Cummins: Capital

Question 1

RAROC

Answer 1

Net income divided by allocated capital

NI should be after taxes and interest expense

Question 2

If RAROC < cost of capital

Answer 2

Tighten UW standards

Re-price insurance

Withdraw from LOB

Question 3

Economic Value Added

Answer 3

Return on investment in excess of expected return

EVA_i = Net income_i - r_iC_i

Where r is the hurdle rate

Question 4

EVAOC

Answer 4

Net income divided by capital, minus the hurdle rate

Question 5

Estimating cost of capital

Answer 5

“Pure play” - finding monoline companies

“Full-information betas” - use data based on conglomerates and conduct regressions

Question 6

Issues with RBC for allocation

Answer 6

Questionable accuracy

No theoretical foundation

Based on book values

Ignores interest rate risk

Only accurate for “average” firm

Ignores correlation

Question 7

Issues with using VaR to allocate capital

Answer 7

Firm may not have enough capital to attain exceedence probability

Does not consider diversification effect

Does not say anything about amount by which losses are likely to exceed resources

Question 8

Insolvency put option

Answer 8

Expected loss to policyholders because of the possibility the firm will default

Payoff = L - Max[L - A, 0]

Question 9

Merton-Perold view of marginal capital allocation

Answer 9

Does this in terms of what happens to EPD if entire lines of business are added or removed

May leave some capital unallocated

Question 10

Myers-Read view of marginal capital allocation

Answer 10

Instantaneous interpretation

Allocation based on what happens to EPD in response to very small changes in liabilities

Allocates all capital

Question 11

CAPM allocation

Answer 11

Question 12

Required rate of return under CAPM allocation

Answer 12

Each line implicitly pays interest for use of funds and receives rate of return based on systematic risk of the line

Question 13

Three problems with using CAPM to allocate capital

Answer 13

1. CAPM only rewards firm for bearing systematic UW risk
2. LOB betas difficult to estimate
3. Rates of return driven by not just beta

Question 14

Risk capital

Answer 14

Smallest amount that can be invested to insure the value of the firm’s net assets against a loss in value relative to the risk-free investment

Question 15

M-P method of allocation steps

Answer 15

1. Calculate risk capital required by firms that combine two businesses
2. Calculate marginal capital needed when excluded business is added to two-business firm

Question 16

M-P argument against full allocation of capital

Answer 16

It will lead firms to reject projects that would add to its market value; excess capital can be allocated to corporate level

Question 17

M-R formula for surplus required per dollar of liabilities

Answer 17

Question 18

Three most important sources of costly capital

(Friction costs)

Answer 18

Agency and informational costs

Double taxation of investment income

Regulation may force insurer to hold inefficient portfolios

Question 19

Exceedence probability

Answer 19

Probability that actual losses exceed expected losses plus allocated capital

Question 20

Why investors are willing to accept lower spreads from CAT bonds

Answer 20

Diversification benefits