Cummins Capital Flashcards
Describe debt capital for an insurance company
The debt capital of an insurer is represented by its reserves. This debt capital is proved by the insurer’s customers in the form of premiums.
Unlike a bond holder, insurance policyholders are unable to protect themselves against insolvency through diversification.
Capital is extremely important in the insurance industry as it assures policyholders that their losses will be covered even if the claim amounts are larger than expected
How do firm use capital allocation to maximize the market value of the firm
Using capital allocation to measure performance by line of business and ensuring that each LOB is making an adequate profit to cover its cost of capital and add value to the firm.
2 ways to determine the cost of capital for LOBi for a firm
- Pure Play Technique (estimates the cost of capital by examining mono-line “pure play” firms that only write that line of business.
- Full-information Betas technique (Estimates the cost of capital by running regression on data from other multi-line firms)
Two issues with Pure Play Technique approach to estimate the cost of capital
- It’s difficult to find mono-line firms.
- Even if we found a relevant mono-fine firm, the underwriting risk characteristics may differ significantly from the multi-line firm.
Disadvantage of using EVA (economic value added) to assess the LOB’s performance
- It’s difficult to calculate the cost of capital ri.
- The lack of quality data. Many insurers do not capture the data needed to implement these types of methodologies.
Ways to address a LOB’s poor performance
- re-price the LOB to hit targets
- Tighten underwriting standards
- Withdraw from the LOB
Disadvantage of using RBC (Risk-Based Capital) formula to allocation capital
RBC is a formulaic calculation of required capital developed by US regulators.
1. The regulatory risk charges may not be accurate. (The formula ignores correlations among the firm’s business)
2. The regulatory risk charges are based on book value rather than market value
3. The regulatory risk charges ignore important sources of risk such as interest rate risk
4. There is no theoretical foundation for the RBC formula
How is RBC useful
- RBC identifies most of the important risks faced by insurers
- Regulatory capital may serve as constraint on some of the firm’s activities due to RBC solvency thresholds.
3 problems with the CAPM (Capital Asset Pricing Model) approach
- CAPM reflects systematic underwriting risk, which is the correlation of underwriting performance with the market portfolio. However, insurers are also concerned the about risk of extreme events, which is not captured in the CAPM return.
- LOB underwriting betas are difficult to estimate
- Rates of return are driven by factors other than beta, but CAPM fails to capture these other factors.
3 problems with using VaR for capital allocation
- A firm may not have enough capital to ensure that all LOBs meet the specified exceedence probability. If this occurs, the firm can raise the probability level or raise more capital.
- The stand-alone exceedence probabilities do not reflect diversification across LOBs.
- The VaR approach does not reflect the amount by which losses might exceed the exceedence probability level.
Why using the insolvency put option or EPD to allocate capital is preferable than using VaR?
It considers the expected value of the amount that can be lost rather than just providing the probability of exceeding a specific loss amount.
Advantage of using EPD to allocate capital
It’s consistent with the theory around pricing risky debt contracts.
Disadvantage of using EPD to allocate capital
It does not reflect diversification across LOBs, since it considers each LOB separately.
Describe Merton-Perold (M-P) method to allocate capital
It’s an extension of the EPD method that accounts for diversification.
It rely on risk capital in their capital allocation method.
Two sources of risk capital
- If there is no default risk, risk capital is supplied entirely by the firm
- If there is default risk, risk capital is partially supplied by the liaiblity holders
Differences between Merton- Perold (M-P) method and Myers-Read (M-R) method
Similar to the M-P method, the M-R method uses an option pricing model.
differences:
1. The M-P method allocates capital at the margin by adding entire LOBs to the firm. This is known as macro marginal allocation.
2. The M-R method allocates capital at the margin by determining the effects of extremely small changes in loss liabilities for each LOB. this is known as micro marginal allocation.
3. For M-P method, the sum of each LOB’s capital is less than the total capital. For M-R method, the sum of each LOB’s capital is the same as the total capital
4. M-P method is appropriate when adding lines to the firm. M-R method is appropriate for normal operations.
Characteristics of M-R method
- The sum of each LOB’s capital equals to the firm’s total capital. so the M-R method provides a full allocation of the total capital.
- LOBs with large covariances with the total losses receives a larger capital allocation. because a larger covariance with the loss portfolio increases the overall risk level of the firm.
- LOBs with large covariances with the total assets receive a smaller capital allocation. Because a larger covariance with the asset portfolio decreases the overall risk level of the firm. (acts as a natural hedge)
Why might an insurer prefer use the M-R method over the M-P method?
- The M-R method allocates the full capital of the firm
- Since the M-R method is a micro allocation method, it aligns more closely with the normal operations of the firm. Firms typically make small changes to an existing portfolio.
Why might an insurer prefer to use the M-P method over the M-R method?
The M-R method might be preferable when a firm is adding entire business to the firm
3 biggest sources of frictional costs
- Agency and informational costs (Agency costs are incurred when managers of firms behave opportunistically in a way that fails to maximize firm value. Informational costs are incurred through adverse selection and moral hazard to the extent that these things are not mitigated through pricing and underwriting)
- double taxation (Insurer investment income is taxed twice by the federal government, producing lower investment income than what could be obtained by investing directly in the market)
- Regulatory costs (regulatory have the right to seize control of an insurer if regulatory thresholds are triggered. Other costs include lower investment returns due to investment restrictions imposed by regulators)
Considerations for capital allocation
- Capital allocation should consider both asset and liability risk and allow for coverability between assets and liabilities
- Capital allocation should consider the duration and maturity of liabilities
Describe the spread cost
The cost above and beyond the cost of capital caused by the fact that the capital was held by insurers rather than directly invested in the capital market.
The spread cost should be taken into account in determining whether LOBs are earning the appropriate rates of return.
The cost of capital allocated to a line is the spread cost.
