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CAS Exam 9 > Cummins - Capital > Flashcards

Cummins - Capital Flashcards

1
Q

Capital allocation

Cummins - Capital

A

determination of the amount of a firm’s equity capital that is assigned to each project or LOB

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2
Q

Firm mission

Cummins - Capital

A

maximize market value

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3
Q

Uses for capital allocation (2)

Cummins - Capital

A
  1. measure performance by LOB by ensuring each LOB is making adequate profit to cover its cost of capital
  2. making LOB pricing and UW decisions
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4
Q

Measures of return (3)

Cummins - Capital

A
  1. risk-adjusted return on capital (RAROC)
  2. economic value added (EVA)
  3. economic value added on capital (EVAOC)
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5
Q

Risk-adjusted return on capital (RAROC(i))

Cummins - Capital

A

RAROC = net income after tax & interest expense / allocated capital

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6
Q

Measuring return adequacy using RAROC

Cummins - Capital

A

compare RAROC to cost of capital (aka hurdle rate or required return)

if RAROC >= cost of capital - LOB/project adds to firm value
if RAROC < cost of capital - LOB/project is reducing firm value

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7
Q

Potential firm actions if a LOB is reducing firm value (3)

Cummins - Capital

A
  1. re-pricing the LOB
  2. tightening UW standards
  3. withdrawing from the LOB
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8
Q

Economic value added (EVA) - definition and formula

Cummins - Capital

A

measure of return on investment in excess of its required return

EVA = net income - required return * allocated capital

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9
Q

Measuring return adequacy using EVA

Cummins - Capital

A

EVA >= 0 means LOB adds value to the firm

EVA < 0 means LOB is reducing firm value

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10
Q

Economic value added on capital (EVAOC)

Cummins - Capital

A

rate of return form of EVA

EVAOC = EVA / allocated capital

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11
Q

Methods to determine the cost of capital for a LOB (2)

Cummins - Capital

A
  1. pure play approach

2. full information betas

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12
Q

Pure play approach to estimating the cost of capital for a LOB

(Cummins - Capital)

A

estimates cost of capital by finding mono-line “pure play” firms exclusively offering a single LOB

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13
Q

Reasons the pure play approach is difficult (2)

Cummins - Capital

A
  1. few mono-line firms exist

2. even if a mono-line firm is found, it may have significantly different UW risk characteristics

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14
Q

Full information betas approach to estimating the cost of capital for a LOB

(Cummins - Capital)

A

estimates cost of capital by running a regression on a multi-line firm’s data

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15
Q

Reason the full information betas approach is difficult

Cummins - Capital

A

often lack data needed

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16
Q

Capital allocation techniques (5)

Cummins - Capital

A
  1. risk-based capital (RBC)
  2. capital asset pricing model (CAPM)
  3. value at risk (VaR)
  4. insolvency put option/expected policyholder deficit (EPD)
  5. marginal allocation methods
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17
Q

Reasons RBC should not be used for capital allocation (5)

Cummins - Capital

A
  1. based on worst-case scenario instead of statistical concepts
  2. ignores correlations
  3. based on book value (vs. market value)
  4. ignores important sources of risk such as interest rate risk
  5. has no theoretical foundation
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18
Q

Firm’s equity beta coefficient for CAPM and formulas (2)

Cummins - Capital

A

equity beta = normal CAPM beta&raquo_space; used to estimate the firm’s cost of capital

beta = covariance(firm return, market return) / variance(market return)

beta = beta(assets) * (1 + sum of LOB liability leverage ratio) + sumproduct(LOB beta * LOB premium leverage ratio)

where
liability leverage ratio = liability / total equity and
premium leverage ratio = premium / total equity

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19
Q

LOB required UW return under CAPM (r(i))

Cummins - Capital

A

r = -LOB liability leverage ratio * risk-free rate + LOB beta * market risk premium

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20
Q

TCR under CAPM

Cummins - Capital

A

TCR = 1 - required UW return

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21
Q

Components of the LOB required UW return under CAPM (2)

Cummins - Capital

A
  1. -k(i) * risk-free rate = interest paid by LOB for use of policyholder funds
  2. LOB beta * (market return - risk-free rate) = LOB rate of return based on its systematic risk
22
Q

Implication of CAPM

Cummins - Capital

A

not necessary to allocate capital by LOB, instead charge each LOB for the CAPM cost of capital, which reflects the LOB beta and leverage ratio

23
Q

Problems with the CAPM approach to capital allocation (3)

Cummins - Capital

A
  1. reflects systematic UW risk but does not capture risk of extreme events
  2. LOB betas are difficult to estimate
  3. rates of return are driven by factors other than beta, which are ignored by CAPM
24
Q

Value at risk (VaR)

Cummins - Capital

A

max amount a firm could lose with a specified probability

use w/exceedance probabilities for capital allocation

25
Q

Exceedance probability

Cummins - Capital

A

probability losses from a LOB will exceed the expected losses + allocated capital

epsilon(i) = Pr(Loss(i) > E[Loss(i)] + allocated capital(i))

26
Q

Using exceedance probabilities to allocate capital

Cummins - Capital

A

solve for the amount of capital needed for each LOB such that each LOB exceedance probability = target exceedance probability

27
Q

Exceedance probability curve and relative risk

Cummins - Capital

A

plots probability (y-axis) against (E[L] + C) / E[L] on the x-axis - curve slopes down & right

more risky LOB have a higher x-axis ratio for a given probability level

28
Q

Interpretation of required capital to expected loss ratio

Cummins - Capital

A

$ amount the insurer would need to commit in capital for each dollar of expected losses to achieve the given exceedance probability

= 1 - asset-to-liability ratio

29
Q

Problems with the VaR approach to capital allocation (3)

Cummins - Capital

A
  1. firm may not have enough total capital to meet the specified exceedance probability
  2. does not reflect diversification benefit (b/c uses stand-alone exceedance probabilities)
  3. does not reflect the amount by which losses will exceed the exceedance probability
30
Q

Insolvency put option (aka expected policyholder deficit (EPD))

(Cummins - Capital)

A

considers the policyholders’ claim on the firm a put option on the firm’s assets (A) with strike price = firm’s liabilities (L)

at maturity:
if A >= L, policyholders receive L
if A < L, policyholders receive A

31
Q

Value of the policyholders’ claim under the insolvency put option/expected policyholder deficit (EPD)

(Cummins - Capital)

A

value of policyholders’ claim = PV(losses) - value of the insolvency put option

= Le^-rt - value of put option

32
Q

Reason the insolvency put option/expected policyholder deficit approach is superior to VaR for capital allocation

(Cummins - Capital)

A

it considers the expected value of loss (vs. the probability of losses exceeding a specific amount)

33
Q

Advantage of the insolvency put option/expected policyholder deficit approach to capital allocation

(Cummins - Capital)

A

consistent with the theory of pricing risky debt contracts

34
Q

Disadvantage of the insolvency put option/expected policyholder deficit approach to capital allocation

(Cummins - Capital)

A

does not consider diversification

35
Q

EPD ratio

Cummins - Capital

A

EPD ratio = EPD / Liabilities

36
Q

Asset-to-liability ratio

Cummins - Capital

A

A / L = 1 + C / L

37
Q

Marginal capital allocation methods (2)

Cummins - Capital

A
  1. Merton-Perold (M-P)

2. Myers-Read (M-R)

38
Q

Risk capital

Cummins - Capital

A

smallest amount that can be invested to insure value of firm’s net assets

39
Q

Sources of risk capital (2)

Cummins - Capital

A
  1. if no default risk, risk capital is supplied by the firm

2. if default risk, risk capital is partially supplied by liability holders

40
Q

Merton-Perold (M-P) method for capital allocation

Cummins - Capital

A

extension of the insolvency put option/expected policyholder deficit method that accounts for diversification

M-P allocated capital(i) = total capital - capital (all LOB except i)

where the total capital and joint capital are estimated using EPD

41
Q

Merton-Perold (M-P) method vs. Myers-Read (M-R) method total % of firm’s capital allocated

(Cummins - Capital)

A

M-P will allocate < 100% - unallocated capital = “corporate” level capital

M-R will allocate 100%

42
Q

Best use for the Merton-Perold (M-P) method for capital allocation

(Cummins - Capital)

A

decision-making when adding entire LOB to the firm

43
Q

EVA and RAROC metrics in Merton-Perold (M-P) method vs. Myers-Read (M-R) method

(Cummins - Capital)

A

M-P produces higher EVA and RAROC b/c of unallocated capital

44
Q

Myers-Read (M-R) method for capital allocation

Cummins - Capital

A

allocates capital by determining the effect of very small changes in loss liabilities for each LOB

allocated capital = s(i) * L(i)
s(i) = s - (dp/dsigma) / (dp/ds) * [(sigma(i,L) - sigma(L)^2) - (sigma(i,V) - sigma(L,V))] / sigma

s = surplus-to-liability ratio 
p = insolvency put option per $ of liabilities 
sigma(i,L) = covariance parameter b/w losses in LOB & firm's losses
sigma(i,V) = covariance parameter b/w losses in LOB & firm's assets 
sigma(L,V) = covariance parameter b/w firm's losses & assets
45
Q

Main difference between Merton-Perold (M-P) method and Myers-Read (M-R) method for capital allocation

(Cummins - Capital)

A

M-P uses a macro marginal allocation

M-R uses a micro marginal allocation

46
Q

Best use for the Myers-Read (M-R) method for capital allocations

(Cummins - Capital)

A

decision-making for firm’s normal operations

47
Q

Allocated capital under the M-R method when a LOB has a large covariance with total assets

(Cummins - Capital)

A

receives less allocated capital b/c the large correlation reduces risk (acts as a natural hedge)

48
Q

Allocated capital under the M-R method when a LOB has a large covariance with total losses

(Cummins - Capital)

A

receives more allocated capital b/c of increased risk

49
Q

Agency costs (frictional costs)

Cummins - Capital

A

costs incurred when managers behave opportunistically in a way that fails to maximize firm value

50
Q

Informational costs (frictional costs)

Cummins - Capital

A

costs incurred through adverse selection & morale hazard

51
Q

Sources of costly capital/market frictions/frictional costs (3)

(Cummins - Capital)

A
  1. agency & information costs
  2. double taxation of investment income
  3. regulatory costs/restrictions leading to insurer’s holding inefficient portfolios
52
Q

Reason a spread (aka cost of capital) develops b/w returns that could be earned by investing directly in capital markets and actual returns earned on capital for insurers

(Cummins - Capital)

A

existence of market frictions/frictional costs

CAS Exam 9 (26 decks)

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