
pages are attached.
Page 5
New material has been added to Section 1.6 on Microinsurance. Replacement pages are
attached.
Page 19
The reference to the FSA has been amended to refer to the FCA.

Chapter 5
Page 5
The government hopes that, following the publication of the policy on social care in
early 2013 and the greater certainty regarding the cost of care, more long-term care
insurance products will be developed. However, at the time of writing it is unclear how
the insurance industry will respond to the proposals.
Chapter 6
Page 34
The third bullet point in the first list under the heading External influences has been
deleted.
Chapter 8
Page 25
The first sentence and the bullet point list following it have been amended as follows:
We have four different variables, which may each be subject to different future rates of
inflation. We therefore need to consider:
inflation of claims costs
inflation of premiums
inflation of administration expenses
inflation of claims expenses.
The paragraph below the bullet point list has been deleted.
Chapter 9
There have been a number of changes to the material in this chapter. A replacement
chapter is attached.

Chapter 11
Chapter 12
Throughout this chapter references to the FSA have been updated to refer to the PRA.
Page 1
The link in the final paragraph has been amended to read:
http://www.bankofengland.co.uk/pra/Pages/solvency2/default.aspx
Page 12
The first paragraph of ActEd text has been deleted.
Page 15
The first bullet point list has been amended to include the following point:
protect policyholders
The text below this list has been amended to read:
It is currently planned to be operative from the beginning of 2014, although a delay is

expected by many people. Transitional arrangements may be available for some
aspects.
Chapter 13
Pages 7-8
Pages 23-24

Chapter 14
Pages 7-9
There have been a number of small changes to the material on these pages, generally
updating the references to the FSA. Replacement pages are attached.
Pages 15-19
There have been a number of changes to the material on these pages. Replacement
pages are attached.
Pages 35-36
There have been a number of small changes made to the chapter summary.
Chapter 15
Chapter 16
Throughout this chapter references to the FSA Returns have been amended to refer to
the supervisory Returns.
Page 21
The second sentence of the third paragraph has been amended to also mention Working
Paper 67.
Page 32
The following text has been added to the section headed Assessment of overseas
markets:
Microinsurance is one way that insurers could look to expand into less developed
overseas markets.

Chapter 17
Page 7
The reference to the FSA half way down this page has been amended to refer to the
PRA.
Page 14
The second paragraph in Section 4.9 has been amended to read:
Policy wording needs to be regularly reviewed as it is very difficult to anticipate fully

the types of medical conditions and scenarios that could lead to a valid claim being
made on a policy.
Chapter 18
Throughout this chapter, all references to free reserves have been amended to refer to
free assets and the term stocks has been amended to securities.
Page 5
The reference to the NAEI in Question 18.8 has been amended to refer to an average
earnings index.
Chapter 19
Page 40
The second point in the first bullet point list has been amended to read lapses.
Chapter 22
Page 11
In Solution 22.2, the reference to the FSA has been updated to the PRA.

Page 13
The second paragraph has been amended to read:
From 21 December 2012, insurance companies are no longer able to use gender as a rating
factor at all.
Chapter 24
Page 23
In the first paragraph the reference to FSA sales regulation has been updated to say
financial sales regulation.
Page 25
In Solution 24.1, the reference to the FSA has been updated to the FCA.

3 Changes to the Q&A Bank

There have been no significant changes to the Q&A Bank questions or solutions.
However, mark allocations have been amended to reflect the actual exam marking. In
particular, very few points will score a full mark in the exam, so many points that
previously scored a whole mark have been split into two half marks. Also, some points
that previously scored a quarter mark have been changed to score a half mark.
These changes are not listed here. In the Subject SA1 exam, it is always safest to
assume that each valid point you make will score half a mark.
Any other changes worth noting are listed below:
Q&A1
Question 1.3(iv)
Suggestion (b) has been amended to read:
(b) Underwriting should be restricted to a simple proposal form that asks for basic
demographic information (ie age and location only).
Solution 1.3(iv)(b)
The following changes have been made to points in this part of the answer:
If the nursing home has strict criteria for admission, only taking those for whom care is
essential, then it is likely that age will be the rating factor having the most significant
effect on future mortality. []
The restricted risk classification (ie only age and location) may increase the extent of
cross-subsidies within each risk group. []
Changes to legislation affecting the underwriting process (eg age being prohibited from
use as a rating factor) may lead to a review of the underwriting policy or contract design
in the future. []
The following points have been added to this solution:
Gender is also likely to have a significant impact on future mortality but as this is not
able to be used as a rating factor an average mix of business will need to be assumed. [1]

Location will have an effect on expected future mortality, along with the expected cost
of cover. []
The following point has been deleted from this answer:
Gender would not be allowed as a rating factor for any policies sold in the EU from 21
December 2012. []
Q&A2
The marks available for each question have changed as follows:

Question 2.3 is now worth 3 marks.
Question 2.7(i) is now worth 3 marks.
Question 2.3
Part (d), expenses, has been deleted.
Question 2.7(iii)
The reference to the FSA has been updated to refer to the PRA.
Solution 2.1
The rate of corporation tax used has been updated to 23%.
Solution 2.3
Part (d) of the solution has been deleted.
Solution 2.10
The point on counter-cyclical premiums has been amended to read:
The use of counter-cyclical premiums (or a volatility balancer) or a matching

adjustment are also being considered. []
Solution 2.11
The reference to the FSA in this answer has been updated to refer to the PRA.

Q&A3

Question 3.3(ii) is now worth 36 marks.
Question 3.4(i) is now worth 19 marks.
Question 3.4(iii) is now worth 9 marks.
Q&A4
Solution 4.4(ii)
In the final point of this answer, the reference to the FSA has been updated to the PRA.
Q&A7
Solution 7.1(iii)(a)
The reference to the FSA in the third point from the bottom of page 3 has been updated
to the PRA.
Solution 7.1(iii)(b)
The reference to the FSA in the final point has been updated to the PRA.

4 Changes to the X Assignments

As with the Q&A Banks, mark allocations have been amended to reflect the actual
exam marking. In particular, many points that previously scored a whole mark have
been split into two half marks, and some points that previously scored a quarter mark
have been increased so score a half mark.
These changes are not listed here. In the Subject SA1 exam, it is always safest to
assume that each valid point you make will score half a mark.
Any other changes worth noting are listed below:
X1
Solution X1.2(i)
The following point has been added to the solution:
It is essentially for people who are not going to get better and is distinct from acute
medical care as it is not principally concerned with curing or alleviating particular
medical conditions. []
The final point has been deleted from the answer.
Solution X1.3(ii)
The first sentence of the second point in the Underwriting section has been deleted.
X2
Solution X2.1(iii)
The following point has been added at the end of the first part of the solution:
This could also happen if the DAC asset was reduced. []
Solution X2.2(i)
The final point has been amended to read:
Annual levy limits are specified in the regulatory Handbook. []

Solution X2.3
The following point has been added as the penultimate point in the Classification of
benefits for tax section on page 9:
Where there are material surrender or maturity benefits the product may be classified as
Class I or Class III (depending on whether it is non-linked or linked) and taxed as
BLAGAB. []
Solution X2.4
Throughout this answer the following references have been updated:

UK Actuarial Profession updated to the Institute and Faculty of Actuaries
FSA updated to the regulator
Board for Actuarial Standards updated to the Financial Reporting Council.
Solution X2.4(ii)
The value of the BCRR has been updated to 3.7m euro in the second point on page 14.
X4

X4.1(i) is now worth 3 marks.
X4.1(v) is now worth 11 marks.
Solution X4.1(i)
The final point of this answer has been deleted.

5 Other tuition services

In addition to this CMP Upgrade you might find the following services helpful with
your study.
5.1 Study material
We offer the following study material in Subject SA1:

Mock Exam
Additional Mock Pack.
For further details on ActEds study materials, please refer to the 2014 Student
Brochure, which is available from the ActEd website at www.ActEd.co.uk.
5.2 Tutorials
We offer a Block Tutorial (lasting two full days) in Subject SA1.
For further details on ActEds tutorials, please refer to our latest Tuition Bulletin, which
is available from the ActEd website at www.ActEd.co.uk.

5.3 Marking
You can have your attempts at any of our assignments or mock exams marked by
ActEd. When marking your scripts, we aim to provide specific advice to improve your
chances of success in the exam and to return your scripts as quickly as possible.
For further details on ActEds marking services, please refer to the 2014 Student
Brochure, which is available from the ActEd website at.
5.4 Feedback on the study material
ActEd is always pleased to get feedback from students about any aspect of our study
programmes. Please let us know if you have any specific comments (eg about certain
sections of the notes or particular questions) or general suggestions about how we can
improve the study material. We will incorporate as many of your suggestions as we can
when we update the course material each year.
If you have any comments on this course please send them by email to SA1@bpp.com
or by fax to 01235 550085.

SA1-02: Health and care insurance products (1) Page 13
Dilnot Commission
In July 2010 the UK Government set up the Commission on Funding of Care and
Support to be chaired by Andrew Dilnot.
In July 2011 the Dilnot Commission produced a report on social care, which
recognised the urgent need to secure a fair and sustainable funding approach to
the provision of long term care, particularly as demand increases due to the
ageing population. The Dilnot report recommended such an approach, based on
the partnership model whereby costs are shared between individual and State.
You can read the report (Fairer Care Funding) on the Dilnot Commissions website at:
http://www.dilnotcommission.dh.gov.uk/
Recommendations included a cap on the maximum amount (eg 35,000) that an

individual would have to contribute to the cost of their care over their lifetime,
above which the State would provide the funding.
The report suggested that the cap should be between 25,000 and 50,000, but
considered 35,000 to be the most appropriate and fair figure.
Individuals would also have to contribute to general living costs, but at a

recommended standard level.
In addition, a significant increase to the current means test asset threshold was
proposed (see also Section 4.3 of Chapter 5).
The recommendation was that the means-tested threshold should be raised from
23,250 to 100,000.
Other recommendations included greater alignment between social care and

welfare benefits, and increased integration of State health care and social care
provision.
In early 2013, the UK government announced an intention to adopt the principles

recommended by Dilnot, but with a higher maximum contribution cost of 72,000
and a means test asset threshold of 123,000. These changes are planned to be
implemented in 2016.
So, nobody will need to pay more than 72,000 for their long term care, and this amount
will reduce for anybody with assets less than 123,000. However, these costs just relate
to personal care. Individuals will still have to pay for accommodation costs which one
UK charity estimates to be around 10,000 per year.
The new policy is expected to cost an additional 1bn a year by the end of 2020.

Page 14 SA1-02: Health and care insurance products (1)
The known liability limitation may help to generate an increased market for
financial products, to insure an individual up to the maximum contribution cost.
Insurers are currently exposed to considerable risk if they offer long-term care products
that indemnify policyholders for the full cost of care as the time spent in care, its initial
cost and inflation are all unknown. This uncertainty leads to large margins, high
premiums and low sales.
The new proposals are intended to allow insurers to offer policies with payouts capped
to 72,000. This reduces the risk for insurers leading to less need for margins in the
pricing basis. The public could then buy long-term care insurance that fully covered
their needs at a more affordable price.
However, to make this system work, the public and insurance industry would need to
have confidence that the Government would not change the rules at a future date.
There is also likely to be a related national awareness campaign, which may also
help the insurance market.
There have been comments by senior members of the Institute and Faculty of Actuaries
suggesting that this might be an appropriate time to better link pensions and long term
care saving.
1.5 How private medical insurance products meet the needs of

customers
When the National Health Service (NHS) was founded, following the Beveridge
Report in 1948, its philosophy was that medical services should be available to
all without cost at the point of delivery. It was thus to be funded through the
general taxation system, with the appearance of being free to the user.
Whilst this was a serious threat to the private medical insurance (PMI) industry
and indeed caused many of the existing players to merge under the combined
banner of the British United Provident Association (BUPA), it soon became clear
that the new National Health Service did not meet everyone's medical needs.
Question 2.12
List the main medical needs that are not always provided by the NHS.

BUPA was, and still is, one of the major providers of private medical insurance in the
UK. Also around this time a number of other small medical insurers, mainly in the
London area, clubbed together to form Private Patients Plan (PPP). In the 1990s, PPP
demutualised and was subsequently taken over by AXA insurance.
Insurance had a role to play in providing the funds for a policyholder to choose
the how, where, when and why of medical care delivery to suit his or her
requirements over and above what was available on the NHS.
Question 2.13
This choice is also available to the public by paying for private medical care directly.
So why does insurance play such an important role?
In the 1980s and 1990s the increasing demands placed on the NHS, faced with
inflating costs and greater utilisation generally from an ageing population, has
meant a lesser quality of service to members of the public. As its limited budget
attempted to cope with this escalation in calls for treatment, waiting lists
lengthened, at least until the early years of the 21st century.
However, recent government measures have attempted to reduce NHS waiting lists.
These shortfalls over the years encouraged many to seek alternatives.
You will recall from Subject ST1 that PMI is sold to two main types of customer:
employers (to cover their workers) and individuals. These are the two main markets for
PMI.
Company bosses sought to have their key staff covered, not just as a perk of
executive position, but also to ensure that persons vital to the enterprise were
treated quickly with minimal disruption to the work effort.
More individuals also applied for insurance in their own right, for private rooms as
well as for the avoidance of waiting for treatment on the NHS.
Thus products have evolved that meet a customer need. Certain individuals (or
employers on behalf of employees) seek treatment for illnesses or conditions in
private hospitals where provision of care can be attained swiftly and in relative
comfort. Insurance is an obvious way of spreading the cost in advance of need
over all such customers who seek the security of knowing that the expense will
be met when required.

Page 15a SA1-02: Health and care insurance products (1)
1.6 How microinsurance can meet the needs of customers
Microinsurance is insurance that is targeted towards those who are working, but
with low incomes.
The International Labour Organization (an agency of the United Nations) defines
microinsurance as a mechanism to protect poor people against risk (accident,
illness, death in family, natural disasters etc) in exchange for insurance premium
payments tailored to their needs, income and level of risk.
It is characterised by limited benefits and very low premiums, for reasons of

affordability. It is not a product type in itself; it is the fact that it is aimed at those
on low incomes that makes it microinsurance.
Insurance premiums can be for as little as $1 per month.
Of most relevance to Subject SA1 are health microinsurance products

(eg contributing to the costs of hospitalisation, primary health insurance or
maternity care) and disability microinsurance products (to provide financial
protection in the event of inability to work due to an illness or injury).
Often microinsurance is sold alongside microfinance. So someone can borrow a small

sum to help set up a business and can insure the repayments against death or sickness.
Banks may only be willing to give such loans if insurance is in place.
By its nature, microinsurance is particularly important for the developing world

and is currently well developed in India and some parts of Africa.
For example, there are health insurance microinsurance schemes operating in Senegal,
Bangladesh, Vietnam and India.
Although microinsurance is not sold in the UK as such, the concept is of interest

to UK life insurance companies, particularly those with existing overseas
operations.
There are a number of different models for offering microinsurance, however it is this
partner-agent model that is generally considered to generate the most benefits for
everyone involved. The insurer (or partner) increases its new business volumes via the
local agents. The local agents earn commission on sales, driving economic growth.
The local population who purchase the microinsurance will benefit from having health
insurance at a lower cost than a traditional product.
An alternative approach is known as the full-service model. The local agents run the
microinsurance scheme through health centres or hospitals which they own and run.

SA1-02: Health and care insurance products (1) Page 15b
Microinsurance is generally based on a pooling or a community rating approach,

and in some countries can be compulsory.
Microinsurance enables individuals who would not otherwise be able to afford it

to purchase some degree of financial protection. Those on low incomes are
more vulnerable to adverse events, having fewer savings to support themselves
in times of need.
Without health insurance, individuals may have to use savings, or sell any assets or
livestock which they may have.
It also helps to avoid the need for those individuals to rely on money-lenders,
who may be expensive and unscrupulous.
Some provision of health cover can be especially reassuring to families,

particularly in countries where the State welfare support system is limited.
The challenges arising for UK insurance companies operating in this area are
discussed in Chapter 16 Section 3.11.

All study material produced by ActEd is copyright and is sold
for the exclusive use of the purchaser. The copyright is owned
by Institute and Faculty Education Limited, a subsidiary of
the Institute and Faculty of Actuaries.
Unless prior authority is granted by ActEd, you may not hire

out, lend, give out, sell, store or transmit electronically or
photocopy any part of the study material.
You must take care of your study material to ensure that it is

not used or copied by anybody else.
Legal action will be taken if these terms are infringed. In

addition, we may seek to take disciplinary action through the
profession or through your employer.
These conditions remain in force after you have finished using

the course.

Appendix UK Disability Welfare Benefits

The following is a brief description of some of the benefits available under the
UK welfare system. Receipt of any of these benefits may affect the ability to
claim another. The amounts of each benefit are not given due to their
complexity; it is more important to gain an understanding of the types of benefit
provided by the State. More detailed information can be found on the
Department for Work and Pensions website at www.dwp.gov.uk or on the
governments public service website at www.direct.gov.uk.
Attendance Allowance (AA)
Attendance Allowance (AA) is a tax-free benefit for people aged 65 or over who
need help with personal care because they are physically or mentally disabled.
You may get AA if:

you have a physical or mental disability, or both
your disability is severe enough for you to need help caring for yourself
you are aged 65 or over when you claim.
If you are under age 65, you may be able to get Personal Independence Payment.
Carer's Allowance
Carers Allowance is a benefit to help people who look after someone who is
disabled. You do not have to be related to, or live with, the person you care for.
You can claim Carers Allowance if you are aged 16 or over and spend at least 35
hours a week caring for a person getting one of the following benefits:
Attendance Allowance
Disability Living Allowance
Constant Attendance Allowance.
Further details of the Constant Attendance Allowance are given in the section on
Industrial Injuries Disablement Benefit below.

Disability Living Allowance (DLA) / Personal Independence

Payment (PIP)
Disability Living Allowance (DLA) is a tax-free benefit for individuals who need
help with personal care or have walking difficulties because they are physically
or mentally disabled.
You may get DLA if:

you have a physical or mental disability, or both
your disability is severe enough for you to need help caring for yourself or
you have walking difficulties, or both.
DLA has two parts called components:

a care component if you need help looking after yourself or supervision
to keep you safe
a mobility component if you cant walk or need help getting around.
Some people will be entitled to receive just one component; others may get both. The
care component and mobility component are paid at different rates depending on how
your disability affects you.
Up to April 2013, a further eligibility requirement was that you had to be under 65
when you first claimed.
From April 2013 a new benefit, Personal Independence Payment (PIP), has
replaced DLA for disabled people of working age, ie aged 16 to 64. PIP is a non-
means tested, tax-free payment that can be spent as chosen.
There are no current plans to replace DLA with PIP for children under 16 and
people of age 65 and over who are already receiving DLA.
Employment and Support Allowance (ESA)
Employment and Support Allowance (ESA) gives people of working age a

replacement income if they have an illness or disability that affects their ability to
work.
ESA consists of two phases: the assessment phase and the main phase. The
basic assessment phase rate is paid for the first 13 weeks of your claim while a
decision is made on your capability for work through the Work Capability
Assessment.

When you make a claim for ESA, you have to complete a questionnaire about how your
illness or disability affects your ability to complete everyday tasks. The assessment
may also request a medical report from your doctor and / or require you to undertake a
medical assessment.
There are two groups within the main phase:

The Work Related Activity Group a work-related activity component is
paid in addition to the basic rate in return for attending work-focussed
interviews.
The Support Group if your illness or disability has a severe effect on
your ability to work, you will not be expected to take part in any work-
related activity and you will receive a support component in addition to
the basic rate.
People in the Support Group are paid a slightly higher rate of ESA than those in the
Work Related Activity Group. Both are significantly higher than that paid during the
assessment phase.
However, people in the Work Related Activity Group who do not attend
work-focussed interviews do not receive the work-related activity component
and their benefit level is equivalent to the Job Seekers Allowance.
A new Universal Credit system is planned to be introduced in late 2013 (for new
claimants) which will combine and replace a number of existing benefits,
including income-related Employment and Support Allowance. Existing
claimants will be transferred to this new system under a phased process.
Industrial Injuries Disablement Benefit
Industrial Injuries Disablement Benefit is extra benefit money if you are ill or
disabled from an accident or disease caused by work.

In particular, you can claim Industrial Injuries Disablement Benefit if, because of
a job you have done, you are suffering from:
a disease caused by working with asbestos
asthma
chronic bronchitis
deafness
pneumoconiosis (including silicosis and asbestosis)
tenosynovitis
prescribed disease A11 (previously known as vibration white finger)
another illness that may be covered by the Industrial Injuries Scheme.
If you get Industrial Injuries Disablement Benefit at the 100 per cent rate and
need daily care and attention, you may get Constant Attendance Allowance
(CAA). This is paid at four different rates.
If you get Exceptional or Intermediate rate CAA and you need permanent
constant care and attention, you may also get Exceptionally Severe Disablement
Allowance.
Statutory Sick Pay (SSP)
Statutory Sick Pay (SSP) is paid to employees who are unable to work because
of sickness. SSP is paid by your employer for up to a maximum of 28 weeks.

SA1-05: General business environment (1) Page 11
1.5 Leading players
Many UK long-term insurers offer critical illness cover.
Any life company offering mortgage-related life insurance will also wish to provide
their customers with CI cover. Group CI insurance is more specialised, with a small
market.
Fewer offer income protection insurance as it requires specialist staff and

certainly needs sophisticated systems to administer, price and analyse
experience. As a result it can be a challenge to make this line profitable due to
the expenses incurred both in servicing it and in managing it to ensure that the
claims incurred are within the insurers tolerance.
Equally there are only a select few companies offering LTCI (and, at the time of
writing no companies offering the pre-funded version). The same concerns
apply as for income protection insurance, plus the important one of lack of
demand.
PMI is another line for the specialist insurer, with the same demands of expert
staff and specialist systems. There is a further need to have strong relationships
with hospitals and consultants, as their costs and behaviour in deciding upon
medical treatment will directly impact the claims cost.
The leading PMI players are those with appropriate systems, effective
distribution models, experienced and knowledgeable staff, relationships with key
third parties and a name trusted by the public.
1.6 Lessons from abroad
Dovetailing different State systems
Insurance products in other territories will generally have arisen as a

complement to the State benefits on offer there. Different worldwide national
healthcare systems will be considered in some detail in Chapter 23.
An actuary advising on matters of health and care should be aware of other

systems of State welfare provision in order to identify possible alternative
strategies for the UK.

Page 12 SA1-05: General business environment (1)
Example
As an example, critical illness cover was largely derived from the dread disease
concept in South Africa. The dread disease product was developed to provide
the sufferer with funds that could be used either to purchase treatment or to deal
with the financial consequences following treatment. On being imported to the
UK, the scope of the product was quickly expanded.
Product innovations from different cultures and mindsets
Other innovations will need careful analysis and possible market testing before
development. The products that cover major medical expenses, which offer
lump sums in a tiered fashion to cover the cost of treatment on a non-indemnity
basis, were also developed in South Africa, but have not had the same success
as CI. This is possibly because the absence of indemnity coverage was too
great a negative, despite its relative cheapness, and because customers can
have low awareness of the typical costs of medical treatment and so do not
appreciate the value of the product.
Question 5.6
Explain in more detail why the absence of indemnity coverage on major medical
expenses (MME) cover is a big negative.

This is a difficult area that must be handled with great sensitivity. Some insurers will
end up breaking the rules and paying for chronic conditions, perhaps on moral
grounds. This can be seen as offering good customer service, but insurers must allow
for the financial implications of such decisions.
3.5 Product types confused
A survey conducted in 2001 indicated that a significant number of people with CI

policies believed their product to be income protection insurance. Are there
further problems in store here?
Question 5.15
What are the potential problems in such misconceptions?
This issue will least affect those insurers who have sold their customers the right
product.

4 The role of the State in healthcare provision
4.1 Complementary roles of State and insurers
The State provision of healthcare is a fact of life in the UK and has changed little
in objective over the years. Thus, for the most part, insurers try to provide
coverage in areas where UK welfare benefits are not available or are deemed to
be inadequate.
Depending on the precise nature of the product chosen, PMI can be an

alternative to the NHS for acute in-patient procedures and certain out-patient
consultations or treatment. It does not, however, attempt to compete with the
accident and emergency nor the general practitioner services of the NHS.
CI has no obvious counterpart in State healthcare benefits.
IP provides benefits that augment UK welfare provision, which is intended to

provide only a subsistence level. Additionally, IP benefits can continue to
retirement, if the disability persists; UK welfare payouts may run for a shorter
duration, or change definition and amount after an initial period. There is thus a
clearly defined role for insurance in this area.
The State currently provides benefits on disability in old age, on a means-tested

basis. LTCI therefore has a niche for those whose prospective wealth is above
the expected threshold, at the time of needing care. In this way, the claimant is
not forced to sell assets, such as the family home, in order to meet costs.
The eligibility to State benefits on long-term care partly depends on your level of
savings, including the value of your home. In England, if this is above a certain
threshold you will be expected to meet all of the costs of personal and residential
long-term care initially (nursing care is free), and so most people in this situation will be
forced to sell their homes in order to meet the costs of care. There are more details of
these means-tested arrangements later in this section.
4.2 Means testing
As mentioned above, one possible solution to the governments increasing

social welfare cost is through means testing, as a way of targeting funds to
those who need them most. This suggests that certain individuals will have to
pay for their own healthcare in the future; this is especially true in the area of
long-term care. However, the elderly in the UK have a high proportion of their
assets in owner-occupied property. The liability for care home provision for the
minority who will need it is likely to be best financed by purchasing an
immediate needs annuity on entry into care.

Critical illness
The State does not provide lump sum benefits on disability.
Clearly, CI insurance meets this need, if there is such a need, but only for the
specific conditions covered.
Long-term care insurance
As has already been described in Chapter 2, there has been protracted

debate on the governments funding of costs of long-term care,
particularly under a background of an ageing population and pressures
on tax revenue.
Free nursing care (services that require a registered nurse) has been
available since October 2001.
In England, other long-term care benefits are means tested.
The State will currently only cover personal and residential care costs if
an individuals assets are 14,250 or less. If assets are between 14,250
and 23,250 some help may be available, but only after a stringent means
test. Those with assets exceeding 23,250 must normally fund the full
costs of residential or nursing home care. As mentioned in Chapter 2, it is
planned that the approach to long-term care funding will change in 2016
following the Dilnot report.
The above figures are those in force as at April 2013.
The situation is different in Scotland, Wales and Northern Ireland.

For example, in Scotland, subsidised personal and nursing care is free (up to
certain levels) for those requiring it. In Wales and Northern Ireland there are
different means-tested arrangements.
We mentioned in Chapter 2 that the UK government intends to adopt the principles of

the Dilnot Commission so that the States funding of long-term care will change from
2016.

Private medical insurance
The NHS plan, published in 2000, set out the governments plans to significantly
increase public expenditure on, and significantly modernise, the NHS. If its aims are
achieved, there will, in theory, be no need for private health insurance at some point in
the future. However there are doubts over whether the plan is sustainable in the face of
scarce resources (eg shortage of nurses) and increasing demand for health care (eg due
to demographic changes).
Having said that, progress has already been made attempting to improve the quality of
treatment (eg by reducing waiting times) and improve efficiency. The government
plans to introduce foundation trusts, which are not-for-profit organisations with assets in
public ownership. These will be responsible for providing care. There will be a clear
focus on costs, but certain standards, such as reduced waiting times, will have to be met.
They will be audited, and there will be checks on service and quality.
Public-private partnership initiatives are being used. For example, a private finance
initiative (PFI) may be used to fund the construction and maintenance of a new NHS
hospital. This is an arrangement where a private sector contractor provides the capital
required to build and run the hospital building. The NHS then takes a long-term lease
on the building and its facilities, requiring a regular payment by the NHS. The
contractor is required to meet the service standards incorporated in the lease.
The NHS is also increasingly contracting out the provision of some services to private
firms. For example, private firms (mainly overseas) are performing certain routine
operations on behalf of the NHS.
Question 5.19
What are the advantages and disadvantages to the NHS of using PFIs to build NHS
hospitals?

The areas to note for PMI are therefore:
The NHS originally promised lifetime health care but already certain
benefits for the elderly are means tested and others fall outside of free
provision for the majority of the population eg prescriptions and dental
and optical care.
Full State provision is inconsistent with a low tax culture it is difficult to

know what will give will other items of government spending be reduced
or will tax rates rise?
PPP / PFI (Public Private Partnership / Public Finance Initiative) in

healthcare provision (hospitals) is a first step to sharing the funding; will
this expand to benefit provision and insurers?
A focus on limiting waiting times for treatment has potentially brought

into question the value of one of the key benefits of PMI: faster access to
treatment.
Party politics things will change when the political party in power
changes.
However, all of the main political parties have stated that NHS treatment should be free
to all at point of use, and so are unlikely to offer tax breaks for PMI.

5 The role of employers in the provision of health and

care benefits
In this section we consider group heath products provided by an employer for its staff.
We consider the influences on the demand for the two main products, group IP
insurance and group PMI.
As mentioned earlier, the majority of both the private medical and income
protection insurance markets is employer sponsored. The attitude of employers
to such staff benefits is key to the future insurance revenue streams for these
two products.
5.1 Valued benefits
From an employers point of view, disability or medical benefits may be a normal

part of the remunerative package, with the advantage that PMI may assist in an
early return to work and IP demonstrates a continuing financial responsibility
when an employee is ill for a prolonged period.
Such benefits within an employment package may be also a significant incentive

in attracting and retaining staff, or to incentivise and reward individuals on
promotion to higher grades.
5.2 Tax efficiency
It may be tax efficient for the insurance premiums to be paid by the employer
where these are then allowed as a business expense. An IP claim benefit (under
group income protection cover) is paid gross to the employer who then passes it
on to the employee via the payroll system, so it is subject to tax and National
Insurance contributions in the hands of the employee in the same way as was
their pre-disability salary.
PMI is also tax efficient for the employer but different in that the employee is
taxed on the premiums paid by the employer as a benefit in kind; any
subsequent benefits or payouts are received tax free.
So HM Revenue & Customs will regard the value of PMI premiums paid by the
employer as part of an employees income. Hence the value of these premiums will be
taxed as income in the hands of the employee.
These have to be compared with the alternative of the individual paying

premiums out of taxed disposable income. The policyholders end benefits
would be tax free in both cases.

Individual premiums on PMI policies will also incur Insurance Premium Tax
(currently 6%).
5.3 Relative cost
In general, due to economies of scale and greater pooling, group risks tend to be
priced more cheaply per person than if the disability policy were bought on a
stand-alone (ie individual) basis. However there are many examples where this is
not the case, eg a young person in an elderly workforce where a single unit rate
is calculated, or an office worker in a heavy engineering company based in North
East England may get a cheaper rate by applying to the insurer directly.
The above examples are comparing group schemes where there is a significant
employee contribution and each employee is charged the same premium regardless of
their individual risk factors.
However, group schemes are normally paid by the employer and membership is
often compulsory for employees. Therefore, in these circumstances, opting out
for cheaper individual cover is neither financially advantageous, nor is it
possible.
Even if cover were voluntary and the premiums were being paid by the employees, the
cost of cover for the scheme as a whole is likely to be less than the total cost of
individually purchased products.
Question 5.20
Economies of scale and experience rating are cited as two reasons for this. What other
factors may contribute to this difference?
In addition, lives that are in poor health may be covered under a group scheme
up to the free cover level for IP and may be eligible for some group PMI benefits,
but may be unable to obtain suitable (or any) individual cover because of their
poor health.
Some large group PMI schemes also offer cover to employees on a Medical History
Disregarded (MHD) basis. This means that any medical conditions that existed before
the cover started would be covered, whereas they would normally be excluded under
individual cover. These schemes are usually heavily experience-rated, or cost plus
(ie self insured), so that most or all of the risk is borne by the employer.

This page has been left blank so that you can keep the chapter
summaries together for revision purposes.

SA1-07: Product design and pricing (1) Page 11
Question 7.13
The initial expenses for immediate needs annuities tend to be significantly higher than
those for normal life annuities. Why is this?
Some plans have sought to immunise the policyholder from future care cost
escalation by pre-agreeing benefit escalation rates with a specified list of
nursing homes. However, these were agreements between the policyholder and
care home. The insurer therefore needed to ensure that the policyholder
understood that it was not responsible for the quality of care or any failure to
honour the agreement.
The benefit amount could be level or escalate, either at a fixed rate (often 5% per
annum) or linked to RPI, plus perhaps 2% per annum. Nursing home care
inflation has typically been near to RPI, although as the care costs are primarily
staff-based, they are more likely to rise in line with national average earnings
over the long term; also building and legal cost inflation may influence rates of
increase.
Immediate needs products are typically priced by individual underwriting, based

on the expected mortality experience given the medical condition of the
applicant.
Pre-funded long-term care insurance
Here we are considering LTCI policies for which premiums are payable in advance of
the benefits being needed. These premiums may be single or regular.
Benefit payment
The benefit payment is dependent upon the claim definition, which may be
triggered by a single or a multiple set of events. The single event may itself
depend on a level of disability and its continuation for a specified period.
Different benefits may also be payable depending on the level of disability.
So a single event definition may require a policyholder to have been unable to carry
out specified ADLs (see below) for a specified period of time before claim payments
can start.
The multiple event trigger may require the disability event to be the first event
from a list specified in the policy conditions (eg for an integrated rider plan such
as critical illness cover).

Page 12 SA1-07: Product design and pricing (1)
In this example the order in which events happen is important in determining which
benefits are paid under the policy. So if the first event to occur was the diagnosis of a
critical illness covered by the CI insurance definition, then the policy lump sum benefit
would be paid out. Subsequent requirements for costs of care will be deemed to be
covered by the CI cover sum insured, and no claim for long-term care benefits would be
triggered under the policy.
For more restrictive plans it may require all of the events to be triggered (eg one
or more events, including a minimum age, prior nursing care, entry into a
nursing home, as well as a minimum level of continuing disability).
The type of benefit could be selected from a range of alternatives, including a

single lump sum payment, an annuity certain, a lifetime benefit subject to
ongoing disability, or a restricted benefit (eg payable for a maximum period, or to
a maximum total amount) also subject to ongoing disability.
There is therefore a considerable variation in the design of the products benefits.
Question 7.14
Suggest a common rationale that underpins the alternatives listed in the last paragraph
of Core Reading.
Benefits could be level or escalate, at a fixed rate or linked to the increase in an

index such as RPI.
Claims definition
In the UK all existing pre-funded long-term care insurance products use

activities of daily living (ADLs) and cognitive impairment as the claims trigger to
measure dependency. The number of ADLs failed denotes the level of
dependency. Whilst the Association of British Insurers has produced a
benchmark set of definitions, these have not been universally applied. It has,
however, been agreed by the ABI members that their insurance claim definitions
will be no harder to fail than the ABI benchmark definitions.
Question 7.15
Suggest why this agreement has been reached by the ABI members.
The actuary has to decide which ADLs will be included in the contract and the
definition of each ADL.

The ABI benchmark list of ADLs is:

Washing the ability to wash in the bath or shower (including getting into
and out of the bath or shower) or wash satisfactorily by other means.
Getting dressed and undressed (dressing) the ability to put on, take
off, secure and unfasten all garments and, if needed, any braces, artificial
limbs or other surgical appliances.
Feeding yourself the ability to feed yourself when food has been
prepared and made available.
Maintaining personal hygiene the ability to maintain a satisfactory level
of personal hygiene by using the toilet or otherwise managing bowel and
bladder function.
Getting between rooms (mobility) the ability to get from room to room
on a level surface.
Getting in and out of bed (transferring) the ability to get out of a bed
into an upright chair or wheelchair and back again.
In addition, there is a mental impairment trigger. This means a need for care or
supervision as a result of deterioration in, or loss of, mental capacity (covering
memory, knowing who and where they are, an awareness of time and the ability
to solve simple problems and make rational decisions) from an organic cause
(ie a disease such as Alzheimers or irreversible dementia, but excluding
depression, or the side effects of other medication).
Question 7.16
So there are some mental conditions, such as depression, that are not fully covered by
LTCI. This suggests that there may be genuine cases of hardship that would not be
covered even for a policyholder who was fully insured.
This appears to be a failing of the insurance industry. What would you say in response
to this?
The claims trigger requires the policyholder to be incapable of performing these

activities alone and without endangering the health or well-being of the
policyholder or others.

2 Claims management
In this section we consider further product design features that can help insurers to
control the future claim costs under their policies, so as to keep prices down and
improve competitiveness.
One such feature is self retention where policyholders have to pay some of any claim
cost themselves thereby providing a financial incentive to claim less. This has the
effect of reducing claim frequency, claim size, and duration of claim (as appropriate).
As well as the basic claim definitions, there are items that can be included in the
policy conditions relating to the management of any claim arising under the
health contract. Such conditions may control to some extent the amounts that
the insurer will pay under the contracts, enabling greater accuracy in estimation
and affording potential for competitiveness. This is especially true where the
insured takes a share in the financial payment for his / her disability (such as
under a self-retention limit) thus smaller claims (with relatively high expenses)
may be avoided, as might some of the more discretionary calls on the policy.
This last point relates mainly to PMI, where a policyholder may have a choice of
whether or not to claim under the policy for treatment. Instead he or she may choose:
to pay for themselves
to have treatment under the NHS
not to have treatment at all.
These alternatives may be particularly attractive if a no-claims discount is in operation

(see below).
2.1 Private medical insurance
The self-retention limit can take a number of forms, often used in conjunction
with one another.

So, by making it clear to policyholders from the outset what the maximum increase can
be, any increase up to the maximum will meet with their expectations, and so (in theory)
the incidence of selective lapsing will be reduced, and the ability of the company to
increase charges at all may actually be increased. The cap does, of course, limit the
actual extent of upwards review possible, thereby limiting the value of the reviewability
itself. Fixing the maximum level to obtain the right balance between these conflicting
aims is therefore an important aspect of product design in these cases.
Where experience is better than expected, some offices will reduce the
premiums on their reviewable products.
Question 8.31
What effect(s) will this have on the pricing basis for the contract?
Given the greater uncertainty over future claims experience for health insurance
products, guarantee loadings for these products would be expected to
significantly exceed those for a mortality product.
For PMI business, the problem of claims uncertainty is less acute since the
insurer can re-price annually. The situation is different where guarantees are
given, but currently very few UK PMI policies have guarantees. However, regular
re-pricing can create business retention problems if the increase in premium
levels is material.
Statement of good practice
Joint co-operation of the financial services regulator (at the time, the FSA), the
FOS and the ABI has attempted to clarify the position under reviewable long-
term protection policies (May 2005).
The Financial Ombudsman Service (FOS) is an independent service established by law

to resolve individual disputes between consumers and financial organisations. It had
suggested that it might consider some reviewable terms under CI insurance policies to
be unfair.
The financial services regulator has been working on its initiative to treat customers
fairly (TCF) as part of its role as enforcement authority for financial firms under unfair
contract terms regulations. See Chapter 14 for more on TCF.

As a result, in May 2005, the FSA (then the regulator) published a Statement of Good
Practice for insurers entitled Fairness of terms in consumer contracts. The Statement
gives guidance as to how firms may draft what they call variation clauses, of which
reviewable policies is an example, in terms that are fair. The Statement applies to all
insurance contracts. The full version can be downloaded at:
http://www.fca.org.uk/your-fca/documents/fairness-of-terms-in-consumer-
contracts. This may be useful background reading, although the details are not
required for the exam.
At the same time, the ABI issued draft advice to its member insurers on improving
clarity for customers with reviewable contracts. The FOS also clarified the approach it
would take to dealing with complaint cases on such contracts (ie they will take account
of the FCA Statement and ABI advice when making its decisions).
The aim (of this co-operation) is that consumers get:
clearer explanations of what reviewability means and why (or not) they
should choose it against guaranteed rates
greater confidence that review increases or decreases are calculated fairly
continued availability of reviewable-rate products in the future
the ability to buy valuable protection at a lower price than would apply to
similar cover if sold at guaranteed rates
access to new forms of protection that insurers might not otherwise be
prepared to offer.
So the aim is to benefit both customers and insurers.
The practical implications for insurance companies are:
Where premiums are reviewable, this should be prominently shown in

product literature and the basis for reviews should be clearly set out.
The ABI advice also specifies information regarding the review that should be
stated in the policy conditions. This information includes the review frequency
and an explanation of how various assumptions will be used to calculate
premiums.
Insurers should base reviewable premiums on assumptions that they

believe are valid for the full term of the policy.
The assumptions on which premiums are based should be reviewed

regularly. The assumptions used for in-force business should be
consistent with those used for new business with justifiable grounds for
any differences.

At reviews, premium increases can only be made if the insurer changes

one or more of the relevant assumptions stated in the policy for valid
reasons (as defined in the statement).
The FCA Statement gives some guidance as to what, in its view, is likely to be
valid, and hence regarded as fair. However, it points out that, ultimately, this
will be a matter for the courts to decide.
At reviews, insurers should not aim to recoup earlier losses from claims.
This is not likely to be seen as a valid reason for changing the assumptions!
Assumptions that are more likely to be changed for valid reasons are, for
example, the insurers expectation of future claims and the incidence of taxation
on the insurer.
When a premium changes as a result of claims experience (and expected

future claims) it should be made clear that this does not relate to the
claims experience of the individual policyholder but to the general claims
experience for similar policies.
Policy reviews should always take place as specified in the policy.
The results of the review should be notified to the customer.
If premium rates increase as a result of a review, individual customers

may be given the option to continue paying the same premium but reduce
the sum assured instead. If the policyholder is offered the choice and
elects to reduce cover then this would be done with his / her agreement.
The ABI advice is that insurers should not unilaterally reduce benefits
(eg impose additional exclusions) without offering customers the alternative of
paying an increased premium (and, of course, this increase would need to be
justified).
Where insurers offer a policy with a choice of guaranteed or reviewable

premium types, an explanation of the differences should be given.
Insurers should keep records of the assumptions used to calculate

premiums and analyses undertaken to support reviews.
The paper entitled Life Treating Customers Fairly Working Party (SIAS, March
2007) discussed these issues in more detail. Details are given in the background reading
list in Chapter 1.

6.3 Increase options
Including an increase option is something we might wish to consider in our product

design. The basic idea is for cover to be increased (under long-term policies) without
further evidence of health.
We might consider this as guaranteed renewability with increments.
There are two types of option under which increases in the benefit can be
secured without formal underwriting.
The first covers those options whereby the increases in benefit are incorporated
in the original contract and operate automatically.
The increases may be at a fixed level, eg 3% pa, or linked to a published external index,
like RPI.
They may be subject to pre-ordained premiums, which may:

be level throughout the lifetime of the policy
increase in line with the benefit
increase by some other specified pattern.
Alternatively, increments may be costed as they arise. The increase can be in

line with RPI, CPI, national average earnings or a fixed percentage.
Question 8.32
Explain briefly whether costed increases in premiums cause premiums to rise more or
less steeply than where premiums are pre-ordained to increase annually in line with
benefit increases. (Assume that the same increases in benefits take place under both
versions, and the policy is CI insurance.)
The second type of option is that which includes a periodic opportunity for the
policyholder to increase the benefit by a fixed percentage, by means of a new
policy, costed in the normal way, based on the then-current age and outstanding
term.
Note that the new benefits will be charged at the companys standard premium rates
current at the option date, even though the policyholder will not be re-underwritten,
which leads to an option cost. A loading would need to be included in the original
premium basis to pay for this. The details of pricing this type of option are described in
Subject ST1.

SA1-09: Long-term insurance company taxation Page 1
Chapter 9
Long-term insurance company taxation
Syllabus objective
(d) Understand the legal, taxation and regulatory framework as applicable to UK

health and care insurance.
taxation of UK health and care products: premiums, benefits, profits

taxation of mutuals, proprietaries and providents.
(This is only part of Syllabus objective (d).)
0 Introduction
This chapter covers taxation of UK long-term insurance companies. The taxation of
short-term insurers is covered in Chapter 10.
The material in these two chapters is quite detailed and heavy-going in places. So,
dont worry if you cannot remember the details on your first read through it is more
important to understand the concepts covered. The Subject SA1 exam is more likely to
examine your understanding of taxation and how it applies to health insurance. Having
said that, anything in the Core Reading is examinable in Subject SA1, and the
well-prepared student will have learned this material by the time of the exam.
We first look at how long-term business is classified for tax purposes. Section 2 covers
the taxation of PHI business and long-term protection contracts. Sections 3 and 4 cover
the taxation of other forms of long-term business within a mutual company. Section 5
extends the picture to cover proprietary companies, and Section 6 covers tax rates.
Sections 7 9 continue the discussion with some additional comments on specific

health and care products, including details of how policyholders are taxed.

Page 2 SA1-09: Long-term insurance company taxation
1 Classification of long-term business for tax purposes

Since 1 January 2013, for tax purposes a UK long-term insurance company has
to treat the following as separate businesses:
Basic Life Assurance and General Annuity Business (BLAGAB)
Other Long-Term Business (OLTB).
Prior to 2013 there were separate tax funds for BLAGAB, Gross Roll-up Business
(GRB) and PHI Business. You dont need to know the old tax rules for the exam, but
you may see references to these old tax funds in past exam questions and your wider
reading around the course.
BLAGAB covers long term assurance and annuity contracts other than the
following:
pensions business
ISAs (Individual Savings Accounts)
child trust funds

life reinsurance business
overseas life assurance business
PHI business (see below).
Subject SA1 is concerned with the products included within PHI business. Knowledge
of the other products included in the above list is not needed for this subject.
BLAGAB also does not include long-term protection business written on or after
1 January 2013.
There had been concerns that the taxation of protection business created a barrier to
entry. A new insurer selling protection business would have needed to price using gross
expenses and so would be at a disadvantage to some other insurers that could have
priced using net expenses. As we will see later in this chapter, all insurance companies
will now be taxed on this business in the same way (on their trading profits).
Protection business written from 1 January 2013 is included in OLTB.
For this purpose, protection business is broadly defined as any long-term

insurance contract under which the benefits payable cannot exceed the amount
of premiums paid, except on death or in respect of incapacity due to injury,
sickness or other infirmity.

So term assurances would be considered as protection contracts under this definition,

but endowments would not.
There is no definition of PHI business in UK tax legislation and for tax purposes
the definition used is that given in the Financial Services and Markets Act 2000
(FSMA 2000) (Regulated Activities) Order 2001 (No. 544), which is:
Contracts of insurance providing specified benefits against risks of persons

becoming incapacitated in consequence of sustaining injury as a result of an
accident or of an accident of a specified class or of sickness or infirmity being
contracts that:
(a) are expressed to be in effect for a period of not less than five years, or
until the normal retirement age for the persons concerned, or without limit
of time, and;
(b) either are not expressed to be terminable by the insurer, or are expressed
to be so terminable only in special circumstances mentioned in the
contract.
FSMA 2000 is covered further in the chapters on legislation. The FSMA 2000
(Regulated Activities) Order 2001 is a statutory instrument that defines various classes
of insurance business.
Permanent health insurance is the name used in UK legislation for what are now
usually referred to as income protection (or long-term sickness insurance) plans. As
you will see later in this chapter, other long-term health policies, such as CI and LTCI
contracts, could also be classified as PHI business.
Thus the key points are:

Benefits are payable on accident or sickness as defined in the contract.
The term must be at least five years (or to retirement if less).
The contract is (broadly) not cancellable by the insurer.
The OLTB category incorporates all other business, and so it covers pensions
business, ISAs, child trust funds, reinsurance of life assurance, business
sourced from overseas, PHI business and long term protection business written
on or after 1 January 2013.
The OLTB category incorporates the previous GRB and PHI categories. It also
contains some business that was previously classified as BLAGAB: all long term
protection business written on or after 1 January 2013 is no longer treated as
BLAGAB, but instead forms part of the OLTB category.

The change in the taxation of protection business does not apply to business written
before 1 January 2013 to maintain consistency with the way that this business has been
priced. This is particularly important for XSI insurers (well explain what this means
later in this chapter) who may have priced this business assuming net expenses and so
would have made a loss following the tax change.
It should be noted that long-term insurance companies which have only ever
written protection business may elect to have all of their business classified as
OLTB.
So instead of having their protection business taxed as BLAGAB for old policies and
OLTB for new policies, the company can simplify the process so that all business is
taxed as OLTB. The impact for these companies of having old business taxed on OLTB
trading profits is likely to be negligible as they would probably have been taxed on
profits under the BLAGAB system too.
1.1 Apportionment between funds
There will not usually be separate sets of assets for the different types of business
described above (especially where non-linked business is concerned).
The insurer has to allocate its trading profits and all component parts of its
revenue account between the different categories of its business.
Rules on the apportionment of investment return have been subject to much

revision over past years. From 1 January 2013 the allocation of trading profits
and investment returns between the two categories must be determined on a
commercial rather than a prescribed basis.
So if the company matches its long-term care annuities with bonds, then HM Revenue
and Customs (HMRC) would expect the investment return from the bonds to be
allocated to the annuities for taxation purposes too. This is in contrast to the previous
system where complex rules set by HMRC were used to determine the allocation.
Knowledge of how these apportionments are done is not needed for the
purposes of this subject.
As the Core Reading says, for examination purposes you can assume that somehow each
item of the revenue account (eg investment return) is allocated to each of the tax funds.
The company would not necessarily use exactly the same apportionments in its pricing
calculations.

2 Other Long-Term Business (OLTB)

OLTB is liable to corporation tax (at the full corporation tax rate) on its trading
profits, which is intended to be a reasonably intuitive measure of profit made
by the shareholder on this part of the business.
It can be noted that a mutual company would not normally have a taxable OLTB
profit.
A mutuals profit would usually be zero as any surplus made would ultimately be
passed back to the with-profits policyholders as bonuses.
The taxable trading profit is derived from figures from the statutory accounts,
broadly as follows:
P + I' + A' E C (V1 V0) + (D1 D0) L
where:
P = premiums receivable in respect of OLTB contracts

I' = OLTB share of investment income
A' = OLTB share of change in value of the assets this may be
negative
E = expenses including commission attributable to OLTB
C = benefit payments made in respect of OLTB contracts
V0 = value of OLTB liabilities at beginning of year
V1 = value of OLTB liabilities at end of year
D0 = value of OLTB DAC assets at beginning of year (see
Chapter 14)
D1 = value of OLTB DAC assets at end of year
L = absolute amount of any OLTB loss brought forward from
previous year end.
[Other accounting adjustments may be necessary, but further knowledge of such

adjustments is not required for this Subject.]
Note that, in contrast to the calculation for BLAGAB, the OLTB investment income
includes dividends. The E in the above formula is full expenses, ie the acquisition
expenses are not spread in the way that BLAGAB acquisition expenses are (but instead
we can allow for a DAC asset).
Also, before 1 January 2013 the above calculation was calculated separately for Gross
Roll-up Business and PHI Business.

Note that before 1 January 2013, this calculation was based on figures from the
supervisory Returns. It is possible that further changes to the determination of
OLTB profit may result from implementation of Solvency II and/or IFRS
developments.
Part of the reason for bringing in the changes to the tax rules was that the completion of
the supervisory Returns would stop once Solvency II came into operation. The delay in
implementing Solvency II means that the tax rules have actually changed before the
solvency rules change.
Since the move from taxable surplus within the supervisory Returns to
accounting profit at 1 January 2013 would tend to give rise to an immediate profit
or loss, transitional arrangements were put in place to bring this into tax over a
period of ten years.
This will come as a great relief to any companies that would have been facing a giant
tax bill if the change had triggered a sudden jump in profits, eg because their statutory
accounts have much lower reserves than in the supervisory Returns.

3 Basic Life Assurance and General Annuity Business

(BLAGAB)
3.1 Method
Tax is payable in respect of BLAGAB on the IE basis. (It appears as this in tax
legislation.)
The term IE is standard terminology. It stands for income minus expenses, where
the I and E components have the specific meanings given below.
The components of IE are as follows:
Investment income from real estate, gilts, bonds and deposits. Dividend
income from equities (both UK and overseas) is excluded as this is
already deemed to have suffered tax.
Realised chargeable gains on real estate and equities, allowing for the
effects of indexation in respect of realised gains. Indexation is not
applied to realised losses.
Mark-to-market or mark-to-model capital movements in gilts, bonds and

derivatives.
Miscellaneous income (eg reinsurance income).
BLAGAB allocation of expenses, subject to the spreading of acquisition

expenses.
Income component of general annuities (except for immediate needs

annuities see Section 9.3).
Some details concerning the components of I
The indexation that applies to investments other than gilts, bonds and derivatives is
Retail Prices Indexation (RPI). Indexation can be used to reduce gains but cannot be
used to create or enhance a loss.

The taxation regime for gilts, bonds and derivatives means that they are taxed on total
return (ie income plus gains) over the year, with no indexation of capital gains on
fixed-interest securities. Index-linked securities, however, do receive the benefit of
indexation of capital gains.
If the mark-to-market basis is used to calculate capital movements, this means that
any gains or losses for a year are determined using start- and end-year market prices (or
the prices at which the securities were traded if bought or sold during the year).
Example
Consider a 2-year zero-coupon bond, bought for 18,000 and redeemed for 20,000.
If the bond has a market value of 19,300, say, at the end of the first year then, under
the mark-to-market basis, gains of 1,300 and 700 respectively will be recognised in
the two years.
However, if the market value fell to 17,800 at the end of the first year (perhaps due to
concerns over default risk) a loss of 200 would be recognised. If the issuer goes on to
redeem the bond at the end of year two, then a subsequent gain of 2,200 will be
recognised.
The insurer cannot offset net realised losses against investment income. Instead it has
to carry them forward for offsetting against future net realised gains.
Dividend income from equities is sometimes referred to as franked investment income

(FII). It does not appear as a component of I because it is not subject to tax in the hands
of the recipient. Tax has already been paid on dividend income received from
companies because the dividends are paid from those companies post-tax profits.
Reinsurance income (as an example of miscellaneous income) refers to outwards

reinsurance of certain types of BLAGAB business. By reinsuring part of its business
the insurer may pass some reserves to the reinsurer. As a result, the insurer's assets, and
hence investment income, are lower leading to lower taxable income. To counter this
form of tax avoidance, HMRC calculates the income that would have been received if
the insurer had not reinsured the business. So reinsurance income refers to the
investment return on the reinsurers reserves, rather than the claims paid by the
reinsurer.

Some details concerning the components of E
For annuities taken out since 1 January 1992, the allowable portion of annuity
payments is the total annuity payments less the corresponding total capital
contents. This reflects the income part of the annuity payments, which are not
taxable in the insurers hands as the policyholder has to pay tax on this element of
the payments they receive.
Many general annuity contracts qualify for whats known as capital content, in which
case the annuitant only pays tax on the amount by which each annuity payment exceeds
the capital content. The capital content is calculated by dividing the premium paid by
an expectation of life at the vesting date of the annuity, based on a mortality table
specified by the HMRC.
This makes sense: it means that the premium is basically being returned tax-free. The
balance of each annuity payment is known as the income content.
The expectation of life takes into account the mode of payment of the annuity, any
guarantee period and any fixed rate of increase.
Question 9.1
Explain the logic for allowing the income portion of annuity payments to be set off
against investment return in the company taxation calculation.
Knowledge of what the allowable portion is for annuities taken out before
1 January 1992 is not needed for the purposes of this subject.
If E is greater than I, the excess is effectively carried forward and added to the
next years E. Any amount so carried forward is referred to as unrelieved
expenses or XSE (excess E).
The expenses in E include both administration expenses and commission, but all
acquisition expenses, ie expenses that relate to the acquisition of new business
including all commission payments, have to be spread equally over seven years.
This means that even renewal commission is treated as an acquisition expense.

A particular years BLAGAB expense deductions are therefore made up of:
(1) non-acquisition BLAGAB expenses from that year
(2) 1/7 of acquisition BLAGAB expenses from that year
(3) postponed acquisition expenses from previous years, ie 1/7 of previous

acquisition expenses from last year, the year before, the year before that ...
(4) unrelieved expenses brought forward (if any)
(5) income component of general annuity business (except immediate needs

annuities).
3.2 IE computation
The I-E computation is performed for BLAGAB business only.
Tax rates
The rate of tax is at the policyholder rate (20% as at April 2013) unless any part of
the profit is deemed to be shareholder profit. In a mutual, it would not be
expected that any part would be shareholder profit.
So, for a mutual long-term insurer, the IE computation applies without further
adjustment.
In a proprietary company, the shareholder profit would be expected to be

material and further calculation is required. This is because HM Revenue &
Customs (HMRC) requires part of the profit to be taxed at the more usual rate of
corporation tax (23% as at 6 April 2013).
The rate of corporation tax has reduced in recent years. The government has announced
plans to reduce the rate of corporation tax further each year so that it will be 20% in
2015.
For proprietary companies, the further steps required to compute the tax bill are
summarised in Section 5 below.
Rationale behind the IE approach
Although this division of IE sounds odd, there is compelling justification for

this approach as is shown below.

The IE result was historically designed to be a quick and effective calculation of

the sum of shareholder and policyholder profit. Policyholder profit can be
regarded as the excess of claim amounts over premiums paid and has to arise
from profitable investment returns over charges incurred.
So to justify the IE calculation we can consider the classic revenue account

statement of profit as follows:
Shareholder Profit = P(premiums) + I(income and gains) - E(expenses) - C(claims)
Here, claims can be considered to be increases in policy reserves plus a claim

payment in excess of the opening policy reserve.
Remember that for a mutual insurer, there will be no shareholder profit. Hence, setting
the above equation to zero demonstrates that the policyholders profit (ie the excess of
claims received) must arise from investment income and gains less expenses.
Policyholder Profit is therefore equal to C P and we can re-express the

equality as:
Shareholder Profit + Policyholder Profit = I E, as required.
The rationale here is that both the insurer and the policyholders should be taxed on the
profits that they make. The above result demonstrates that the total taxable amount is
(approximately) IE. This justifies there being no further taxation on insurers or
policyholders in respect of BLAGAB business.

4 Overall taxation of life assurance business for a mutual

The overall taxation for a mutual operates as follows:
The taxable amounts in each of the funds are individually subject to a minimum
of zero. You cannot use any OLTB loss to reduce tax in the BLAGAB fund.
Neither can you use BLAGAB XSE to offset trading profits.
If BLAGAB IE is negative, the unused E are known as unrelieved expenses and

are carried forward to the next years BLAGAB calculation. (This situation is
known as being XSE. The reverse is known as being XSI.)
If there are OLTB trading losses, these are carried forward to offset OLTB profits
in future tax years.
There now follows three questions to test your understanding of this topic. Use a tax
rate of 20% for OLTB trading profits.
Question 9.2
Calculate the corporation tax paid by a mutual in the following circumstance:
BLAGAB IE = 100
OLTB trading profits = 20
Question 9.3
BLAGAB IE = 100
Question 9.4
BLAGAB IE = 100

5 Additional considerations for proprietary companies

Most of what was described in the previous section on mutuals also applies to proprietary
companies. This section describes the differences for proprietaries.
5.1 Overview
The two main differences between mutual and proprietary taxation both spring from a
concept called minimum profit. Minimum profit is the HMRCs attempt to measure the
shareholders profit in respect of the companys BLAGAB business.
OLTB business is then taxed separately and has no impact on the BLAGAB calculation.
Minimum profit has two roles in the taxation of a proprietarys BLAGAB business:
(1) It is used to split the total taxable income in the IE computation between
shareholders and policyholders. The different parts of income are then taxed at
different rates.
(2) It is used to determine a minimum amount of taxable income, the minimum

profits test. This test is also sometimes referred to as the profits test or profits
assessment. If an adjusted IE computation produces an answer lower than the
minimum profit, then it is modified so that it gives an answer equal to the
minimum profit. The minimum profits test is then said to bite.
In this case (ie when the minimum profits test bites), all of the total taxable income is
regarded as shareholders and so none of it is taxed at the policyholders rate.

5.2 Apportionment of taxable income between policyholders and

shareholders
The aim of the tax legislation is to tax:

the policyholders share of the insurers taxable income, ie the IE
computation, at the tax rates that would apply if the insurer were a mutual
the shareholders share of the insurers taxable income at the standard
rate of corporation tax.
There are special provisions for dividend income.
The dividend income (ie franked investment income) referred to here is the BLAGAB
dividend income only. OLTB dividend income will be included in the OLTB trading
profits.
An overview of this process is:
1. A quantity called minimum profit is determined as a measure of the shareholders

BLAGAB profit for the year. This is deemed to be the shareholders share of the
BLAGAB taxable income. (How minimum profit is calculated is described in the
next section.)
2. Of this minimum profit, some part is deemed to have come from BLAGAB
dividend income, and so does not suffer any further tax.
3. The rest of the minimum profit (and the OLTB trading profit), the shareholders
unfranked profit, suffers tax at the standard rate of corporation tax (currently
23%).
Details of this allocation of the minimum profit between the part derived from
the BLAGAB dividend income and the remainder are not needed for this
subject.
4. The remainder (if any) of the taxable income in the IE computation (the
policyholders unfranked share) is taxed at the same rates that apply in a mutual.
You will recall that in a mutual, both BLAGAB IE and trading profits are taxed at 20%.
In a proprietary, some of this taxable income will instead be taxed at 23%, while the rest
continues to be taxed at 20%.
A simple numerical example will illustrate this. For simplicity we shall assume in this
example that there is no dividend income.

Example
BLAGAB IE 200
OLTB trading profits 140
Minimum profit 80
Total Taxable Income (TTI) 340
Here:
220 would be taxed at 23%, this being the shareholders share (the BLAGAB
minimum profit plus the OLTB trading profits)
120 would be taxed at 20%, this being the rest of the TTI.
Question 9.5
The following figures apply to a proprietary long-term insurance company.
BLAGAB IE 520
OLTB trading profits 260
Minimum profit 40
No dividend income was received.
Calculate the amount of corporation tax payable.
5.3 The minimum profits test
The UK tax authorities consider it desirable that as far as possible the taxation of
proprietary long-term insurers is consistent with the basis applicable to
proprietary trading companies in other industries.
Therefore a minimum profits test is applied to the IE result. This is also

known as the excess adjusted life assurance trade profits test, with the
minimum profit being referred to as the Life Assurance Trade Profits (LATP).
The test was previously known as the Notional Case I (NCI) test.
The minimum profit is effectively the surplus arising on the BLAGAB business
(including BLAGAB share of non-taxable dividends).

The minimum profit for the BLAGAB business will be calculated using a similar
formula to the OLTB trading profit shown in Section 2.
If the minimum profit is negative then the minimum profit is taken as zero and a
loss can be carried forward to its calculation in the following year.
Minimum tax test
If the minimum profit is positive, it is then compared with the result of an

adjusted BLAGAB IE computation. The adjusted IE figure is the IE result plus
the BLAGAB share of dividend income.
This BLAGAB share of dividend income is included as a net figure, with no grossing
up.
If the minimum profit is higher than the adjusted IE computation, then the
allowable expenses in the IE computation are effectively restricted so that the
two are equal. The amount by which the allowable expenses are so restricted
(the excess adjusted life assurance trade profits) is carried forward as XSE and
added to the following years allowable BLAGAB expenses. When such a
restriction applies, the company is frequently referred to as being excess E.
Note that being XSE is not synonymous with having the minimum profits test bite. A
company can also be XSE if its BLAGAB IE amount is negative.
Note also that rather than actually tax the profits, we adjust the IE computation to
produce the required amount of taxable income. Because the amount of expenses we
have been allowed to use this year has been restricted, the legislation allows us to carry
forward XSE to the next year.
Minimum profit exceeds I
It is important to note that in certain circumstances the minimum profit may

exceed the I in the IE amount including equity dividend income. So even by
restricting all E, the tax charged on the resulting I will be less than would be
charged if the long-term insurance company were taxed as any other trading
company. In this case, the I is increased so that the increased I equals the
minimum profit and the amount of the increase is carried forward in a form that
is equivalent to additional restricted expenses.

Example
Adjusted IE amount (ie including the BLAGAB share of net dividend income):
IE
= 250 150
= 100
Situation 1
Minimum profit 50
Minimum profits test does not bite.
Situation 2
Minimum profit 175

Minimum test is biting. As a result, it is XSE with E restricted to 75 (with the result that
I E = 250 75 = 175).
Situation 3
Minimum profit 350

Even if E were to be restricted to 0, I E = 250 0 = 250, which would still be less than
the minimum profit. Hence, I is increased to 350 so that now I E = 350 0 = 350.
5.4 When an insurer may be excess E
A company that has unrelieved carried-forward expenses due to the expenses

restriction under the minimum profits test is referred to as having excess E.
For example, this may arise if the company has been recently established so has
little value in the form of accumulated investment funds but is incurring
relatively onerous expenses, and so has low I but high E.
Question 9.6
Explain why an insurer is more likely to be excess E in the situation given above.

An insurer may also temporarily become excess E due to:
1. large BLAGAB profits, for example from a weakening of the liability

valuation basis, which would result in the minimum profits test biting.
2. or it might be due to significant capital falls in the bond markets so that

the net return from gilts and bonds is negative.
Another common reason for being excess E was where a long-term insurance
company issued significant volumes of BLAGAB contracts that have high
expenses relative to investment income, such as protection business. However
since new protection business is no longer taxed under the I-E basis from 1
January 2013, this will gradually cease to be valid.
You may find it helps you to understand the above circumstances better if you recall
that profit is essentially:
(P C) + (I E) (V1 V0) + (D1 D0).
Thus IE is actually a part of a profits calculation, although the definitions of I and E

may not be quite the same in the profits and IE calculations. Therefore anything that
affects BLAGAB premiums or claims or change in reserves or change in DAC, but not
IE, will tend to change the balance between an IE assessment and a profits
assessment. Equally, different treatment of I or E in the two assessments will affect
their relative sizes.
Question 9.7
In the light of the above, explain Point 1 in the last section of Core Reading.
Point 2 probably requires further explanation. It is assumed that bonds are being held as
assets to best match the liabilities. Bonds will be included in the IE calculation on a
mark-to-market basis, and so I will be reduced in this case, leading to lower IE.
However, in the minimum profits calculation, the reduction in I is likely to be more or

less offset by a reduction in the reserves. This is because (ignoring any mismatching
effects), prices of bonds will fall, leading to increased prospective yields, and so the
valuation interest rate that is used to calculate the reserves can be increased.
Hence, IE is likely to reduce by more than profits.

6 Tax rates
We have mentioned the relevant tax rates in a long-term insurance company throughout
the last few sections. We now present a summary of those rates.
6.1 Mutual companies
For a mutual BLAGAB IE and OLTB trading profits are taxed at 20%.
6.2 Proprietary companies
For a proprietary, we need to consider the minimum profit.
The minimum profit needs to be allocated between the part derived from the
equity dividend income and the remainder. Details of this allocation are not
needed for the purposes of this subject.
If the minimum profits test does not bite (ie the minimum profit is lower than the
adjusted IE figure) then:
an amount of the IE equal to that part of the minimum profit not derived
from dividends is taxed at the corporation rate
the balance is taxed at the policyholder rate.
If the test does bite then:
the IE is all taxed at the corporation rate.
Remember that when the minimum profits test bites, IE is altered so that it equals the
minimum profit.
In both cases the IE value is that originally calculated, and so excludes any
dividend income.
Recall that the minimum profits test applies only to BLAGAB business. The OLTB
trading profits would be taxed at the corporation rate.

7 Critical illness (CI) cover taxation
7.1 Classification and insurer taxation
Long-term business
FSMA 2000 (Regulated Activities) Order 2001 (No. 544) Schedule 1 Part II sets out
the classification of long-term insurance business.
You will recall that the FMSA 2000 (Regulated Activities) Order 2001 is a statutory
instrument that defines various classes of insurance business. Schedule 1 of this
Order describes the classes of insurance business, and is in two parts: Parts I and II
apply to short-term and long-term businesses respectively.
For long-term insurance business, the most important classes for this subject are:
Class I Most non-linked business
Class III Linked business
Class IV PHI business.
Critical illness business is classified as Class IV (PHI business), even if there is a

modest element of life cover attaching to the product, provided that the
conditions, as described in Section 1 of this chapter, are met.
However, if there is a significant amount of life cover, such as on most accelerated CI

contracts, the CI benefit must be considered separately.
An insurer may write an insurance contract that contains elements of both life
assurance and critical illness benefit. Such business written from 1 January
2013 is classified fully as OLTB. However, such hybrid contracts written before
that date may need to be dissected for the purposes of completing the tax return,
with the life assurance element being classified as BLAGAB (unless it can be
shown that either of the amounts concerned is immaterial).
Short-term business
Short-term CI policies can also exist, eg written on an annually-renewable basis.
If either of the PHI business conditions described in Section 0 of this chapter is

not met, the product would be classified as short-term Class 2 (sickness) under
Schedule 1 Part I of the FSMA 2000 (Regulated Activities) Order 2001 (No. 544),
and taxed as general insurance business.

The most important classes of short-term insurance business for this subject are:
Class 1 Accident
Class 2 Sickness.
The principles for the taxation of general insurance business are covered in Chapter 10.
Group business
The classification and insurer taxation comments apply equally to individual and
group policies.
We now turn to the policyholder taxation of long-term CI policies, with short-term

policies being covered in Section 7.5.
7.2 Taxation of individual policies
Premiums
Premiums under individual policies do not normally qualify for tax relief.
Benefits
Stand-alone CI
Benefits payable under stand-alone critical illness policies are tax-free.
Accelerated CI and inheritance tax
For accelerated critical illness policies, one potential problem area is inheritance
tax (IHT).
Originally critical illness policies were deemed unsuitable to be written in trust

because of the reservation of benefit rules.
A reservation of benefit is where an inheritance (or other gift) is not given in full, so
that either the person receiving has conditions attached or the person giving keeps back
some of the benefit. The problem with critical illness policies is that the benefit is being
received whilst the policyholder is alive and so how inheritance tax applies (even if
written under trust) is open to debate.

However, increasingly policies are now being written as split trusts whereby the
death benefits are paid outside the estate but the lifetime benefits may be paid to
the policyholder. This is suitable as long as it is clearly distinguishable when the
benefits are payable on critical illness and when they are payable on death.
Trust law requires that the policy is treated as a whole so it cannot be written
with part of it under trust and the other part not. This effectively means that a
trust can only be used when 100% of the death benefit is accelerated on
contraction of a critical illness. This route will still leave a grey area when the
policyholder dies after contracting a critical illness but without claiming the
critical illness payment. HMRC will regard this as avoiding IHT unless the legal
representatives of the deceased policyholder can show that the omission was
not deliberate.
7.3 Taxation of group policies
Premiums
If the employer pays the premium (as is usually the case for these schemes), it is
usually deductible as an allowable business expense in its corporation tax
assessment. From the employees perspective, payment of the premium by the
employer would be taxable as a benefit in kind.
Question 9.8
Explain what is meant by benefit in kind in the context of UK taxation, and describe
how the value of these benefits might be assessed.
Benefits
Usually the benefit is paid directly to the employee and is tax-free.
7.4 Keyman critical illness benefit
Taxation of Keyman critical illness policies needs a special mention.
Question 9.9
What is keyman critical illness cover?
There is no specific legislation on the taxation of keyman insurance, so insurers would

be advised to discuss their specific details with the HMRC.

HMRC will consider each case on its merits but, as a general rule, premiums
would be an allowable deduction against the firms corporation tax.
This is in the circumstances where the product is viewed as a business necessity, and
thus premiums are treated as normal corporate expenses.
However, if the policy were on the life of a director who was a major shareholder,
it is unlikely that the deduction will be allowed.
This is because the insurance could be seen as being (at least partly) for the
shareholders own benefit rather than the companys. For example, the inability of the
key employee to work may affect the share price, and so it would be easy to argue that a
motive for effecting the cover was to protect the share price.
Policy proceeds are a trading receipt of the firm and are therefore taxable.
7.5 Short-term business
If the critical illness policy is deemed to be general insurance business (ie it

does not meet the conditions in Section 0), premiums are subject to insurance
premium tax (IPT), currently at the rate of 6%.
The insurer would normally pass this tax straight on to the policyholder in the form of
higher premiums. However, as far as administration goes, the tax is still payable by the
company to the HMRC.
The taxation of short-term business is covered in Chapter 10.

8 Income protection (IP) insurance taxation
Most of the comments made in Section 7.1 (for CI) apply equally to IP contracts
as regards their classification and also from a tax perspective (ie if they are
Class IV long-term business then they are taxed as OLTB, or if they are Class 2
short-term then they are taxed as general insurance business).
8.2 Taxation of individual policies
Premiums
Premiums under individual policies do not normally qualify for tax relief.
Benefits
The taxation of benefits under individual policies depends on whether the

premiums are paid by the life insured or the employer.
Premiums paid by the life insured
With effect from 6 April 1996, benefits under individual IP policies are tax free.
This measure was brought in to encourage self-provision.
The introduction of the tax-free status of benefits led writers of individual IP to

review and reduce the benefit limits for new policies. The aim of the review was
to set benefits at a level that enables claimants to maintain a reasonable
standard of living in relation to their pre-disability earnings while still providing a
financial incentive to return to work. The formula adopted varies considerably
between insurers.
Benefits for policies in force before 6 April 1996 are also exempt from income tax
from that date. As these policies were taken out before the benefit limitations
were reviewed they may provide very high replacement ratios resulting in little
incentive for the claimant to return to work.
Premiums paid by the employer
Benefits under individual IP policies where the premiums are paid by their
employer are subject to tax in the same way as group arrangements. (See
Section 8.3 below.)

8.3 Taxation of group policies
Premiums
Premiums paid by the employer for employees
Premiums are treated as a business expense and therefore the employer will
qualify for tax relief (at the corporation tax rate). Premiums are not assessed for
tax on the employee as a benefit in kind.
Premiums paid by the employer for a controlling director
Premiums are not normally allowable as a business expense (and hence eligible
for tax relief) except at the discretion of HMRC. This discretion is unlikely to be
exercised unless the scheme also provides comparable benefits (at comparable
cost) for a significant number of employees. The premium will not, however, be
assessed for tax on the director as a benefit in kind.
Premiums paid by the employee
No tax relief is allowed.
Benefits
The taxation of benefits under group policies depends on whether the premiums
are paid by the employee or the employer (and then who the benefit is for).
Premiums paid by the employer for employees
Where benefits are payable to the employer, they are taxed in his or her hands as
a trading receipt. However, the employer will then pass the benefit on to the
employee in the form of salary, thereby obtaining a compensating tax credit.
In other words, this benefit will be treated as a business expense.
The income will be taxed in the hands of the employee under PAYE and will be
subject to the deduction of NI contributions.
PAYE stands for Pay-As-You-Earn, a system used in the UK whereby tax is deducted
from the income at source, rather than receiving income gross of tax and calculating
(and paying) tax at a later date.
If benefits are payable directly to the employee or to the employer on trust for the
employee then they are treated as part of the employees remuneration and taxed
as earned income.

Premiums paid by the employer for a controlling director
The situation above effectively applies regardless of whether or not relief has
been obtained on the premiums.
So the rules for when premiums are paid by the employer for its employees also apply
here.
Premiums paid by the employee
Benefits in respect of the part of the total premium that is paid by the employee
are tax free in exactly the same way as under individual policies.
Partnerships
A scheme for partners is effectively a group of individuals with each paying

their own premiums and hence the benefits are tax free.
8.4 Continuation options
Question 9.10
What is a continuation option?
If a policy is effected under a continuation option and the premiums are being
paid by the policyholder, the tax treatment will be the same as for a normal
individual policy. If, however, the premiums are still being paid by the former
employer (a situation that does not often arise), there are two possible courses
of action when a claim arises, as follows:
1. The insurer pays the claimant the appropriate benefit net of income tax.
2. The benefit is paid to the claimant gross of tax and it then becomes an
issue for HMRC to sort out with the claimant.
The reason that the employer normally stops paying premiums on any continuation
options is that the option is often given as a post-employment benefit.

9 Long-term care insurance (LTCI) taxation
9.1 Classification of LTCI
The taxation of LTCI can be extremely complex. Most products are written as Class IV
(disability or PHI) business and hence taxed on profits. However, as youll see below
there are many exceptions to this.
The taxation of LTCI also depends on whether the policy is pre-funded or is for
immediate care.
9.2 Policyholder tax
Pre-funded LTCI
The policyholder taxation rules for pre-funded LTCI solutions are governed by
Finance Act 1986. This states that all LTCI benefits, whether capital or interest,
which are triggered by a disability event should be tax free.
The government encourages LTCI in order to reduce the burden on the State.
Immediate needs annuities (INAs)
Since 1 October 2004, payments under an Immediate Needs Annuity (INA) that
are made to a registered care provider for the care of the person covered under
the policy are generally not taxable in the hands of the insured person.
A policy will qualify as an INA if, when it was taken out, it is a purchased life
annuity and:
one of its purposes was the provision of personal care for the person
covered under the policy, and
care was needed because of mental or physical impairment, injury,
sickness or other infirmity and that was expected to be permanent.
Policies taken out before 1 October 2004 would qualify as INAs if they met the
qualifying conditions at the time when they were taken out.
A care provider is someone who carries on such a business and is registered

under the relevant Act to do so.
Payments to local authorities for the care of the person covered under an INA
also qualify for relief.

Payments under INAs to a care provider that is not a local authority will generally
be a trade receipt of that entity.
In other words, the payments will be treated as an item of income, contributing to the
care providers profits. These profits will in turn be taxed, like any other business.
Any payments made directly to the insured person or persons other than a registered
care provider cannot qualify for the tax exemption, even if it is from a policy that
qualifies as an INA. Any such payment or part of a payment has therefore to be treated
as taxable income of the insured person.
Annuities that dont meet the above qualifying conditions for example, because they
provide cash payments will be taxed in the same way as for general annuity business.
If an annuity does not qualify as an INA, it would be taxed in the same way as
normal for this type of product (ie part of each payment that represents a return
of capital is tax exempt, but the part that represents interest on capital would be
taxed as income in the hands of the policyholder).
This was described in Section 3.1. The policyholder is taxed on the income content
of the benefit. The capital content is not taxed, because this represents a return of
premium, which the policyholder has already paid tax on.
In this event, as the determination of the split between capital and interest is
based on standard mortality tables, a much larger proportion of each payment
would be taxed as income relative to that which would have been deduced
should it be based on the policyholders probably much reduced life expectancy
compared to a normal life of the same age.
Question 9.11
Explain the last paragraph.
Pre-funded LTCI
Long-term care insurance business is often written as Class IV (ie PHI business)
and so would be taxed as OLTB.

HMRC is concerned to ensure that there is no avoidance of tax in respect of the

investment element of contracts that have surrender or maturity benefits.
Therefore HMRC has argued that products with such benefits should be treated
for taxation purposes as Class I or Class III (depending on whether non-linked or
linked respectively) life insurance.
Pre-funded long-term care insurance with material surrender or maturity benefits

would therefore be subject to tax on the BLAGAB IE basis (assuming that it
does not meet the definition of protection business). (It should also be noted
that in practice HMRC reserves the right to tax contracts slightly differently in
special circumstances.)
Question 9.12
What is the main advantage and disadvantage to the insurer of the product being taxed
as OLTB, rather than as BLAGAB?
Immediate needs annuities (INAs)
Immediate needs annuity (INA) products may instead be written as general

annuity business, and hence taxed as BLAGAB.
As the policyholder does not pay tax on the income element of each annuity
payment, the insurer is not able to obtain a deduction for this element in its
BLAGAB IE computation in the same way that it does for purchased life
annuities.
Recall from Section 9.1 that policies that meet the qualifying conditions to be INAs for
tax purposes have benefits that are tax-free in the hands of the policyholder. It therefore
follows that the insurer will pay tax on the full IE.
However, where an annuity used for LTCI purposes does not qualify for the INA
treatment then the insurer does deduct the interest content of such payments in
its tax computation in the usual way.
This computation was described in Section 3.1.


Chapter 9 Summary
Tax funds
From 1 January 2013, for tax purposes a UK long-term insurance company has to treat
the following as separate businesses:
Basic Life Assurance and General Annuity Business (BLAGAB)
Other Long-Term Business (OLTB).
OLTB includes the following:

pensions business
ISAs and child trust funds
life reinsurance business
overseas life assurance business
PHI business
long term protection business written from 1 January 2013.
OLTB taxation
OLTB is liable to corporation tax on its trading profits.
From 1 January 2013 the trading profits are based on the statutory accounts. Before
then, the profits were based on the supervisory returns.
BLAGAB taxation in a mutual
Tax is payable in respect of BLAGAB on the so-called IE basis.
BLAGAB I is:
Investment income from real estate, gilts, bonds and deposits. (Dividend income
from equities is excluded.)
Chargeable gains on real estate and equities, allowing for the effects of
indexation
Capital movements in gilts, bonds and derivatives
Miscellaneous income (eg reinsurance income).
BLAGAB dividend income is received with no further liability to tax.

BLAGAB E is:
non-acquisition BLAGAB expenses
1/7 of acquisition BLAGAB expenses
postponed acquisition expenses from previous years
unrelieved expenses brought forward (if any)
income component of general annuities.
If I > E, corporation tax at the policyholder rate of income tax (20%) is paid on IE.
If E > I, the excess expenses are carried forward unrelieved to the following years
calculation.
Role of minimum profit
The two main differences between mutual and proprietary taxation of life assurance
business both spring from a concept called minimum profit.
Minimum profit is effectively the surplus arising on the BLAGAB business (including
BLAGAB share of non-taxable dividends).
Minimum profit has two roles in the taxation of a proprietarys BLAGAB business:
(1) It is used to split the total taxable income in the IE computation between
shareholders and policyholders. The different parts of income are then taxed at
different rates shareholders unfranked income is taxed at the corporation rate
and policyholders unfranked income is taxed at the policyholder rate.
(2) It is used to determine a minimum amount of taxable income, the minimum

profits test. If an adjusted IE computation produces an answer lower than the
minimum profit, then it is modified so that it gives an answer equal to the
minimum profit. In this case, the company carries forward unrelieved expenses
(excess E).
In certain circumstances the minimum profit may exceed the I in the IE amount
including net dividend income. In this case, the I is increased so that it equals
the minimum profit, and the amount of the increase is carried forward in a form
that is equivalent to unrelieved expenses.

When a company may be excess E
An insurer is more likely to be excess E if:

it has been recently established, or
it issued significant volumes of BLAGAB protection contracts (before 1 January
2013) that have high expenses relative to investment income.
An insurer may also temporarily become XSE as a result of the minimum profits test for
the following reasons:
a weakening of the valuation basis used for the supervisory returns
significant capital falls in the bond market so that the net return from gilts and
bonds is negative.
Critical illness insurance taxation
This is classed as OLTB and taxed on profits. However if the contract was written
before 1 January 2013, then it may be split into a CI component (taxed as PHI business)
and any life component (taxed as BLAGAB).
For individual business, stand-alone CI benefits are tax-free. Accelerated CI policies

may be written as split trusts, in order that that inheritance tax is not charged on benefits
paid following a CI claim. In this case the CI benefit must be equal to the death benefit.
For group business, premiums paid by the employer earn tax relief, but employees are
taxed on these as benefits in kind. Usually benefits are paid direct to the employee and
are tax-free.
Short-term critical illness policies are taxed as general insurance business and are
subject to IPT.
Income protection insurance taxation
This business is classed as OLTB and taxed on profits.
For individual policies, premiums do not get tax relief, and benefits are tax free unless
the employer is paying the premiums.
For group policies, premiums do not get tax relief unless paid by the employer (but not
normally if the life covered is a controlling director). Benefits are taxed only if
premiums are paid by the employer for the benefit of the employee.

Long-term care insurance taxation
Pre-funded LTCI benefits are tax-free.
Payments, under a policy that meets certain conditions to qualify as an Immediate

Needs Annuity (INA), that are made to a registered care provider for the care of the
person covered under the policy are generally not taxable in the hands of the insured
person.
However, for annuities that dont qualify to be INAs, the insured will be taxed on the
income content of the benefit payments.
LTCI is often written as OLTB and so the insurer is taxed on trading profits. However,
pre-funded LTCI with material surrender or maturity benefits may be taxed on
BLAGAB IE.
INAs may instead be written as general annuity business, and hence taxed as BLAGAB.
The insurer cannot obtain a deduction for the interest component in the IE computation
for INAs where benefits are tax-free in the hands of the policyholder.

Chapter 9 Solutions
Solution 9.1
Policyholders will have to pay tax on the income content of the annuity payments when
they receive them. Yet the investment return on the assets backing the annuity business
(which generates the income portion for the policyholder) is also taxed. It would be
double taxation if the income portion were not allowed as an offset.
Solution 9.2
(100 0.20) + (20 0.20) = 24.0
Solution 9.3
(100 0.20) = 20.0
The OLTB loss of 10 will be carried forward to offset future OLTB trading profits.
Solution 9.4
20 0.20 = 4.0
Within the BLAGAB fund, the company will carry forward excess expenses of 100.
Solution 9.5
Minimum profit is 40. So this (and the OLTB trading profits) is taxed at 23%.
The remainder of the BLAGAB IE , ie 520 40 = 480, is taxed at 20%.
Therefore, the corporation tax payable is:
((40 + 260) 0.23) + (480 0.20) = 165
Solution 9.6
The high expenses arising will depress the value of IE, perhaps even extinguishing it.
Profits may still be being made, so profit may be higher than IE.

Solution 9.7
Weakening the valuation basis reduces V1 and so increases reported profit. This makes
it more likely that the minimum profits test will bite.
Solution 9.8
Under UK pay-as-you-earn taxation rules, an employee will have to pay tax on certain
benefits that an employee receives from his or her employer. In other words, the value
of these benefits are treated as additional salary. These taxable benefits are known as
benefits-in-kind.
For insurance benefits, a common way of assessing the value to be taxed is by using
the premium (that the employer effectively pays on behalf of its employees). So, even
though the employee receives these benefits free of charge, in some cases employees
need to pay tax in respect of them.
Solution 9.9
Keyman CI cover is where an employer takes out cover on a key member of staff.
Premiums are paid by the employer who also receives the benefits, rather than passing
them on to the employee. This protects the employer from loss of productivity,
business, etc as a result of the key workers critical illness.
Solution 9.10
A continuation option is where an employee who previously has group IP cover, leaves
employment and is allowed to continue the cover, normally without any further
evidence of health being required.
Solution 9.11
The capital content is calculated by dividing the premium paid by an expectation of life.
This is calculated using standard mortality tables, whereas we would expect actual
mortality for lives taking out these contracts to be heavier than this. The premium is
therefore being divided by a number higher than wed expect in practice, and so the
capital content is too low, and hence the income content is too high.

Solution 9.12
The main advantage is that usually a lower tax charge applies, if taxed on profits rather
than I E, because investment income could be significant for pre-funded LTCI.
The main disadvantage is that product design is restricted, for example death benefits
and surrender values could not be offered.





the course.

SA1-11: Legislation (1) Page 1
Chapter 11
Legislation (1)
Syllabus objective
(d) Understand the legal, taxation and regulatory framework as applicable to UK

health and care insurance:
supervision of valuation of assets, liabilities and capital
requirements
conduct of business rules.
(This is only part of Syllabus objective (d).)
0 Introduction
Why should insurance business suffer more legislation than, say, washing machine
manufacturers? One of the reasons is that there is more scope for the purchaser to lose
out financially. With insurance you have to trust the insurer to pay valid claims as and
when they arise in the future.
The uncertainty underlying insurance business means that it is not just a question of
trusting the honesty of the insurer. The insurer may be very well meaning but if their
business is not soundly managed, they may well have collapsed by the time you make a
claim. There is clearly a danger of policyholders suffering at the hands of unscrupulous
or incompetent operators.

Page 2 SA1-11: Legislation (1)
UK legislation aims to protect policyholders from this by implementing controls over:

the classes that an insurer can sell
the people who run the company
the level of financial strength
information that is published about the company.
Furthermore, as it is difficult to totally prevent each individual insurance company from

collapsing, there are schemes to ensure that policyholders do not lose out if this were to
happen.
This chapter starts with the following topics:

the Financial Services and Markets Act 2000
the objectives of the regulators
an introduction to some regulatory handbooks.
We then cover the prudential supervision of the UK business of long-term insurers:

capital management requirements
valuation of assets rules
valuation of liabilities rules.
Next, we describe the prudential supervision of the UK business of short-term insurers

in particular the assessment of statutory solvency.
Finally in this chapter, there is a section covering regulation issues that apply to both
long-term and short-term insurers.
The next three chapters continue the discussion of legislation by covering:

Solvency II
the statutory role of the actuary (both in long-term and short-term insurance)
policyholder protection
treating customers fairly
equality legislation
profit reporting for long-term insurers.
There is a lot to learn in these four chapters, but most of it is bookwork rather than
application. We suggest you work through these four chapters a number of times before
the exam so that the information can sink in slowly over time.

1 The Financial Services and Markets Act 2000 (FSMA)

From 1 December 2001, UK insurers have been subject to regulatory
requirements under the Financial Services and Markets Act 2000 (FSMA). At that
time, the Financial Services Authority (FSA) assumed its full powers and
responsibilities as the single regulator for all financial services companies.
The Financial Services Act 2012 has made substantial changes to FSMA which
largely came into effect on 1 April 2013. In particular, the FSA was replaced by
two new regulatory bodies:
The Prudential Regulation Authority (the PRA) is a subsidiary of the Bank

of England and is responsible for the prudential regulation of all deposit-
taking institutions, insurance providers and large investment firms.
The Financial Conduct Authority (the FCA) is responsible for regulation of

conduct in financial markets (and the infrastructure that supports those
markets) and the prudential regulation of financial services companies
that do not fall under the scope of the PRA (eg insurance brokers and
smaller investment firms).
Accordingly, insurance companies are now dual regulated in the UK: the PRA is
responsible for their prudential regulation, while the FCA is responsible for their
conduct regulation.
Therefore, the PRA will be the regulatory body concerned with solvency and capital
requirements and the FCA will be the regulatory body concerned with ensuring
customers are treated fairly amongst other things.
The regulatory environment described in this chapter is that current as at the

time of writing (April 2013). All actuaries and students should of course keep up-
to-date with regulatory changes, although for the purposes of the Subject SA1
examination answers based either on what is described here or on more up-to-
date regulation will in principle be acceptable.

2 Objectives
The PRA has the following objectives in respect of insurance company
supervision:
promoting the safety and soundness of the companies that it supervises
contributing to securing an appropriate degree of protection for those
who are or may become policyholders.
A key feature of the PRAs approach is risk-based supervision. The PRA

assesses the risk that a particular firm, activity or issue poses to the PRAs
objectives and concentrates its supervisory effort on high-risk areas. It is not
the PRAs role to ensure that no insurance company fails.
So the firms that represent the greatest risk (perhaps because of their large size or lack
of capital) will be subject to the greatest scrutiny by the PRA.
The FCAs key objective is to ensure that the relevant markets function well,
under-pinned by:
securing an appropriate degree of protection for consumers
promoting effective competition in the interests of consumers
protecting and enhancing the integrity of the UK financial system.
The FCA intends to take early action to prevent problems occurring for consumers,
rather than taking action against firms after the event. So the FCA will be concerned
with the product lifecycle right from the start at the design stage and can even ban
products where necessary.
Prior to this separation of regulatory responsibilities, the FSA used the ARROW
framework (Advanced Risk Responsive Operating Framework) to operate its
integrated approach to risk management, including regular assessment visits.
Under the new regime two separate risk mitigation programmes operate, with
each of the PRA and FCA performing supervisory reviews of insurance
companies.
2.1 Regulatory Handbooks
The two regulatory Handbooks contain all the rules and guidance issued by
either the PRA or FCA respectively.
The regulatory Handbooks are available on the internet at

http://fshandbook.info/FS/index.jsp.

In line with the previous single FSA Handbook, each is divided into Blocks and
each Block is subdivided into modules. A module may be either a sourcebook
(containing mandatory regulatory obligations) or a manual (containing
provisions relevant to the relationship with the regulator, such as enforcement
and fees).
The Blocks and modules which are most relevant to Subject SA1 are as follows:
Block 1: High Level Standards
Block 1 deals with the overarching requirements for all authorised companies
and approved persons.
Block 2: Prudential Standards
Block 2 contains the detailed prudential rules that apply to regulated insurance
companies (largely in the PRA Handbook).
IPRU-INS (Interim Prudential Sourcebook for Insurers) has been largely

repealed but retains the reporting requirements for insurance companies.
GENPRU (General Prudential Sourcebook) and INSPRU (Prudential

Sourcebook for Insurers) cover the remainder of the detailed prudential rules
that apply to insurance companies.
GENPRU contains general rules covering all financial institutions. The PRA maintains
a number of additional sourcebooks, each with rules for specific sectors. For example:
BIPRU covers banks, building societies and investment firms
INSPRU covers insurance companies.
Block 3: Business Standards
Block 3 sets out the requirements that will affect companies in their day to day
business, particularly market conduct (largely in the FCA Handbook).
COBS (Conduct of Business Sourcebook) contains the conduct of business

rules that apply to insurance companies; its primary concern is investment
business.
ICOBS (Insurance: Conduct of Business) covers the regulation of sales of pure

protection and general insurance products.

Block 4: Regulatory Processes
Block 4 describes the operation of the regulators supervisory and disciplinary

functions.
Block 5: Redress
Block 5 covers the rules for dealing with complaints from, and paying
compensation to, customers.
Parts of the Handbook that are of particular relevance to health and care
insurance companies are covered in the following section.

3 Prudential Supervision
3.1 Prudential Sourcebooks
GENPRU and INSPRU cover aspects such as capital adequacy, mathematical

reserves, capital resource requirements, the Individual Capital Assessment (see
Section 4.4) and the management of various risks.
3.2 Interim Prudential Sourcebook for Insurers (IPRU-INS)
The main sections of IPRU-INS that have not been replaced by INSPRU relate to
financial reporting.
IPRU-INS comprises two volumes with any contents remaining:

Volume 1 Rules
Volume 2 Appendices to the Rules.
Volume 1 contains the accounts and statements rules that require insurance
companies to produce annual accounts and returns to the PRA in a prescribed
format and to produce an annual actuarial valuation of the business. The
reporting of group capital adequacy is also covered.
Volume 2 sets out the detailed format of the annual returns to the PRA. The
forms that have to be submitted are covered under a series of Appendices;
knowledge of the detail of these is not required for Subject SA1.
These annual returns were formerly known as the FSA Returns. They are discussed
more fully in Section 8.2.
3.3 Insurance: Conduct of Business Sourcebook (ICOBS)
ICOBS sets out the requirements relating to the business processes involved in
selling and administering non-investment insurance relating to both insurers and
intermediaries.
This applies to protection and general insurance business, which includes most health
business (excluding LTCI).
ICOBS applies to all firms conducting non-investment insurance business,

including intermediaries, but excluding reinsurance. It offers separate rules for
retail and commercial customers.

Retail customers are individuals that purchase insurance for their own purposes.
Contrast this with commercial customers (eg employers), who buy insurance for
business needs.
It covers business risks in the UK and / or persons insured resident in the UK. It
also applies to e-commerce activity and distance marketing.
The ABI has issued a number of Statements of Best Practice, which set out guidelines
for the selling and marketing of each of the main health insurance product types. We
shall cover these guidelines in detail in Chapter 24.
ICOBS changes from ICOB
Some more detail on the ICOBS requirements is given in Chapter 24. However, it is
worth noting the changes that were made to this sourcebook, which were effective from
January 2008 when ICOB was replaced by ICOBS.
A differentiated approach to regulating the way in which insurance business covered

by ICOBS is carried out was introduced:
For most forms of general insurance business (including PMI), this meant a
move towards more high-level principles-based regulation, and so the number of
detailed rules was reduced.
However, for protection products, which include IP, CI and PPI (Payment
Protection Insurance), a small number of additional rules were introduced in
order to improve selling practices in areas where the regulator felt that customers
may be losing out. For example, a seller is now required to disclose orally all
the main characteristics of a product.
3.4 Authorisation
Companies need to obtain permission from the relevant regulator in order to

carry out a regulated activity. Information on the requirements and process to
be followed for obtaining such permission (and a facility to generate an
authorisation application pack) can be found on the PRA/FCA websites.
A similar process has to be followed for the authorisation of individuals who

carry out specified roles, called controlled functions (see Chapter 14).

Long-term insurance business is a regulated activity. Under FSMA 2000

(Regulated Activities) Order 2001 Schedule 1 Part II, contracts of long-term
insurance are divided into the following main classes:
I. Life and annuity
II. Marriage and birth
III. Linked long-term
IV. Permanent health
V. Tontines
VI. Capital redemption
VII. Pension fund management
VIII. Collective insurance
IX. Social insurance.
Insurers that write long-term insurance business may include general business
Classes 1 (Accident) and 2 (Sickness) as supplementary benefits to their main
long-term business classes.
Of course, a company that writes short-term insurance business (ie a general insurer)
may write classes of general insurance business as their main business provided it is
authorised to do so. Only general insurance classes 1 and 2 are relevant to health
insurance.
A company may not undertake insurance of a particular class unless it is

specifically authorised to do so. If it is authorised in the UK, it may transact the
same class in any other EU state. It would be subject to UK supervision.
Similarly, a company authorised in another EU state may transact business in
the UK subject to supervision in its own home state.
3.5 Supervision Manual (SUP)
The Supervision Manual (part of Block 4) is intended to enable firms to

understand the regulators approach to their ongoing supervision, once
authorised.
Amongst other things, it covers the appointment, qualifications and

independence of auditors as well as their duties. It also covers the way in which
firms are expected to co-operate with their auditors.
The manual also covers the appointment, qualifications and duties of actuaries
in respect of long-term insurers and Lloyds (see Chapter 14).
The statutory roles and duties of actuaries are covered in detail Chapter 14.

4 Long-term business solvency assessment

The next three sections of this chapter are concerned with long-term insurance. The
requirements for short-term insurers are covered in Section 7. Requirements applying
to both long-term and short-term insurers are covered in Section 8.
The Financial Services and Markets Act 2000 gives the financial services
regulators the power to make rules and issue guidance, which are consolidated
within the PRA and FCA Handbooks. These are broken down into a number of
different manuals or sourcebooks, as described earlier in this chapter. The
General Prudential sourcebook (GENPRU) and the Prudential sourcebook for
Insurers (INSPRU) currently contain the prudential and notification requirements
for insurers.
This section covers capital management for long-term insurance under GENPRU and
INSPRU. Sections 5 and 6 describe the rules for valuing assets and liabilities in more
detail.
The current supervisory solvency requirements, often termed Solvency I, are

outlined in this chapter. The following two chapters describe the Solvency II
regime, which is planned to replace Solvency I. Solvency II will be enacted
through a new Prudential sourcebook for Insurers (SOLPRU).
4.1 Two Pillars
The main thrust of these sourcebooks (ie GENPRU and INSPRU) is to set
standards for capital management and demonstration of solvency. They
introduce the concept of two Pillars:
Pillar 1, which covers public solvency information that appears within the
supervisory Returns. The solvency calculation itself is based on
prescriptive rules, and production of the Returns is mandatory on an
annual basis.
Pillar 2, the Individual Capital Assessment (ICA), which covers a

confidential assessment of solvency for the PRA, recognising all the risks
to which a firm is exposed, and based on the firms own calculation
methods. It is therefore a far less prescriptive calculation than for Pillar 1,
although the firm has to justify its methods and assumptions fully.
Note that there is no prescribed timeline for production and submission of

Pillar 2 results to the PRA, although such calculations are expected to be
carried out no less frequently than annually.

GENPRU 1.2.40 says that an ICA should be calculated at least annually and
more frequently if other changes (eg in the business or in the operating
environment) demand it.
4.2 Two types of firms
For the purposes of Pillar 1 GENPRU classifies each firm as one of the following:
A realistic-basis life firm, which has with-profits insurance liabilities in

excess of 500m thus not deemed relevant to Subject SA1
A regulatory-basis only life firm, which does not satisfy the

requirements to be a realistic-basis life firm.
Most with-profits insurers will therefore be classified as a realistic-basis life firm.

The requirements of Pillar 1 for these insurers involves holding capital that is the
greater of two calculations on the following bases:
a regulatory basis, which satisfies the minimum EU requirements (Peak 1
valuation)
a realistic valuation, which requires the firm to carry out a market-consistent
valuation of its with-profits business (Peak 2 valuation).
This is commonly referred to as the twin-peaks approach. However, for insurers

writing predominantly health business only Peak 1 will apply, and this is described here.
The details of the Pillar 1 Peak 2 calculation are beyond the scope of Subject SA1.

Figure 1 illustrates the requirements for a regulatory-basis only life firm. The
component parts are defined in the following section.
Regulatory
Surplus
Admissible
Assets RCR
LTICR
Mathematical
Reserves
Figure 1: Pillar 1 Peak 1 for a regulatory-basis only life firm
4.3 Pillar 1 Peak 1
Admissible assets
The valuation of assets and the associated admissibility rules will be covered in
Section 5.
Mathematical reserves
INSPRU 1.2 contains the detailed rules and guidance for determining the mathematical
reserves.

The main requirements of INSPRU relating to the calculation of mathematical

reserves can be summarised as follows:
Mathematical reserves must be established using a prospective actuarial

valuation on prudent assumptions, including sufficient margins for
adverse deviations.
INSPRU contains detailed rules concerning individual assumptions.
Mathematical reserves must avoid any future valuation strain.
This means that, on the basis of the current valuation assumptions, future
valuation provisions can be covered by the future income less outgo arising from
the contracts themselves and the assets covering the value of the current
liabilities under them.
Thus provision must be made now for all (prudently) expected future outgo that
cannot be covered from future net cashflow. If this were not done, then the
contracts would be expected to make future calls on the companys free assets.
This would defeat a fundamental purpose for establishing reserves, because there
is no guarantee that the free assets will be there when required.
You may have come across the expression eliminate future negative cashflows
as another way of expressing avoid future valuation strain.
Valuation rates of interest cannot exceed 97.5% of the risk-adjusted yields

on the backing assets (risk-adjusted means having reduced the yield on
the backing assets to allow for the risk of default).
Assets can be notionally apportioned between different types of contract for the
purpose of determining the weighted average risk-adjusted yield on the assets
backing each liability type.
Different maximum valuation rates of interest can then be determined for

different classes of backing assets.

The rules describe how to determine the appropriate yield for different asset
classes. For example:
For fixed-interest securities, the yield is the gross redemption yield.

For non-gilts this would have to be adjusted downwards to allow for
default risk.
For property it is the rental yield, calculated as the ratio of the rental
income over the previous year (net of expenses) to the market value.
Any changes that are known about by the valuation date (eg a change in
rents) must be taken into account.
For equities it is the dividend yield (if the dividend yield is more than the
earnings yield) otherwise it is the average of the earnings yield and the
dividend yield. As for property, any changes that are known about by the
valuation date must be taken into account.
The valuation interest rate must be reduced to allow appropriately for tax.
There are restrictions on the yields that can be assumed to be earned on

sums to be invested in the future at unknown rates of interest.
Minimum capital requirement (MCR)
In addition to its mathematical reserves, a long-term health insurer must hold

sums at least equivalent to the minimum capital requirement (MCR).
For without-profits insurance classes, the MCR is defined as being equal to the
higher of the base capital resources requirement (BCRR) and the sum of the
long-term insurance capital requirement (LTICR) and the resilience capital
requirement (RCR):
ie MCR = max (BCRR, LTICR + RCR)
[Note that the RCR is only required for regulatory-basis only life firms, not for
realistic-basis life firms.]
The BCRR is the minimum amount of capital that must be held in accordance
with EU Directives. For most UK long-term health insurers, for the year from
31 December 2012 this was 3.7 million for proprietary companies and 2.775
million for mutuals.
These amounts are subject to increases that are broadly in line with the change in the
European index of consumer prices.

Long-term insurance capital requirement (LTICR)
The LTICR is calculated by multiplying defined measures of capital at risk

(eg based on mathematical reserves) by fixed percentage factors.
For example, for long-term health insurance classified as Class IV business, the LTICR
is the sum of:
4% of the net mathematical reserves, ie adjusted for reinsurance, and
an amount based on previous years experience.
Resilience capital requirement (RCR)
Finally the resilience capital requirement (RCR) is calculated by identifying a

range of assets to back the insurers long-term insurance liabilities. These are
then subjected to a series of market risk scenarios, specified by the PRA. The
RCR is then defined as the capital shortfall arising in the assets as result of the
combined effect of these equity value, property value and fixed-interest yield
scenarios.
The RCR is designed to show that the firm will still be able to demonstrate statutory
solvency after the market shocks. The actual size of the shocks depends on market
conditions prior to the valuation date. The equity values shock is in the range of a 10%
to a 25% fall and the property values shock is in the range of a 10% to 20% fall. The
fixed-interest yield shock is the more onerous of a fall or rise in fixed-interest yields of
20% of the long-term gilt yield.
4.4 Pillar 2
Three core rules
The thrust of the Pillar 2 framework is to require all firms to assess all the risks
to which they are exposed and hold sufficient capital to cover those risks.
This assessment is known as the Individual Capital Assessment (ICA) and it must be
carried out in line with specified standards known as the Individual Capital Adequacy
Standards (ICAS).

In contrast to the detailed rules covering Pillar 1, the Pillar 2 requirements of

INSPRU are expressed as three core rules, covering:
1. methodology of capital resources assessment
2. a requirement to base the ICA capital requirement submitted to the PRA

on a 99.5% one-year survival probability (ie 0.5% ruin probability) or
equivalent comparable basis over a longer term
3. adequacy of documentation in ICA submissions.
Beyond these core rules INSPRU sets out supplementary guidance, recognising
the fact that there is no uniform way in which to carry out an ICA.
Firms are expected to embed their ICA processes within the day-to-day running
of their businesses. This means that the ICA concept and models should be
understood by senior management and other relevant areas of the business, and
not confined solely to the actuarial function. Companies should also be able to
demonstrate that the ICA is considered in the context of ongoing business
decisions for example in pricing, product range offered, investment strategy,
merger and acquisition activity and is not just seen as a financial reporting
exercise.
The ABI has also published A Guide to the ICA Process for Insurers which
describes a variety of established practices used to develop an ICA submission.
The ActEd notes that follow consider the three core rules in turn and are based on the
INSPRU supplementary guidance and key material from the ABI guide.
Methodology of capital resources assessment
The supplementary guidance set out in INSPRU states that the assessment of the
adequacy of the firms capital resources must:
1. Reflect the firms assets, liabilities, intra-group arrangements and future plans.
The ICA should therefore demonstrate that the firm has sufficient capital to
make planned investments and to meet its plans for new business. It should also
ensure that the firm would be able to fulfil its existing commitments if it had to
close to new business.

2. Be consistent with the firms management practice, systems and controls.
In particular, firms should be realistic and practical in assessing the scope of

management actions. For example, reducing staff numbers in the event of
declining business volumes may be a possible action, but the firm should
consider the associated effect on staff retention and quality and on its ability to
maintain business functions to meet its commitments to customers. Similarly,
increases in variable charges might be a possible management action within the
terms and conditions of unit-linked policies, but the firm should consider how
quickly and by how much it would implement charge increases in practice given
the issues of treating customers fairly and competitive pressures.
3. Consider all the material risks that may have an impact on the firms ability to
meet its liabilities to policyholders.
The ABI guide discusses the major risks that firms are likely to consider, while
recognising that not all of the risks will be relevant to every firm.
Examples of the risks that a firm should assess under Pillar 2 are as
follows:
as under Pillar 1, market and interest rate risk
credit risk (including reinsurance risk) (the risk of loss if another
party fails to perform its financial obligations or fails to perform them in
a timely fashion)
operational risk (the risk of loss resulting from inadequate or failed
internal processes, people and systems or from external events)
mortality and morbidity risk
persistency risk
expense risk
the risks attaching to the firms pension scheme
liquidity risk (the risk that, although solvent, a firm is either unable to
meet its obligations as they fall due or can only do so at excessive cost)
group risk.

For example, in considering market risk scenarios the ABI guide suggests
considering:
both increases and decreases in the market values of different asset
classes (taking into account that opposing movements in the value of
different asset classes may be more onerous than all values moving in the
same direction)
allowing for the cost of rebalancing assets where matching or hedging
strategies do not completely eliminate exposure to market risks
changes to the shape of the yield curve (as well as parallel shifts in the
yield curve)
currency fluctuations (if any assets or liabilities are non-sterling
denominated)
severe economic or market downturn leading to adverse interest rate
movements
unanticipated losses and issuer default
price shifts in asset classes and their impact on the entire portfolio
inadequate valuation of assets
the extent of any mismatch between assets and liabilities, including
reinvestment risk
a dramatic change in interest rate spreads
the extent to which market moves could have non-linear effects, eg on
derivatives.
Question 11.1
Suggest stress tests that could be conducted in respect of:

(i) liquidity risk
(ii) operational risk.
4. Use a valuation basis that is consistent throughout the assessment.
The valuation should not contain margins for risk nor should it be optimistic.
The firm should carry out a broad reconciliation of its ICA balance sheet with
corresponding entries in its audited accounts. This will enable firms to identify
(and ensure that they understand and are comfortable with) any differences.

Firms should base their ICA calculations on the use of market-consistent

techniques. This allows all firms to take credit for a market-consistent
assessment of the present value of future profits on all their in-force business.
As a consequence of this, firms may have greater free assets under Pillar 2 than
under Pillar 1, because they may not be able to take credit for such future profits
under Pillar 1.
99.5% one-year certainty of solvency (or equivalent)
As noted above, one of the explicit requirements of ICA is that the capital
requirement submitted to the PRA is based on a 99.5% one year survival
probability, or equivalent measure. For example if a firm believes that it is
appropriate to its business, an equivalent lower confidence level can be used
over a longer timeframe.
In carrying out the ICA assessment, the PRA expects firms to conduct stress and
scenario tests in respect of each risk. In practice, there is often limited data
available from which to assess the likelihood of extreme events, particularly for
operational risks.
Stress testing is where the values of individual parameters are changed in order to
determine the effect of each change on the firms business. Scenario testing is where
the values of a number of parameters are changed simultaneously to determine the
combined effect on the firms business.
Although firms are not bound by the 99.5% one-year certainty of solvency, they should
be able to justify their choice of a different confidence interval and time period and
explain how it is comparable to the 99.5% and one-year combination.
Practical application
A widespread and practical method of complying with the 99.5% solvency

requirement is to apply separate 1 in 200 shocks (or stress tests) to each of the
risk factors identified over a one-year period, allowing for one-years new
business (and the possibility of closure to new business), and then recalculate
the (market consistent) surplus capital at the end of the period.
However, other possible methods of calculation exist (eg the run-off method,
which looks at the amount of capital needed at outset to ensure a firms ability to
cover its liabilities until the last policy has gone off the books, allowing for
suitable stresses to the risk factors).

Applying stress tests to each different risk factor gives the capital requirement
for each separate risk in isolation. In order to arrive at an aggregated capital
requirement reflecting all risks, these need to be combined in a way that reflects
any diversification benefits that exist between the various risks (ie the degree to
which individual risks are correlated). This may be done through the use of
correlation matrices (noting that, under the extreme event conditions being
tested, correlations may differ from those observed under normal conditions).
So using a correlation matrix approach, the aggregated capital requirement can be

calculated as follows:
Aggregated capital requirement = Corrij Capi Cap j

i j
where:
Capi = capital requirement under risk i
Corrij = correlation between risks i and j.
The following table shows a simplified example of a correlation matrix for an insurance
company selling stand-alone critical illness business. So for example, the correlation
between morbidity risk and expense risk is 50% in this case. In practice, the correlation
matrix will include many more risks.
Morbidity
j
Expense
Lapse
i
Morbidity 100% 0% 50%
Lapse 0% 100% 50%
Expense 50% 50% 100%
Table 11.1 Correlation matrix example

Question 11.2
Using the table above, calculate the aggregated capital requirement if the separately
calculated capital requirements are as follows:
capital requirement for morbidity risk = 100 million
capital requirement for lapse risk = 10 million
capital requirement for expense risk = 20 million.
It should also be recognised that a combination of a certain subset of events

happening at the same time, with an overall probability level of 1 in 200, may
produce a higher capital requirement than combining all of the individual capital
requirements for separate 1 in 200 events using a correlation matrix. This is
caused by non-linearity and non-separability of individual risks, the latter
referring to the ways in which risk drivers interact with each other. Separate
allowance needs to be made in the ICA for these effects.
Stochastic model
The design and calibration of any stochastic model used in quantifying the
capital requirement in relation to economic risks is important.
In particular, the probability distribution used should properly reproduce the

more extreme behaviour of the variable being modelled, both in the size of the
tail of the distribution and, where appropriate, in the path taken during the
simulation period.
For ICA calculations, a real world asset model should be used and this should
be arbitrage free. It is generally appropriate to calibrate such models with
reference to actual historic parameters, but advanced techniques may be
required to ensure appropriate fit to the tail of a distribution, to ensure that the
distributions do not understate the frequency of more extreme outcomes.
ICA submission documentation
Unlike the prescribed forms of Pillar 1, there is no standard form for an ICA submission
and the regulator reported a wide variation in the quality and length of firms ICA
submissions (from 4 pages to over 800 pages!) during the first year of the ICAS regime.
Excessively short reports needed to be re-submitted. The supplementary guidance in
INSPRU and the ABI guide now give some more guidance on the ICA submission.

The written ICA submission to the PRA must:

Document the reasoning and judgements underlying the assessment and, in
particular, justify the assumptions, method and results.
Identify the major differences between the 99.5% one-year certainty of solvency
(or equivalent) and any other assessments carried out by the firm if it chooses to
use a different confidence level.
Individual capital guidance (ICG)
Firms submit their own confidential ICA calculations to the PRA, which then
reviews them and issue Individual Capital Guidance (ICG). If the PRA is satisfied
with a firms ICA calculations, the ICG will simply equal the ICA. However, if the
PRA believes that a firm has not adequately assessed all the risks to which it is
exposed, it will set the ICG at a level higher than the ICA that the firm has
calculated.
The less a firm is able to demonstrate that its risk assessment processes capture and
quantify all its risks, then the higher the PRA is likely to assess its ICG to be. When
setting ICG the PRA considers both quantitative measures (ie sets a number for the
amount of capital the PRA thinks appropriate) and qualitative issues (eg the PRA will
comment on any risk management concerns it has).
A firms submission of its ICA and the PRAs review and issue of ICG is an ongoing
process over a number of months rather than a single event. In particular, this process
will involve discussions between the firm and the PRA.
ICG is expressed in such a way that it can be applied to future dates, eg as a % of the
ICA. For example, suppose a firms ICA calculation is 100m at 31 December 2013
and the PRA gives an ICG of 110m (ie 110% of the ICA). Then, if the firms
calculated ICA at 31 December 2014 is 150m, it can assume the PRA would give ICG
of 165m.
Question 11.3
Are there any issues arising as a result of expressing ICG in terms of the firms ICA
results?
ICG is confidential between the PRA and the firm.

Question 11.4
Ive heard people use the phrase Pillar 2 firm, but I dont know what this means.
Since the phrase realistic-basis life firm refers to a firm that has to perform a
realistic-basis valuation (ie Peak 2) I thought perhaps a Pillar 2 firm would be one that
had to perform a Pillar 2 calculation. Is this correct?
How would you answer this person?
ICAS+
Delays in the proposed implementation of Solvency II (see Chapter 12) have

resulted in the UK regulator announcing its intention to allow companies to use
their preparatory Solvency II models to meet the requirements of the Individual
Capital Adequacy Standards (ICAS) framework.
This should save a considerable amount of work by combining the models used to
calculate the ICA and to prepare for the introduction of Solvency II. Companies will
also be able to use some of their Solvency II documentation in their ICA submission.
However, some extra work is required to reconcile the old ICA model to the new
ICA/Solvency II model.
Further knowledge of this ICAS Plus or ICAS+ approach is not currently

required for the Subject SA1 examination.
Question 11.5
A lot of new acronyms have been introduced in this section, so its worth pausing to
check that they make sense to you.
For each of the following acronyms, state what the letters stand for, define the term and
explain its use:
RCR
LTICR
BCRR
MCR
ICAS
ICA
ICG.

5 Pillar 1 Peak 1 valuation of assets
5.1 Introduction
Detailed rules apply to the valuation of assets under Pillar 1, and these are set
out in the Prudential sourcebooks. What follows covers assets relating to
non-linked business written by regulatory-basis only life firms, and only brings
out the main principles.
The rules cover:

which assets are admissible
limits on admissibility
how to value different types of asset.
By admissible we mean whether a particular type of asset can be counted towards the
total value of assets published in the supervisory returns and used to demonstrate
solvency.
The rules adopt this admissibility approach rather than limiting the amount of actual
investment in particular types of asset.
For assets relating to linked business, there are separate rules that specify the
assets or indices to which such business may be linked. These are referred to
as permitted links and are beyond the scope of this subject.
5.2 Admissible assets
Only assets that are admissible may be taken into account for valuation
purposes. The list is beyond the scope of Subject SA1.
The list of admissible assets includes debt securities, bonds, loans, shares, land and
buildings, approved derivatives, tangible fixed assets and cash. The full list is given in
Appendix 7 of GENPRU 2.
The list of admissible assets was drawn up with the aim of excluding assets:
for which a sufficiently objective and verifiable basis of valuation does not exist
whose realisability cannot be relied upon with sufficient confidence
whose nature presents an unacceptable custody risk
the holding of which may give rise to significant liabilities or onerous duties.

Investment in inadmissible assets is not prohibited, but inadmissible assets may not be
taken into account for valuation purposes. So an insurance company could invest in art,
gold, wine etc if it wished, but it would have to attribute a zero value to these
investments in its statutory asset value.
Question 11.6
How much of a discouragement is this rule to actual investment in this sort of asset?
5.3 Market risk and counterparty limits
The counterparty limits restrict the extent to which the admissible assets may be taken
into account for valuation purposes. The purpose of the admissibility limits is to limit
the exposure to credit risk, ie loss if a counterparty fails to perform its contractual
obligations.
There is no limit to how much of any security issued by any government or local
authority may be taken into account.
For other types of asset, the rules specify maximum amounts which can be taken
into account. These are broadly expressed as a percentage of the insurers
mathematical reserves plus capital requirements.
Examples of such percentages are:

10% for each piece of land or property
3% for cash
1% for each holding of an unlisted share.
The rules also specify maximum amounts of exposure to counterparties. Accumulation

of exposure to a particular counterparty might arise, for example, through holdings of
both equity and debt capital in the same company.
The rules also cover how any derivative holdings should be treated, when deriving the
exposure to each counterparty. Derivatives might be held, for example, to protect the
companys solvency position or to back guaranteed equity products. Broadly, exposure
is increased by long positions in futures and options and decreased by short positions.
The aim of these limits is to restrict concentration risk, where the exposure of
the company to the financial instruments of a single issuer becomes too high.

Question 11.7
Discuss how well the limits achieve this aim.
5.4 Valuation of admissible assets
Having identified which assets are admissible, and the limits on the extent to which
these assets are admissible, the final stage is to determine the value that can be
attributed to them.
The methods of valuing the main types of asset are summarised below:
Quoted investments should be valued at bid price.
Loans may be valued at their face value if it is reasonable to assume that

the amount can be recovered.
Land and buildings must be valued by a qualified valuer on an

open-market sale basis.
For tangible fixed assets, depreciation applies on a straight line basis.
Cash at bank and deposits are valued at face value.
For holdings in subsidiary undertakings, complicated rules exist, beyond

the scope of this subject.
Question 11.8
Comment on the statement:
Admissibility rules restrict an insurance companys freedom to invest in unusual or

risky assets.

6 Pillar 1 Peak 1 valuation of liabilities for long-term

insurers
The regulatory rules relating to the valuation of unit-linked contracts are deemed
to be outside the scope of this course. Students are referred to Subject SA2 for
the necessary development.
The methods and bases described below apply to valuations relating to Pillar 1
for regulatory-basis only life firms.
As noted above, there are differences in valuations depending on whether a firm is

realistic-basis or regulatory-basis only. This section continues to assume for the
purposes of Subject SA1 that all long-term health insurers are regulatory-basis only life
firms. These are therefore Peak 1 valuations.
6.1 Methods of valuation
Non-linked contracts
The format of the supervisory returns requires either a net premium or gross
premium method.
A gross premium method would normally be used for health business.
The following is permitted:
discontinuance rates can be allowed for within the gross premium

valuation, even where this has the effect of reducing reserves
The assumed discontinuance rates must be prudent. Care needs to be taken here.
For example, for a particular policy a low assumption may be prudent early in
the policy term, when initial expenses may still have to be recouped, but a high
rate may be prudent at later durations. A strict interpretation of the rules would
require assessing the direction of prudence on a policy-by-policy basis, but in
practice firms have adopted more pragmatic approaches, eg grouping policies
and testing sensitivities for representative sample policies.
policies with no guaranteed surrender value can have a negative reserve

(ie can be treated as an asset).
The only limit on negative reserves is that a firms total mathematical reserves
must be at least as much as the surrender values of any unit-linked and
index-linked contracts at the valuation date.

The above allowances were introduced as at 31 December 2006, but regulatory

consultation and confirmation of the details of implementation occurred shortly before
that date. Perhaps for this reason, not all insurance companies took advantage of the
relaxation of the rules as at 31 December 2006.
Question 11.9
Suggest another reason why an insurance company may have chosen not to take
advantage of these new rules.
Minor classes of business
Approximate methods, for example a multiple of the premium, may be used if the
resulting reserves are at least as high as those that would otherwise be
calculated in accordance with the rules. For minor classes of business the time
saved in not using a more precise methodology usually outweighs the resulting
extra prudence in the reserves.
Options
INSPRU requires appropriate reserves to be set up for policyholder options. In

particular, where there is considerable variation in the cost of the option
depending on the conditions at the time the option is exercised and where that
variation constitutes a material risk for a firm, it will generally be appropriate to
use stochastic modelling.
In carrying out such stochastic modelling, firms should take into account the likely
choices to be made by policyholders in each scenario and firms should make and retain
a record of the development and application of the model.
Where stochastic modelling is not undertaken, market option prices should be

used to determine suitable assumptions for the valuation of the option.
Other classes of business
It would be possible for the examiners to expect you to suggest a method or basis for the
valuation of other classes of business. If they did, they would expect you to apply the
principles of conventional methodology where appropriate + pragmatism + prudence
to the situation described.

6.2 Assumptions
This section outlines the considerations that should be made when setting each
assumption for valuing liabilities of typical non-linked health and care contracts.
The assumptions required to value the liabilities will depend on the nature of the
contract to be valued and the method to be used. The following assumes a
gross premium valuation method.
Mortality / Morbidity A prudent assessment of future mortality / morbidity

allowing for the companys recent experience.
Interest rate A prudent assessment of future returns on the assets

backing the without-profits reserves, subject to this not
exceeding the maximum allowed by the rules, reduced to
allow for tax.
Expenses These need to take account of the actual expenses in the

12 months preceding the valuation date and the possibility
that the company might close to new business 12 months
after the valuation date. Care needs to be taken, in
expressing the assumption, for the possibility that
withdrawals might render inadequate the allowance for
expenses.
Question 11.10
Why might withdrawals occur and how would this affect the expense assumption?
Commission The rate of renewal commission would be known.
Inflation rate A prudent assessment of future expense inflation, probably

consistent with the interest rate.
Tax rate Will take account of the current and future expected tax
basis of the companys BLAGAB fund (if relevant).
Withdrawals A prudent allowance for discontinuance rates can be used in

the valuation, even where this has the effect of reducing
reserves. Care is needed when assessing the direction of
prudence.

6.3 Variations in experience and other factors
Adverse variations in assumptions such as mortality, morbidity and interest

rates would be allowed for by taking margins, but note that using a heavier
mortality assumption with a net premium valuation will not necessarily increase
the reserve.
Adverse variations in expense experience can be allowed for through a margin in

any explicit expense or inflation assumptions or, where there are none, in the
inflation assumption used to test the adequacy of the implicit allowance for
future expenses in a net premium valuation.
Global reserves may be required to allow, amongst other things, for:
the additional mortality for AIDS if it has not been allowed for in the
individual contract reserves
future expenses, especially those in the closure to new business test, not
covered in the individual contract reserves
cashflow mismatching between the assets and the liabilities
the future tax that may become payable on currently unrealised capital
gains
data errors or doubts about the accuracy of the data
the risk of credit default by reinsurers.
For contracts that contain cash options, a check would need to be made that the
reserve held, including any reserve held for the options, was sufficient to meet
any guaranteed amount available within 12 months of the valuation date, and
that the future expected progress of the reserve (on the valuation assumptions)
remains sufficient to provide for the amount available on exercise of the cash
option at any future point.
This last check is required on a policy-by-policy basis, and is normally reflected in the
individual policy reserve figures.

7 Assessment of statutory solvency for a UK short-term

insurance company
7.1 Financial resource requirements
As for long-term insurance companies, PRA-regulated firms are required to

maintain adequate financial resources under both Pillar 1 and Pillar 2
assessments. The principles underlying these assessments are generally the
same as those for long-term insurance business.
7.2 Pillar 1 valuation
The valuation rules set out how a firm should recognise and value assets,
liabilities, equity and income statement items. In general, where no specific
valuation rules are set out in GENPRU or INSPRU, recognition and valuation of
assets and liabilities should be in accordance with GAAP.
The rules for valuing assets were discussed in Section 5. Admissibility rules only allow
certain assets to count for the purposes of demonstrating statutory solvency. Other
assets may be held, but they cannot be included in the asset valuation for statutory
purposes. The result of this is that insurers will tend to:
invest in good quality assets
spread investments across a wide range of assets.
The valuation of short-term liabilities under GAAP was covered in Chapter 10.
Short-term business insurers can only discount outstanding claims for the
purpose of calculating capital resources in respect of Class 1 (Accident) or
Class 2 (Sickness) or to reflect the discounting of annuities, even if discounting
is more widely used in their financial statements. For Classes 1 and 2, the
average time from the accounting date to settlement date must be at least four
years, so discounting is unlikely to be applicable to a portfolio of (short-tailed)
PMI business.
Discounting means reducing the value of reserves to allow for investment income
expected to be earned until claims are paid. This rarely applies to health insurance
business because claims are usually paid quickly.

7.3 Pillar 1 capital requirements
All insurance companies must also comply with capital resource requirements
based on EU Directives.
For short term business insurers, the Minimum Capital Requirement (MCR) is the
greater of:
the General Insurance Capital Requirement (GICR)

(which is the greatest of:
the premiums amount
the claims amount and
the brought forward amount)
and
the Base Capital Resources Requirement (BCRR), ie Minimum Guarantee
Fund (MGF).
The premiums amount for health insurers is equal to between 16% and 18% of gross
premiums adjusted for the effect of reinsurance.
The claims amount for health insurers is equal to between 23% and 26% of gross claims
adjusted for the effect of reinsurance.
The brought forward amount is the same as the GICR that applied during the prior
financial year, except where claims outstanding have fallen during that financial year.
If they have fallen, the brought forward amount is itself reduced by the same percentage
fall.
The BCRR is an absolute amount set at an EU level dependent on classes of business

underwritten, and the amounts are subject to automatic indexation.
7.4 Quality of capital resources
There are certain restrictions in the use of capital for regulatory solvency purposes.
Available capital resources are divided into tiers, reflecting the differences in the
extent to which the capital instruments concerned meet the purpose and
conform to the loss absorbency and permanence characteristics of capital.
Higher quality capital is known as Tier 1 capital and capital instruments falling
into Core Tier 1 capital can be included in a firms regulatory capital without
limit.

Tier 1 capital (eg most equities) includes assets that:

are able to absorb losses
are permanent
rank for repayment upon winding up after all other debts and liabilities
have no fixed costs.
Other forms of capital are either subject to limits or, in the case of some
specialist types of capital items, may only be included in capital resources with
the express consent of the PRA by waiver.
Tier 2 capital (eg most subordinated debt) does not meet the requirements above and is
therefore restricted when considering regulatory capital available.

8 Regulation issues for both long- and short- term

insurances
8.1 Breaches in solvency
Insurers are required to have systems in place to monitor compliance with the
capital requirements at all times and to be able to demonstrate the adequacy of
capital resources at any particular time if asked to do so by the PRA. If an
insurer breaches the requirement they are required to take prescribed actions,
the details of which depend on the specific breach ie which level of capital
requirement is no longer met. The actions include notification to the PRA and
submission of a plan of restoration within a specified timeframe.
Once an acceptable plan has been submitted to the PRA, it must be implemented
by the insurer.
In practice, if an insurer even comes close to breaching the Minimum Capital

Requirement, then it may come under scrutiny from regulators, rating agencies, and
other interested parties.
8.2 Supervisory Returns
All UK insurers have to give annual returns to the PRA. In the past these have been
known as DTI Returns or FSA Returns. This is where statutory solvency calculations
are publicised.
As mentioned in Section 3.2, all insurers (with some limited exceptions) must
prepare annually a revenue account, balance sheet and profit and loss account
in the format prescribed by IPRU-INS.
The Returns comprise a large number of forms, containing very detailed financial
information about the insurer. This information is available to the public since
any person has a right to request a copy from the insurer. This availability
means that competitors, journalists, brokers and many others have access to an
insurers detailed financial information.
However, the amount of detail contained in the supervisory Returns is far short of that
needed to make any real in-depth analysis of a companys profitability. It is more
useful as an indication of a companys ability to meet statutory solvency levels, and
hence is most useful to establish the level of protection available to policyholders.

The PRA uses the annual Returns prepared by insurance companies as a key
source of information to monitor the financial resources of an insurer and the
adequacy of mathematical reserves. The PRA's primary concern in relation to
the Returns is the solvency of an insurer, ie with its ability to meet future claims
payments to policyholders.
The main forms that an insurance company must complete are:
Balance sheet and profit and loss account

Revenue account and additional information
Valuation summaries, by broad type of contract
Directors certificate and auditors report
Abstract of valuation report (a description of the actuarial valuation and
key features of the liabilities of the company).
There are many forms, covering detailed analysis of assets, claim payments,
expenses, new business, liabilities, ceded reinsurance, etc.
Out of all the forms in the supervisory Returns, the one that is most frequently looked at
is probably the statement of solvency. Form 1 is used for general insurance business
and Form 2 applies to long-term insurance business.
8.3 Passporting
Passporting rights give an insurer or reinsurer regulated in one EEA (European

Economic Area) state the right to set up a branch in another EEA state or do
business there on a cross-border basis.
The EEA is the European Economic Area, and consists of the EU member States, plus a
few others (such as Iceland and Norway). Note that passporting rights do not apply in
the Channel Islands or the Isle of Man, as these are not EEA States. There is a special
arrangement with Switzerland, even though it is not an EEA State.
The rights for Passporting arise under the FSMA single market directives which
for health and care insurers are likely to be:
the Third Non Life Directive
the Consolidated Life Directives
the Reinsurance Directive.
These are European Union (EU) wide directives.

As a result of Passporting the insurer / reinsurer is subject to their home state

regulator rather than the host state regulator.
However, these firms may also need to deal with the regulators of the host states, eg in
providing information, which may also charge them a fee.

Chapter 11 Summary
Financial Services and Markets Act 2000 and the regulators
From 1 December 2001, UK insurers have been subject to regulatory requirements

under the Financial Services and Markets Act 2000 (FSMA).
On 1 April 2013 the Financial Services Authority (FSA) was replaced by two new
regulators:
The Prudential Regulation Authority (PRA)
The Financial Conduct Authority (FCA).
The PRA has the following objectives:

promoting the safety and soundness of the companies that it supervises
contributing to securing an appropriate degree of protection for those who are or
may become policyholders.
The FCAs key objective is to ensure that the relevant markets function well, under-
pinned by:
securing an appropriate degree of protection for consumers
promoting effective competition in the interests of consumers
protecting and enhancing the integrity of the UK financial system.
Regulatory Handbooks
The two regulatory Handbooks contain all the rules and guidance issued by the PRA or
FCA respectively.
Sections of the Handbook include:

Prudential sourcebooks including INSPRU, GENPRU and IPRU-INS
Insurance: Conduct of Business Sourcebook (ICOBS)
Supervision Manual (SUP).

Capital management requirements for long-term insurers
The main thrust of GENPRU and INSPRU is to set standards for capital management
and demonstration of solvency. They introduce the concept of two Pillars:
Pillar 1, which covers public solvency information that appears within the PRA
Returns on the basis of prescriptive rules. Most long-term health insurers only
have to satisfy the requirements of Peak 1.
Pillar 2, the Individual Capital Assessment (ICA), which covers a confidential
assessment of solvency for PRA.
Pillar 1 Peak 1
This requires a firm to have enough capital to cover:

Mathematical reserves on prudent assumptions
LTICR (Long Term Insurance Capital Requirement)
RCR (Resilience Capital Requirement)
BCRR (Base Capital Resource Requirement) if this is greater than LTICR +
RCR.
The maximum of LTICR + RCR and BCRR is called the Minimum Capital
Requirement (MCR).
Pillar 2
Pillar 2 requires all firms to assess all the risks to which they are exposed and hold
sufficient capital to cover those risks. This is known as Individual Capital Assessment
(ICA).
The Pillar 2 requirements of INSPRU are expressed as three core rules, covering:
methodology of capital resources assessment
a requirement to base the ICA capital requirement submitted to the PRA on a
99.5% one-year non-ruin probability (or equivalent comparable basis over a
longer term)
adequacy of documentation in ICA submissions.
Firms submit their own confidential ICA calculations to the PRA, who then review
them and issue Individual Capital Guidance (ICG). If the PRA is satisfied with a firms
ICA calculations, it will set its ICG at the same level.

Examples of the risks that a firm must assess under Pillar 2 are as follows:
market and interest rate risk
credit risk (including reinsurance risk)
operational risk
mortality and morbidity risk
persistency risk
expense risk
the risks attaching to the firms pension scheme
liquidity risk
group risk.
Valuation of assets
Detailed rules apply to the valuation of assets under the Prudential sourcebooks. Only
assets that are admissible may be taken into account for valuation purposes. For most
types of asset, the rules specify maximum amounts of each type and maximum amounts
of exposure to counterparties that can be used.
The method of valuation is prescribed for each asset type, eg quoted assets should be
valued at bid price.
Valuation of liabilities for long-term insurers
Under Pillar 1, a gross premium method would normally be used, unless the contract is
with-profits. Discontinuance rates can be allowed for and policies with no guaranteed
surrender value can have a negative reserve (ie be treated as an asset).
It would generally be appropriate to use stochastic modelling for valuing options.
Assumptions used to calculate reserves are influenced by legislation, prudence, the

nature of the contract being valued and the method being used.
Variations in experience and other factors are allowed for by margins in individual
reserves or by global additional reserves.

Statutory solvency assessment for short-term insurers
In demonstrating statutory solvency, there are rules for valuing assets, liabilities, equity
and income statement items. In general, where no specific valuation rules are set out in
the Prudential sourcebooks, valuation should be in accordance with GAAP. Only
certain assets may be included in capital resources.
For short-term insurers the minimum capital requirement (MCR) is the greater of the
GICR and a base capital resources requirement, which is an absolute amount set by the
EU.
The GICR is the higher of three amounts:

the premiums amount
the claims amount
the brought forward amount.
Short-term insurers are also required to maintain adequate financial resources under the
Pillar 2 assessment.
Regulation issues for both long- and short- term insurances
Insurers must have systems in place to monitor solvency requirements at all times.
There are rules specifying the action insurers must take if solvency is breached.
All UK insurers must give annual returns to the PRA. These consist of various forms in
prescribed formats.
Passporting rights allow insurers / reinsurers to do business in countries within the EEA.

Chapter 11 Solutions
Solution 11.1
(i) Liquidity risk
Possible stress tests in assessing liquidity risk include:

mismatching between expected asset and liability cashflows
the inability to sell assets quickly
the ability to withstand sharp, unexpected increases in claims or reductions in
premium income
the need to sell large amounts of assets at different levels of market liquidity.
(ii) Operational risk
Possible stress tests in assessing operational risk include:

Fraudulent activity occurring
Technological risks occurring, eg failure of hardware or software
Reputation or brand risks occurring, resulting in a loss of policyholders
Marketing and distribution risks occurring, eg loss of a sales channel
Legal risks occurring, eg a non-insurance related legal action being pursued
against the firm
Management risks occurring, eg staff strikes
Resourcing problems of key functions, eg risk management.
Solution 11.2
1002 + 102 + 202
Aggregated capital requirement = +2 0.5 100 20
+2 0.5 10 20
= 112.69 million
Note that as the risks are not 100% correlated with each other, the aggregated capital
requirement is less than the sum of the capital requirements for each separate risk. This
demonstrates the benefits of diversification amongst the risks.

Solution 11.3
Expressing ICG in terms of ICA in this way assumes that the nature of the firm and its
risks continues broadly unchanged. This can be allowed for to some extent by tailoring
the expression of ICG. For example, ICG may be subject to some monetary minimum
(eg ICG = 110% of ICA with a minimum ICG of 100m) or parts of the ICG may be
removed if the firm takes certain risk mitigation actions.
However, this type of tailoring cannot allow for all possible future developments and, if
there are material changes to the firms business, these should be notified to the PRA so
that ICG can be reassessed.
Expressing ICG in terms of ICA increases the reliance of the PRA on the modelling
underlying the ICA and so the models may be subject to more scrutiny. Also, the PRA
is then reliant on firms informing the PRA of material changes in their ICA modelling
techniques and assumptions. These techniques and assumptions are likely to change
considerably as firms gain more experience of the ICAS regime.
If the PRA believes the ICA model is seriously flawed (eg it missed some key risks), the
PRA could decide not to base ICG on ICA at all and to express it as a fixed monetary
amount or as a % of MCR.
Solution 11.4
The person is incorrect. All firms must perform Pillar 2 calculations, so the phrase
would be unnecessary if it had the meaning suggested.
A Pillar 2 firm is one whose Pillar 2 capital requirement is more onerous than its
Pillar 1 capital requirement. Since a firms Pillar 2 capital requirement isnt public
information, only the firm itself and the PRA will know if the firm is a Pillar 2 firm.

Solution 11.5
Pillar 1 acronyms:
RCR = Resilience Capital Requirement

This is the capital required to maintain solvency following a specified
stress test.
LTICR = Long-Term Insurance Capital Requirement

This is calculated by multiplying defined measures of capital at risk by
fixed percentage factors.
BCRR = Base Capital Resources Requirement

This is a form of minimum guarantee fund.
MCR = Minimum Capital Requirement

MCR = max {LTICR + RCR , BCRR }
This is the minimum required solvency margin in excess of mathematical

reserves.
Pillar 2 acronyms:
ICAS = Individual Capital Adequacy Standards

This framework requires a life insurance company to self-assess the
capital appropriate to its individual risk profile, as a complement to the
minimum capital requirements.
ICA = Individual Capital Assessment
This is the assessment required by ICAS under Pillar 2 of the PRAs

regulatory regime. It is generally based on a 99.5% one-year survival
probability.
ICG = Individual Capital Guidance

The PRA will provide Individual Capital Guidance, specifying any
additional capital to be held over and above the core Pillar 1 requirement.
This may or may not be the same as a companys ICA.

Solution 11.6
For a company with little capital it would be a very significant discouragement. A

company with substantial free assets could hold a small but significant amount of such
inadmissible assets without practical limitations on its business.
(Most companies would probably consider anything more than a tiny investment in such
assets as inappropriate anyway.)
Solution 11.7
The rules are well designed to avoid concentration of risk in a single investment such as
one company or property.
They are not well designed to avoid concentration of risk in:

a single asset class
a particular market sector (eg utilities for equities, retail property)
a particular country or region.
To take an extreme (theoretical) example, a health insurance company might invest all
its assets in twenty large shopping complexes in London and south-east England.
In practice, companies voluntarily diversify in order to control risk.
Solution 11.8
The admissibility rules do not prohibit investments in unusual or risky classes of assets
(the rules dont say you must invest in gilts or you must not invest in art).
However by restricting the amount that can count for statutory purposes, the rules do
encourage diversification and investment in safer assets.
Solution 11.9
If a company is a Pillar 2 firm, ie one whose Pillar 2 capital requirement is more

onerous than its Pillar 1 capital requirement, then the systems changes required to
implement the changes may have achieved no benefit in terms of reducing the
companys amount of required capital.

Solution 11.10
If the company were to close to new business 12 months after the valuation date,
policyholders might see this as a sign of weakness and therefore decide to surrender
their policies.
So, not only would there be no new policies to spread fixed costs over, but the size of
the in-force portfolio would reduce at an increased rate. This would require a higher
per-policy expense assumption, than if the possibility of closure were ignored.





the course.

Level Overview
Level 1 Developing an EU legislative instrument that sets out the key
framework principles, including implementation powers
Level 2 Developing more detailed implementing measures (delegated acts
and technical standards)
Level 3 Developing supervisory guidance and common standards, and
conducting peer reviews and consistency comparisons
Level 4 Enforcement across the Member States
At the time of writing (April 2013), progress has been made on the first three
Levels but these have not yet been fully finalised and ratified. The current
timetable expects formal agreement of the Omnibus II text in 2013 (this updates
the Level 1 measures originally set out in the 2009 Solvency II Directive) followed
by approval of the Level 2 implementing measures. This will be followed by the
introduction of Level 3 guidance.
The European Parliament is expected to vote on Omnibus II in October 2013.
Development of the regime has been supported through a number of

Quantitative Impact Studies (QIS) that insurance companies have been asked to
complete, and through liaison with national supervisory bodies.
The largest and last QIS was QIS5. QIS5 took place in October 2010 and was based on
data from the 2009 year end. Over 70% of UK insurance companies participated in
QIS5.
EIOPA (the European Insurance and Occupational Pensions Authority, one of the
EUs main financial supervisory bodies and which developed from the body
previously known as CEIOPS (the Committee of European Insurance and
Occupational Pensions Supervisors)) has provided technical advice and support
to the European Commission for the development of the delegated acts under
Level 2, and is responsible for producing some of the technical standards and
the Level 3 additional guidance.
The Solvency II Directive will apply to all insurance and reinsurance companies
with gross premium income exceeding 5 million or gross technical provisions
in excess of 25 million.
The timetable for implementation is currently uncertain. At the time of writing

(April 2013) it is planned to be operative from the beginning of 2014, but a delay
to this date is widely considered to be likely.

Transitional arrangements may be available for some aspects, although any

such transitional arrangements adopted must be at least equivalent in effect to
the Solvency II proposals and should be in place for up to a defined maximum
period only. The intention is to avoid unnecessary disruption of markets and
availability of insurance products. Full compliance with the new regime should
be encouraged and achieved as quickly as possible.
The transitional arrangements should be confirmed once the Omnibus II Directive is

published. A number of specific transitional arrangements have been discussed, eg the
classification of the quality of certain types of capital issued prior to Solvency II.
1.2 Structure
The Solvency II framework comprises three pillars.
Threepillarapproach
Pillar1: Pillar2: Pillar3:
Quantitative Qualitativerequirements Reporting,disclosure

requirements andsupervisoryreview andmarketdiscipline
Balancesheet Governance SFCRand RSR

MCR ORSA Disclosure
SCR Supervisoryreview Transparency
Marketconsistent Business Disclosure

valuation governance Transparent
Riskbased Riskbased markets
requirements supervision
This overview diagram of the pillars is closely based on a version produced by the UK
regulator. It is not part of the Core Reading.
You may remember the 3 pillars (eg from Subject CA1). This section gives a brief
introduction to each (and expands the acronyms in the overview diagram).
Pillar 1: Quantitative requirements
Pillar 1 sets out the minimum capital requirements that firms will be required to
meet. It specifies valuation methodologies for assets and liabilities (technical
provisions), based on market consistent principles.

Under Pillar 1 there are two distinct capital requirements:

the Solvency Capital Requirement (SCR)
the Minimum Capital Requirement (MCR).
The SCR can be calculated using a prescribed standard formula approach, or by

using a company-specific internal model, which has to be approved by the
regulator.
The SCR and MCR both represent capital requirements that must be held in
addition to the technical provisions.
There are similarities between the component parts of Pillar 1 and those of the current
PRA regime, eg the valuation of assets and liabilities, defining of required capital
amounts, classification of the available capital to be taken into account to meet these
capital requirements.
Pillar 2: Qualitative requirements and supervisory review
Pillar 2 is the supervisory review process, under which supervisors may decide
that a firm should hold additional capital against risks that are either not covered
or are inadequately modelled under Pillar 1.
Each insurance company will be required to carry out an Own Risk and Solvency
Assessment (ORSA). The ORSA requires each insurer to:
identify the risks to which it is exposed
identify the risk management processes and controls in place
quantify its ongoing ability to continue to meet the MCR and SCR.
Pillar 3: Reporting, disclosure and market discipline
Pillar 3 is the disclosure and supervisory reporting regime, under which defined
reports to regulators and the public are required to be made.
Question 12.1
Why do you think Pillar 3 requires an insurance company to make public disclosures to
the market?
Pillars 2 and 3 are often together referred to as Pillar 5 due to the synergies between
them. For example, the ORSA (from Pillar 2) is one of the Pillar 3 defined reports to
the regulator.

Overall
This combination of:

minimum capital standards
qualitative risk management requirements
a well-defined and rigorous review process of companies solvency by
supervisors
prescribed disclosures to supervisors, policyholders and investors
has been designed to deliver a more modern and secure prudential regulatory
system.
It should be noted that the Solvency II Pillars differ in definition from those under
the current UK regulatory regime (as described earlier in the previous chapter),
so care should be exercised when referring to them. For example, Solvency II
Pillar 1 shares many characteristics with the current UK Pillar 2 regime.
The three Pillars are considered in more detail in Sections 2 and 3 of this chapter
and in the following chapter.

The correct discount rate to use will depend on the currency and timing of the cashflow
to be discounted. The same discount rates will be used by all insurance companies,
ie EIOPA will provide a set of rates to all firms that covers all currencies.
An illiquidity premium is defined as the additional compensation that investors

gain by bearing the risk from holding an illiquid asset. The extent to which the
risk-free discount rate used to discount technical provisions can include an
allowance for the illiquidity premium remains under consideration, with a
number of different possibilities having been suggested. Under QIS5 (a field
test of the development of Solvency II, performed in 2010), insurance
companies could allow for a specified proportion of the illiquidity premium,
where the proportion varied depending on the extent to which the future liability
cashflows were themselves illiquid.
For example, QIS5 required companies to use a 100% illiquidity premium for without-
profit annuities, a 75% illiquidity premium for most with-profits policies and a 50%
illiquidity premium for other policies such as protection. However, no illiquidity
premium was allowed for some classes of business.
The final framework might instead adopt the use of counter-cyclical premiums,
allowing firms to use a higher discount rate for liabilities only in times of
financial stress, as determined by EIOPA.
When asset values fall substantially, insurance companies (and banks) may need to sell
these assets and buy safer assets in order to protect their solvency. These sales will lead
to further price falls and so will make the cycle of boom and bust worse. Market values
may then become unreliable and may no longer represent the underlying worth of the
asset.
So the idea of counter-cyclical premiums is to allow firms to place a lower value on

their liabilities in times of general economic stress. This would reduce the need to sell
certain assets during a crisis and should help dampen the effect of the cycle on asset
prices.
In June 2013, EIOPA issued its advice that counter-cyclical premiums should be
replaced by a simpler and more predictable measure called the volatility balancer.
EIOPA believes that the volatility balancer will be a better way to deal with the
distortions caused by excessive price volatility.
The concept of a matching adjustment (originally matching premiums) has

also been proposed for insurance companies with long-term predictable
liabilities and hold-to-maturity assets which are expected to produce
cashflows which match those of the liabilities.

The matching adjustment is calculated in a similar way to an illiquidity premium in that

it allows insurance companies to use a higher discount rate to reflect some of the extra
return from illiquid bonds.
To qualify to use a matching adjustment the insurance company must hold assets that
closely match the liabilities after allowing for the impact on asset cashflows of default
and downgrades. It applies to annuity business.
These aspects continue to be worked on, and more details are expected as the
framework develops.
2.2 The risk margin
The risk margin is intended to increase the technical provision to the amount
that would have to be paid to another insurance company in order for them to
take on the best estimate liability. It therefore represents the theoretical
compensation for the risk of future experience being worse than the best
estimate assumptions, and for the cost of holding regulatory capital against this.
The risk margin is determined using the cost of capital method, ie based on
the cost of holding capital to support those risks that cannot be hedged. These
include all insurance risk, reinsurance credit risk, operational risk and residual
market risk.
An example of residual market risk occurs when the duration of liability cashflows is
longer than the duration of available risk-free assets.
The cost of capital method
1. The risk margin calculation involves first projecting forward the future
capital that the company is required to hold at the end of each projection
period (eg year) during the run-off of the existing business.
For Solvency II, the projected capital requirement is a subset of the SCR
(see Section 3), consisting of those risks that cannot be hedged in
financial markets.

2. These projected capital amounts are then multiplied by a cost of capital

rate.
This rate can be considered to represent the cost of raising incremental

capital in excess of the risk-free rate, or alternatively it represents the
frictional cost to the company of locking in this capital to earn a risk-free
rate rather than being able to invest it freely for higher reward. For
Solvency II it is currently proposed that it is a fixed rate of 6% per annum.
3. The product of the cost of capital rate and the capital requirement at each
future projection point is then discounted, using risk-free discount rates,
to give the overall risk margin.
A non-simplified full projection of the SCR in the first step would be complex as it
would potentially involve nested stochastic calculations. To complicate matters further,
the SCR depends on the risk margin, which introduces a circular argument to the
calculation of the risk margin.
Since the projection of the SCR is potentially complex, various simplified

approaches can be used.
For example, this could involve selecting a driver (eg reserves or sum at risk)
which has an approximately linear relationship with the required capital or its
components. The initial capital requirement can be expressed as a percentage
of that driver, and the projected capital is then approximated as the same
percentage of the projected values of the driver. In practice, more sophisticated
methods using a combination of drivers and correlations may have to be used.
Suppose a particular health insurance company sells only critical illness.
The company has projected the aggregate sums at risk on the critical illness policies at
each year-end until all the current critical illness business is run off as follows:
t 0 1 2 3 4 5
Sum at 100m 90m 85m 82m 80m 0m
risk
The company has calculated its SCR at time 0 to be 10m.
Question 13.3
Use the simplified approach described above to estimate the SCR at each year-end.

Page 9a SA1-13: Legislation (3)
Although the risk margin must be disclosed separately for each line of business,
it is proposed that it can be reduced to take into account diversification between
lines up to legal entity level. The allocation of diversification benefit can be
approximated by apportioning the total diversified risk margin across lines of
business in proportion to the SCR calculated on a stand-alone basis for each
line, or by other approximate methods if appropriate given the materiality of the
results.
Question 13.4
Suppose now that the company in the previous question also had a portfolio of in-force
immediate needs annuities and that the SCR if calculated for the annuities in isolation
would be 30m. The companys overall SCR (which benefits from the diversification
across lines of business) is 34m.
In determining its risk margin, what amount should the company use as the SCR at
time 0 in respect of the critical illness business?

Validation standards the internal model must have been fully validated
by the insurance company and must be subject to regular control cycle
review, including testing results against emerging experience.
Examples of validation a company might perform include sensitivity testing,

independent reviews and checking of model outputs (eg asset prices) against
external sources of data.
Documentation standards the design and operational aspects of the

internal model must be clearly and thoroughly documented.
The documentation must provide a detailed outline of the theory and

assumptions underlying the model and indicate any circumstances under which
the internal model does not work effectively.
The use test is seen as one of the most challenging aspects of gaining internal
model approval. As well as embedding the model throughout the company and
developing an effective risk culture, companies will need to be able to evidence
that this is the case.
Examples of how companies might evidence this include showing evidence of senior
management discussion and sign-off of models and assumptions (internal governance)
and having all risks identified by the risk management system as inputs into the internal
model (risk management processes).
Companies should also be able to demonstrate that their internal model plays a
significant role in their ORSA.
The quality of data and assumptions can also be an issue. A key challenge is
that historic data available to calibrate extreme events is limited, particularly for
morbidity risks. In practice, it is likely that some industry consensus will emerge
over some of the core stresses, eg 99.5th percentile equity fall based on a
commonly used index and method. It will be important for companies to allow
for their own specific features however, eg the extent to which their actual equity
holdings are more or less volatile. Similarly, setting dependency structures and
correlation factors that apply under extreme conditions is challenging.
Furthermore, an internal model can be structured in any way that the company
chooses, provided the above tests are met. It does not have to follow the
structure of the standard formula, and can for example be based on stochastic
simulations rather than stress tests plus correlation matrices, perhaps using
copulas to model dependency structures. Calibration of such stochastic models
will also require care and expertise.

A copula is a function that can be used to create a joint distribution function from the
marginal distribution functions of random variables. So, for example, we can use a
copula to model the joint behaviour of interest rates and inflation and so calculate the
probability of high inflation occurring at the same time as low interest rates say.
A tight deadline has been imposed of just six months from the supervisory
authority receiving an application for internal model approval to communication
of the decision. Many regulators (eg in the UK) have therefore chosen to set up a
more informal approach (called pre-application), encouraging companies to
engage with them early on in their model development and refinement
processes.
In the UK, the approval process is known as the Internal Model Application
Process (IMAP). The regulator has been issuing sets of guidelines for insurance
companies in relation to this process based on the latest versions of Level 1 and
Level 2 proposals, noting that formal final approval cannot be given until the new
Solvency II regulations come into force.
Although it is a more informal approach, the IMAP pre-application process has a

defined series of steps, eg preparation of a self-assessment pre-application pack,
agreement of a workplan, regular progress reporting from the firm to the PRA, PRA
review on reaching of defined milestones.
As part of IMAP, the PRA requires companies to submit a detailed self-

assessment template which provides evidence of compliance with the relevant
requirements, including the six tests mentioned above. It also requires
information on the risks which are covered by (and any which are excluded from)
the internal model.
Having already developed models for the similar ICA calculation described
earlier in Chapter 11, it is anticipated that insurance companies within the UK,
particularly larger ones with economies of scale, will be more likely to use the
internal model option than insurers in some areas of continental Europe.
However, many UK health insurance specialist companies are unlikely to have
such economies of scale.

2.3 Some other legislation relevant to insurers
The Core Reading lists the following, and so you should be aware of these, even if you
do not need to know the details.
Financial Ombudsman Service
This is described in Section 2.1 above.
Unfair Terms in Consumer Contracts Regulations 1999
These regulations give the FCA and some consumer bodies powers to challenge
firms that are using unfair terms in their standardised consumer contracts.
Under the regulations the general test of whether a term is unfair is based on
whether, contrary to good faith, it could give a significant advantage to the firm
that could cause detriment to the consumer.
An example of an unfair contract term is one that allows an insurer to change the
terms of the contract without consulting the policyholder unless it does so for a
valid reason set out in the contract.
Complaints concerning possible unfair contract terms may be referred to the

Financial Ombudsman Service.
Equality Act 2010 and EU Gender Directive
The Equality Act makes it unlawful to discriminate against people on the

grounds of various protected characteristics such as age, pregnancy and
disability. The EU Gender Directive requires firms to use unisex premium rates.
We cover these in Section 4.

3 Treating customers fairly (TCF)

The concept of Treating Customers Fairly (TCF) is enshrined within regulation:
a firm must pay due regard to the interests of its customers and treat them
fairly. It is clear that the responsibility for satisfying the TCF requirements rests
with the Board and senior management of a long-term insurance company.
Compliance with TCF requirements is regulated by the FCA. Senior management

is expected to incorporate its approach to treating customers fairly into the
firms corporate strategy, and to support delivery of the strategy with an
appropriate framework of controls. Effective delivery will include ensuring that
the firm:
has in place a process to identify the needs of the customers for whom
they are designing, manufacturing and/or distributing products
understands the financial capabilities of its customers and the impact and
effectiveness of its communications on their ability to understand
sometimes complex issues
provides clear, fair and not misleading advertising, marketing and

disclosure materials as well as communications after the point of sale
maintains a balance between increasing sales and not exposing

customers to inappropriate risks, particularly in the design and marketing
of new products
measures, monitors, controls and reviews the risks arising from products
for both existing and potential new customers. This includes dealing with
current changes in the economic or market environment as well as stress
testing against possible future changes in the environment.
finds a way to stress test possible risks to the firm arising from its retail
business taking into account product types, sales methods and after
sales requirements
puts in place appropriate control functions to enable delivery of the

strategy
provides timely, informative and relevant management information to

monitor the effectiveness of the strategy.
These are all sensible requirements that are in the best interests of the firm anyway. If
all of the above items are in place, then the risk of bad publicity due to unhappy
policyholders is much reduced.

The formal requirement to treat customers fairly can be taken as incorporating the
concept of policyholders reasonable expectations (PRE), which has been around for
many years.
In designing its strategy, the FCA expects a firms senior management to have
regard to all stages of the product lifecycle, including product design, financial
promotions, advice (including remuneration of advisers), information at the point
of sale, treatment after the point of sale, and complaints.
TCF is applicable to all types of insurance policy, particularly those that have
discretionary elements for example health insurance policies with reviewable terms.
The holders of such contracts may reasonably expect that firms will behave fairly and
responsibly in exercising the discretion that is available to them. They may also expect
a reasonable degree of continuity in a firms approach to determining variable charges
or benefits.
3.1 Professional guidance
Both the Financial Reporting Council and the Institute and Faculty of Actuaries provide
guidance on TCF.
Guidance given by the Financial Reporting Council in the Insurance TAS states
that reports which require projection of cashflows under alternative scenarios
shall describe how any changes in the assumption about the way discretion is
exercised in the alternative scenarios considered are consistent with the fair
treatment of the policyholders affected.
Actuarial Profession Standard L1 (Duties and responsibilities of life assurance

actuaries) see Section 1 above states that The responsibilities of members
to whom this APS applies are central to the financial soundness of the long-term
insurance business of the firms in respect of which they act, and to the fair
treatment of policyholders.
APS L1 applies to the Actuarial Function Holder, the With-Profits Actuary and the
Reviewing Actuary (it also applies to the Appropriate Actuary in work connected with
friendly societies, but knowledge of the work of Appropriate Actuarys is beyond the
Subject SA1 syllabus).
It goes on to cover the need for the Actuarial Function Holder to ensure that the
firms management are aware at all times of his / her interpretation of its
obligations to treat its customers fairly.

Note that the role of Actuarial Function Holder is an advisory one. The Board of
directors and senior management must take overall responsibility for the actuarial
aspects of their firms business, based on the advice of their actuaries.
The Insurance TAS and APS L1 are both mentioned again in Chapter 15.
3.2 Matters to be considered
Although TCF is of particular relevance to with-profits policies, it is also

applicable to any type of without-profits or unit-linked policy, particularly those
that have discretionary elements. The latter would include:
variable charges on linked policies
the unit pricing basis for linked policies
non-guaranteed surrender values
variable-rate contracts such as renewable critical illness (non-guaranteed
premium rates).
Another example of a variable-rate contract would be a CI policy with reviewable

premiums.
For any policy that has a discretionary element, the holders of such contracts
may reasonably expect that firms will behave fairly and responsibly in exercising
the discretion that is available to them. They may also expect a reasonable
degree of continuity in a firms approach to determining variable charges or
benefits.
In the normal day-to-day management of a firm, TCF is virtually synonymous

with equity.

It is helpful to build up a list of topics to consider in addressing any issue

relating to TCF. This would include:
The contents of sales literature, advertisements, promotional material,

illustrations, quotations, policy projections and policy documents.
Since all of these documents might restrict the actions open to the firm in the
future, they should be written very carefully with this in mind.
Whether changes to the terms of reviewable contracts, such as charges

for mortality and morbidity risks and expenses under unit-linked
contracts, are reasonable compared with a firms past practice and
communications to policyholders, and the practice of the whole industry.
Attaching sufficient importance to expectations relating, for example, to

surrender values, early retirement values, and options to extend or
convert a policy.
Policy guarantees.
Whether any proposed course of action is sound and prudent by the

normal standards of the industry, and fair to different classes of
policyholder, as well as to policyholders relative to shareholders.
3.3 Consumer outcomes
Six consumer outcomes have been defined, which explain what the FCA wants
TCF to achieve for consumers.
Outcome 1: Consumers can be confident that they are dealing with firms where
the fair treatment of customers is central to the corporate culture.
Outcome 2: Products and services marketed and sold in the retail market are
designed to meet the needs of identified consumer groups and are
targeted accordingly.
Outcome 3: Consumers are provided with clear information and are kept
appropriately informed before, during and after the point of sale.
Outcome 4: Where consumers receive advice, the advice is suitable and takes
account of their circumstances.
Outcome 5: Consumers are provided with products that perform as firms have
led them to expect, and the associated service is of an acceptable
standard and as they have been led to expect.

Outcome 6: Consumers do not face unreasonable post-sale barriers imposed

by firms to change product, switch provider, submit a claim or
make a complaint.
Industry measures to meet TCF requirements under reviewable policies were covered in
Chapter 8.

If an insurer wishes to decline or impose special terms on a life or health

insurance policy for a disabled person, it is lawful to do so provided the adverse
decision is based upon information or data that is relevant to the assessment of
the risk to be insured and which is from a source upon which it is reasonable to
rely, and provided the decision is reasonable having regard to the information or
data relied upon and any other relevant factors.
So special terms can be imposed on disabled people as long as there is adequate

evidence that this is fair. This illustrates the importance of obtaining sufficient
relevant and accurate data, not just for pricing, but for making good underwriting
decisions and justifying them.
If youre interested in knowing more about this Act, you can look at it on the internet at
http://www.legislation.gov.uk/.
The following section considers discrimination by sex (gender).
4.2 EU Gender Directive
The EU Gender Directive was passed in 2004, being aimed at implementing the
principle of equal treatment between men and women in the access to and supply
of goods and services.
The Equality Act 2010 transposed this Directive into UK legislation.
In its original form the EU Gender Directive included an opt-out in respect of

financial and insurance products provided that certain conditions were met.
If an insurer wanted to use gender as a rating factor it had to publish data that supported
its differing treatment of males and females. Many insurers referred to CMI data for
this purpose.
In March 2011, the European Court of Justice gave its ruling on the legality of the
insurance opt-out provision, concluding that it is not valid and should therefore
be removed with effect from 21 December 2012. From that point, insurance
companies have no longer been able to use gender as a rating factor for new
business.
Reviewable premiums are not treated as new business for the purpose of this
legislation. However, insurance companies do need to be careful to avoid the use
of proxy rating factors (ie highly correlated to gender) that might be deemed to
be indirect discrimination and thus also not permitted.

In June 2011 the UK government issued a statement that in its view the ruling only
related to contracts issued after 21 December 2012, meaning that existing contracts are
not affected.
In December 2011 the Treasury issued a consultation document on its proposed

approach to implementing the ECJ judgement. However, it should be noted that only
the courts can provide an authoritative interpretation of the legislative provisions. We
note some of the key points from the consultation document below.
The Treasury believes that it is still permitted to offer single-sex services in a range of
circumstances, for example where only people of one sex have need of that service.
This may be relevant where insurers are covering risks that only affect one sex, such as
prostate or ovarian cancer.
The Treasury does not believe that the ruling prohibits the collection of data on an
applicants gender. So an insurer will be aware of the mix of lives it is insuring and will
be able to offer unisex rates which reflect this mix. Therefore the Treasury believes that
it is legitimate for an insurer with a large proportion of male lives to charge a premium
that was heavily weighted towards male mortality / morbidity.
Similarly, the Treasury believes that insurers may reserve on the basis of gender and
buy reinsurance that is priced on the basis of the gender mix in the business they are
reinsuring.
The Treasury believes that the ECJ ruling only applies to new contracts. The
consultation states that a renewal will almost certainly create a new contract, but a
review of a contract under its terms is less likely to do so.
Further details of the Treasurys response can be found at: http://www.hm-

treasury.gov.uk/condoc_insurance_benefits_and_premiums_gender_neutral.htm
Clearly, the inability to differentiate between gender when setting premium rates
has significant implications for insurance pricing, particularly for health
insurance products where there are material observed differences between
morbidity experience according to gender. Rather than simply averaging
premium rates, additional contingency loadings are needed for the risk of
business mix by gender not being as expected within the unisex pricing.
A particular difficulty in estimating the gender mix is that it is likely to vary within a
single product, eg the proportion of males may be higher at higher sums assured. Also,
the judgement may itself change the proportions of males / females buying certain
products.

The Treasurys consultation document presents a number of graphs that show how
insurance risk varies with gender and age. The Treasury expects that initially premium
rates will move to be close to the current rates for the higher risk gender (due to adverse
selection and a risk-averse approach to underwriting). Over time, competition is
expected to drive average premium rates back down until they stabilise at a higher rate
than the current average (due to the selection effect).

5 Financial reporting of long-term insurance
5.1 Introduction
We have already mentioned that UK insurance companies have to produce returns to the
supervisory authority, ie the PRA. These returns disclose a value of surplus assets,
ie assets minus liabilities, and this is known as reporting on the supervisory basis.
As well as producing the supervisory returns required by the PRA, UK insurance

companies must also report profits in their annual Report and Accounts under
the more general requirements of either the Companies Act 1989 or EU-approved
International Financial Reporting Standards (IFRS).
Since 22 December 1994, Regulations have been made under the Companies
Act, which require long-term insurance company accounts to be produced
according to the rules of the EU Insurance Accounts Directive. The Directive
requirements are spelt out in more detail by the ABI in its Statement of
Recommended Practice (SORP). This SORP describes how long-term insurance
business should be accounted for in order to comply with the Generally
Accepted Accounting Principles in the UK (UK GAAP). The UKs Accounting
Standards Board (ASB) (now the Accounting Council of the Financial Reporting
Council) is required to confirm that the SORP complies with its own reporting
rules. This is termed as reporting on the Modified Statutory Basis. The
Regulations are now overruled in certain cases by the need to comply with IFRS.
The Financial Reporting Council collaborates with the International Accounting

Standards Board (IASB) both in order to influence the development of international
standards and in order to ensure that UK standards are developed with due regard to
international developments.
From 1 January 2005, all UK listed insurance companies have been required to
use EU-approved IFRS when preparing their consolidated accounts.
However for:
the subsidiaries of listed companies
unlisted groups
the holding companys own accounts
the use of IFRS is optional and companies can continue to use UK GAAP.
Many subsidiaries still report on a UK GAAP basis, although there is increasing

adoption of IFRS.
At the time of writing, the future of UK GAAP remains unclear and considerable
debate is taking place about the eventual convergence of IFRS and UK GAAP.

In December 2004 the ASB published Financial Reporting Standard

(FRS) 27, which imposed additional requirements for year-ends on or after
1 January 2005.
In addition, FRS 26 came into effect in 2006. This applies International

Accounting Standard (IAS) 39 rules on accounting for those non-participating
contracts that contain minimal insurance risk.
These are known as investment contracts and are not very relevant to Subject SA1.
The ABI revised its SORP with effect from December 2005 in order to comply
with FRS 27 and FRS 26. A further minor change was made at December 2006 to
accommodate amended supervisory reporting regulations which, amongst other
things, permit policies with no guaranteed surrender value to have a negative
provision.
This supervisory reporting rule change was mentioned in Chapter 11.
IFRS 4 marks the completion of the first of two phases of work to prepare a new
international standard for the reporting of insurance contracts. The standard defines an
insurance contract and requires all such contracts to be valued in accordance with
local accounting standards. For UK insurers this means compliance with FRS 27.
The Modified Statutory Basis described below conforms with FRS 27. FRS 27 also
requires that certain detailed information about capital requirements and targets is
disclosed.
It should be noted that, for accounting periods beginning on or after 1 January

2015, current UK GAAP will be replaced by three new Financial Reporting
Standards: FRS 100, 101 and 102 (new UK GAAP). As for any such accounting
standards, early adoption is permitted.
The application and interaction of all the accounting standards described above is rather
confusing. The diagram on the next page summarises the current position for UK
insurance companies. You might find the diagram helpful in piecing together the
information in this section and for revision.

Subsidiary of listed company

Type of company and Listed holding company:
accounts Listed company:
Consolidated accounts Own (non-consolidated)
accounts
Unlisted company
EU-approved IFRS optional

Accounting standards
EU-approved IFRS Can use UK GAAP (ie MSB)
applying
MSB incorporates FRS 27 and
FRS 26
Insurance contracts can be valued using Investment contracts must be valued

local standards, ie MSB using IAS 39
FRS 26 brings MSB into

line with IAS 39 for
investment contracts
This section covers the Modified Statutory Basis (MSB) including the impact of FRS 27
and FRS 26. However, the profit reporting story isnt finished there. In addition to
these Companies Act or IFRS accounts (the primary accounts), many proprietary
companies choose to publish additional profit information in their accounts using
different (achieved profit or embedded value) methods. This section therefore goes on
to look at these supplementary approaches.
The general topic of profit recognition (when in a long-term contract is it safe and
appropriate to recognise the profit made?) is an important one. You should find that the
numerical examples help to clarify things that may not make perfect sense immediately
from the text.

Chapter 14 Summary
The statutory role of the actuary
The Supervision Manual (SUP) sets out the statutory actuarial roles of Actuarial
Function Holder and With-Profits Actuary for a long-term insurer.
The Reviewing Actuary is independent both of the insurer and of its actuarial function.
He or she advises the auditors as part of their audit of the long-term insurers accounts.
Policyholder protection
The FOS deals with disputes between policyholders and insurers. The FSCS provides
some compensation to policyholders from financially distressed insurers. The unfair
contract terms regulations, the Equality Act and the OFT also help to provide
policyholder protection.
Treating customers fairly (TCF)
The FCA expects senior management of insurance companies to incorporate their

approach to treating customers fairly into their firms corporate strategy, and to support
delivery of the strategy with an appropriate framework of controls.
Specific guidance on TCF matters is contained within the Insurance TAS and APS L1.
TCF is particularly applicable to policies that contain discretionary elements, such as

those with reviewable premiums.
The FCA has defined six consumer outcomes, which explain what they want TCF to
achieve for consumers.
Equality legislation
The Equality Act makes it unlawful to discriminate against people on the grounds of
various protected characteristics such as age, pregnancy and disability. However, an
insurer may underwrite based on a persons age or disability provided the decision is
based on data that is relevant to the risk.
Prior to December 2012, insurers had been permitted to use gender as a risk factor
provided certain conditions were met. However, following a European Court of Justice
ruling the use of gender as a rating factor is not permitted from 21 December 2012.

Financial reporting of long-term business
Reporting under Modified Statutory Basis (MSB) is necessary to comply with the EU
Insurance Accounts Directive.
The main features of the MSB are:

Assets are included at full market value.
Liabilities are divided into technical provisions, the FFA and shareholder funds
(as relevant).
A technical account shows various items of cashflow.
For proprietaries, a non-technical account gives information on retained profits.
Acquisition costs are deferred using a DAC asset.
The Achieved Profits Method (APM) uses embedded value techniques to recognise the
profits expected to arise on existing business in the long-term insurance fund. The
method involves the following steps:
Make assumptions about future experience.
Project future shareholder transfers, based on future statutory surpluses arising
(and on future value of projected bonuses, if relevant, for with-profits business).
Discount these transfers to the present to give the shareholder value. Any
shareholder interest in free assets in the long-term insurance fund is also
included in shareholder value.
The APM profit in an accounting period is the change in the shareholder value
plus the supervisory basis profit transfer in that period.
Companies may use one or both of the following approaches to allow suitably for risk:
Including risk margins in the estimates of future experience.
Including a margin for risk in the discount rate applied to the estimated future
transfers (recommended approach under EEV principles).
By 2006, the UK listed life insurance companies that had prepared traditional embedded
values or APM results for supplementary reporting had adopted the European
Embedded Value Principles. It is expected that they will be replaced by Market
Consistent Embedded Value Principles.

SA1-15: Professional standards and guidance Page 1
Chapter 15
Professional standards and guidance
Syllabus objective
(e) Describe the principles underlying the requirements of the professional

standards and guidance relevant to actuaries practising in or advising UK
health and care operations.
0 Introduction
In this chapter we study the actuarial professional standards and guidance relevant to
the UK health insurance industry. You should already be aware at least of the existence
of these and may have even read some.
When carrying out work for a UK insurance company an actuary (or actuarial
student) must comply with all relevant requirements under the Financial Services
and Markets Act (FSMA), together with any professional standards or guidance
relevant to the work being done and the professional body to which he or she
belongs.
Standards required of members of the Institute and Faculty of Actuaries (IFoA)

are detailed in the Actuaries Code, Technical Actuarial Standards and Actuarial
Profession Standards.
The Actuaries Code is covered in the next section, which describes professional
guidance generally. We give more details on Technical Actuarial Standards below and
in Section 2. Actuarial Profession Standards and other guidance relevant to health
insurance are discussed in Section 3.
Professional standards that are deemed to be technical in nature are produced

and maintained by an independent body, the Financial Reporting Council (FRC).
The FRC is independent of the IFoA. The IFoA retains responsibility for the setting
and maintenance of ethical standards (the Actuarial Profession Standards).

Page 2 SA1-15: Professional standards and guidance
These principles-based Technical Actuarial Standards (TASs) are mandatory for

all members of the IFoA when undertaking work that is within the scope of that
TAS. The IFoA retains the responsibility for regulation of members and in
particular requires members, to whom the standards apply, to observe them.
The TASs relevant to Subject SA1 are:

TAS D, Data
TAS R, Reporting
TAS M, Modelling
Insurance TAS
Transformations TAS.
These are described in Section 2 below.
The standards described in this chapter can be found by following the Regulation link
from the main menu on the IFoAs website (www.actuaries.org.uk). From here you can
access the Professional Standards Directory which includes all the guidance
maintained by the IFoA. From the Regulation link you can also access the Financial
Reporting Council website. Alternatively, you can find the FRC website directly at
http://www.frc.org.uk/.

1 Professional standards
The Professional Standards Directory on the IFoAs website enables members to
access the current FRC standards and the current version of the standards
issued by the IFoA: the Actuaries Code and Actuarial Profession Standards.
The Actuaries Code sets out five core principles that all members of the IFoA
are expected to observe in their professional lives, and that must be complied
with in both the spirit and the letter. The content of the Actuaries Code is
outside the scope of this subject, but should be known by all members (students
and actuaries) of the IFoA.
The Actuaries Code contains the following five principles:

integrity
competence and care
impartiality
compliance
open communication.
The Regulation area of the IFoAs website also includes Information and
Assistance Notes (IANs) and other non-mandatory resource material, which are
intended to provide helpful material on particular matters. Unlike the TASs, IANs
are not mandatory and, therefore, members do not have to follow them, being
free to obtain and follow alternative advice from other sources. However,
because they are part of professional guidance, a member may have to
demonstrate that he / she has considered them, if relevant. The IFoA has to
ensure that the content of an IAN does not conflict with any of the FRC
standards.
So far, the IFoA has released Information and Assistance Notes covering the following
topics:
The Actuary and Activities Regulated under FSMA 2000
The actuary as an expert witness.
The first of these related to investment-related business only, and so at the time of
writing, there are no IANs that are directly related to health business.
Descriptions in the rest of this chapter reflect the up-to-date versions as at

30 April 2013. Students are not required to have knowledge of changes made
after this date for the purpose of Subject SA1. However, if your answer to an
exam question reflects knowledge of such changes, this answer will, in principle,
be acceptable.

2 Technical Actuarial Standards

This section describes the scope and purpose of the TASs that are relevant to health and
care.
Subject SA1 students are expected to be familiar with the underlying principles
of the relevant TASs, but will not be examined on the detail.
In other words, you should learn and understand the content of this section. However,
for background reading for the exam, and to help your career, we recommend that you
read the relevant TASs at least once. These can be accessed on the FRC website.
The TASs comprise generic TASs and practice area specific TASs, eg the Insurance
TAS.
2.1 Generic TASs
Question 15.1
State the aspects of actuarial work that each of TAS R, TAS D and TAS M cover.
TAS R, TAS D and TAS M are Generic TASs, which means that they apply to any
work that is commonly (or exclusively) performed by actuaries and that falls
within the scope of one or more of the Specific TASs (see below).
TAS R
The purpose of TAS R is to ensure that the reporting of actuarial work includes
sufficient information to enable users to judge the relevance and implications of
the reports contents, and that the information is presented in a clear and
comprehensible manner.
TAS R sets out a number of requirements that reports would be expected to contain
anyway. For example, TAS R requires each report to contain statements on its purpose,
intended users, sources of data and assumptions used.
However, TAS R is intended to improve past practice in a number of areas. For

example, where uncertainty exists the report must comment on the nature and extent of
the uncertainty. Also, it is not sufficient to state a net present value of cashflows, but in
addition, reports should indicate both the nature and timing of cashflows.

TAS R defines the following types of report:
aggregate report the set of all component reports relating to a piece of work
component report a document given to a user in permanent form (hard copy or

electronic) containing material information which relates to work within the
scope of TAS R.
So TAS R refers not only to big weighty reports of a hundred or more pages, but also to
draft reports, emails and presentations.
TAS D
The purpose of TAS D is to ensure that data used in the preparation of reports is
subject to sufficient scrutiny and checking so that users can rely on the resulting
actuarial information, and that appropriate actions are taken where data is
inaccurate or incomplete.
TAS D also requires that the processes described above are sufficiently documented so
that a technically competent person with no previous knowledge of the exercise would
be able to understand the matters involved and assess the judgements made.
TAS M
The purpose of TAS M is to ensure that actuarial models used in the preparation
of reports sufficiently represent the issues on which decisions will be based, and
are fit for purpose both as theoretical concepts and as practical tools.
To be fit for purpose, the model should be a satisfactory representation of some aspect
of the world in the context of the purpose for which it is being used. The model should
be checked and no more complex than can be justified, and results should be capable of
being reproduced.
Further, TAS M requires that models be properly documented and that

significant limitations and their implications be reported.
2.2 Specific TASs
As well as these Generic TASs, the FRC has published a set of Specific TASs,
applying to work in particular areas. Of most relevance to this subject is the
Insurance TAS.

Insurance TAS
The Insurance TAS applies to all reserved work (ie where there is a regulatory or
legal obligation that this work be performed by a qualified actuary) concerning
insurance business, and any work concerning insurance business which is used
in reports.
The Insurance TAS applies to both long-term and general insurance.
The scope includes work relating to:

the production of financial statements
regulatory returns
embedded value reports
pricing
business reorganisations
the exercise of discretion in relation to premiums or benefits.
Its purpose is to ensure that management and governing bodies of insurers can
understand and rely on the information supplied by their actuaries, and
appreciate its limitations. It also requires that information provided to
policyholders is relevant, comprehensible and sufficient for their needs.
Principles include:
Determination and use of appropriate and relevant assumptions.
Assumptions should be derived from sufficient relevant information (or else as
much relevant information as is available). Shortcomings in one assumption
should not be compensated for by adjustments to another assumption.
Explanation of the approach taken to determine discount rates.
This should include the rationale for inclusion and derivation of any illiquidity
premium included in the discount rates.
Allowance for, and explanation of, future trends in assumptions.
Explanation and analysis of changes between methods and assumptions
used in related exercises.
Explanation of the relationship between prudent and neutral estimates.

In relation to discretion (which includes the management of reviewable

charges and premiums):
Ensuring that any management actions modelled are consistent
with the fair treatment of policyholders.
Providing indication in reports of the effects of the proposed action
on the policyholders and on any estate.
It can be noted that the Insurance TAS is principles-based and intended to be

durable, containing few references to legislation and regulations.
Transformations TAS
Another TAS of relevance to health and care insurance actuaries is the

Transformations TAS. This gives more detail on principles that should be
applied in actuarial work relating to business reorganisations which affect
policyholders, including Part VII transfers.
The Transformations TAS covers any actuarial work involving a transfer of assets or
liabilities from one insurer to another. It also covers any actuarial work carried out to
support decisions about modifications to policyholders entitlements.

3 Other professional standards and guidance

This section lists the other current professional standards and guidance that are
of most relevance to this subject. Subject SA1 students will not be examined on
the detail of these resources.
3.1 Actuarial Profession Standards
The following Actuarial Profession Standards are of relevance:
APS L1 (Duties and responsibilities of life assurance actuaries) covers the

responsibilities specific to statutory actuarial roles relating to long term
insurance business.
The statutory actuarial roles relevant to Subject SA1 are the Actuarial Function Holder
and the Reviewing Actuary. These were covered in Chapter 14.
Question 15.2
Briefly describe the role of the Actuarial Function Holder and the Reviewing Actuary.
APS L2 (The Financial Services and Markets Act 2000 (Communications by

Actuaries) Regulations 2003) primarily relevant to Actuarial Function Holders
(and With-Profits Actuaries), and covers their obligations to whistleblow to the
regulators under the stated regulations.
Matters that may need to be communicated to the regulators include:

contravention of legislation by an insurer
significant risk that an insurers assets may become insufficient to meet
liabilities
significant risk that the insurer did not or may not take into account policyholder
interests.
3.2 Non-mandatory resource material
As noted earlier, the IFoA also produces other non-mandatory resource material
which is intended to provide helpful guidance for its members.

These include:
Whistleblowing a guide for actuaries and Whistleblowing a guide

for employers of actuaries.
These leaflets are intended to help all actuaries (and their employers)
understand their whistleblowing obligations, both professionally and
legally, and to alleviate concerns that they may have about such
responsibilities.
The IFoA has also put in place a confidential advice line that gives advice on
when and how best to raise concerns. Details of the advice line and the above
guides can be found at:
http://www.actuaries.org.uk/regulation/pages/whistleblowing.
Conflicts of interest a guide for actuaries.
This leaflet builds on the provisions of the Actuaries Code in relation to

conflicts of interest and sets out views on good practice regarding such
conflicts and how they might be managed.
The guide can be found at:

http://www.actuaries.org.uk/regulation/pages/conflicts_of_interest.

4 End of Part 2
What next?
1. Briefly review the key areas of Part 2 and/or re-read the summaries at the end
of Chapters 9 to 15.
2. Attempt some of the questions in Part 2 of the Question and Answer Bank. If
you dont have time to do them all, you could save the remainder for use as part
of your revision.
3. Attempt Assignment X2.
Time to consider learning and revision products
Face-to-face Tutorials If you havent yet booked a tutorial, then maybe now is the
time to do so. Feedback on ActEd tutorials is extremely positive. Here are a few
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It is one of the only opportunities you get to have your questions answered
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You can find lots more information on our website at www.ActEd.co.uk.
Buy online at www.ActEd.co.uk/estore

Chapter 15 Summary
The Actuaries Code sets out five core principles which all members of the IFoA are
expected to observe in their professional lives.
The Professional Standards Directory also includes Information and Assistance Notes
(IANs) which are intended to provide helpful material on particular matters.
Technical Actuarial Standards are issued by the Financial Reporting Council. TASs are
principles-based.
The TASs of relevance to Subject SA1 are:

TAS R: Reporting
TAS D: Data
TAS M: Modelling
Insurance TAS
Transformations TAS.
The IFoA has issued the following Actuarial Profession Standards:

APS L1 (Duties and responsibilities of life assurance actuaries)
APS L2 (The Financial Services and Markets Act 2000 (Communications by
Actuaries) Regulations 2003).


Chapter 15 Solutions
Solution 15.1
TAS R, TAS D and TAS M cover reporting, data and modelling respectively.
Solution 15.2
The Actuarial Function Holder provides technical advice to the board in respect of
long-term insurance liabilities. This may be on, for example, risks, capital
requirements, and methods and assumptions to be used for actuarial investigations.
The Reviewing Actuary is independent both of the insurer and of its actuarial function.
He or she advises the auditors as part of their audit of the long-term insurers accounts.





the course.

SA1-16: Evaluations Page 19
Insurers need to be wary of linking the admission of health and care claims to
that of the State or State-sponsored scheme. Typically, the requirements for
admission of the claim in a public healthcare system are far less rigorous than
the private insurer. This leads to a far higher level of claim.
In the UK, private medical insurers tie the admission of claims to that of the State
scheme by:
requiring referral from the claimants own GP
under certain policies, such as six week plans, only accepting claims if the
NHS waiting list for the required treatment is longer than a specified time.
Question 16.9
Explain why insurers could not just specify the same policy conditions and level of
claims control for the proposed territory as they operate for PMI business in the UK.
3.8 Regulation and legal matters
Advice will be required on legal and regulatory matters where local custom and
practice will need to be taken into account.
Clearly, a detailed knowledge of the relevant legislation and regulation will be required,
but also an understanding of how these rules are interpreted and used in practice will be
equally important. For the purposes of Subject SA1, knowledge of overseas regulation
is not required.
3.9 Contracts
The insurer will need to put contracts in place, subject to local law. Local
representation will be vital to see that these are interpreted and effected as
originally intended.
3.10 Reinsurance
Reinsurers can provide much assistance in establishing health insurance markets

overseas. This can range from being able to assess risks particular to the local territory
to providing the data required to model the viability of the proposed launch. The
reinsurers assistance can therefore be essential to the success or otherwise of the
project. This is discussed in more detail in Chapter 17.

Page 19a SA1-16: Evaluations
3.11 Example: microinsurance
As described in Chapter 2, microinsurance targets those who are working but on

low incomes, generally in developing countries. There will be specific
considerations for an insurance company wishing to expand into such a market.
Opportunities
Microinsurance can provide an insurance company with the opportunity to break

into new markets and hence generate more profits.
The potential market for microinsurance is huge. Four billion people live on less than
$8 a day. However, less than 5% of these people are currently insured.
There is also a wider social benefit in providing access to insurance cover for
such socio-economic groups. This more inclusive approach might form part of
an insurance companys ethical strategy.
There may be grants available from development funds and governments to

support microinsurance initiatives, in order to generate an insurance culture
within the lower income sector.
Such institutions may provide these grants in the belief that microinsurance can help to
reduce poverty by helping people to avoid debt and providing them with more stable,
predictable costs that enable them to invest for the future.
Target market considerations
The potential policyholders may not have access to bank accounts and, even if
they do, may not always bank their income. They typically have short-term
planning horizons and manage their risks through a number of informal means,
including social networks.
They also often have limited familiarity with formal insurance. There is,
therefore, potential for not understanding the nature of the contract sufficiently,
and expecting more than is actually provided by the limited benefits. Financial
literacy is often low in microinsurance target populations, and insurance
companies in some instances collaborate with regulatory and other
organisations to deliver financial education. This can be particularly difficult in
areas with low basic literacy rates, so in some cases pictures and acting is used
to explain how insurance works.
Aside from not always understanding how insurance works, potential customers
may also not understand how it compares to other personal risk management
tools, such as savings. They may believe that insurance is only for the rich and
often dont trust insurance companies, being highly suspicious of their motives.

SA1-16: Evaluations Page 19b
Other launch considerations
The product will most likely be launched in an overseas territory, so the

considerations mentioned in Sections 3.2 to 3.10 will be relevant.
The main issues for the insurance company will relate to pricing and profitability.
Risks can be very specific to the local target market, and pricing needs to reflect
this. However, with microinsurance being a relatively new market, there is
generally only limited suitable existing data available. It can be difficult to set
the premium and benefit levels accurately, and the design needs to be kept
simple.
Given the low premium/benefit nature of microinsurance, margins per policy are
generally also low and so insurance companies need to aim for high sales
volumes. Achieving this may not be straightforward: in some countries, as
noted above, there may be limited or no trust in insurance companies.
It may take several years before a company builds sufficient scale to be profitable.
Distribution of products and collection of premiums can be more difficult and

expensive than for traditional insurance. Therefore having a low-cost operating
model is also vital in order to achieve adequate profitability levels.
Microinsurers need to adopt very efficient methods of selling policies and collecting
premiums. One approach has been to use mobile phone companies to sell insurance and
to collect premiums when pay-as-you-go phones are topped up. This can be an efficient
method of distribution as the number of people with a mobile phone is often more than
ten times greater than the number of people with insurance.
Other challenges in designing, pricing and monitoring microinsurance include:
Difficulty in recording member and claims information, and hence in

performing experience monitoring.
Normal insurance definitions may not be applicable, eg the definition of

a household, and so new definitions and designs need to evolve to suit
the circumstances of the microinsurance client.
Coping with potentially huge volumes of small policies.

Page 20 SA1-16: Evaluations
4 Finding appropriate data / information for the above

analyses
4.1 Introduction
The above analyses referred to are:

assessment of the market for launch of a new company
assessment of a company or portfolio for takeover
assessment of overseas markets.
However, the points made in this section are relevant to many other analyses in which
the health actuary will be involved.
The various sources of data that can be used to analyse the claims experience of health
insurance products were discussed in Subject ST1.
Question 16.10
List these sources of data.
4.2 Own experience
This is the only data set that takes into account the companys particular
circumstances, distribution channels and product variations. However it is not
relevant in company-launch or portfolio-launch situations, and may only have
partial relevance in a takeover or merger situation.
Health and care data sets need to be collected over a long period.
As we discussed in Section 2.2, far more data need to be collected on health products
than on comparable life products for it to be credible enough to make decisions.
However, the underlying experience does start to lose relevance over time.
Question 16.11
Why is this more of a problem for PMI than for long-term health products?

SA1-18: Asset-liability matching Page 7
2 The effect of free assets on asset selection

An insurance company will have free assets (may be termed free reserves in
a short-term insurance company), which represent the excess of assets over
liabilities.
Some of an insurance companys free assets must be held securely to cover its
minimum solvency capital requirements, as noted above. The excess will be
available to invest in a way that is likely to produce a good long-term return, for
the shareholders in a proprietary insurance company, or for the with-profits
policyholders in a mutual insurance company.
Question 18.10
The size of the free assets will not be measured in absolute terms only. With what will
an insurer compare the size of the free assets?
It is important to realise that an insurer has a duty to the policyholders to invest

wisely to protect its ability to meet its liabilities to them. However, a proprietary
insurer also has a duty to its shareholders to sustain and enhance the return that
it achieves on the assets over and above those that it retains to meet the
minimum solvency capital requirements. This means that it needs to invest
some of its free assets long term in equities, both UK and overseas, and perhaps
in direct property investment as well if the scale of the funds available for
investment is sufficient for it to build a diversified portfolio.
The existence of the free assets enables the insurer to exercise a freer
investment strategy than if the assets merely equalled the liabilities. However,
the extent to which that freedom may be exercised will depend on the actual
level of the free assets relative to the statutory solvency requirements.

Page 8 SA1-18: Asset-liability matching
3 Estimating the investment income in future time

periods
The process of estimating income from the investments is relatively
straightforward. For all types of investment, it is important to make allowance
for the expenses of investment.
Reinvestment rates are also important.
Each of the main asset categories is now considered in turn.
3.1 Fixed-interest securities
Ignoring the possibility of sale and the risk of default, the stream of income and
redemption proceeds from fixed-interest securities is of known amount and term.
Although some gilts have a spread of redemption dates at the option of the government,
these securities are unlikely to form a significant proportion of an insurers portfolio
and should have little practical impact.
Where the risk of default is non-zero, an appropriate allowance should be made

for the possibility of default.
Provided our portfolio of such fixed-interest securities is well diversified, we can make
an allowance by a slight reduction in the income or proceeds. Given that the cumulative
probability of default will increase over time, we might make a simple adjustment of the
following form:
decrease amounts by % in the first year
decrease amounts by 1% in the second year
decrease amounts by 1% in the third year
decrease amounts by 2% in the fourth year, and so on.
Our choice of reduction factor (eg % per year above) could depend on the average
quality of our non-gilt portfolio.
In practice, this type of adjustment is, arguably, spuriously precise.

SA1-23: National healthcare systems Page 27
Purchasing of interventions
Purchasing is the process by which pooled funds are paid to providers in order
to deliver a specified or unspecified set of health interventions. Purchasing can
be performed passively or strategically.
Passive purchasing implies following a predetermined budget or simply paying

bills when presented.
Strategic purchasing involves a continuous search for the best ways to

maximise healthcare system performance by deciding which interventions
should be purchased, how, and from whom. This means actively choosing
interventions in order to achieve the best performance, both for individuals and
the population as a whole, by means of selective contracting and incentive
schemes.
Purchasing uses different instruments for paying providers, including budgeting.

Recently, many countries, including Chile, Hungary, New Zealand and the UK,
have tried to introduce an active purchasing role within their public health
systems.
In fact, in the UK, the various parts of the NHS have taken an active role in purchasing
medical services for many years. The private sector is being used to treat a significant
number of NHS patients. In addition, independent treatment centres have been
established to reduce NHS waiting lists for certain procedures and diagnostic tests
(eg hip and knee replacements, hernia repair and gallbladder and cataract removal).
Many of these centres are privately owned.
6.3 Other considerations in financing
Traditionally, most policy discussions regarding healthcare system financing

centre around the impact of public versus private financing on healthcare
system performance.
The importance of the public financing in healthcare systems was discussed earlier in
this chapter.
For personal healthcare, however, it is not the public-private dichotomy (split)

that is most important in determining health system performance, but the
difference between prepayment and out-of-pocket spending. Thus private
financing, particularly in developing countries, is largely synonymous with
out-of-pocket spending or with contributions to small, voluntary and often highly
fragmented pools. In contrast, public or mandatory private financing (from
general taxation or from contributions to social security) is always associated
with prepayment and large pools.

Page 28 SA1-23: National healthcare systems
Fairness of financial risk protection requires the highest possible degree of

separation between contributions and utilisation. This is particularly so for
interventions that are high cost relative to the households capacity to pay. In
addition to affording protection against having to pay out of pocket and, as a
result, facing barriers to access, prepayment makes it possible to spread the
financial risk among members of a pool.
Healthcare systems throughout the world attempt to spread risk and subsidise
the poor through various combinations of organisational and technical
arrangements. In practice, in the majority of health systems, risk and income
cross-subsidisation occurs via a combination of two approaches: pooling and
government subsidy.
6.4 Funding pressures
OECD Health Data 2012 shows that healthcare spending continues to put
pressure on government budgets.
Unfortunately this report is only available to subscribers, so you wont be able to

download it from the OECD website unless your employer has already subscribed.
In almost all OECD countries total spending on healthcare has been rising faster
than economic growth, pushing the average ratio of healthcare spending to GDP
from 7.8% in 2000 to 9.7% in 2009, although 2010 figures show a slight fall to
9.5%.
The factors pushing healthcare spending up, as noted above, will continue to
keep costs high in the future.
Question 23.11
State three factors that are pushing up healthcare spending.
For example, the use of expensive magnetic resonance imaging (MRI) units more than
doubled between 2000 and 2008. The use of computer tomography (CT) scanners has
also increased. There are concerns that some of these procedures are unnecessary and
many countries are now trying to promote the rational use of expensive medical
technologies.
Together with the economic downturn of recent years, this has led to a sharp
increase in the ratio of healthcare spending to GDP in some countries. For
example, in Ireland the percentage of GDP devoted to healthcare increased from
7.7% in 2007 to 9.5% in 2009, although this fell a little in 2010 to 9.2%.

SA1-23: National healthcare systems Page 29
The United States had the highest spending at 17.6% and Mexico had the lowest at
6.2%. The UK spent 9.6% of GDP on healthcare.
The United States spent around $8,250 per person on healthcare in 2010, which
was considerably higher than the $3,300 per person average across all OECD
countries. The next highest per person amounts (Norway and Switzerland) were
much lower than the United States per person spending, but still some 60%
higher than the OECD average.
It is partly this high level of spending that has encouraged the government in the USA
to try and introduce a revised healthcare bill. The Patient Protection and Affordable
Care Act was signed into law in 2010. The act should ensure higher proportion of
people have insurance. For example, by prohibiting gender or pre-existing conditions
being used to rate policies, reducing excesses on some areas of cover and requiring
employers to offer health insurance.
Governments of most OECD countries meet the majority of the burden of

healthcare costs. The 2012 report shows that the proportion of healthcare
expenditure met by the government has increased or broadly stabilised (at high
levels) in most countries.
The proportion of government expenditure spent on healthcare increased from an

average of 12% in 1990 to 16% in 2008.
Given the urgent need to reduce budget deficits, many OECD governments
continue to have to make difficult choices in order to sustain their healthcare
systems:
curb the growth of public spending on health
cut spending in other areas
raise taxes.

Page 30 SA1-23: National healthcare systems

SA1-24: UK best practice Page 1
Chapter 24
UK best practice
Syllabus objective
(m) Understand areas of best practice in UK health and care provision, including
the ABI guidelines.
0 Introduction
This chapter covers areas of best practice in the provision of health insurance that the
health and care actuary should be aware of. Section 1 covers general areas of best
practice, relating to:
sales
continual monitoring of TCF (treating customers fairly)
product design
data sharing
pricing.
Section 2 covers the ABI guidelines that relate to health insurance products in quite
some detail.
It may be useful to keep abreast of current developments in these areas. Keeping an eye
on the websites and periodicals listed in the Further Reading section in Chapter 1 will
help you to do this.

Page 2 SA1-24: UK best practice
1 General areas of best practice
1.1 Sales
As mentioned in Chapter 11, companies need to comply with sales regulation,

including:
Requirements on firms relating to the sales process, ie if the firm is giving
advice, a policy is recommended that is adequate for the customers
needs.
Firm status disclosure, whereby the firm must provide information to its
customers on the service that it is providing in an understandable format.
Proposals on fair treatment of consumers including, for example, the
FCAs views on whether commission should be disclosed, an unfair
inducements rule and cancellation periods.
Product information measures to ensure that customers get key product
information at a time when it can influence their decision making.
Claims handling standards to require firms to deal with claims fairly and
promptly.
Training and competence regime for individuals selling and managing
insurance contracts
Complaint proposals to require firms to meet certain standards when
handling complaints and to provide customers with access to the
Financial Ombudsman Service for regulated activities.
You will recall from Chapter 11 that the sales and marketing regulations for protection
and general insurance business are contained in the regulators Insurance Conduct of
Business sourcebook (ICOBS).
There are stronger regulations for the selling of LTCI. These fall under the same
regulations as investment products, whether or not there they have an investment
element. Details are in the regulators Conduct of Business sourcebook (COBS).
Both ICOBS and COBS can be accessed via the PRA/FCA websites. The details of the
regulations are not examinable, but they do provide useful background information.

1.2 Continual monitoring of TCF
The requirement to treat customers fairly must also be borne in mind. Chapter 13 gives
details of these requirements.
Question 24.1
Outline the six consumer outcomes that the FCA expects to achieve through treating
customers fairly.
The regulatory requirement to treat customers fairly (see Chapter 14, Section 3)
also reinforces the need for continual monitoring in the relevant areas, which
include the sales process, the claims process and the overall management of the
customer relationship.
Policyholders form expectations about the benefits to which they are entitled
under their health and care insurance policies and the level of service standards
that they will receive. These expectations (referred to historically as
policyholders reasonable expectations, sometimes shortened to PRE) arise
mainly from the sales process, ie from what the individual was told to encourage
him / her to buy. Additionally, insurance company advertising may have
influenced expectations. Finally, any regular communications from the insurer
will further define what the policyholder expects from the insurance contract.
The company has a duty of care to analyse the policyholders reasonable

expectations and to correct matters where there is disparity between belief and
reality.
As mentioned above, this is all part of an insurers responsibilities under the regulators
treating customers fairly initiative. See Chapter 14 for more details on this.
Question 24.2
Suggest ways that a health insurer can monitor the expectations of policyholders to
ensure that customers are being treated fairly (ie the information it should collect and
how it should be analysed).

1.3 Product design / standardisation of definitions
Variation in product design is a feature of a competitive marketplace and hence

there are at least as many variations in products as there are players. However,
the growing importance of critical illness business in the 1990s to long-term
insurers resulted in the establishment of a working party drawn from the bigger
providers, their reinsurers and broker representatives, to consider the
standardisation of disease definitions. The objective was to make the contracts
easier to compare, largely on price, and thus easier to sell.
Ultimately, the ABI (Association of British Insurers) took over responsibility for
the running of this committee. It was successful in obtaining widespread
agreement to a single set of definitions, although the effect that this had on the
subsequent volume of sales is impossible to gauge.
This has meant that cover offered by different insurers has become more similar in
recent years. The fact that comparisons are now easier has received a favourable
response from consumer groups (such as Which?), and also from brokers, as this makes
it easier to offer best advice.
In coming up with the set of definitions, the parties involved have kept in mind the
importance of having clear, unambiguous policy wording. It is hoped that this will help
to reduce the number of disputed cases when claims arise on these policies.
This industry-wide agreed set of common definitions has now been incorporated into
the ABI Statement of Best Practice for critical illness cover see Section 2.3 below. It
continues to be updated on a regular basis.
There have been some similar initiatives in the other healthcare product lines.
The IP insurance industry and the PMI industry have also agreed a set of common
definitions for many of the terms used in policies (see Sections 2.2 and 2.5 below).
More details on the ABI guidelines are given in Section 2.
1.4 Data sharing
Industry healthcare data is collected by the Continuous Mortality Investigation

(CMI), supported by the Institute and Faculty of Actuaries, for income protection
and critical illness insurance products. The objective is to compile generic
statistics that offices may use for pricing and reserving.

For critical illness insurance, to date there have been too few claims to issue a table of
claim diagnosis rates that is fully credible at all ages of interest. However, in Working
Paper 50 the CMI has published separate tables for males and females, smokers and
non-smokers split by policy duration.
Data on IP insurance is more extensive and the CMI produce regular reports on both
individual and group IP cover experience. The results are of the form of inception and
termination rates, split by several factors, such as deferred period and occupation class.
The CMI also published data that could be used to support the use of gender as
a factor in the assessment of insurance risks, although (as explained in
Chapter 14) insurers in the EU have been unable to differentiate consumer prices
by gender for new business written from 21 December 2012.
Additionally, the ABI collects data from its members on policies, premiums and
claims, which it compiles and publishes in quarterly and annual bulletins. The
purpose here is to highlight market trends.
Data collection is also performed by some reinsurers on an annual basis to

illustrate other features of the health and care insurance market.
For example, for critical illness insurance, some reinsurers (eg Swiss Re) produce
figures (separate to the ABIs) on new business sales and proportions of claims split by
cause.
1.5 Pricing
There is little to connect the pricing activity of competing insurers, except

possibly the support of a limited number of reinsurers and the reliance on similar
CMI data.
However, the level of competitors rates will be an important consideration for an

insurer in determining the final premiums to charge.

2 ABI guidelines
2.1 Purpose and scope
The insurance industry has developed various guidelines for the selling of health
products. These are known as Statements of Best Practice.
The intention behind these guidelines is that policy terms / conditions should be
as robust as possible in differentiating between what is, and is not, covered in
order to:
create a clear expectation of the scope and limitations of the cover
allow valid claims to be paid promptly
minimise the number of disputed claims to avoid disappointment.
The Statements as issued apply to individual (not group) protection policies.

However, other bodies (eg Group Risk Development (GRiD)) have developed
similar best practice recommendations for group protection products.
In fact, certain parts of the current Statement of Best Practice for CI insurance do apply
to group CI insurers (see Section 2.3). The Statement of Best Practice for PMI applies
to both individual and group PMI insurers (see Section 2.5).
GRiD is a forum of insurers, reinsurers and intermediaries in the group risk insurance
market ie group life, IP and CI insurances. Its key aim is to promote the development
of this type of insurance.
There are separate Statements of Best Practice for each of IP insurance, CI insurance,
LTCI and PMI. They give guidance on what information should be given to
prospective customers, and the layout and wording to be used in this information. For
example, this information might be contained in whats known as a Key Features
Document. The Statement of Best Practice for IP insurance also contains Guidance
Notes for certain policy terms and conditions.
The Statements are mandatory for ABI members and supplementary to any relevant
regulatory or legal requirements, such as those contained in ICOBS. However, where
the Statements and regulation conflict, the latter will overrule.
All Statements of Best Practice, the Key Features Documents and the Guidance
Notes are reviewed regularly to ensure that they continue to reflect current
legislative and regulatory requirements and market practice.

Full details of these Statements are available on the ABIs website, www.abi.org.uk.
However, these can be tricky to find, particularly as some of the Statements are updated
regularly. At time of writing (May 2013) we found the latest Statements by searching
for the name of the document on the ABIs website. You may also find some of the
Statements via the particular product from the Insurance and Savings menu.
These provide useful background information, although the following sub-sections

outline the important details.
2.2 ABI Statement of Best Practice income protection insurance

(January 2005)
The following contains a brief overview of the contents of this document.
Designed for consumers
The Statement of Best Practice falls under the ABI Life Insurance (Non
Investment Business) Selling Code of Practice. It was developed by the ABIs
Income Protection Working Party, which produced their original proposals
following research to discover what consumers would find most useful as an aid
to understanding and comparing IP products. These proposals were validated
by further consumer research and were subject to wide consultation across the
industry and with key external partners such as the OFT (Office of Fair Trading),
the Financial Ombudsman Service (FOS), and others.
Contents of Statement
The Statement covers the following:

the description of Income Protection Cover in a Key Features Document
Guidance Notes for certain policy terms and conditions
Generic Terms.
Key Features Document
Under ICOBS, insurers can decide whether to give a Policy Summary statement (as
detailed in ICOBS 6) or a full Key Features Document (KFD).
The Statement of Best Practice gives a model KFD part of which, including the layout
of the document, is mandatory on insurers that choose this approach. It requires that the
cover is adequately and clearly described to customers. This is to be done by providing
clear answers to a number of pre-determined questions and headings, such as When
will my plan pay out?.

Guidance Notes for certain policy terms and conditions
1. Definition of Incapacity Own Occupation

2. Definition of Incapacity Any Occupation
3. Limitation of Benefit
4. Proportionate / Rehabilitation Benefits
5. Change of Occupation
6. Claims Notification Period
7. Deferred Period
8. Waiver of Premium
9. Pregnancy Clause
10. Linked Claims
Note that rather than there being a mandatory set of common definitions, only guidance
is given for the above terms. For each term, the Guidance Note describes its purpose,
typical policy wording, and obligations on the insurer. It also gives guidance as to how
to apply the term, but it is recognised that practice will vary between insurers.
Generic Terms
Where any of the following terms are used, the meanings given in the Statement should
be used and other terms should not be used in their place.
1. Deferred Period
The meaning of this term is: The period of incapacity before any benefit is
paid. Note that terms such as waiting period and elimination period should
not be used.
2. Incapacity
This term should be used rather than disability in the literature for example
in the definition of deferred period (above).
3. Generic Product Name Income Protection or Income Protection

Cover
One of these terms must be used to describe the cover ie it should not be
referred to as PHI anymore!

4. Model Exclusions:
Aviation
Criminal Acts
Drug Abuse
Hazardous Sports and Pastimes
HIV / AIDS
Self-inflicted Injury
War & Civil Commotion
Model wording is given for each of these exclusions.
2.3 ABI Statement of Best Practice critical illness cover (February

2011)
This Statement of Best Practice for Critical Illness Cover aims to help protect
consumers and help them understand and compare critical illness policies
through the following:
having a common format for the way critical illness cover is described to
potential buyers at the point of purchase
the use of common Generic Terms
the use of Model Wordings for critical illnesses and exclusions that meet
appropriate minimum standards.
The latter two bullet points apply to group CI cover, as well as individual business, but
all the other provisions of the Statement only apply to individual CI insurance. Each of
these three points is now described in more detail below.
Common format for describing CI cover
Critical illness cover means insurance that pays out on meeting the policy
definition of a specified critical illness and where cancer, heart attack and stroke
are included.
We shall see below that cancer, heart attack and stroke all need to have specific
definitions.

Critical illness cover is to be described in a Policy Summary document carrying

the regulatory Key Facts logo or a Key Features document, depending on the
underlying product type, for example, whether it is an investment or a pure
protection product for the purposes of regulation. This is intended to allow
consumers to compare the critical illness cover of different insurers, accepting
that the underlying products may be different.
Remember that pure protection products are subject to the terms of ICOBS. This only
requires that potential customers are given a policy summary document. However,
products with an investment element come under COBS, which requires greater
disclosure in whats known as a Key Features document.
Examples of both types of document are given in the Statement. These are referred to
generically as the product information. This should be given to potential customers
interested in purchasing CI insurance at the earliest opportunity.
Question 24.3
In 2009, the health and care insurer BHSF launched an innovative product providing
critical illness cover for cancer only. It offers three levels of cover, depending on the
severity of the cancer.
What is incorrect about the above statement?
Generic terms
Where any of the following generic terms are used they should have a specific meaning,
as shown in the Statement, and other terms should not be used in their place. For
example, the assessment period is defined as:
The period during which we will assess a condition before we make a decision on
whether or not to accept a claim. The assessment period will typically start on receipt
of the claim and will not normally be longer than 12 months, as long as we have all the
evidence we need. Also, the assessment period should only apply to claims for the
conditions which must be permanent for cover to apply.
The Generic Terms and associated descriptions are intended to establish the
context in which each term should be used. Insurers may use them as
definitions or as part of a glossary of terms.

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What changes have been made to the syllabus objectives and core reading?

What changes have been made to the syllabus objectives and core reading?

What is the purpose of the ABI Statement of Best Practice for Critical Illness Cover?

What is the purpose of the ABI Statement of Best Practice for Critical Illness Cover?

SA1: CMP Upgrade 2013/14 Page 1

This CMP Upgrade contains:

all major changes to the Syllabus objectives and Core Reading.

The Actuarial Education Company IFE: 2014 Examinations

1 Changes to the Syllabus objectives and Core Reading

1.1 Syllabus objectives

Objective (a) has been amended to read:

Objective (c) has been amended to read:

Objective (f) has been amended to read:

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1.2 Core Reading

This section contains all non-trivial changes to the Core Reading.

Long-term care a review of global funding models

Demystifying the risk margin: theory, practice and regulation.

ERM for health insurance from an actuarial perspective.

The first sentence of Section 1.2 has been amended to read:

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The third paragraph of Core Reading has been amended to read:

In early 2013, the UK government announced an intention to adopt the principles

Replacement pages are attached.

The degree of anti-selection must be costed as well as controlled.

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The first sentence on this page has been amended to read:

Fraudulent features of insurance (deliberate non-disclosure, falsifying the nature

The section headed Changes to Incapacity Benefit has been deleted.

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Section 2.4, Accuracy of costing, has been deleted.

the underperformance and lack of transparency of with-profit funds

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The final paragraph on this page has been amended to read:

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Most UK PMI insurers require customers to obtain authorisation prior to

it can result in an increase in PMI claims as people live longer but

The section headed Retiring younger has been deleted.

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Contracts written under long-term business regulations must have a minimum

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The final paragraph on this page has been amended to read:

Inflation on claims and premiums will be a function of the product design, eg if

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All information included in Chapters 12 and 13 is current as at the time of writing

The bullet point list has been amended to read:

increase the level of harmonisation of solvency regulation across Europe

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The final paragraph has been amended to read:

The first paragraph of Core Reading has been amended to read:

Membership of the FOS is compulsory for all regulated UK financial services

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The final sentence has been amended to read:

Annual levy limits are specified in the regulatory Handbooks.

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The concept is of most relevance to long term insurance business.

The fourth paragraph in Section 5.2 has been amended to read:

The third paragraph in Section 3.1 has been amended to read:

Under proportional reinsurance, the solvency requirements for a particular line