16. (7 points) You are given the following information for a GIC-type product issued by a
life insurance company.
•The corporate tax rate is 35%.
•The current estimate of the company’s credit risk premium is 1.5%.
Liability information:
Initial deposit $1000
Maturity date 3 years
Credited rate 4.2%
Interest payments paid annually
Valuation interest rate equal to credited rate
Asset information:
Allocated capital 8.0% of statutory reserves
Risk- free rate 3.0%
Expected asset portfolio yield, before
expected defaults 6.3%
Assume no expenses and that the tax adjustment is calculated without risk premiums.
(a) (2 points) Describe the steps used in determining the company’s credit risk
premium to be used with the direct method of performing a fair valuation of
liabilities. For each step, indicate the basis for determining appropriate
assumptions.
(b) (5 points) Determine the fair value of the liability at time 0. Use the direct
method.
COURSE 8:Fall 2002 -17- GO ON TO NEXT PAGE
Investment
Afternoon Session
17. (6 points) Gedda Life’s SPDA product has a surrender charge that starts at 6% and
declines 1% per year for 6 years. The minimum guaranteed credited rate is 4%. The
SPDA block is currently supported by the following portfolio of assets, with maturities
ranging from 2 to 10 years:
10% government bonds
50% corporate bonds and private placements
15% mortgage-backed securities
25% commercial mortgages
Explain how each of the following derivatives can be used as part of the ALM strategy
for this line and describe the risks being hedged.
(a) Interest Rate Cap
(b) Spread Lock
(c) Yield Curve Swap
(d) Interest Rate Floor
(e) Prepayment Cap
COURSE 8: Fall 2002 -18- STOP
Investment
Afternoon Session
18. (4 points) Your company’s CFO is considering pricing interest-sensitive insurance
liabilities using the required spread on assets (RSA) generated by simulating interest rate
paths from an arbitrage- free stochastic interest rate model.
(a) Compare the key characteristics of MBS securities and insurance company SPDA
contracts that support the use of similar pricing and valuation methodologies.
(b) Explain under what circumstances the option adjusted duration (OAD) must equal
the mean term of liabilities (MTL) for an SPDA product.
(c) Predict the impact of each of the following cha nges taken separately on the RSA,
OAD and MTL of a typical SPDA product.
(i) Increasing the credited rate at issue and reset by 50 basis points.
(ii) Increasing the base level of surrenders that are not related to the level of
interest rates.
(iii) Increasing the level of surrenders that are related to the level of interest
rates.
(iv) Increasing the rate credited by all competing insurance companies by 50
basis points.
**END OF EXAMINATION**

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