CAS Exam 7 Spring 2018, Question 1
Study guide: Exam 7
ABC Insurance is a commercial insurance company with complex agent/broker distribution channels. ABC Insurance is exploring the acquisition of Target X to increase its distribution flexibility.
Target X is an innovative mobile app based insurer that allows small business owners to customize and purchase general liability and property policies from their cellphones without the aid of an agent/broker.
Target X has consistently achieved a 15% ROE and 6% growth rate. Assume the risk free rate is 4%, the equity market risk premium is 5%, and company \beta is 1.10.
Target X has provided ABC Insurance with its abbreviated balance sheet as of December 31, 2017:
| Assets ($000) | Liabilities ($000) | ||
|---|---|---|---|
| Cash | 17,250 | Unpaid Claims | 5,000 |
| Investments | 3,250 | Unpaid Claims Expenses | 1,250 |
| Intangible Assets | 2,000 | Unearned Premium Reserves | 8,500 |
| All Other Assets | 1,000 | All Other Liabilities | 2,750 |
ABC Insurance has obtained Price-Book Value multiples for similar, recent transactions across the industry:
| Acquisition | ROE | Growth Rate | Discount Rate | Price-Book Value |
|---|---|---|---|---|
| #1 | 15% | 6% | 9.5% | 1.00 |
| #2 | 10% | 3% | 9.5% | 1.25 |
| #3 | 15% | 6% | 13.9% | 1.50 |
| #4 | 15% | 6% | 9.5% | 1.70 |
| #5 | 15% | 6% | 2.3% | 1.75 |
| #6 | 5% | -2% | 2.3% | 1.90 |
Target X also provided ABC Insurance with the following data from its most recent unpaid claims analysis, which utilized an over-dispersed Poisson (ODP) bootstrap model with five parameters:
ODP Bootstrap Model Fitted Incremental Paid Claims ($000) as of (months):
| Accident Year | 12 | 24 | 36 |
|---|---|---|---|
| 2015 | 2,703 | 1,297 | 1,000 |
| 2016 | 3,547 | 1,703 | |
| 2017 | 4,250 |
Unscaled Pearson Residuals as of (months):
| Accident Year | 12 | 24 | 36 |
|---|---|---|---|
| 2015 | 0.91 | -1.31 | 0 |
| 2016 | -0.79 | 1.15 | |
| 2017 | 0 |
Standardized Pearson Residuals as of (months):
| Accident Year | 12 | 24 | 36 |
|---|---|---|---|
| 2015 | 2.12 | -2.12 | 0 |
| 2016 | -2.12 | 2.12 | |
| 2017 | 0 |
Random Sample of Standardized Pearson Residuals as of (months):
| Accident Year | 12 | 24 | 36 |
|---|---|---|---|
| 2015 | 2.12 | 2.12 | -2.12 |
| 2016 | -2.12 | -2.12 | |
| 2017 | -2.12 |
Part a (1 point)
A type of strategic risk posed by the acquisition above is project risk - the risk of entering an acquisition without contemplating integration costs, timelines, reserve deficiencies, etc. Describe two additional types of strategic risk specific to the acquisition above.
Part b (1 point)
A primary cause of property & casualty insurer insolvency is deficient loss reserves. Describe two additional potential sources of insolvency specific to the acquisition above.
Part c (1.25 points)
Create a reasonable range of firm values for Target X using the Price-Book Value transaction multiples.
Part d (2 points)
Calculate the mean of the accident year 2017 incremental paid between 24 and 36 months for the given random sample of standardized Pearson residuals.
Part e (1 point)
Calculate the variance of the accident year 2017 incremental paid between 24 and 36 months for the given random sample of standardized Pearson residuals.
Part f (0.5 points)
Describe how to incorporate process variance in the accident year 2017 incremental paid between 24 and 36 months for the given random sample of standardized Pearson residuals.
Part g (0.5 points)
Assume Target X's claims settlement rate will change after the acquisition. Briefly describe how this may impact the process risk and parameter risk of Target X's unpaid claims model.
Part h (0.25 points)
Assume Target X's actuarial department will operate independently after the acquisition. Briefly describe the internal systemic risk correlation between Target X and ABC Insurance.
Answer this question and see the worked solution