Boot Camp: Calcs B

Intro

This Boot Camp article covers a few more easy versions of the most important types of calculation problems. It is a follow-on from the Calcs A boot camp article. We're saving the more difficult problems for the Combat Training articles. I bet you can't wait!

Accounting for Bonds

This paper, CIA.Accting, is dense, hard to read, and appears on almost every exam. Luckily, the exam questions are repetetive. You need to understand how the 3 different classes of bonds are dealt with from an accounting standpoint. The 3 bond classes are: (HTM, AFS, HFT) = (Held to Maturity, Available for Sale, Held for Trading)

Warning: The minutiae in the next several paragraphs is going to be mind-numbing. I'm talking boring beyond belief. But it's 1 of the 4 standard question types from the CIA accounting paper, so let's just get it out of the way in boot camp. (You'll have a chance to review it in the main part of your combat training.)

There are 6 tables from Section 3 of the paper that you absolutely, positively HAVE TO UNDERSTAND!!! But I don't like the way these tables are laid out, so I created my own tables (see below). A typical exam question might be as follows:

If market rates go up (or down), what effect does a HTM bond have on the NI, OCI, Equity. (NI = Net Income, OCI = Other Comprehensive Income)

• This is the easiest case because HTM bonds have no effect on NI, OCI, Equity. If you're asked about AFS or HFT bonds, you have to do a little more work to come up with the answer. That's were these tables come in. The answer to the question above can be found in the first 2 rows of this table. ("--" means "no effect")

market rate	bond type	A + L	NI	OCI	Equity
up	HTM		--	--	--
down	HTM		--	--	--
up	AFS		up	down	depends
down	AFS		down	up	depends
up	HFT		depends	--	depends
down	HFT		depends	--	depends

If the question had asked about AFS or HFT bonds, then just find the appropriate row in the table and read across to see the effect on NI, OCI, Equity. Of course, this isn't enough - you must also be able to explain the reasoning behind these entries. (Note that the column for A + L or Assets + Liabilities is intentionally blank. You could insert the appropriate entries, but they aren't relevant to the reasoning.) To explain the reasoning behind the above table, we need 2 more similar tables, 1 for the effect that Assets have on the balance sheet items, and 1 for the effect of the Liabilities:

market rate	bond type	Assets	NI	OCI	Equity
up	HTM		--	--	--
down	HTM		--	--	--
up	AFS	down	--	down	down
down	AFS	up	--	up	up
up	HFT	down	down	--	down
down	HFT	up	up	--	up

market rate	bond type	Liabilities	NI	OCI	Equity
up	HTM		--	--	--
down	HTM		--	--	--
up	AFS	down	up	--	up
down	AFS	up	down	--	down
up	HFT	down	up	--	up
down	HFT	up	down	--	down

Let's use the tables to answer this question:

If market rates go up , what effect does an AFS bond have on the NI, OCI, Equity.

Locate the up/AFS row in the Asset table and observe that (NI, OCI, Equity) = (--, down, down) Locate the up/AFS row in the Liability table and observe that (NI, OCI, Equity) = (up, --, up)

Then "sum" these vectors to get (up, down, depends).

(Note that down + up = depends because we don't know the relative magnitude of the down and the up.)

You don't have to memorize these tables.

• The way to learn this is to practice thinking through the reasoning behind each row in the Asset and Liability tables. It isn't hard, but during the exam, it's easy to get ups and downs confused if you're rushing. Remember, as the Brits do: Keep calm and carry on...

See (2016.Fall #13d) for a classic example of this type of question.

Here are few points to keep in mind:

1. The HTM rows are easy because these bonds are not affected by changes in market rates.
2. Market rates & discount rates always move in the same direction.
3. If market rates go up then asset & liability values go down (and vice versa.)
4. Only AFS Assets affect OCI (Other Comprehensive Income).

mini BattleQuiz You must be logged in or this will not work.

Premium Liabilities: DPAE/PDR (Easy Version)

This is a simplified version of the standard DPAE/PDR calculation. The full version is explained in the main BattleWiki article. CIA.PrLiabs.

Calculate the max allowable DPAE and the premium deficiency, if any:

year	2016
net UPR	69,580
FutRe (Future Reinsurance Costs)	4,260

maintenance	4,175
UEComm (Unearned Commission)	1,045

Basic Formulas:

• We're asked to calculate DPAE, so let's start with the basic formula: (All quantities below are net unless it specifically says gross or ceded.)

DPAE = UPR - PolLiabs(UPR) + UEComm

• Notice that we already know 2 of the 3 items in this formula: UPR = 69,580 and UEComm = 1,045. Great start!

• Since the missing piece in the above formula is PolLiabs(UPR), let's write down the formula for that:

PolLiabs(UPR) = APV + FutRe + maint

• Again, we know 2 of the 3 items in this formula: FutRe = 4,260 and maint = 4,175. We're really cooking!

• But the APV is the hard part. This is what makes the problem difficult, but since this is supposed to be the easy version, I'm going to just tell you that APV = 70,981.

Putting it all together:

• Now it's just a matter of working your way back up. Using APV = 70,981 we calculate:
  • PolLiabs(UPR) = 70,981 + 4,260 + 4,175 = 79,416
• Then:
  • DPAE = 69,580 - 79,416 + 1,045 = -8,791

But since the result is negative, there is no DPAE. Rather we have a premium deficiency reserve of 8,791.

mini BattleQuiz You must be logged in or this will not work.

MSA Ratios

MSA stands for Market Security Analysis. They are a Canadian-owned analytics firm focused on the Canadian insurance industry. In case you're curious, their website is located here

There are 4 broad questions from this reading that you may be asked: (In practice, however, most of these ratios do not appear on the exam.)

• What are the names of the MSA ratios?
• What are the acceptable ranges?
• What are the formulas for each ratio?
• What do they mean?

There are 18 MSA ratios but let's look at just the first 4.

Regulatory Earning Warning Ratios:

Name of Ratio	Acceptable Range	Formula	Meaning
MCT (Minimum Capital Test)	> 150%	CapAv / minCapReq	measure of capital adequacy
ROE (Return on Equity)	> 5.4%	( NI.preTax - TotTax ) / Eq	sustainability of earnings
ROR (Return on Revenue)	> 6.2%	( U/W.Inc - CapGains + InvInc + IncFrmSubs ) / GWP	income relative to revenue-generating capacity
ROA (Return on Assets, after tax)	> 2.6%	( NI.preTax - TotTax ) / (2-yr avg of assets)	efficiency measure for income-generation

The MCT ratio is discussed at length in the paper OSFI.MCT. The BattleQuiz below contains easy versions of calculating the other 3. Note that when you're asked to calculate an MSA ratio, you're also always asked to use that ratio to comment on the financial health of the company. Unfortunately, that means you have to memorize the acceptable ranges.

mini BattleQuiz You must be logged in or this will not work.

Discount Rate

The must-know list from this paper, CIA.Discnt, is...drum roll...

What are the considerations when selecting a discount rate (or expected investment return rate)?

This question has been asked at least 5 times on recent exams!! (See BattleHack #1 on the BattlePlan page for other top questions.)

The answer is: MARY-(IE)-CapG

• M: METHODS: for asset valuation & reporting investment income
• A: ALLOCATION: of assets & investment income by LOB
• R: RETURN: on assets @ B/S date
• Y: YIELD: on assets acquired after B/S date
• (IE): INVESTMENT EXPENSES & losses from default
• CapG: Capital G/L: on assets sold after B/S date

Memorize this NOW!! (They don't normally ask you for all 6, usually 2-4, but if you have a good memory trick, it isn't much harder to learn all 6.)

Calculating a Discount Rate

• This is a calculation problem that has come up twice: (2016.Spring #13i), (2015.Spring #20a), sometimes as part of a larger problem. (It's actually pretty easy.)

• Let's look at the (2016.Spring) problem. It's a long, LONG problem, but the first step is to calculate the discount rate. For this, we need the last 3 rows of the 2nd table, the table on page 14 of the exam.

Description	Bond #1	Bond #2
annual effective yield	2.31%	3.23%
modified duration	0.972	1.888
market value	$10,030	$10,060

• Calculate the discount rate as follows:

discount rate = a weighted average of the annual effective yields with weights = (duration) x (market value)

• weight for Bond #1 = 0.972 x 10,030 = 9,749
• weight for Bond #2 = 1.888 x 10,060 = 18,993

discount rate = [ (2.31% x 9,749) + (3.23% x 18,993) ] / ( 9,749 + 18,993) = 2.92%

Note that in the mini BattleQuiz below, some of the BattleCards are actually old exam questions. Click E in the left-hand column to open a PDF with the full exam question and answer.

mini BattleQuiz You must be logged in or this will not work.

Summary

The Full BattleQuiz shows the BattleCards for previous mini BattleQuizzes all at the same time.

Full BattleQuiz You must be logged in or this will not work.

• Back to BootCamp