11. (8 points) You are the pricing actuary for a multi-national reinsurance company, ABC
Re. WXY Life has approached you regarding a transaction that wo uld efficiently utilize
WXY Life’s expiring tax loss carry forwards (TLCF).
Note the following:
•WXY Life is rated BBB- by a well known credit rating agency.
•None of WXY Life’s existing business is currently reinsured.
•Local regulations prohibit WXY Life from taking a reserve credit for reinsurance.
•ABC Re does not currently have a relationship with WXY Life.
Below is WXY Life’s projected statutory income:
WXY Life’s Projected Statutory Income
Year Pre-tax Statutory Income Expiring TLCF
2003 -2 10
2004 2
2005 4
2006 5
2007 6
2008 8
2009 8
2010 8
2011 8
2012 8
You have decided to propose a modified coinsurance structure effective December 31,
2003 with the following features:
•Retention equals 25% of all existing business.
•The risk charge equals 4% of beginning of year Outstanding Surplus Account (OSA).
•The modified coinsurance interest rate equals LIBOR + 3%.
•WXY Life can recapture the block of business once the OSA balance reaches zero.
•The initial reinsurance allowance will efficiently use the expiring TLCF.
(a) (5 points) Assume all reinsurance accounts are settled at the end of each calendar
year and LIBOR equals 4% throughout the projection period. Based on the above
projection, determine when WXY Life can recapture the block of business. Show
your work.
COURSE 8: Fall 2003 - 11 - GO ON TO NEXT PAGE
Finance
Afternoon Session
11. Continued
(b) (2 points) Comment on the appropriateness of the level of the risk charge being
offered by ABC Re.
(c) (1 point) Identify the conditions that should be included in this financial
reinsurance treaty in order to gain state regulator acceptance.
12. (5 points) Spencer Life is a medium-sized life insurance corporation with approximately
$100 million in assets under management. The Chief Investment Officer has asked you
to evaluate a tax-structured deal offered by an investment broker. The following details
have been provided:
•Proceeds of the investment are given to the Federal Housing Corporation, a
government-sponsored corporation that builds and rents low-income housing.
•The investment pays a quarterly coupon of LIBOR + 100 basis points.
•50% of the interest income from the investment is deductible for federal tax purposes.
•Alternative investments that are fully taxable and have similar credit risk currently
yield 125 basis points over LIBOR.
•The minimum investment is $1 million.
•Current LIBOR is 1.50%.
•The Federal Tax Rate is 35%.
If Spencer decides to participate in the investment, an interest rate swap will be used to
improve the match between the cashflows from the investment and the corporation’s
fixed-rate liabilities.
(a) Analyze the potential benefits and costs of participating in the tax-structured deal.
(b) Recommend how to use the FAS133 hedge accounting rules to minimize net
income volatility.
(c) Describe the impact on the financial statement and the documentation
requirements under your recommended approach in part (b).
COURSE 8: Fall 2003 - 12 - GO ON TO NEXT PAGE
Finance
Afternoon Session
13. (17 points) Nougat Inc. is a small regional producer of chocolate confectionaries. The
founder and CEO of the company recently retired and placed the company up for sale.
Butterscotch Inc., Caramel Inc., and Fudge Inc. are all confectionary companies that plan
to make bids for Nougat.
•Butterscotch has been a national manufacturer of a variety of candy bars for over 100
years. Butterscotch is 100% owned by a private trust.
•Caramel is a mature multi- national conglomerate that has been in some aspect of the
confectionary business for over 300 years. Over the past decade management has
been pursuing growth through a small number of strategic acquisitions.
•Fudge was started five years ago after Fudge’s founder cashed out of his internet
company and was inspired after reading about a young boy’s trip to a chocolate
factory. The financial press has called Fudge “innovating – not imitating – a hip
company that is taking a shot at bringing growth back to the chocolate business’
bottom line and waist- line”.
Assume the following:
•All physical assets are owned by corporations.
•Capital markets are frictionless. There are no corporate or personal income taxes,
securities can be purchased or sold costlessly and instantaneously, and there are no
bankruptcy costs.
•Corporations can issue only two types of securities, risky equity and risk- free debt.
•Both individuals and corporations can borrow or lend at the risk- free interest rate.
•Investors have homogeneous expectations about the future stream of corporate
profits.
•There is no growth, so all cash flow streams are perpetuities.
•All corporations can be classified into one of several “equivalent return classes” such
that the returns on shares of all firms in that class are proportional to, and perfectly
correlated with, all other firms of that class.
You are provided with the following information:
Nougat Butterscotch Caramel Fudge
Expected return 10% 10% 10% 10%
Expected operating profits 100,000 200,000 200,000 200,000
Debt outstanding @ 5% interest 0 0 1,000,000 100,000
Shares of Stock 50,000 40,000 20,000 38,000
Financing plans for acquisition
of Nougat N/A 100% equity 50% debt,
50% equity
Not yet
determined
COURSE 8: Fall 2003 - 13 - GO ON TO NEXT PAGE
Finance
Afternoon Session

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