9. (4 points) Martha, the CEO of a large life insurer, has contacted you, a consulting
actuary, with concerns regarding fair value accounting.
(a) Describe the differences between fair value and entity specific valuations.
(b) Explain the impact that a downgrade in the firm’s credit standing would have
under both valuation methodologies.
(c) Martha notes that the market value of many of the company’s liabilities is not
available. Describe a fair value accounting methodology that can be used for
valuation purposes under these circumstances and the principles underlying this
methodology.
COURSE 8: Fall 2003 - 8 - GO ON TO NEXT PAGE
Finance
Afternoon Session
10. (14 points) “Hemlock Inc. poisons investors as it files Chapter 11 bankruptcy - $2
billion of corporate bond defaults – stock is delisted.”
That was the headline that three business people faced as they scanned the business
section of the morning paper.
Dominic is a Portfolio Manager for the Parthenon Investment Grade Bond Fund, a fund
that attracts investments from smaller insurance companies. Dominic had relied on
private sector watchdogs when he purchased newly issued Hemlock Inc. debt for the fund
just six months ago. At that time, and as recently as last week, various NRSROs had
rated Hemlock BBB or its equivalent.
Isabel is the head of the Investment Committee for Mt. Olympus Insurance Company
(MOIC), Parthenon’s largest investor. MOIC’s liabilities consist of 75% whole life
insurance and 25% fixed deferred annuities. In addition to a significant investment in
Parthenon, MOIC has additional Hemlock debt and a small stock position in Hemlock.
As a result, MOIC had greater exposure to Hemlock than its peers. MOIC is currently
rated B++ by A.M. Best. A review meeting with A.M. Best is scheduled for later in the
week due to the arrival of a new CEO at MOIC and dwindling life insurance sales.
Nicholas, the Chief Actuary for MOIC, chairs the committee that meets with and
responds to requests by the insurance rating agencies. He received a phone call this
morning from the MOIC analyst at Standard & Poor’s, who asked for a meeting with the
MOIC committee next week to discuss the impact of the Hemlock bankruptcy.
(a) (6 points) Dominic had a voice mail from Isabel upon arrival at his desk. She
demands to know how his fund could be holding such a large position in a
company that has gone bankrupt.
Formulate a response to Isabel that includes the following:
(i) Explain what a rating issued by an NRSRO means.
(ii) Explain how an NRSRO collects and uses information to arrive at a rating.
(iii) Describe the shortcomings of NRSROs that could explain how Hemlock
was rated investment grade at the time of its default.
(iv) Describe attempts by NRSROs to mitigate these shortcomings.
(b) (4 points) Nicholas grills Isabel on her conversation with Dominic before racing
upstairs to brief the new CEO on the upcoming meeting with A.M. Best.
(i) Explain how A.M. Best arrives at a company rating.
(ii) Suggest steps that MOIC can take to manage the ratings process with
A.M. Best.
COURSE 8: Fall 2003 - 9 - GO ON TO NEXT PAGE
Finance
Afternoon Session
10. Continued
(iii) Predict the action that A.M. Best will take with respect to MOIC’s rating
and the basis for that action.
(iv) Predict possible ramifications of A.M. Best’s action.
(c) (4 points) The new CEO’s bonus is partially dependent on maintaining or
improving MOIC’s ratings and partially dependent on revamping MOIC’s
dwindling life insurance sales, which are down 30% from three years ago.
Focusing on the upcoming Standard & Poor’s meeting, he asks Nicholas to
determine the impact of recent events.
You are given the following tables of information regarding MOIC, updated to
reflect the Hemlock event.
ASSET % OF PORTFOLIO
Cash 5%
U.S. government securities 15%
NAIC 1 – public corporate bonds 25%
NAIC 2 non-144(a) private placements 30%
Non-investment grade bonds 5%
Common stock 20%
YEAR ANNUAL EARNINGS
ADEQUACY RATIO
2002 170%
2001 190%
2000 185%
1999 200%
1998 225%
(i) Describe the impact of the Hemlock event on MOIC under the Standard &
Poor’s Capital Adequacy model.
(ii) Describe how Standard & Poor’s would view MOIC’s liquidity.
(iii) Calculate the current weighted average Earnings Adequacy Ratio and
comment on the prospects for 2003’s Earnings Adequacy Ratio. Show
your work.
COURSE 8: Fall 2003 - 10 - GO ON TO NEXT PAGE
Finance
Afternoon Session

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