Chapter 11: Financial Planning Flashcards
Requirements that a model should satisfy
[8]
- Must be valid, rigorous enough for its purpose and adequately
documented - Should be capable of adequately reflecting the risk profile of the
financial products, schemes, contracts or transactions being modelled - Parameters used must allow for all those features of the business being modelled that could significantly affect the advice being given
- Inputs to the parameter values should be appropriate to the business being modelled and account for any special features of the provider and the economic and business environment in which it is operating
- Workings of the model should be easy to appreciate and communicate. Results should be displayed clearly. Model should exhibit sensible joint behaviour of model variables
- Outputs from the model should be capable of independent verification for reasonableness and should be communicable to those to whom advice will be given
- Model, however, must not be overly complex so that either the results become difficult to interpret and communicate or the model becomes too long or expensive to run, unless this is required by the purpose of the model. It is important to avoid the impression that everything can be modelled.
- Model should be capable of development and refinement – nothing complex can be successfully designed and built in a single attempt.
- Range of methods of implementation should be available to facilitate testing, parameterisation and focus of results.
High level reasons as to why an insurer uses financial models?
[3]
- Premium calculation
- Solvency
- Business planning
How can financial models assist in premium calculations?
[5]
- Arrive at a risk premium per policy
- Select rating factors
- Determine premiums using experience-rating procedures
- Estimate the effect of changing the level of cover by changing the levels of deductibles
- Estimate the effect of changes in the terms and conditions of the policy wording
How can financial models assist in solvency?
[2]
- Assess and project the level of solvency
- Allocate capital to different classes or categories of business
How can financial models assist in business planning?
[8]
- Assess the benefits and costs of reinsurance
- Assist in the design of a suitable reinsurance programme
- Estimate the likely variability of claims experience
- Reserve for uncertainty, for example, to estimate the possible effect of industrial diseases on the reserve run-off
- Value portfolios for purchase/sale
- Optimise investment strategy and asset performance
- Identify trends in claims at an early stage, for example, decline in the performance of certain contracts
- Assist senior management in strategic decision-making and developing business strategy
The aim of a general insurer’s financial plan will be to ensure that the actions it takes and the decisions it makes result in the achievement of its aims.
What will the plan involve?
[3]
- Setting goals
- Strategy to meet the goals
- Targets to measure the success of the strategy
What are two key considerations in the plan?
- The trade-off between growth and expenses of developing the business
- Nature, size and structure of risks that they are exposed to
What are the key assumptions required in the modelling process?
[10]
- Time horizon (capitalization and modelling horizon)
- Risk measures used
- Economic environment
- Investment returns
- Insurance cycle and impact on loss ratios
- Future written premium income
- Future claims (attritional, large and cat)
- Reinsurance
- Future expenses
- Catastrophes
What is the capitalisation horizon?
The number of years of new business to be modelled.
Capitalisation horizon can also be influenced by the benchmarks set by senior management in consultation with the owners
What is the modelling horizon?
The modelling horizon is the number of future years for which the cash flows are projected
What are the four types of financial planning models?
- Deterministic
- Stress and Scenario
- Stochastic
- DFA
What are the steps to apply when using a deterministic model?
[8]
- Specify the purpose of the investigation
- Collect data
- Group and modify the data
- Choose the form of the model, identifying its parameters and variables
- Ascribe values to the parameters using past experience, where appropriate, and use appropriate estimation techniques
- Check that the goodness of fit is acceptable and attempt to fit a different model if not
- Run the model using selected values of the variables
- Run the model using estimates of the values of variables in the future
What are the steps to apply when using a stochastic model?
[11]
- Specify the purpose of the investigation
- Set the risk measure
- Collect data
- Group and modify data into relatively homogeneous lines of business
- Choose a suitable density function for each of the variables to be modelled stochastically
- Specify correlations between variables
- Estimate the required parameters for the chosen probability density function(s)
- Check the goodness of fit is acceptable and attempt a fit with different density function(s) if it is not
- Construct a model based on the chosen density function(s)
- Run the model many times, each time using a random sample from the chosen density function(s)
- Produce a summary of the results that shows the distribution of the modelled results after many simulations have been run
DFA represents a systematic approach to financial modelling, which projects financial results under a variety of possible scenarios, showing how outcomes might be affected by changing business, competitive and economic conditions
What is the purpose of DFA? [3]
Provide management with info on:
- Interaction of decisions from different areas of company’s operations
- Risk and return trade-offs in emerging strategic opportunities
- Evaluating market alternatives
What aims does a DFA model help management achieve?
[3]
- Absorbing the transfer of policyholder’s risk
- Earning an appropriate return on capital
- Minimising exposure to insolvency
