Brehm #2 Flashcards
The evolutionary process of decision making using ERM (3)
- deterministic project analysis - single deterministic forecast where uncertainty is handled judgmentally
- dynamic financial analysis (DFA)/risk analysis - uses simulation to produce forecasts of distributions where uncertainty is handled judgmentally «_space;current state
- certainty equivalent - extends DFA and formalizes judgment by quantifying corporate risk preferences using a utility function
Argument for moving towards step 3 in the evolutionary process (certainty equivalent)
both shareholders and managers want to maximize market value
Franchise value
= PV (future earnings growth)
*risk management aims to protect franchise value
Market value
market value = book value + franchise value
Advantages of the certainty equivalent (3)
- objective
- consistent
- repeatable
Corporate risk tolerance
combination of factors such as organization size, financial resources, and ability and willingness to tolerate volatility
Efficient frontier graph
plots risk (x) against return (y)
Explore options that either:
- reduce risk without sacrificing return
- increase return without increasing risk
- or scenarios in between
Economic value added (EVA) formula
EVA = NPV (return) - cost of capital
positive EVA = value added
negative EVA = value destroyed
Economic capital
economic capital = VaR at a remote probability (such as 1-in-3000)
Advantages of allocating capital using economic capital (4)
- unifying measure for all risks across org
- more meaningful to management (vs. RBC/capital adequacy ratios)
- forces firms to quantify risks and combine them into probability distributions
- provides framework for setting acceptable risk levels for the organization as a whole and individual business units
Main categories of risk measures (3)
- moment based
- tail based
- probability transforms
Description and examples (2) of moment-based risk measures
probabilistic expectations of random variables
ex: variance or standard deviation, semi-standard deviation
Disadvantages of moment-based risk measures (2)
- favorable deviations are treated the same as unfavorable ones
- may understate risk because lower moments do not adequately capture market attitudes
Alternatives to moment-based risk measures that better capture market attitudes (2)
- skewness
2. exponential moments - reflects all losses but is more responsive to large losses E [ Y * exp ( c * Y / E [ Y ] ) ]
Disadvantage of using tail-based risk measures
emphasize large losses only
Types of tail-based risk measures (5)
- VaR
- TVaR
- XTVaR
- expected PH deficit (EPD)
- value of default put option
XTVaR tail-measure and idea behind it
XTVaR = TVaR - overall mean
idea: if the mean is financed through other funding, capital is only required for losses above the mean
Expected PH deficit (EPD) tail-measure
EPD = ( TVaR - VaR ) * probability of default
where probability of default = 1 - probability level
gives the unconditional expected value of defaulted losses
Value of default put option tail-measure
market value of risk for firm’s right to put claims back to the policyholders if capital or reinsurance is exhausted
Description of probability transform risk measures and examples (2)
measures risk by shifting more probability towards unfavorable outcomes and computing a risk measure with the transformed probabilities
ex: expected loss under transformed probabilities, weighted TVaR
Meaning of marginal risk decomposition
change in overall company risk b/c of change in business unit volume should be attributed to that business unit
Characteristic of marginal decompositions and examples of common marginal decompositions (2)
sum up to company risk measure
ex: standard deviation and TVaR
Requirements for marginal decomposition (2)
- ability to change volume in a homogeneous fashion (ex: quota share)
- scalable risk measures - rho ( a * y ) = a * rho ( y )
Co-measure
sum of covariances = variance
Risk factors analyzed in Asset Liability Management (ALM) (4)
- change in interest rate
- inflation risk
- credit risk
- market risk
Paradigms for measuring value in reinsurance (3)
reinsurance:
1. provides stability
2. frees up capital
3. adds market value to the firm
Marginal ROE
marginal ROE = change in cost of reinsurance / change in required capital
When releasing capital (buying reinsurance) want low marginal ROEs that are below the cost of capital
When consuming capital (switching to less expensive reinsurance) want a higher marginal ROE above the cost of capital
Method to reduce standard deviation and cost
eliminate favorable distributions
cost = lower profitability in the good years
Interpretation of the mean when comparing programs
avg income/loss
difference = net cost of reinsurance
Interpretation of the safety level for comparing programs
best case performance in a good year for a given probability level (higher = better)
Interpretation of the smallest simulated event for comparing programs
worst case loss in a bad year
Measuring efficiency in UW results comparison graphs
plots loss amounts vs. cost at various probability levels
to be efficient, must have lower loss at a given probability
Sources of required capital (2)
- theoretical models (ex: VaR, TVaR, XTVaR, WXTVaR)
2. practical models (ex: BCAR, RBC, S and P)
Disadvantage of using practical models to set capital requirements
relies on risk proxies (such as premiums or reserves) rather than the risk itself
As-if loss reserves
loss reserves that would have existed at the beginning of AY if business had been written in a steady state in all prior years (b/c loss reserves absorb capital)
Proxy for amount of capital absorbed by AY
proxy for capital absorbed by AY = current reserves + as-if loss reserves
Reason combined ratio is a bad cost measure for reinsurance
gives a distorted picture of effects of reinsurance on earnings because of impact of high ceded costs on the expense ratio
Good cost measure for reinsurance
NPV ( expected earnings )
Disadvantages of allocating capital (2)
- Arbitrary- different risk measures give different allocations
- Artificial - each business unit has access to insurers total capital
Methods to allocate capital (2)
- Proportional allocation - allocate the total risk measure proportionally using individual business unit risk measure
- Marginal decomposition - calculate the overall risk measure and then calculate marginal co-measures for each business unit
(Marginal decomposition is preferable b/c it reflects how the risk from each BU impacts the total risk profile)
Benefit to the insurer from purchasing reinsurance for CBA
Reduced cost of capital
(Cost of capital = k * required capital) and measure the amount reduced with each option
Meaning of stability for measuring value in reinsurance (3)
- Protects surplus
- Improved predictability of earnings
- Customers’ assured recovery of losses
Asset liability management definition
Comprehensive analysis and management of asset portfolio in light of current liabilities and future cash flows of a going-concern company
Difference between asset liability management and duration matching
Duration matching only considers risk of interest rate changes whereas ALM considers additional risk factors
Challenge with duration matching for insurance
Variable amount and timing of cash flows
Approach (steps) for asset liability modeling (6)
- Start with models of asset classes, existing liabilities, and current business operations
- Select a risk metric (e.g. standard deviation)
- Select a return metric (e.g. earnings or ROE)
- Determine time horizon and constraints (e.g. regulatory limits on asset classes)
- Run model on variety of investment strategies, UW strategies, and reinsurance options
- Create an efficient frontier
