11 - Return on Capital Flashcards
What are the benefits of capital allocation?
1) Pricing - take account of cost of capital to support business
2) Risk selection - to select the risks that best employ the available capital
3) Performance measurement - To assess the performance relative to the capital
4) Performance attribution - Between business units, classes and UWs - which could be used for remuneration
5) Strategic Decision Making - Assessing a new opportunity or future UW strategy
What are the two main challenges to incorporating capital costs?
1) Developing frameworks to measure performance and drive profit enhancement
2) Incorporating appropriate target loadings in premium rates to reflect the true cost of capital
What are the desirable attributes of a capital allocation method?
1) Be consistent with the modeled capital for the whole business
2) Reflect the risk of individual business segments relative to one another and the business as a whole
3) Be justifiable and consistent
4) Reflect the interrelationships between risks, in particular reflect diversification benefits
What are the two main elements of capital cost?
1) Capacity Occupation Cost
2) Capital Call Cost
Describe Capacity occupation cost
This is the opportunity cost to compensate a firm for missing out on other opportunities.
Typically described as a risk adjusted hurdle rate, its the difference between the safe investments required by regulation and the the higher return investments available if free to invest.
Describe Capital Call Cost
This is a risk loading that compensates for the potential erosion of capital to pay claims.
This should depend not only on the probability of call but also the distribution of the amount of a capital call.
We also should consider the the reduction in future uw capacity as a result of the call (known as capcity downtime)
Give a simple pricing formula involving cost of capital
Premium = expected loss +capital *cost of capital (consumptive and non consumptive)
What two elements need to be selected in order to allocate capital
A risk measure
A capital allocation method
What are the desirable characteristics of a risk measure
Easy to communicate and apply
Observable, measurable and not manipulable
Consistent with perception of risk
Quantifies risk in a manner that is understandable
Consistent with the basis used to aggregate capital
Results in an internally consistent allocation of diversification benefits
Results in a coherent allocation
What 4 conditions are needed for a risk statistic to be coherent?
1) Monotonicity- if one portfolio is always worth more than another it cannot be riskier
2) Linear homogeneity - Scaling a portfolio by a constant will change the risk by the same proportion
3) Sub-additivity - Combining two portfolios will not create more risk
4) Translational Invariance - adding a portfolio with a known guaranteed outcome to an existing portfolio reduces the risk by a guaranteed outcome
What are some common risk measures:
Variance/semi variance VAR TAIL VAR Expected policyholder default Transformed loss measure
Advantages/Disadvantages to Variance?
+ widely understood
- Not coherent as not monotonic
Advantages/Disadvantages to VAR?
+ widely understood
- Not coherent as fails sub additivity
What measures are coherent?
Tail VAR
Transformed loss measure
List some capital allocational methods
Proportional
Marginal last in
game theory
Equalise relative risk
What characteristics are required for a allocation method to be coherent?
1) Diversification benefit- allocation to sub portfolio should be the same as when considered separately
2) Symmetry- if the risk of two portfolios is the same, the allocation should be the same
3) Cash in a sub portfolio reduces allocation accordingly
What three issues are there with deciding a capital rate?
1) Deciding the overall cost of capital for the firm- what do you base this on?
2) The relationship between the amount of capital allocated, the different capital requirements faced by the firm and actual amount of capital held by the firm
3) Whether the cost of capital rate should be equal for all business lines.
List 11 issues with Capital allocation an actuary is likely to face
1) Gathering sufficient quality data
2) Sensitivity to specific assumptions
3) Selection of appropriate risk measures
4) Ensuring consistency with companies broader enterprise risk management framework
5) Communication and interpretation of results across business
6) Sufficient staff and resources to embed capital considerations into decision making
7) Incorporation of capital loads at risk level
8) Allowance for fixed capital costs such as operations - flat or proptional?
9) Help UWs appreciate the gearing of returns on capital and hence the significance of pricing terms and conditions
10) Convincing senior management of the benefits of ROC methodology
11) Evolving the methods over time as understanding of risk improves.
