Capital 2 Flashcards
What are the risks in companies that we need capital to manage?
- Asset risks -> Events that may cause a reduction in the mkt value or income from the assets
- Liability risks -> Events that may increase liabs.
- Asset/Liability risks -> Events that move both asset/liab values st. the outcome is negative
- Operational risks -> Events that cause losses as result of inadequate/failed internal processes, people & systems or from external events
What are the ASSET related risks in insurance companies?
- Default risks
- Market movements risk
- Concentration risk
- Liquidity risk
- Risk of losses from assets that do not have intrinsic value
Default risks
- Risk that investor does not receive the expected return on asset or risk of total loss of the asset
- > Includes default of reinsurer
- > Credit risk (default on loans) is major risk for banks
Market movements risk
- Financial statements show assets at mkt value, so fall in asset value reduces available capital
Concentration risk
- Significant proportion of funds invested in ONE asset
eg. large loan to ONE client, large holding in ONE property. If something goes wrong with the asset eg counterparty defaults => large losses incurred wrt one asset
Liquidity risk
- Asset is difficult to sell for cash to meet immediate liabilities
-> Only way to obtain cash for the asset would be to
sell it at a loss
-> Company may be forced to borrow money
Risk of losses from assets that do not have intrinsic value examples
Examples:
- > Works of fine art, wine, vintage cars etc.
- > Loans to related parties eg. subsidiaries
- > Goodwill (asset value additional to mkt value)
- Allowed in company accounts after acquisition or due to company reputation
- —> These assets may need to be excluded from statutory valuations
What are the LIABILITY related risks of a insurance company?
- Pricing risk
- Concentration of liability risk
- Valuation risk
- Unexpected external event risks
Pricing risk
- Risk that premiums will not cover liabilities taken on ie. risk that the experience (claims/expenses) is worse than expected. Risks from
- > Fixed premiums of life insurance products
- > Loan repayments based on fixed-interest rates
Concentration of liabilities risk
- Liabilities are concentrated with a particular client, portfolio or geographic area
=> higher risk from bad events for that client or in that particular geographic area
Valuation risk
- Risk that reserves are not large enough to meet claims & expenses
- May need to increase the size of the reserves hence reducing the free capital available
What do reserves need to cover?
- Future claims wrt premiums received
- Outstanding claims
- Incurred but not reported (IBNR)
- Unearned premiums or unexpired risk
-> Premiums received to provide cover for period
which has not yet expired - Options in contracts eg. guaranteed insurability or
guaranteed premium rates
Unexpected external event risks
- Risk of events occurring that significantly change the context of the insurance problem:
- > Change in regulations
- > Court decisions increasing eligible claims
- > Major change in economic conditions
- > Terrorist attacks
What are the ASSET/LIABILITY risks related to an insurance company?
- Market risk
- Operational risk
Market risk
- Risk that change in mkt values or economic variables results in value of assets changing unfavourably relative to liabs
- > Major risk for pension schemes where liabs typically have longer duration than available assets eg. if interest rates fall liabs increase more than assets
Operational risk
- Risk of financial loss from inadequate or failed internal processes , people or systems or from external events
Examples:
- > Admin errors such as overpayment of a benefit
- > Failure of IT systems leading to closure of a part of operations
- > Fraud or mismanagement
- > Compliance problems leading to fines
o Some internal risks can be reduced by improving controls
o Difficult to calculate likelihood of operational risk due to lack of relevant data however financial firms are still required to consider operational risks in detail
Capital required may be based on different criterion for example:
(1) Amount of capital needed st. probability of losses from risks will not exceed the capital w prob. x%
x% -> accepted level of confidence
Need stochastic model of risk to calculate capital req.
(2) Amount of losses from risk based on stress tests
- > Stress tests based on risk related adverse events
(3) Regulatory capital requirements (may change from country to country)
Diversification benefits for capital requirements:
- Total required capital for a business UNIT (line) is likely to be less than the sum of capital needed for each of the business units’ individual risks
- Because the risks will not be 100% correlated with each other
- Similarly, capital req. for a company is likely to be less than the sum of capital required for individual business units eg. Consider a life company that sells both life cover + pension benefits (risks offset each other)
Wrt. the impact of diversification, what are questions that the company should address?
- Given the capital needs for each business unit, what is the capital need for the company overall?
- > What allowance is made for diversification?
- > How does the company allocate the overall capital to business units?
How does economic capital compare with regulatory capital?
- Economic capital may be higher or lower than regulatory capital
eg. If regulator is concerned w reducing prob. of failure, regulatory cap. req. might be higher than economic cap. req.
Rationale behind capital allocation:
- Organisation aims to make return on capital (profit)
- Need to analyse return on capital for each business unit
-> Need to notionally allocate capital to each business
unit to analyse return on capital - Might allocate less capital to business unit than on a standalone basis to reflect diversification benefits
- This increases return on capital for each business unit
What tools does an insurer have to manage the amount of capital it holds?
- Reinsurance
- Financial Reinsurance
- Securitisation
- Issuing debt or equity
- Internal restructuring eg. changing assets, weakening valuation basis, deferring surplus/dividend distribution to members/shareholders and retaining profit
How reinsurance effects on capital requirements:
- Reduces the amount of variability/size of claims
- Reduces new business strain as reinsurer pays commission to insurer upon acquisition of business
What is Financial reinsurance (FinRe)?
- Arrangement that provides capital usually by exploiting regulatory, solvency & tax arbitrages
What is securitisation?
- Involves converting an illiquid asset into tradable cashflows eg. insurers may transfer underwriting risk to capital markets by bundling insurance policies and securitising them
- Provides liquidity for the company
Competing objectives of capital management that actuaries will need to consider when providing advice:
(1) Model both existing & projected new business to assess cap. reqs. for the provider’s business plans to be achieved at a given ruin probability while considering statutory & regulatory requirements throughout lifetime of the business
(2) Consider the cost of holding capital to shareholders and to the company such that capital is not held unnecessarily (less inefficiency)
Regulatory restrictions on calculating capital requirement:
- Regulator may prescribe rules concerning how provisions are calculated wrt future liabs.
- Future is difficult to predict => calculation of provisions/capital reqs will contain margins for prudence
- Prudence achieved by setting cautious assumptions for provisions; or requiring additional capital to be held; or a combination of both
