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Nicole Seaman

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Learning objectives: Distinguish between mortality risk and longevity risk and describe how to hedge these risks. Evaluate the capital requirements for life insurance and property-casualty insurance companies. Compare the guaranty system and the regulatory requirements for insurance companies with those for banks. Describe a defined benefit plan and a defined contribution plan for a pension fund and explain the differences between them.

Questions:

704.1. A defined benefit pension fund is 50.0% invested in equities and 50.0% invested in bonds. If we assume the simplest possible balance sheet, which is MOST LIKELY to be the net effect of a scenario where equities are approximately flat but interest increase by 100 basis points? Please note this is a variation based on Hull's EOC Question 3.18, so it makes simplifying assumings such as (i) the rate increase is a parallel shift of both short- and long-term interest rates, (ii) durations are not managed, and (iii) the fund is not hedged.

a. Improvement in funded status because present value of liabilities decreases more than assets decrease
b. Improvement in funded status because present value of assets increases more than liabilities increase
c. Deterioration in funded status because present value of liabilities increases more than assets increase
d. Deterioration in funded status because present value of liabilities decreases more than assets decrease


704.2. In regard to these statements about insurance companies, each is generally true EXCEPT which is false?

a. Property-casualty insurance companies hold more capital than life insurance companies
b. Annuity contracts are exposed to longevity risk, but life insurance contracts are exposed to mortality risk
c. Basel II and Basel III determine the regulatory capital requirements for life insurance and property-casualty insurance companies in both the U.S. and European Union (EU)
d. In the U.S., the guaranty system for banks than for insurance companies: there is a permanent federal fund for banks, but there is insurance companies do not have a permanent fund


704.3. Suppose the following assumptions for a certain defined benefit pension plan:
  • Employees work for 35.0 years earning wages that increase with inflation.
  • They retire with a pension equal to 70.0% of their final salary.
  • This pension also increases with inflation. The pension is received for 18.0 years.
  • The pension fund's income is invested in bonds that earn the inflation rate.
Which of the following is nearest to an estimate of the percentage of an employee's salary that must be contributed to the pension plan if it is to remain solvent? Hint: Do all calculations in real rather than nominal dollars. (Please note this is based on Hull's EOC Question 3.15)

a. 9.0%
b. 18.0%
c. 36.0%
d. 72.0%

Answers here:
 
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