Corubulo's Notes Flashcards
3 Non-actuarial techniques (developing an investment strategy)
- Mean-variance optimisation
- Asset allocations based on market capitalisations
- Shadowing strategies of comparable institutions
4 Actuarial techniques (developing an investment strategy)
- Pure/exact matching
- Asset liability models
- Mean-variance with liabilities
- Liability hedging:
- Full hedging
- Approximate hedging
Pure matching
- Asset proceeds coincide precisely with net liability outgo
- Sensitivity of timing & amounts need to be known with certainty
Restrictions of Pure matching
- Except for fixed liabilities (matched with zero coupon bonds) it is rarely possible in practice.
- Suitable assets might not be available / prohibitively expensive.
It is, however, still useful as a benchmark position.
Full hedging / matching
Liabilities ‘behave’ (ito values, returns, CFs) in the same way as assets in terms of all relevant factors affecting assets and liabilities.
In practice it is achievable in limited circumstances.
- Unit price determined by reference to the portfolio
- It can be difficult if the benchmark is determined externally
- Derivatives (especially OTC) are extensively used
Approximate hedging
Hedging with regards to specific factors:
- Nature (fixed/real)
- Term
- Currency
- Immunisation (interest rates)
Immunisation
- Used when pure matching is not possible
- Invest so that “A-L or A/L” is immune to small interest rate changes
Reddingtons classical theory (immunisation)
- PV(liability outgo) = PV(asset-proceeds)
- DMT(liability outgo) = DMT(asset-proceeds)
- Spread arount DMT of asset-proceeds >= Spread arount DMT of liability outgo
Limitations of immunisation
- Aimed at fixed liabilities
- possibility of mismatching profits removed
- theory relies on small changes in interest rates
- theory assumes flat yield curve + same change in interest rate at all terms
- Requires constant rebalancing of portfolio
- Assets with suitably long DMT may not exist
- Unknown timing of asset proceeds / liability outgo.
Asset-liability models
- Measures risk of not meeting investment objectives
- Allows for variation in assets and liabilities simultaneously
- Usually a stochastic model
- Enables comparison of projected asset proceeds / liability outgo under different strategies to find an optimum strategy
- Encourages investors to formulate explicit objectives
Mean-variance portfolio theory with liabilities
- Extends portfolio theory to take account of investor’s liabilities
- Consider size of surplus at end of a single period
- Use mean-variance theory to minimize variance of surplus for a given expected return
In practice, we need to decide how to determine:
- value of the liabilities versus the assets
- variance and covariance of liabilities with assets
3 Components of overall investment risk
- Strategic (or policy) risk
- Structural risk
- Active (or manager) risk
Strategic (or policy risk)
Risk of poor performance of Strategic Benchmark relative to the Fund’s Liabilities
Structural risk
Strategic benchmark ≠ Aggregate of portfolio benchmarks
Active (or manager) risk
Risk that Managers underperform their portfolio benchmarks
Risk budgeting
Process of setting of risk limits.
Setting an overall risk limit, then deciding how to
… allocate the overall risk limit across all the activities/sources that give rise to investment risk
… in order to maximise overall return within the overall risk limit.
Historic tracking error
SD of difference between returns on portfolio and the benchmark (observed)
Forward looking tracking error
Estimate of future SD based on current portfolio structure, which is based on:
- expected future volatility of stocks / markets vs the benchmark
- expected future correlations between stock / markets
Active money
- Deviation from benchmark portfolio for a specific position
- The closer to zero, the more passive the fund
- Not a complete picture of risk taken on.
Ideal Criteria for a risk to be insurable
- Moral hazard must be avoided as far as possible
- The probability of the event occurring must be small
- Risks must be independent
- There must be a limit on the overall liability on the insurer
- Similar risks must be able to be pooled to reduce the variance and hence achieve more certainty
- There should be sufficient existing statistical data available to enable the insurer to estimate the extent of the risk and its likelihood of occurrence
(not mentioned)
- Policyholder must have a financial interest in the risk
- Risk must be of a financial and reasonably quantifiable nature
- Claim amount must be commensurate with the size of the loss
Why might a motor insurer want to investigate certain claims?
- To ensure that the claim is valid:
- – in terms of the peril covered
- – and the claim amount not being inflated
- Ensure that the claim is in accordance with the policy’s terms and conditions
- Investigate representative samples to help the insurer better understand the risk profile and aid pricing / underwriting
- May help to set new terms and conditions or types of claims (if the risk profile is changing)
- May help in providing advice to the insured on how to avoid (or reduce) claims. I.e. safety & security issues.
Describe the main criterion a company would use to determine whether or not to investigate a particular claim
- amount of the claim
Either actual claim amount or the estimated potential claim amount.
Large claims over a threshold would be investigated.
The rationale being that the potential savings on investigating small claims wouldn’t compensate for the expense, time or hassle involved.
The amount could be a fixed cash value or may be relative to average claim amounts.
Allowance would be needed for inflation of claims cost.
The threshold may vary by type of claim or other rating factor.
Liquidity risk
risk that the individual or company, although solvent, does not have sufficient financial resources available to enable it to meet its obligations as they fall due.
Operational risk
Refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
What actions might a health insurance company take to reduce the deterioration in its solvency position
- control expenses
- expense investigation
- better / more stringent underwriting
- improve claims underwriting
- monitor claim validity
- remove unnecessary margins (overly prudent) in the pricing basis
- Use reinsurance to limit the volatility of claims or protect it from risk
Capital management tools which might be suitable for a mutual life company
Financial reinsurance:
Can be used to provide a capital benefit to a mutual insurance company although there will be some risk transfer involved.
Securitisation
Subordinated debt
Banking products
- liquidity facilities
- contingent capital
- senior unsecured financing
Derivatives
May be used to manage risk relating to long-term interest / inflation rates, and/or manage risk relating to long-term mortality experience.
Internal:
- – funds could be merged
- – assets could be changed
- – the valuation basis could be weakened
- – the distribution of surplus could be deferred
Outline why a new insurance company might need capital
WORKING CAPITAL - a cushion against fluctuating trade volume.
START-UP CAPITAL - to obtain premises, hire staff, purchase equipment and set up a suitable management system to administer the liabilities, collect premiums etc.
CLAIMS MIGHT ARISE before the provider has had enough time to accumulate sufficient funds from premiums to pay the benefits.
STATUTORY REQUIREMENT - to hold a provision in excess of the best estimate value of future outgo.
COMMISSIONS to brokers/intermediaries will use a high proportion of initial premiums.
FINANCIAL STRENGTH is important to (prospective) policyholders, agents, rating agencies and providers of capital.
Longevity risk
The risk of losses due to mortality being lighter than expected.
Why might an individual want to transfer longevity risk?
The risk is important: risk that the individual’s savings are used up while they are alive so unable to maintain desired standard of living.
To the individual this risk is non-diversifiable, so transfer is the best way to manage it.
Good risk management enables a provider to (12)
- Improve the
- – STABILITY
- – QUALITY of their business
- Improve their growth / returns by
- – EXPLOITING RISK OPPORTUNITIES
- – BETTER MANAGEMENT AND ALLOCATION OF CAPITAL
- Identify opportunities arising from NATURAL SYNERGIES
- Price products to reflect their INHERENT LEVEL OF RISK
- Give stakeholders in their business confidence that the business is WELL-MANAGED
- To satisfy the regulator / STATUTORY REQUIREMENTS
- Improve JOB SECURITY for employees
- DETECT RISKS EARLIER thereby avoiding surprises
- meaning that they are CHEAPER AND EASIER to deal with
- Determine COST-EFFECTIVE means of risk transfer
6 risks faced by a pensions product
- market risk:
- – assets do not perform in line with expectation and there is not enough to cover the liability
- – a risk mismatch between the assets and liabilities, perhaps by term / nature
- longevity risk:
- – the pensioners survive longer than expected
- inflation risk:
- – the benefits becoming worth less to members
- liquidity risks:
- – funds not available as they become due, or at an unsatisfactory cost
- more people retiring eligible for the benefit than expected
- Counterparty risk (default of an insurer / debtor)
Systematic risk
Risk that affects an entire financial market or system.
It is not possible to avoid systematic risk through diversification.
Diversifiable risk
Arises from an individual component of a financial market or system.
It is possible not to take on diversifiable risk as (by definition) you should be able to diversify it away.
3 Types of credit risk
- Counterparty risk
- Asset default
- Debtors failing to pay
4 Advantages of using reinsurance
- provide technical expertise
- data, knowledge and experience
- could reduce volatility in claims figures
- could lower capital requirements
4 Disadvantages of using reinsurance
- pass on profit to the reinsurer
- decreases the flexiblity as they might impose requirements on pricing, underwriting and claims assessment
- increased administration
- introduce counterparty risk
Describe the circumstances that might lead to a risk:
- not needing financial coverage
The risk would need to be trivial.
Alternatively insurance / guarantees may already exist from the government / external bodies.
The risk may be non-financial and there may be processes in place to deal with this.
Describe the circumstances that might lead to a risk:
- being retained
In this case the risk would be material if it arose.
However, the company may think that the risks are unlikely to bite.
Or they have sufficient funds to cover any potential costs themselves.
Suitable alternatives may not be available or may be too expensive.
The company may be happy to take extra measures to deal with the risk.
The company may want to retain any upside of the risk.
Describe the circumstances that might lead to a risk:
- being fully transferred
If the company is risk-averse.
They believe that insurance is necessary since even if the risk is unlikely, its impact will be too great for them to cover.
Alternatively they may believe that they will be taking on significant risk but the premium represents value (and/or they can afford it)
This may be a legal requirement.
Describe the circumstances that might lead to a risk:
- being partially transferred
They may not be able to afford a full-cover premium.
This could be a trade-off between the likelihood and costs of minor incidents versus the saving in premium.
Insurance companies may be unwilling or unable to accept the full risk.
6 Assumptions that may be needed for funding a pensions scheme
- Mortality before retirement
- Mortality after retirement
- Future changes in mortality
- Future salary levels
- Future investment returns
- Future inflation rates
Reasons why different schemes might use different assumptions in setting their funding level
Different:
• membership profiles and maturity
• demographic characteristics of the scheme memberships
• investment strategies
• scheme size
• funding aproach
• measures of inflation in the scheme rules
• assumptions
• benefits (some provide additional benefits)
• views of trustees
• models to assess risks
• levels of knowledge about their membership
How could the cost of a state policyholder protection scheme be met?
The cost of the scheme may be spread across:
• Policyholders (higher premiums / charges)
• Capital providers (ranking of capital provided on insolvency)
• Companies (levies on insurance companies)
• State (funded through taxation)
Advantages of using a standard model prescribed by the regulator
- The standard model would not require detailed work to be done on building the specific model
- There will be considerable time and effort involved on the part of the insurance company in reviewing and seeking approval for an internal model.
- There will also be significant costs involved
- The company may not have enough data / experience to build its own model
- The prescribed model may fit well with its products and risks, and thus be appropriate.
- The model needs to be resilient over time, which will be easier with a standard model than with an internal model (since the regulator will assist)
- a standard model may help address any concerns that the public may have with the company. This could lead to increased confidence.
- May allow the insurance company to obtain regulatory approval quicker from the regulator as they will not need to review and approve the internal model along with understanding any specific risks.
Risk management tools an insurer could use
• Diversification:
- – by lines of business
- – geographical region
- – providers of reinsurance
- – investment asset classes
- – investment assets held within each class of business
• Claims control procedures
— only pay out claims intended and defined in the policy. Paying more claims will reduce profit, but consider the cost of claims control.
- Underwriting at the proposal stage
- Management control systems (good management controls can reduce the provider’s exposure to risk)
- – Monitoring of liabilities to detect accumulation of risk
- – Accounting and audit (ensure accurate provisions and capital requirements, and that premiums are collected. It reassures providers of finance)
- – Options and guarantees
- Reinsurance can be used to reduce capital or the level of claims
- Alternative risk transfer
- produces tailor made solutions for risks that the conventional market would regard as uninsurable.
- — These might include: Integrated Risk Cover, Securitisation, Post Loss funding, Insurance derivatives, Swaps
Underwriting
The assessment of potential risks so that each can be charged an appropriate premium.
Goals of underwriting
- Protection from anti-selection, including misrepresentation at the proposal stage
- Identify risks for which special terms need to be quoted.
- For substandard risks, the underwriting process wil identify the most suitable approach and level of special terms to be offered.
- Risk classification to ensure that all risks are rated fairly.
- Ensure that claim experience does not depart too far from that assumed in the pricing basis.
- Financial underwriting to reduce risk for larger proposals.
- Consider the cost / benefit of underwriting.
Discuss the purpose of claims control systems
to ensure that only the “right” claims are paid.
to protect against fraudulent or excessive claims. Only pay claims within the policy conditions.
Discuss the purpose of management control systems
Management control systems are focused on the operational management of the risk exposures.
Good quality data focused on the risk factor exposures is essential to adequately manage and provision for the risk.
A company will have a risk appetite to cost effective controls around the data.
However, a control failure is an operational risk event.
Good accounting and audit procedures do not change the risks, however, failure to apply good accounting or audit procedures can cause unintended risks, eg too high provisions can understate financial strength and cause a “run-on-the-bank” scenario. Lower credit ratings can close of risk management tools where counterparties will not do business or only at a higher price.
Failure of the accounting or audit procedures is an operational risk event and could cause regulatory issues.
Monitoring liabilities taken on is an essential operational risk management tool. It can detect operational risk events mis-pricing of risks or failures in claims control systems. It is also a risk management tool to balance the risks accepted to stay within risk appetite.
Consider cost / benefit of setting up and implementing the controls.
Liquidity risk (in the context of a company)
Liquidity risk is the risk that a financial institution does not have sufficient financial resources available to enable to meet it financial obligations as they fall due.
Liquidity risk (in the context of financial markets)
Where a market does not have the capacity to handle (at least, without a potential adverse impact on the price) the volume of an asset to be bought or sold at the time when the deal is required.
Market risk
The risks related to changes in investment market values or other features correlated with investment markets, such as interest or inflation rates.
The risks can be divided into
- the consequences of changes on asset values
- the consequences of investment market value changes on liabilities
- the consequences of a provider not matching asset and liability cashflows
Operational risk
Risk relating to losses due to failed or inadequate internal processes, people or systems, or from external events.
The risk can be controlled or mitigated by an organisation.
Business risk
Risk specific to the business undertaken
information asymmetry
the situation where at least one party to a transaction has information which the other party or parties do not have.
What might be the advantages of an industry-standard modelling system above internal systems?
- less prone to model errors (more valid / rigorous)
- less prone to data errors
- better documented
- independent verification of outputs for reasonableness (or external audit) should be easier / cheaper
- workings of the model should be easier to appreciate and communicate
- less likely to have material errors in the valuation results
- complying with professional guidance should be easier and cheaper
- regulators should have more confidence in the results
- outputs are likely to be clearer - more standardised / consistent
- stochastic modelling should be more accurate and quicker
Specific risk
The risk that arises from an individual component of a financial market or system.
Can be eliminated by diversification.
Categories of risk to which a hydro-electric and tidal power plant company is exposed to
• Political:
- risk that any government subsidies currently available are withdrawn.
• Regulatory
New regulation, e.g. environmental, may make future and/or current plant more expensive or enviable
• Financing
There is a risk that finance may become more expensive or difficult to access
• Market
Risk of a decrease in oil prices, making renewables less attractive.
Fluctuations in overall demand or supply of alternatives may reduce prices available.
• Business
There is a risk that costs are greater than expected (components, labour)
• External e.g. Natural
There is a risk of long term changes to weather / climate so that output is not as expected making projects less attractive.
• Operational
Breakdowns, technical faults, incompetence, fraud, or labour unrest may mean production stops or losses arise.
• Currency
There is likely to be a currency risk if plants are located in different countries to where the power is supplied to or components are manufactured abroad.
• Credit
Users of power may default on payment. Or subsidies may not come through on time.
• Liquidity
There might be a risk that expensive emergency finance is needed.
• Crime
Plants may be targets for terrorism.
Or attempts by customers to avoid payment for supplies.
• Reputation
Failure to ensure continuity of supply may seriously damage the company’s credibility and so jeopardise future contracts.
