Cummins Capital Flashcards
Briefly describe the uniqueness of debt capital for insurance companies
An insurer’s deb capital is provided by its customers (policyholders) in form of premiums.
Unlike bondholders, insurance policyholders are unable to protect themselves against insolvency through diversification. In most cases, policyholders buy insurance through a single insurer.
Capital is extremely important in insurance industry as it assures policyholders that their losses will be covered even if claim amounts are larger than expected.
Briefly describe a firm’s true mission
Maximize its market value.
Firms do this by using capital allocation to measure performance by LOB and ensuring each line is making an adequate profit to cover its cost of capital and add value to the firm.
If a LOB is found to make inadequate profit, firm can maximize firm value by withdrawing that LOB. Even if this leads to decline in revenue, it may actually increase firm value.
Calculate RAROC and use it to make decisions.
RAROC = Net Income / Capital
Net income is after taxes and interest expenses.
If RAROC higher than LOB CoC, writing LOB is consistent with firm value maximization.
Identify 3 potential solutions when RAROC smaller than hurdle rate.
- Reprice LOB
- Tightening underwriting standards (shrink)
- Withdraw from LOB
Calculate EVA and use it to make decisions.
EVA = Net income - r*C
r is LOB CoC
If EVA positive, writing the LOB is consistent with firm value maximization.
Calculate EVAOC and use it to make decisions.
EVAOC = EVA/Capital
If EVAOC is positive, writing the LOB is consistent with firm value maximization.
List 2 methods for determining CoC for a LOB when firm writes multiple LOBs
- Pure Play Technique
- Full Information Betas Technique
Describe the Pure Play Technique to determine CoC
Estimates CoC by examining mono line pure play firms that only write that LOB.
List 2 issues with the Pure Play Technique.
- It’s difficult to find mono-lines firms
- Even if we do find such firm, the uw risk characteristics may differ significantly from multi-lines firm.
Describe the Full Information Betas Technique to determine CoC.
Estimates CoC by running regressions on data from other multi-lines firms.
Name an issue with Full Information Betas Technique.
Lack of quality data.
Many insures do not capture the data needed to implement these types of methodologies.
Describe RBC technique to allocate capital.
Regulatory risk-based capital (RBC) is the minimum capital required to avoid regulatory intervention.
Rt = R0 + (R1^2 + R2^2 + R3^2 + R4^2 + R5^2)^0.5
The square root is a covariance adjustment implicitly assuming zero correlation between risks 1 to 5.
R0: RBC for holding of stocks of firm’s subsidiaries
R1: investment RBC
R2: Loss reserves RBC
R3: Written P RBC
R4: Credit RBC
R5: Off-balance Sheet RBC
Describe the investment RBC
Accounts for various charges of bonds, stocks and other investments.
Describe the loss reserve RBC.
Allows for risk of adverse development in reserves (unfavourable PYD)
Describe the Written P RBC
Accounts for possibility that LR on NB greater than expected.
Describe the Credit RBC
Allows for possibility that agents and reinsurers will default on obligations.
Describe the Off-Balance Sheet RBC
Allows for unexpected payments from contracts that do not show up on BS such as loan guarantees for subsidiaries.
When does RBC trigger regulatory actions.
If insurer total capital below 200% of RBC, regulatory actions might be taken.
Even if LOB capital below LOB required capital, if firm total capital greater than required capital, there will be no regulatory actions.
List 4 reasons why using RBC is unwise
- Regulatory risk charges may not be accurate.
For example: some charges are based on worst case scenarios rather than statistical concepts such as variance and covariance.
The formula ignores correlation among businesses. - Regulatory risk charges are based on book value rather than market value.
- Regulatory risk charges ignore important sources of risk such as interest rate risk.
Even if charges were accurate, they would be only for average firm in industry. - There is no theoretical foundation for RBC formula.
Business may be charges for too much or too little capital leading to suboptimal decisions.
List 2 reasons why RBC is still important despite its limitations.
- RBC identifies most of the important risks faced by insurer.
- Regulatory capital may serve as constraint on some firm’s activities due to RBC solvency thresholds.
Describe the Capital Asset Pricing Model (CAPM)
CAPM allows managers to compare preferred method to results generated by classic techniques.
Calculate expected return on equity (CoC) under CAPM for:
1. Single LOB
2. 2 LOBs firm
r_E = r_f + b_E*(r_M - r_f)
b_E = Cov(r_E, r_M)/Var(r_M)
r_E = I/E = r_A(E+L1+L2)/E + r1(P1/E) + r2(P2/E)
b_E = b_A(1+k1+k2) + b1s1 + b2s2
ki = Li/E
si = Pi/E
Calculate Net Income under CAPM for 2 LOBs
I = r_AA + r1P1 + r2*P2
A = E + L1 + L2
Calculate the Required UW Return under CAPM and explain it in words.
ri = -kir_f + bi(r_M - r_f)
Each LOB pays interest for use of policyholders funds (-kir_f) and receives a rate of return based on systematic risk of LOB (bi(r_M - r_f))