Brehm CH2 Flashcards
3-step evolutionary process of decision analysis
- Deterministic project analysis (uses a single deterministic forecast for project cash flows, an objective function such as present value or internal rate of return is produced
- Risk Analysis (Forecasts of distributions of critical variables are fed into a Monte Carlo simulation engine to produce a distribution of present value of cash flows)
- Certainty Equivalent (Extension of risk analysis that quantifies the intuitive risk judgment by means of a corporate risk preference or utility function)
Examples of debates centers on the role of corporate risk preference in an efficient market/modern portfolio theory world
- Diversified investors with small holdings in all available securities are concerned only with non-diversifiable (systematic) risks
- Diversifiable risk does not command any risk premium in the market, since it can be diversified away by simply holding the market portfolio
- Investors require a risk premium as compensation for bearing systematic risk
- Firm managers should focus on maximizing shareholder value
- Since their shareholders can diversify away firm-specific risk, the shareholders are indifferent towards it.
- Therefore, firm managers ought to be indifferent to firm-specific risk as well.
Why is it hard for managers to handle risk management within a firm in practice
- Those managing the firm have no way to identify which of the risks they face are firm specific and which are systematic.
- Market-based risk signals (such as risk-adjusted rate) often lack the refinement needed for managers to mitigate or hedge the risk
Mechanism for capture risk tolerance in an Internal Risk Model (IRM)
- Take an aggregate loss distribution, with many sources of risk
- Assesses the impact of possible aggregate loss outcomes on the corporation
- Assigns a cost to each amount of impact
- Attributes the cost back to the risk source
In order to select one of the efficient portfolios, the firm must answer:
- How much risk (standard deviation) are we wiling to tolerate? (asking risk tolerance)
- How much reward are we willing to give up for a given reduction in risk, and vice versa? (asking risk preferences)
- Are the risk-reward tradeoffs available along the efficient frontier acceptable to the firm? (Allow the firm to select among available returns for given risk levels)
Major Components of Internal Risk Model
- Data Classification and Organizational Scheme
- Capture exposures and loss history
3a. Estimate event frequency and severity distributions
3b. Corporate hedging
3c. Correlations and shock scenarios - Develop aggregate loss distribution
5a. Corporate risk tolerance
5b. Cost of capital allocated
5c. CBA (Cost Benefit Analysis) on Mitigation and hedging
Formula for Economic Value Added (EVA)
NPV return - cost of capital
positive EVA is said to “add value”
Describe Return on Risk-Adjusted Capital (RORAC)
Allocate risk capital first and then using it to assign the cost of that risk capital to portfolio elements.
The RORAC is the product of a risk-adjusted capital amount and a hurdle rate.
Advantages of using economic capital (like VaR)
- it provides a unifying measure for all risks across an organization
- It’s more meaningful to management than risk-based capital or capital adequacy ratios.
- It forces the firm to quantify the risks it faces and combine them into a probability distribution
- It provides a framework for setting acceptable risk levels for the organization as a whole and for individual business units.
Disadvantage of using moment-based measure like variance and standard deviation as a risk measure
- The favorable deviations are treated the same as unfavorable ones.
- As quadratic measures, they may not adequately capture market attitudes to risk (they understate the risk)
Alternative risk measures that address the issues with variance and standard deviation
- Semistandard deviation (uses only the unfavorable deviations)
- Skewness (since this uses a higher moment, it might better capture market attitudes)
- Exponential moments (since it capture the effect of large losses on the risk exponentially, it better capture market attitude)
Examples of Tail-Based Measures
Tail-based measures emphasize large losses only.
VaR, TVaR, XTVaR, EPD, Value of default put option
Classifications of risk measures
- Moment-based
- Tail-based
- Probability transforms (shifting the probability towards the unfavorable outcomes and then computing a risk measure with the transformed probabilities)
Example of a tranformed measure
- the expected loss under the transformed probabilities like CAPM (Capital Asset Pricing Model) and Black-Scholes option pricing
How transformed probabilities overcome some of the shortcomings of popular risk measures
TVaR is often criticized because it is linear in the tail (a loss twice as large is considered twice as bad). Under the transformed probabilities, TVaR becomes WTVaR (weighted TVaR), this is not linear in the tail and considers a loss that is twice as large to be more than twice as bad.
Practical considerations for required capital
- Customer reaction (some customers care deeply about the amount of capital being held by insurers and/or the financial rating of an insurer. A decline in financial ratings can lead to declines in business
- Capital requirements of rating agencies (different rating agencies require different amounts of capital to be held by an insurer)
- Comparative probability of new and renewal business (renewal business tends to be more profitable due to more informed pricing and underwriting)
Describe two ways for risk allocation
- Allocate the overall risk to the individual business units (calculate the overall risk measure, then calculate the risk measure for each individual business unit, Allocate the overall risk measure to the individual business units in proportion to their individual risk measures)
- Estimate the contributions of the individual business units to the overall risk
(Define the risk measure as an average of company results under certain conditions, the contribution from each business unit is the average of the business unit’s results under the same conditions. Both VaR and TVaR can be used in this way, and they are additive decompositions, which means that the business units’ contributions to VaR add up to the overall company VaR)
What does having a marginal method mean
This is a desirable feature of a risk decomposition methodology.
Marginal means that the change in overall company risk due to a small change in a business unit’s volume should be attributed to that business unit.
Conditions required for a marginal decomposition
- Works when the business units can change volume in a homogeneous fashion
- Works when the risk measure is scalable. (or homogeneous of degree 1)
Features of marginal decompositions
All marginal decompositions sum up to the company risk measure.
All marginal decompositions are also co-measures.
Examples of risk measures that can be expressed as marginal decompositions
TVaR
Standard deviation
When does using decomposition of a risk measure to measure risk-adjusted profitability of business unit works well?
If the risk measure is proportional to the market value of the risk. The, the ratio of the profit of a unit to its risk measure would be proportional to the ratio of the profit to the market value of the risk. So the business units with higher ratio would have more profit.
2 disadvantages of leverage ratios
- They do not distinguish among business classes
- They do not incorporate risks other than underwriting risks
How are leverage ratios being used
They are used to evaluate capital adequacy. In US, we use IRIS (such as Gross written premium to surplus ratio, Net written premium to surplus ratio, change in writings, surplus aid to surplus).
What risks are captured in Risk-Based Capital (RBC)
- Investment asset risk
- credit risk
- Premium risk
- Reserve risk
Why there might be significant differences among the models in the levels of the factors
- The use of the models (The A.M Best and the S&P models are used to determine whether the company will be viable in the long term, while regulatory models are used to evaluate the one-year likelihood of solvency)
- Presence of a covariance adjustment (Many models have covariance adjustment to reflect the independence of the various risks components in the risk-based capital model)
What is the largest component of credit risk
Reinsurance recoverable
Recent best practices used by regulators for scenario testing
- The risk-based capital (RBC) model is used as a base metric
- Each insurer performs its own assessment of its RBC needed based on certain underlying principles and rules.
- The regulator reviews the company’s analysis and has the right to provide an alternative capital requirement based on the company’s assessment
Critical features of financial projection model
- Correlations among risks
- Reflection of management response to adverse financial results
Ways to increase its A.M. Best’s Capital Adequacy Ratio (BCAR) to maintain an A rating for an insurer
- Issue Surplus Notes (to increase its adjusted surplus)
- Purchase Reinsurance (to reduce required capital)
Why the increases from issuing surplus notes is on less than a dollar-for-dollar basis?
- The interest on the surplus note is higher than A.M. Best’s estimate of the insurer’s annual return on capital
- The amount of surplus notes exceeds 20% of capital.
- Required capital is increased slightly due to increase in invested asset (this increases asset risk)
What is asset-liability management (ALM)
A comprehensive analysis and management of the asset portfolio in light of current liabilities, future cash flows of a going-concern company, incorporating existing asset and liability portfolios as well as future premium flows.
Risk factors that asset-liabilities considers
- Duration
- Interest rate changes
- inflation risk
- Credit risk
- Market risk
Describe Asset-Liability Modeling Approach
- Start with models of asset classes (stocks, bonds) existing liabilities (loss reserves, receivables) and current business operations (premium incomes, incurred losses ,expenses)
- Define risk metrics for the analysis (such as standard deviation, VaR, TVaR. TVaR are better suited for balance sheet items such as surplus)
- Define return (such as return on equity or earnings)
- Define the timing of the analysis and relevant metrics
5.Consider relevant constraints (regulatory constraints) - Run the model for a variety of investment strategies, underwriting strategies and reinsurance options
- Construct an efficient frontier across the various portfolio scenarios.
3 paradigms for measuring reinsurance value
- Reinsurance provides stability (protection of surplus, improved predictability of earnings, customers’ assured recovery of their insured losses)
- Reinsurance frees up capital
- Reinsurance adds market value to the firm
What kind of reinsurance program is preferred when using reinsurance as capital
- When releasing capital (purchase reinsurance to reduce capital needs), reinsurance program with lower marginal ROE’s are preferred. Programs with lower ROE’s than the firm’s own cost of capital are preferred.
- When consuming capital (changing reinsurance programs to a less expensive option that requires a bit more capital), programs with higher ROE’s are preferred. Programs with higher ROE’s than the firm’s own cost of capital are preferred.
Two classes of models for required capital
- Theoretical models (those that derive required capital and changes in it based on the calculated risk metrics from an enterprise risk model ( such as VaR, TVaR)
- Practical Models (those that derive required capital based on rating agencies, regulatory requirements or actual capital)
Disadvantage of using practical model to derive required capital:
They rely on risk proxies (such as premiums and reserves) rather than relying on the risk itself.
2 advantages of using as-if reserves
- It can measure the impact of accumulated risk caused by correlated risk factors
- The reinsurance being analyzed can be applied to the accident year and the as-if reserves providing a more valid measure of the impact of reinsurance on accumulated risk and on capital absorbed over the full life of the accident year
What is a good cost measure for reinsurance
The net present value of earnings expected from the reinsurance program
What is a poor cost measure for reinsurance
The combined ratio because it can give a distorted picture of the effect of reinsurance on earnings
