CH 18 - 19 (Models) Flashcards
Different Types of Model
+ Focus of Each
- (Single Policy) Profit Test Model
> Expected CFs and Profit pp
> NB for Pricing and Product Design - New Business Model
> Cash + profit from future sales of new business
> NB for future capital required + expected return - Existing Business Model
> Cash + profit from all existing business at point in time
> NB for EV and testing solvency - Full Model Office
> New business mode + Existing business model
> NB for assessing impact of future management decisions
Requirements of a good model (pt 2)
–Valid
–Adequately documented
–Rigorous
–Inputs to parameters need to be appropriate
–Arbitrage free (economic interpretation)
–Behave reasonably
–Length not too long to run or too expensive
–Easy to understand
–Communicable and transparent workings/outputs
–Representativeness (reflects risk profile of contracts being modelled)
–Independent verification of outputs
–Sensible joint behaviour of variables
–Parameters allow for all significant features
–Simple (parsimonious)
–Clear results (transparent)
–Adaptable (versatile in implementation)
–Refineable
–Developable
(evolution process for last 3)
…old:
–appropriate Parameters
–Communicable
–Valid
–Verifiable
–Versatile
(applicable to different contexts)
–major Features captured
Advantages of Deterministic
CAT
- reduced Time and Computing requirements
- reduced spurious Accuracy
Optimal Contexts:
1. Only expectation is sought
2. Specific scenario being tested within a CF model
3. Quick independent check on stochastic
4. Sensitivity testing
5. Within stochastic model (as closed-form approx.) to avoid additional complexity of nested stochastic
Advantages of Stochastic
PIG
- Getting a distribution of results
- Interaction between variables
- Probability needed
Optimal Contexts:
1. Guarantees and Options
2. Resilience and uncertainty is being evaluated (probability)
3. Calculating positive liability where deterministic approach might just produce zero liability
(e.g. min guarantees)
4. Future parameters are considered to vary as a dynamic set
5. Identify high risk future scenarios (worst simulated outcomes)
Model Checks
- Reconcile with previous valuation
- Reconcile last model run
- Ratio checks
- Back of the envelope checks with model points
Calibration of Stochastic Models
- Risk Neutral
> aka Market Consistent
> aka Financial Economic
> Typically used for valuation purposes - Real World
> Reflect LT Expecting
> Typically used for projections
> E.g. Calculating capital level to ensure solvency
Use of Models
- Pricing
- Return on Capital
- Capital Requirements
- Profitability
- Investment strategy
- Future supervisory solvency position
- General financial projections
Profit Criteria
- NPV
- IRR
- DPP
NPV (Def + limitations)
> Profit signature discounted at RDR
Economic theory implies it to be the best profit criterion
Typically presented as % of sales cost or premium income (standardise by effort + market size)
LIMITATIONS:
> Dependent on RDR being appropriate
> Context is perfectly free and efficient capital market
> Subject to law of diminishing returns
(higher costs for same return with more and more units)
> Says nothing about competition
(high NPV means nothing if not sell-able)
IRR (Def + limitations)
> Rate of return at which discounted value of CFs is zero
LIMITATIONS:
> Might not exist
(profits from outset)
> Might not be unique
(changes in sign of profits)
> Can’t be related to other indicators
DPP (Def + limitations)
> Policy duration at which profits that have emerged have a PV of zero
Useful when recouping initial capital investment quickly is important
LIMITATIONS:
> No context of overall profitability
Two Key Methods (????)
> Supervisory (regulatory) values
Economic values
(expected experience
/market consistent basis)
Purpose of Capital
-demonstrate financial Strength
-Opportunities (ventures like mergers/acquisitions)
-cover Unexpected events
(can reduce reinsurance)
-Smooth dividends/bonuses
-Start-up capital
-Statutory capital (regulatory)
-Investment freedom (mismatching)
-allow company to offer Guarantees
-on-Going capital needs (working capital)
Purpose of Sensitivity Testing
- showing Vulnerability of results to unexpected future experience
- assist product Design to make product less sensitive to uncertain factor
- help determine Margins that may be necessary in a basis
- help to determine Variance of profit or return on capital
- Qualitative check that model is working correctly
