Chapter 6: Financial Planning Flashcards

1
Q

Prime objective in modelling

A

To enable an actuary to give a general insurer appropriate advice so that it can be managed in a sound financial manner.

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2
Q

A model should ideally meet 9 requirements

A
  • The model being used must be valid, rigorous enough for its purpose and adequately documented.
  • Adequately reflects the risk profile of the financial products, schemes, contracts or transactions being modelled.
  • Parameters must allow for all those features of the business being modelled that could significantly affect the advice being given.
  • The inputs to the parameter values should be appropriate to the business being modelled.
  • Workings should be easy to appreciate and communicate.
  • Communicable and capable of independent verification.
  • Not be overly complex so that results become difficult to interpret and communicate or the model becomes too long or expensive to run.
  • Capable of development and refinement.
  • A range of methods of implementation should be available to facilitate testing, parameterisation and focus of results.
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3
Q

15 Reasons why an insurer uses financial models

A

PREMIUM CALCULATION:

  • to arrive at a risk premium per policy
  • to select RATING FACTORS
  • to DETERMINE PREMIUMS using experience-rating procedures
  • to estimate the effect of changing the level of cover by changing the levels of deductibles
  • to estimate the effect of changes in the terms and conditions of the policy wording

SOLVENCY

  • to assess and project the level of solvency
  • to ALLOCATE CAPITAL to different classes or categories of business

REINSURANCE

  • to assess the benefits and costs of reinsurance
  • to assist in the design of a suitable REINSURANCE programme

CLAIMS

  • to estimate the likely VARIABILITY of claims experience
  • to IDENTIFY TRENDS in claims at an early stage, for example, decline in the performance of certain contracts
  • to RESERVE FOR UNCERTAINTY, for example, to estimate the possible effect of industrial diseases on the reserve run-off

BUSINESS PLANNING

  • to VALUE PORTFOLIOS for purchase/sale
  • to OPTIMISE INVESTMENT strategy and asset performance
  • to ASSIST SENIOR MANAGEMENT in strategic decision-making and developing business strategy.
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4
Q

The aim of a general insurer’s financial plan

A

To set out courses of company action, subdivided and explained to a level of detail consistent with its purposes, which support or meet the company’s short-term targets and longer-term strategic vision.

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5
Q

Any financial plan must have (4)

A
  • one or more goals
  • a strategy to be followed to achieve those goals
  • a set of targets that will enable the success or failure of the strategy to be measured
  • a financial projection(s)
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6
Q

4 key benchmarks upon which a general insurance financial plan will focus

A
  • expected loss ratios (gross and net of reinsurance)
  • new business volumes and renewal rates
  • capital implication
  • the overall profitability of the company moving forward
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7
Q

Financial planning will often incorporate financial modelling.

Such a model will need to reflect: (2)

A
  • the nature, size and structure of the general insurer

- the future financial position of the general insurer under different scenarios

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8
Q

Capitalisation horizon

A

the number of years of new business to be modelled

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9
Q

Modelling horizon

A

the number of future years for which the cash flows are projected

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10
Q

The capitalisation and modelling horizons should be based on …

A

The type of uncertainty under which we are modelling the liabilities.

The type of uncertainty in this context may be a year-on-year uncertainty or an uncertainty to ultimate.

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11
Q

How should the risk measure be determined?

A

The risk measure should be determined, for example, standard deviation, VaR, T-VaR and so on.

The risk measure should be applied to the variable under consideration, such as the net asset value or loss ratio.

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12
Q

Model usually splits future claims into 3 types:

A

ATTRITIONAL CLAIMS
usually based on a loss ratio model (high frequency, low severity)

LARGE CLAIMS
usually based on either separate claims frequency and severity models or an aggregate loss model

CATASTROPHE CLAIMS
based on a catastrophe model, where available, or based on claims frequency and severity models.

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13
Q

Each of the business claims would usually be split into (4)

A
  • the development of historic notified claims (IBNER)
  • Incurred But Not Reported (IBNR) claims
  • claims from the period of unexpired risk on existing business
  • claims from business that is written in the future
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14
Q

Assumptions about reinsurance will need to take into account (6)

A
  • the reinsurance market cycle
  • the financial strength of the reinsurers

any EXISTING ARRANGEMENTS:

  • any changes that could be made to those arrangements
  • the impact of any new products/features on the existing reinsurance arrangements

POSSIBLE NEW ARRANGEMENTS that could be put in place

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15
Q

4 Types of financial planning models

A
  • deterministic
  • stress and scenario
  • stochastic
  • Dynamic Financial Analysis (DFA)
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16
Q

8 Steps when developing and applying a deterministic model

A
  • 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
17
Q

Stress test

A

Assesses the impact on a financial plan of a major change in a single assumption in the model, e.g. a major change in the future inflation rate.

18
Q

Scenario test

A

Assesses the impact of a combination of stresses. A common example is to assess the impact on solvency of a large catastrophe together with one or more of the reinsurers defaulting.

19
Q

3 Ways in which we can assess variability of claims experience

A
  • determine the number of claims stochastically and assume a deterministic mean claim cost. Ideally we would first divide the claims into homogeneous groups with respect to claim size.
  • determine the claim amounts stochastically for the expected number of claims, or
  • determine both claim amounts and numbers stochastically, using a collective risk model.
20
Q

A stochastic model could involve the following steps: (11)

A
  • 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 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.
21
Q

Dynamic Financial Analysis (DFA)

A

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.

22
Q

DFA’s purpose is to provide management with:

A
  • reliable information about the interaction of decisions from all areas of the company’s operations
  • a quantitative view of the risk-and-return trade-offs inherent in emerging strategic opportunities
  • a structured process for evaluating market alternatives
23
Q

3 Fundamental aims of an insurer

A
  • absorb the transfer of policyholder risks
  • earn an appropriate return on shareholders’ (or other) capital
  • minimise the company’s exposure to insolvency
24
Q

DFA encompasses 4 distinct stages

A

FINANCIAL BUDGETING
A static process which uses only one set of assumptions about the future operating results for a company’s various business units.

SENSITIVITY OR STRESS TESTING
Processes which investigate best case and worst case scenarios along with the expected outcome.

STOCHASTIC MODELLING
Making it possible to describe critical assumptions, and their financial implications, in terms of ranges of possible outcomes, rather than in terms of fixed values and results.

DYNAMIC MODELLING
Incorporating feedback loops and management intervention decisions into the models, enabling differences in financial results arising from alternative strategic decisions to be evaluated by replacing one set of strategic decisions with another, re-running the modelling exercise and comparing the ranges of possible outcomes under each decision path.

25
Q

An integrated DFA model will: (4)

A
  • apply the same macroeconomic conditions (e.g. interest rates, inflation rates and catastrophic events) across all divisions and departments of the insurer
  • allow management to consider both operating needs and conditions in the financial markets as they make investment decisions
  • examine the risk-and-return trade-offs of various investment and operating decisions in terms of how they affect the entire organisation, not in isolation
  • allow management to tailor and integrate their reinsurance programmes for its various departments and the entire company, all at once.
26
Q

A DFA model will support strategic decisions in 11 areas:

A
  • realism of a business plan
  • product and market development
  • claims management
  • capital adequacy
  • capital allocation
  • liquidity
  • reinsurance structure and cost
  • asset/investment strategy analysis
  • rating agency support (demonstration of risk management techniques)
  • merger and acquisition opportunities
  • closure of books of business
27
Q

5 Stages in building a DFA model

A
  • selecting an appropriate model structure (what business areas to include)
  • deciding which variables (e.g. claim costs, premium growth) should be included, and their interrelationships
  • determining the types of scenarios which should be developed and modelled (e.g. interest rate environment, competitive environment, insurance cycle)
  • estimating the parameters that should be used for each variable (i.e. the mathematics that specifies the behaviour of each variable)
  • test and validate the reasonableness of the assumptions and their interactions (e.g. the projection of future claim payments versus historical levels of claim payments)
  • monitor and update regularly
28
Q

6 Issues of DFAs

A
  • Models can be complex and their results difficult to interpret
  • Garbage in, garbage out - the value of a DFA model is only as good as its underlying data input allows.
  • Occasionally, very subjective assumptions are required to be made, especially tail risk and tail correlations.
  • Results may be difficult to communicate to boards of directors.
  • Models are specific to each group - this can lead to difficulties in the consistency of approaches and comparability of results.
  • Lack of market standards - especially from the viewpoint of regulators and credit rating agencies.
29
Q

The modelling process will involve making key assumptions about: (10)

A
  • the time horizon
  • risk measures
  • the economic environment
  • investment returns
  • the insurance cycle
  • future written premium income
  • future claims
  • reinsurance
  • future expenses
  • catastrophes
30
Q

What are the capitalisations and modelling horizons as prescribed under the SAM regulations.

A

Both are one-year.

Often the capitalisation and modelling horizons will be the same.

31
Q

What is the risk measure used in the SAM standard formula?

A

VaR, subject to a confidence level of 99.5% over a one-year period.

32
Q

4 Main areas of risk that a general insurer faces

A
  • claims risks
  • expense risks
  • investment risks
  • business risks
33
Q

What is the type of financial model used in the SAM standard formula?

A

A deterministic model with scenario stress testing.