Brehm Ch2 Flashcards
Decision-Making Approaches
- Deterministic project analysis
Single point estimation, uncertainty is handled judgmentally - Risk Analysis
Forecast distributions of critical variables with Monte Carlo simulation - Certainty Equivalent
(2) + Quantifies judgement with utility function for consistency
Economic Capital
VaR at remote prob (e.g. 1-in-3000)
Pros:
-Unifying measure for all risks
-More meaningful to management than RBC or capital adequacy ratios
-Forces firm to quantify risks into a prob dist
-Provides framework for setting acceptable risk levels as whole and by-unit
Cons:
-ERM models are not reliable at remote probs
Types of Risk Measures
Moment-Based
Tail-Based
Probability Transforms
Generalized Moments
Moment-Based Risk Measures
Ex: Variance, Std Deviation
Cons:
-Favorable deviations treated same as unfavorable
-Quadratic measures may not capture market attitudes to risk
Alts:
-semistandard deviation
-skewness, exponential moments
Tail-Based Risk Measures
Emphasize large loss
Ex: VaR, TVaR, XTVaR, EPD, Value of default put option
Probability Transformed Risk Measures
Shift prob towards unfavorable outcomes then compute risk measure
-Wang Transform approx market prices of standard bonds and CAT bonds
-TVar becomes WTVaR so loss 2x as large is more than 2x as bad
Generalized Moment Risk Measures
Expectations of an RV thats not a simple power
Spectral measures are a class of these
Disadvantages of leverage ratios
Don’t distinguish among business classes
Don’t incorporate risks other than UW risk
Paradigms for Reinsurance Value
- Provides stability (ceded prem - recoveries)
- Frees up capital (ROE vs Target)
- Adds market value to firm
Disadvantages of Allocating Capital
- Arbitrary - Can get many different allocations
- Artificial - Unit has access to entire capital
Alt: allocate cost of capital instead - gives a min profit target per unit
