Butsic: Solvency Measurement

Question 1

Technical insolvency

Answer 1

When obligations exceed assets

Question 2

When solvency regulation would not be necessary

Answer 2

If there was a perfectly efficient market

Question 3

Why solvency protection is desirable

Answer 3

Information asymmetry; less informed personal lines customers

Question 4

Desirable features of a RBC Method

Answer 4

1. Standard should be the same for all classes
2. Should be objectively determined (two identical insurers should have same RBC
3. Must be able to discriminate betwen quantifiable items of meaningful value that differ materially in their riskiness

(Note: risk element must be a balance sheet quantity)

Question 5

When risk is present for a balance sheet item

Answer 5

When future realization of the item can be one of several values, but particular outcome is currently unknown

Question 6

Why probability-of-run criterion is inadequate to express policyholder exposure to loss

Answer 6

It ignores the severity of the ruin

Question 7

Policyholder deficit

Answer 7

Expectd value of the difference between the insurer obligation and the actual amount paid

Question 8

EPD where assets are certain, discrete

Answer 8

Question 9

EPD where losses are certain, discrete

Answer 9

Question 10

EPD where assets are certain, continuous

Answer 10

Question 11

EPD where losses are certain, continuous

Answer 11

Question 12

Assuming normal distribution, EPD ratios

Answer 12

Question 13

If CV is the same, to make d_A = d_L

Answer 13

More capital (per unit of assets) is required for assets than for losses (per unit of losses)

Question 14

When normal distribution is reasonable approximation for variation of aggregate incurred losses

Answer 14

When individual losses occur independently of each other (i.e. non-CAT property insurance)

Question 15

When lognormal distribution is reasonable to approximate variation of aggregate losses

Answer 15

For correlated events

Question 16

Advantages/Disadvantages to lognormal distribution

Answer 16

A: Negative values impossible

A: Skewness of outcomes appears to accord with observed results

D: Sum of two lognormals only approximately lognormal

Question 17

Assuming lognormal distribution, EPD ratios

Answer 17

Question 18

Capital requirement, normal vs. lognormal

Answer 18

Lognormal requires less than normal

Due to skewness of lognormal (asset values cannot be negative)

Probability of large losses higher under normal distribution

Question 19

Accounting treatment for solvency risk measurement

Answer 19

Should directly reveal realizable value variations

Market-value accounting is suitable since failure results in liquidation or repurchase, which happen in market transactions

Question 20

Limits of accounting book value definition of capital

Answer 20

Accounting bias (current recorded value differs from current realizable value

SAP allows insurers to consistently over- or under-value financial statement elements (i.e. not discounting loss reserves)

SAP and GAAP inconsistent

Question 21

Time-dependent nature of risk

Answer 21

Variance will increase through time even though mean could remain constant or decrease

Use variance per unit of time instead

Question 22

Expected insolvency cost over time

Answer 22

Increases with length of time required to pay loss, since spread of possible loss values widens

Question 23

Key requirements to keeping consistent level of policyholder safety

Answer 23

Know time-dependent nature of future realizable values

Insurer can liquidate assets/liabilities at each evaluation point

Insurers will add capital when needed

Question 24

EPD for liability risk element paired with riskless assets

Answer 24

Equivalent to a call opten on the losses with exercise price equal to value of assets at the end of th eyear

Question 25

EPD for asset risk element paired with riskless liability

Answer 25

Equivalent to a put option on the ending assets

Question 26

Mean and variance of capital with two normally distributed assets or liabilities

Answer 26

Question 27

Square root rule for aggregate risk capital

Answer 27

Question 28

If two items are on opposite sides of the balance sheet

Answer 28

Change the correlation sign

Question 29

Key results of Butsic

Answer 29

1. Relevant measure of solvency is PV of EPD as ratio to expected loss
2. Market value removes measurement bias
3. Longer time to realization, greater the risk
4. Capital is not required now for distant contingencies
5. RBC < sum of all RBC elements
   5b. Knowing correlation between risk elements super important