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exam 7 > Brehm ch.2 > Flashcards

Brehm ch.2 Flashcards

1
Q

what is decision analysis?

Brehm ch.2

A

using simulations to drive corporate decision making

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2
Q

list the three steps of the decision analysis process

Brehm ch.2

A
  • deterministic project analysis
  • risk analysis
  • certainty equivalent
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3
Q

what is deterministic project analysis?

Brehm ch.2

A

uses a single deterministic forecast for projecting cash flows to produce an objective function like present value or internal rate of return

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4
Q

how is uncertainty handled in a deterministic project analysis?

(Brehm ch.2)

A

judgmentally (rather than stochastically)

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5
Q

what might a deterministic project analysis reveal?

Brehm ch.2

A

sensitivities to critical variables

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6
Q

what is risk analysis?

Brehm ch.2

A

forecasts of distributions of critical variables are input into a Monte Carlo simulation process to produce a distribution of the present value of cash flows

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7
Q

what is the certainty equivalent step of decision analysis?

Brehm ch.2

A
  • expands upon risk analysis step by quantifying the intuitive risk judgment using a utility function (i.e. corporate risk preference)
  • utility function does NOT replace judgment, just formalizes it in order to consistently apply
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8
Q

why do some believe that the efficient market theory removes the need for the certainty equivalent step of decision analysis evolution?

(Brehm ch.2)

A
  • since investors can diversify away firm-specific risk, it doesn’t have a risk premium and should be ignored
  • goal of firm managers is to maximize shareholder value, so they should ignore firm-specific risk as well
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9
Q

what is the issue with the argument that efficient market theory removes the need for the certainty equivalent step of decision analysis?

(Brehm ch.2)

A

does not provide any practical advice for handling risk management within a firm:

  • difficult to determine which risks are firm-specific and which are systematic
  • market-based risk signals (ex: risk-adjusted rate) often lack the refinement needed for managers to mitigate or hedge the risk
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10
Q

what does the fifth element of internal risk modeling include?

(Brehm ch.2)

A
  • corporate risk tolerance
  • cost of capital allocation
  • cost-benefit analysis for mitigation strategies
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11
Q

we desire a mechanism for internal risk modeling that achieves what four steps?

(Brehm ch.2)

A

1-starts with aggregate loss distribution, with many sources of risk
2-quantifies the impact of possible aggregate loss outcomes on the corporation
3-assigns a cost to each amount of impact
4-attributes the costs back to the risk sources

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12
Q

what is corporate risk tolerance?

Brehm ch.2

A

the organization’s size, financial resources, ability, and willingness to tolerate volatility

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13
Q

what is an efficient frontier of possible insurance portfolios?

(Brehm ch.2)

A

portfolios that minimize risk for a given rate of return

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14
Q

how is a standard efficient frontier graph plotted?

Brehm ch.2

A
  • x-axis is risk

- y-axis is return

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15
Q

what three questions must a firm answer in order to select an efficient portfolio?

(Brehm ch.2)

A
  • how much risk is the firm willing to tolerate?
  • how much reward is the firm willing to give up for a given reduction in risk, and vice versa?
  • are the risk-reward tradeoffs available along the efficient frontier acceptable to the firm?
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16
Q

historically, what has capital allocation referred to?

Brehm ch.2

A

allocating capital itself

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17
Q

why isn’t the historical concept of capital allocation useful for financial firms?

(Brehm ch.2)

A

-risk capital is theoretical -> when insurer writes an automobile policy, no actual risk capital is transferred to the policy

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18
Q

what should financial firms rely on instead of capital allocation?

(Brehm ch.2)

A

allocating the COST of capital

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19
Q

what is one way to allocate the cost of capital?

Brehm ch.2

A

by allocating risk capital first and then using it to assign the cost of that risk capital to portfolio elements

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20
Q

what is the Return on Risk-Adjusted Capital?

Brehm ch.2

A

the product of the risk-adjusted capital and a hurdle rate

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21
Q

what is Economic Value Added and a use for it?

Brehm ch.2

A

EVA = NPV Return - Cost of Capital

method of determining if an activity is worth pursuing

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22
Q

under a cost-benefit analysis and using the EVA approach where the cost of risk capital is determined directly, which mitigation strategies would be implemented?

(Brehm ch.2)

A

strategies that produce positive incremental EVA

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23
Q

under a cost-benefit analysis and using the capital allocation approach where we’ve allocated risk capital, what activities would we pursue?

(Brehm ch.2)

A

pursue activities where the benefit (decrease in required capital) exceeds the costs of implementation

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24
Q

what does economic capital typically refer to?

Brehm ch.2

A

VaR (value at risk) at a remote probability, such as 1-in-3000 (i.e. 99.97% percentile)

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25
Q

what are four advantages of using economic capital?

Brehm ch.2

A
  • provides [F]ramework for setting acceptable risk levels for organization as a whole AND individual business units
  • [U]nifying measure for all risks across an organization
  • more [M]eaningful to management than RBC or capital adequacy ratios
  • forces firm to [Q]uantify the risks it faces and combine them into a probability distr
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26
Q

how is VaR usually calculated for the organization as a whole and individual business units? and why is it beneficial?

(Brehm ch.2)

A
  • usually calculated for all risks combined and then allocated down to individual business units
  • NOT by summing up contributions of individual business units
  • beneficial because it provides a consistent measurement of risk across units
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27
Q

how is the probability level selected for economic capital?

Brehm ch.2

A
  • usually a round number for target level
  • usually selected s.t. economic capital is slightly less than the actual capital being held (i.e. if insurer is holding capital at 1-in-3467 level, chose 1-in-3333)
  • important to note that probability levels like 1-in-3000 are not in range of current modeling for insurers
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28
Q

what are moment-based risk measures?

Brehm ch.2

A

uses the moment of a random variable, such as the change in capital over an accounting period

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29
Q

what are two examples of moment-based risk measures?

Brehm ch.2

A
  • variance

- standard deviation

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30
Q

what are two disadvantages of using variance or standard deviation as risk measures?

(Brehm ch.2)

A
  • favorable deviations are treated same as unfavorable
  • as quadratic measures (ie variance based on second moment) may not adequately capture market attitudes to risk (ie they understate risk)
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31
Q

what are three alternatives to variance or standard deviation as risk measures?

(Brehm ch.2)

A
  • semistandard deviation
  • skewness
  • exponential moments
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32
Q

how does semistandard deviation address an issue of using variance/SD as risk measures?

(Brehm ch.2)

A

only uses unfavorable deviations

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33
Q

how does skewness address an issue of using variance/SD as risk measures?

(Brehm ch.2)

A

since it uses a higher moment, might better capture market attitudes

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34
Q

how do exponential moments address an issue of using variance/SD as risk measures?

(Brehm ch.2)

A

these types of measures capture the effect of large losses on the risk exponentially -> might better capture market attitudes

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35
Q

what do tail-based risk measures emphasize, and what is a disadvantage to this emphasis?

(Brehm ch.2)

A
  • emphasize large losses only

- losses do not have to be large to cause problems for an insurer

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36
Q

what are five examples of tail-based measures?

Brehm ch.2

A
  • VaR
  • TVaR (tail value at risk)
  • XTVaR (excess tail value at risk)
  • EPD (expected policyholder deficit)
  • Value of default put option
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37
Q

what is VaR (value at risk)?

Brehm ch.2

A

percentile of the probability distribution

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38
Q

what is TVaR (tail value at risk)?

Brehm ch.2

A

expected loss at a specified probability level and beyond

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39
Q

what is XTVaR (excess tail value at risk)?

Brehm ch.2

A
  • calculated as TVaR minus the overall mean
  • when mean is financed by other funding (something other than capital), then capital is only needed for losses above the mean
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40
Q

what is EPD (expected policyholder deficit)?

Brehm ch.2

A
  • calculated by multiplying (TVaR - VaR) by the complement of the specified probability level
  • UNCONDITIONAL expected value of defaulted losses
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41
Q

what is the difference between XTVaR and EPD?

Brehm ch.2

A
  • XTVaR is CONDITIONAL expected value of TVaR - overall MEAN

- EPD is UNCONDITIONAL expected value of TVaR - !!VaR!!

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42
Q

what is the ‘value of default put option’ risk measure?

Brehm ch.2

A
  • when capital/reinsurance is exhausted, firm has the right to default on its obligations and put the claims to the policyholders
  • market value of this risk = default put option
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43
Q

how do probability transforms measure risk?

Brehm ch.2

A

shifting probability towards unfavorable outcomes and then computing a risk measure with the transformed probabilities

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44
Q

why are transformed means useful risk measures?

Brehm ch.2

A
  • they often provide the market value of the risk being measured
  • can be used for pricing purposes
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45
Q

what two transforms does the theory of pricing incomplete markets use, and what do they approximate?

(Brehm ch.2)

A
  • minimum martingale transform
  • minimum entropy martingale transform
  • approximate market prices of reinsurance
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46
Q

what does the Wang transform approximate?

Brehm ch.2

A

-market prices of standard bonds and catastrophe bonds

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47
Q

how can transformed probabilities overcome the criticism of TVaR’s linearity in the tail?

(Brehm ch.2)

A
  • under transformed probabilities, TVaR becomed WTVaR (weighted TVaR)
  • NOT linear in tail
  • considers a loss that is twice as large to be more than twice as bad
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48
Q

what are generalized moments?

Brehm ch.2

A

expectations of a random variable that are NOT simply powers of that variable

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49
Q

what are spectral measures? (in words)

Brehm ch.2

A

-a specific class of generalized moments that includes many of the tail-based measures

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50
Q

how can spectral measures be written?

Brehm ch.2

A

E[Y * eta(F(Y))]

for non-negative scalar function eta

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51
Q

if we want to choose a risk measure closer to market value, what measures might we choose?

(Brehm ch.2)

A
  • WTVaR
  • minimum entropy transform
  • exponential moment
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52
Q

what are three examples of variables that influence the amount of capital an insurance company holds?

(Brehm ch.2)

A
  • customer reaction
  • capital requirements of rating agencies
  • comparative profitability of new and renewal business
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53
Q

how does customer reaction influence the amount of capital an insurance company holds?

(Brehm ch.2)

A
  • some customers care deeply about the amount of capital being held by insurers / the financial rating of an insurer
  • often, declines in financial ratings -> declines in business
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54
Q

how do the capital requirements of rating agencies influence the amount of capital an insurance company holds?

(Brehm ch.2)

A

different rating agencies require different amounts of capital to be held by an insurer

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55
Q

how does the comparative profitability of new and renewal business influence the amount of capital an insurance company holds?

(Brehm ch.2)

A
  • renewal business tends to be more profitable due to more informed pricing and underwriting -> important to retain renewal business
  • if renewals comprise 80% of book -> insurer should be able to maintain 80% of its capital in a bad year -> should hold enough capital so that 20% of its capital could cover a fairly adverse event
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56
Q

what are two examples of what risk allocation can be used for?

(Brehm ch.2)

A
  • setting premium and limits by line

- computing risk-adjusted profitability

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57
Q

what are two ways that risk allocation can be done?

Brehm ch.2

A
  • allocate overall risk to individual business units

- estimate the contributions of individual business units to the overall risk

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58
Q

how would an insurance company allocate overall risk to individual business units?

(Brehm ch.2)

A
  • calc overall risk measure
  • calc risk measure for each individual business unit
  • allocate overall risk measure to individual business units in proportion to their individual risk measures
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59
Q

how would an insurance company estimate the contributions of the individual business units to the overall risk?

(Brehm ch.2)

A
  • define risk measure as an average of company results under certain conditions (conditional generalized moment)
  • contribution from each business unit is the average of the business unit’s results under the same conditions
60
Q

how is TVaR a co-measure?

Brehm ch.2

A

-each business unit’s contribution to the overall TVaR is the business unit’s average loss when the overall company loss exceeds the specified probability level

61
Q

what does it mean for VaR to be an additive decomposition?

Brehm ch.2

A

the business units’ contributions to VaR add up to the overall company VaR
**different from marginal (marginal involves derivative)

62
Q

what does it mean for a risk decomposition method to be marginal?

(Brehm ch.2)

A

change in overall company risk due to a small change in a business unit’s volume should be attributed to that business unit

63
Q

what does the marginal property of risk measures link to?

Brehm ch.2

A

financial theory of “pricing proportionality to marginal costs”

64
Q

what does the marginal property of risk measures ensure?

Brehm ch.2

A

when a business unit with an above-average ratio of profit to risk increases its volume, then the overall company ratio of profit to risk increases as well

65
Q

what two conditions are required for a marginal decomposition?

(Brehm ch.2)

A
  • works when business units can change volume in a homogeneous fashion
  • works when the risk measure is scalable
66
Q

what does it mean for business units to change volume in a homogeneous fashion?

(Brehm ch.2)

A

-business units can buy quota share reinsurance and change their volume uniformly by changing the quota share percentage

67
Q

what does it mean for a risk measure to be scalable?

Brehm ch.2

A
  • multiplying the random variable by a factor multiplies the risk measure by the same factor (rho(aY) = arho(Y)
  • aka homogeneous of degree 1
68
Q

what are two properties of marginal decompositions?

Brehm ch.2

A
  • all marginal decompositions sum up to the company risk measure
  • all marginal decompositions are also co-measures
69
Q

what are two common risk measures that can be expressed as marginal decompositions?

(Brehm ch.2)

A
  • TVaR

- standard deviation

70
Q

how can marginal decompositions be found?

Brehm ch.2

A

by taking the derivative of scalable risk measures

71
Q

when does using decomposition of a risk measure to measure risk-adjusted profitability of business units work best?

(Brehm ch.2)

A
  • if the risk measure is proportional to the market value of the risk -> ratio of a unit’s profit to its risk measure would be proportional to the ratio of the profit to the market value
  • > > business units with higher ratios yield more profit
72
Q

how could the cost of capital be allocated (instead of capital itself)?

(Brehm ch.2)

A
  • set minimum profit target of a business unit equal to the value of its right to call upon the capital of the firm
  • excess of the unit’s profit over this cost of capital is added value for the firm
73
Q

why is the business unit’s right to call upon the capital of the firm considered a cost to the firm?

(Brehm ch.2)

A

-company is carrying the risk of the unit’s right to access the insurer’s entire capital
(implicit stop-loss agreement where a business unit can either make money or break even)

74
Q

what is an alternative to option pricing theory for computing the capital cost of the right of a business unit to access the firm’s capital?

(Brehm ch.2)

A

-calculate the expected value of a stop-loss for the business unit at the break-even point
(meaning business unit cannot lose money)

75
Q

how does the economic value of implicit stop-loss compare to its expected value, and what do the authors suggest to address this?

(Brehm ch.2)

A
  • economic value > expected value
  • suggest incorporating full distribution of the profit results for each business unit to obtain a better measure of the true economic value
76
Q

what is an example of a simpler approach to capturing the economic value of the implicit stop-loss?

(Brehm ch.2)

A

-mean plus thirty percent of standard deviation

77
Q

what are two examples of leverage ratios that were historically used to evaluate capital adequacy?

(Brehm ch.2)

A
  • premium-to-surplus ratio

- reserve-to-surplus ratio

78
Q

what are two disadvantages of leverage ratios?

Brehm ch.2

A
  • do not distinguish among business classes

- do not incorporate risks other than underwriting risks

79
Q

what are seven examples of IRIS ratios?

Brehm ch.2

A
  • gross WP to surplus
  • net WP to surplus
  • change in writings
  • surplus aid to surplus
  • two-year operation ratio
  • investment yield
  • liabilities to liquid assets
80
Q

how do RBC (risk-based capital) models assess risk?

Brehm ch.2

A

combine measures of different aspects of risk into a single number

81
Q

what four aspects of risk are generally included in RBC models?

(Brehm ch.2)

A
  • invested asset risk
  • credit risk
  • premium risk
  • reserve risk
82
Q

how do RBC ratios quantify risk?

Brehm ch.2

A
  • each aspect of risk is measured by multiplying factors by accounting values
  • magnitude of factors varies by quality and type of asset, LOB
83
Q

what is an example of accumulation risk?

Brehm ch.2

A

exposure to catastrophic events affecting a large number of insureds

84
Q

how do RBC models typically recognize accumulation risk?

Brehm ch.2

A
  • via stress testing of the impact of a second severe event

- through use of annual AGGREGATE loss amounts rather than per-occurrence losses

85
Q

why are there significant differences among RBC models (US, Canada, Japan, A.M. Best, S&P) in the levels of factors?

(Brehm ch.2)

A
  • use of the models

- presences of a covariance adjustment

86
Q

how are the different RBC models used [differently]?

Brehm ch.2

A
  • AM Best and S&P models are used to determine whether company will be viable in long term -> rating agencies should have higher factors
  • regulatory models are used to evaluate one-year likelihood of insolvency
87
Q

why do many RBC models have a covariance adjustment?

Brehm ch.2

A

intended to reflect the independence of the various risk components

88
Q

what is the impact of a covariance adjustment on required capital via RBC models?

(Brehm ch.2)

A

-total required capital is less than the sum of the individual risk charges

89
Q

what does the reduction in required capital due to a covariance adjustment depend on?

(Brehm ch.2)

A

-relative magnitudes of the risk charges -> greater reductions occur when risk charges are similar in size

90
Q

what is the largest component of credit risk in an RBC?

Brehm ch.2

A

reinsurance recoverables

91
Q

how does the calculation of credit risk due to reinsurance recoverables vary by RBC models?

(Brehm ch.2)

A
  • several models use risk factors that vary with credit quality of reinsurer
  • AM Best increases credit risk charge for companies that are heavily dependent on reinsurance
92
Q

what does Canada’s Dynamic Capital Adequacy Test measure?

Brehm ch.2

A

capital impact due from a predefined list of static scenarios

93
Q

what are recent best practices for RBC used by regulators?

Brehm ch.2

A
  • RBC model as base metric
  • insurer performs own internal assessment, often including scenario testing/stochastic modeling
  • regulator reviews company’s analysis and has right to provide alternative capital requirement based on company’s assessment
94
Q

what does scenario testing for measuring capital adequacy typically involve?

(Brehm ch.2)

A

-preparation of a one to five year financial projection model -incorporation of probability distributions for as many sources of uncertainty as can be modeled

95
Q

what are two critical features of projection models?

Brehm ch.2

A
  • correlations among risk

- reflections of management responses to adverse financial results (for multi-year models only)

96
Q

why is an increase in surplus by issuing surplus notes LESS than a dollar-for-dollar increase in adjusted surplus? (3)

(Brehm ch.2)

A

1) interest on surplus note may exceed rating agency’s estimate of insurer’s annual return on capital
2) amount of surplus note may exceed a threshold %age of capital
3) rating agency may reduce benefit of surplus notes for those reasons

97
Q

what does asset-liability matching ensure?

Brehm ch.2

A

ensures that duration of investment portfolio of a firm matches the duration of the liabilities that those assets support

98
Q

what does asset-liability management do (beyond duration)?

Brehm ch.2

A

considers additional factors such as inflation risk, credit risk, and market risk item

99
Q

in a stand-alone asset portfolio with no liabilities, what are risk-free and risky investments?

(Brehm ch.2)

A
  • short-term treasuries are considered risk-free

- high-yield assets (such as stocks and bonds) are considered risky

100
Q

what risk is introduced when we add fixed-duration liabilities to a stand-alone asset portfolio?

(Brehm ch.2)

A

reinvestment risk:

  • if interest rates drop, total investment income may not be sufficient to cover liabilities
  • if interest rates rise, longer-term investments (with durations > liabilities) introduce risk as well if depressed assets must be liquidated to fund liabilities
101
Q

what is a good strategy to neutralize interest rate changes for fixed-duration liabilities?

(Brehm ch.2)

A

duration matching

102
Q

what is a good strategy for an asset portfolio with liabilities with variable timing and amount?

(Brehm ch.2)

A
  • duration matching no longer possible (duration is unknown)

- model incorporating asset and liability fluctuations would be needed to determine optimal investment portfolio

103
Q

under statutory accounting, what should be noted about finding the ‘optimal’ investment portfolio?

(Brehm ch.2)

A
  • bonds are amortized
  • liabilities are not discounted
  • -> assets provide little hedging to liabilities
104
Q

under GAAP accounting, what should be noted about finding the ‘optimal’ investment portfolio?

(Brehm ch.2)

A
  • bonds are marked to market
  • liabilities not discounted
  • -> assets provide little hedging to liabilities
105
Q

under economic accounting, what should be noted about choosing an ‘optimal’ investment portfolio?

(Brehm ch.2)

A
  • assets are marked to market
  • liabilities are discounted
  • -> hedging does occur
  • -> short-term portfolios increase risk and decrease return
  • -> long-term portfolios increase risk and increase return
106
Q

what does an asset-liability modeling approach start with?

Brehm ch.2

A

models of:

  • asset classes
  • existing liabilities
  • current business operations
107
Q

what are examples of asset classes we might model?

Brehm ch.2

A
  • stocks

- bonds

108
Q

what are examples of existing liabilities we might model?

Brehm ch.2

A
  • loss reserves

- receivables

109
Q

what are examples of current business operations that we might model?

(Brehm ch.2)

A
  • premium incomes
  • incurred losses
  • expenses
110
Q

what are four parameters/assumptions that need to be defined for an asset-liability modeling approach?

(Brehm ch.2)

A
  • risk metrics
  • return (return on equity, earnings)
  • timing of the analysis
  • constraints
111
Q

what goes into defining risk metrics for asset-liability modeling?

(Brehm ch.2)

A
  • can be income-based or balance-sheet based

- appropriate risk measure depends on risk metric

112
Q

what should be considered when defining return for asset-liability modeling?

(Brehm ch.2)

A

-accounting system used should be consistent with the system used for defining risk

113
Q

what should be considered when defining the timing of the analysis for asset-liability modeling?

(Brehm ch.2)

A
  • are we measuring risk and reward over a single period of multiple periods?
  • single period models may not fully capture true nature of a business
  • multi-period models may be too complicated to implement
114
Q

what are two considerations when defining constraints for asset-liability modeling?

(Brehm ch.2)

A
  • which asset classes are not allowed by state regulators?

- which investments would drive risk-based capital numbers too high?

115
Q

what general scenarios should asset-liability modeling incorporate?

(Brehm ch.2)

A

variety of:

  • investment strategies
  • underwriting strategies
  • reinsurance options
116
Q

what should the simulations be reviewed for in the last step of asset-liability modeling?

(Brehm ch.2)

A

-identify conditions in which even the preferred investment/reinsurance options performed poorly –> management may be able to monitor for such conditions and respond proactively

117
Q

what are two items of asset-liability modeling for future research?

(Brehm ch.2)

A
  • better understand correlations between LOB and assets and liabilities
  • better understand link between inflation and future loss payments
118
Q

what is one way to handle a lack of understanding about correlations between LOB and assets/liabilities; and link between inflation and future loss payments?

(Brehm ch.2)

A

-include correlations and inflation sensitivity as random variables within the model

119
Q

what are three paradigms for measuring reinsurance value?

Brehm ch.2

A
  • it provides stability
  • it frees up capital
  • it adds market value to the firm
120
Q

what does it mean for reinsurance to provide stability?

Brehm ch.2

A
  • protection of surplus
  • improved predictability of earnings
  • customers’ assured recovery of their insured losses
121
Q

what is the “cost” of stability provided by reinsurance?

Brehm ch.2

A

ceded premiums minus loss and expense recoveries

122
Q

what is an important comparison when considering capital freed up by reinsurance?

(Brehm ch.2)

A
  • amount paid to purchase reinsurance vs. amount of capital freed up
  • ROE (ratio of amt pd to amt freed) should be less than firms target return
123
Q

why is standard deviation misleading when comparing reinsurance programs?

(Brehm ch.2)

A

SD can be reduced by eliminating favorable deviations (ie compressing the distribution)

124
Q

why is a “worst possible scenario” misleading when comparing reinsurance programs?

(Brehm ch.2)

A
  • very very remote probability of occurring (ex: 1-in-25000 year event)
  • unreasonable level to manage to -> compare at more realistic probability levels (ex: 1-in-100, 1-in-250, 1-in-10)
125
Q

is it better to compare the probability distributions of two reinsurance programs, or the distribution of DIFFERENCES between two programs, and why?

(Brehm ch.2)

A
  • more useful to directly compare the probability distributions
  • percentiles of each distribution probably do not relate to same loss event
126
Q

when looking at a comparison graph showing the cost and loss amount at specified probability levels for various reinsurance programs, what makes a program “efficient”?

(Brehm ch.2)

A

to be efficient at a selected probability, a more expensive program has to have a lower loss level at that probability

127
Q

why might combined ratio be a misleading metric when comparing reinsurance programs?

(Brehm ch.2)

A

if a reinsurance program has slightly stronger u/w results but far more ceded premium, then the combined ratio will actually be worse (even though absolute u/w income is better)

128
Q

what is an example of “releasing” capital?

Brehm ch.2

A

purchasing reinsurance to reduce capital needs

–> LESS capital needed

129
Q

what threshold of ROE is preferred when releasing capital?

Brehm ch.2

A
  • low marginal ROE

- ROE lower than firm’s own cost of capital is preferred

130
Q

what is an example of “consuming” capital?

Brehm ch.2

A

changing reinsurance programs to a less expensive option that requires a bit more capital
–> MORE capital needed

131
Q

what threshold of ROE is preferred when consuming capital?

Brehm ch.2

A

-higher ROE -> higher than firm’s own cost of capital

132
Q

what are two classes of models for required capital?

Brehm ch.2

A
  • theoretical models

- practical models

133
Q

what are theoretical models for required capital?

Brehm ch.2

A

those that derive required capital and changes in required capital, based on calculated risk metrics from the enterprise risk model (such as VaR, TVaR, etc.)

134
Q

what are practical models for required capital?

Brehm ch.2

A

those that derive required capital based on rating agencies (ex: BCAR, S&P CAR), regulatory requirements (ex: RBC, ICAR) or actual capital

135
Q

how is reinsurance considered for theoretical and practice models?

(Brehm ch.2)

A
  • calculate required capital with and without reinsurance, based on chosen risk measures
  • then calc change in required capital
136
Q

what is one disadvantage of practical models for required capital?

(Brehm ch.2)

A

they rely on risk proxies (such as premiums and reserves) rather than relying on the risk itself

137
Q

how can we compensate for the reliance of practical models on risk proxies?

(Brehm ch.2)

A
  • building rating agency and regulatory models into the ERM
  • capital score calculated for each scenario
  • produce prob. distr. of capital scores
  • required capital set at diff. prob levels
138
Q

how do loss reserves create accumulated risks?

Brehm ch.2

A

they absorb capital over multiple periods

139
Q

what are as-if loss reserves for an AY of new business?

Brehm ch.2

A

the reserves that would exist at the beginning of the AY if that business had been written in a steady state in all prior years

140
Q

how do we obtain a proxy for the capital absorbed by an AY over time?

(Brehm ch.2)

A

by combining the current AY with the as-if loss reserves (which represent accumulation of reserves from prior years)

141
Q

what are two advantages of the use of as-if loss reserves?

Brehm ch.2

A
  • can measure impact of accumulated risk caused by correlated risk factors across AYs
  • reinsurance considered can be applied to AY and as-if reserves
142
Q

why is it a benefit to consider the reinsurance of AY and as-if reserves?

(Brehm ch.2)

A

provides a more valid measure of the impact of reinsurance on accumulated risk and on capital absorbed over the full life of the AY

143
Q

why are the results of an accumulated risk analysis highly dependent on underlying projection risk model (e.g. severity trend model)?

(Brehm ch.2)

A

reserves are exposed to trend risk

144
Q

how does including accumulated risk impact the distribution of u/w results and capital onsumed?

(Brehm ch.2)

A
  • distribution of u/w results is less compressed and has bigger tails
  • capital consumed is greater
145
Q

what is a good cost measure for reinsurance?

Brehm ch.2

A

NPV of earnings expected from the program

146
Q

what is a poor cost measure for reinsurance, and why?

Brehm ch.2

A

combined ratio because it can give a distorted picture of the effects of reinsurance on earnings

147
Q

why can measures of stability like standard deviation give misleading pictures of the stability obtained from reinsurance?

(Brehm ch.2)

A

can be lowered by eliminating the chances for favorable deviations

exam 7 (21 decks)

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