Butsic: Solvency Measurement for RBC

Question 1

Risk based capital, RBC

Answer 1

amount of capital needed to protect against the risks to which it is exposed

Question 2

to ensure equity for all parties to insurance contract, RBC method needs to satisfy several criteria:

Answer 2

1. standard needs to be same for all types of insurers (personal v commercial, primary v reinsurers)
2. RBC needs to be objectively determined (2 insurers with same risk exposure need to have same RBC requirements)
3. approach should be able to distinguish between items that differ material in level of riskiness

Question 3

Probability of ruin & issue with measuer

Answer 3

Probability of ruin: commonly used diagnostic to determine the amount of capital necessary to provide the company with adequate level of protection

-issue with measure is that it does not account for severity of ruin (the amount that policyholders stand to lose)

Question 4

Expected policyholder deficit, EPD

Answer 4

expected value of the difference between the amount the insurer is obligated to pay the claimant and the actual amount paid

alternate measure that accounts for severity

Question 5

EPD measures dollar severity of

Answer 5

insolvency risk

Question 6

EPD can consistently measure insolvency risk in such a way that

Answer 6

a standard minimum level of protection is applied to all classes of policyholders and insurers

Question 7

in order to compare policyholder deficits of different insurers,

Answer 7

deficits should be adjusted to reflect the different exposure sizes of each insurer

-can accomplish this by calculating EPD ratio (d)

Question 8

EPD ratio, d

Answer 8

ratio of deficit to expected loss

Question 9

in order to derive capital need of insurer

Answer 9

make assumption that a regulator establishes a capital standard that would produce an equal EPD for all insurers (assuming 5% of expected losses)

-assets are adjusted to achieve this ratio

Question 10

capital requirement for losses that have lognormal probability distribution

Answer 10

is higher than losses that have normal distriubtion

-probability of large losses is higher under lognormal

difference increases as coefficient of variation increases

Question 11

if assets follow lognormal

Answer 11

less capital required under normal case because under lognormal assets cannot be negative

Question 12

if insurer is exposed to several risks

Answer 12

individual capital amounts need to be aggregated

Question 13

for 2 independent lines

Answer 13

less capital per line will be needed to achieve the same EPD ratio for an insurer that has 2 LOBs than for insurer that only has 1

Question 14

capital needed is ____ than need if all of risks were fully correlated

Answer 14

less

Question 15

square root rule

Answer 15

simplified formula that accounts for correlation

can be used to approximate capital need in case of multiple risky assets and/or liabilities

Question 16

if risky items appear on opposite sides of the balance sheet

Answer 16

correlation needs to be multiplied by -1

Question 17

basing RBC calculations on accounting book value

Answer 17

is not appropriate due to inherent accounting bias

Accounting bias: current recorded value does not necessarily equal current realizable value

Question 18

Market value accounting

Answer 18

Market value accounting: based on current realizable value

-preferable for solvency assessment as in event of an insurer’s failure, items of balance sheet are liquidated at market rates

Question 19

prior sections assumed insurer was in runoff situation:

Answer 19

it did not consider the risk from policies becoming effective in future

• there is a lot of risk associated with new policies
• rapid growth has caused several insolvencies in past
• insurers can calibrate the capital need periodically to maintain a constant EPD ratio

Question 20

time span (time horizon) between valuation dates will have

Answer 20

material impact on measurement of risk as range of possible values increases as time span increases

-under RBC system, insurer would need to annually adjust its capital to keep its risk levels consistent: to keep EPD ratio constant, capital should be adjusted such that ratio of capital to reserves remains constant