Definitions I Don't Want To Pull Out My Ass Flashcards
Defined benefit scheme
The scheme rules define the benefits independently of the contributions payable, and are not directly related to the investments of the scheme. The scheme may be funded or unfunded
Defined contribution scheme
Providing benefits with the amount of an individual members benefits depends on the contributions paid into the scheme in respect of that member, increased by the investment earned on those contributions
Fair value
The amount for which an asset could be exchanged/liability settled between knowledgeable, willing parties at arms length
Corporate governance
The high level framework within which a company’s MANAGERIAL DECISIONS are made
Pure matching
Matching of assets and liabilities involves structuring the flow of income and maturity proceeds from the assets so that they coincide precisely with the net outgo from the liabilities under all circumstances
Liability hedging
The assets are chosen in such a way as to PERFORM in the same way as the liabilities
Immunisation
The investment of the assets in such a way that the present value of the assets less the present value of the liabilities is immune to a general small change in the rate of interest
The discounted mean term/duration
The weighted average time to the payments, where the weights are the present values of each payment
Convexity
The sensitivity of the volatility of the cashflows to a change in the interest rate
Active investment management
Where the investment manager has few restrictions on investment choice within a broad remit. It is expected to produce greater returns despite extra dealing costs and risks of poor judgement
— perhaps just a broad benchmark of asset classes
— Manager can make JUDGEMENTS on future performance of specific investments…
— … in both shorts and a long term
— Expected to yield higher returns if market has inefficiencies
— Has extra costs due to more frequent transactions
Passive investment management
— Involves holding assets closely reflecting those underlying an index or specified benchmark.
— The investment manager has little freedom of choice.
— There remains the risk of tracking error…
— …and the index performing poorly
Tactical asset allocation
Involves a short-term departure from the benchmark position in pursuit of higher returns
Risk budgeting
A process that establishes how much risk should be taken and where it is most efficient to take the risk (in order to maximise the return
Strategic risk
The risk of underperformance if the strategic benchmark does not match the liabilities
Active risk
The risk taken by the individual investment managers relative to the given benchmark
Structural risk
Where the aggregate of the individual investment manager benchmarks does not equal the total benchmark for the fund
Retrospective or backward looking/ Historic tracking error
The annualised standard deviation of the difference between actual fund performance and benchmark performance
Forward looking tracking error
An estimate of the standard deviation of returns that the portfolio might experience in the future if its current structure were to remain unaltered. It involves modelling the future experience of the fund based on its current holdings and likely future volatility and correlations to other holdings.
The money weighted rate of return (MWRR)
The discount rate at which the present value of inflows = present value of outflows in a portfolio
Time weighted rate of return (TWRR)
The compounded growth rate of 1 over the period being measured
Scenario analysis
Looks at the financial impact of a plausible and possibly adverse set or sequence of events
Stress testing
Involves assessing the impact of a SPECIFIC adverse event
Stress scenario
The stress test is performed by considering the impact of a set of related adverse conditions that reflect the chosen scenario
Reverse stress testing
The construction of a severe stress scenario that just allows the firm to be able to continue to meet its business plan. The scenario may be extreme but must be plausible
Data governance
The overall management of the availability, usability, integrity and security of data
Data governance policy
A documented set of guidelines for ensuring the proper management of an organisations data
Risk factor
Any factor that has a bearing on the amount of risk presented by a policy
Rating factor
Factors that are more easily identified and maybe used for the underlying risk factors
A derivative
A financial instrument with a value dependent on the value of some other, underlying asset
A forward contract
A non-standardised, over-the-counter-traded contract between two parties to trade a specified asset on a set date in the future at a specified price
A futures contract
A standardised, exchange-tradable contract between two parties to trade a specified asset on a set date in the future at a specified price
A long position in an asset
Having a positive economic exposure to that asset. In futures and forwards dealing, the long party is the one who has contracted to take delivery of the asset in the future
A short position in an asset
Having a negative economic exposure to that asset. In futures and forwards dealing, the short party is the one who has contracted to deliver the asset in the future
An option
Gives the investor the right, but not the obligation, to buy or sell a specified asset on a specified future date at the specified exercise (or strike) price.
An American option
An option that can be exercised on any date before it’s expiry
A European option
An option that can only be exercised at expiry
A warrant
An option issued by a company over its own shares. The holder has the right to purchase shares from the company at a specified price at specified times in the future.
Risk classification
Providers use RISK FACTORS to identify the characteristics of the risks they underwrite, and to POOL risks into HOMOGENEOUS groups. All risks in a group can then be charged the same PREMIUM
Selection
The process by which lives in a population are divided into separate homogeneous groups
Temporary initial selection
Where the level of risk diminishes or increases since the occurrence of a selection process (or a discriminating event)
I.e. occurs when heterogeneity is present in a group that was selected on the basis of a criterion whose effects wear off over time
Class selection
Where a select group is taken from a population consisting of a mixture of different types (‘classes’) of individual with different characteristics
I.e. refers to a factor which is permanent in its effect wrt mortality
Time selection
Where a select group is taken from a population of individuals from different calendar years
Adverse selection
Where the individuals own choice influences the composition of a select group
Anti-selection
— People will be more likely to take out contracts
— when they believe their risk is higher than the insurance company has allowed for in its premiums
—Anti-selection can also arise where existing policyholders have the opportunity of exercising a guarantee or an option.
— when they have the most to gain from it
Example: a younger scheme member lapsing their policy and moving to another scheme leaving the scheme with a worse profile; a member joining the scheme because he knows they pay for benefit not covered elsewhere
— A smoker buying cover from an insurer that does not differentiate on smoking status
Spurious selection
Where the distorting effect of a confounding factor gives the false impression that one of the other forms of selection is present
Selective decrement
Will ‘select’ from the population lives whose rate of decrement from another cause differs from that of the whole population
Mortality convergence
The convergence of mortality between subgroups at higher ages
Model point
A set of data representing a single policy or group of policies. It captures the most important characteristics of the policies that it represents
Model error
A model is developed that is not appropriate to the task at hand
Parameter error
Incorrectly setting parameter values used when the model is run. It can involve individual parameters and/or correlation between parameters
Net present value
The expected present value of the future cashflows under a contract, discounted at the risk discount rate.
The internal rate of return (IRR)
The discount rate that would give a NPV ot 0.
The discounted payback period
The earliest policy duration at which the accumulated value of profits is 0
Variable expenses
Vary directly according to the level of business being handled and may be linked to the number of policies or claims of the amount of premiums or claims.
Fixed expenses
Those that in the short to medium term, do not vary according to the level of business being handled.
Direct expenses
Those that have a direct relationship to a particular class of business.
Indirect expenses
Those that do not have a direct relationship to any one class of business (so they need to be apportioned between the appropriate classes using some appropriate method).
The cost of benefits
The amount that should theoretically be charged for them
The price of benefits
The amount that can be charged under a particular set of market conditions and may be more or less than the cost.
Loss leading
A provider may choose to sell a product that covers its direct fixed and variable costs but does not cover its expense overheads and minimum profit requirements
Marginal costing
A companies fixed costs are covered my margins from business currently on the books, each new policy only needs to cover the variable costs attributable to it and the company will make a profit
Methods of financing benefits: lump sum in advance
Funds that we expected to be sufficient to meet the cost of the benefit can be set up as soon as the benefit promise is made
Methods of financing benefits: Terminal funding
Funds are expected to be sufficient to meet the cost of a series of benefit payments can be set up as soon as the first payment becomes due
Methods of financing benefits: smoothed PAYG
To smooth income and outgo over time by maintaining a fund as a working balance
Methods of financing benefits: Just-in-time funding
Funds that are expected to be sufficient to meet the cost of the benefits can be set up AS SOON AS A RISK ARISES in relation to the future financing of the benefits
Methods of financing benefits: regular contribution
Funds are gradually built up to a level expected to be sufficient to meet the cost of the benefit, over the period between the promise being made and the benefit first becoming payable
Risk vs Uncertainty
Risk arises as the consequence of uncertain outcomes
Uncertainty cannot be modelled, but it is often possible to model risk
Systematic risk
Risk that affects an entire financial market or system and cannot be diversified away.
Diversifiable risk
Arises from an individual component of a financial market or system and can be diversified away.
Enterprise risk management
Involves considering the risks of the enterprise as a whole, rather than considering individual risks in isolation
Market risk
The risks related to changes in investment market values or other features correlated with investment markets, such as interest and inflation rates.
Credit risk
The risk of failure of third parties to meet their obligations
- borrowers defaulting on interest and capital payments
-counterparties to a transaction failing to meet their obligations
-debtors failing to pay for purchased goods / services.
Liquidity risk
The risk that an individual or company, although solvent does not have available sufficient financial resources to enable it to meet its obligations as they fall due, or can secure such resources only at excessive cost.
Liquidity risk in the financial market
Liquidity risk arises when the market does not have the capacity to handle that volume of transacted asset without a potential adverse price impact.
Underwriting risk
poor underwriting standards
Insurance risk
poor claims experience
Financing risk
Providing finance for a project that turns out to be unsuccessful
Exposure risk
exposure to a particular risk being greater than expected, or lower sales volumes
than expected
Operational risk
The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events,
External risk
Arises from external events such as storm, fire, flood or terrorist attack.
Regulatory, legislative and tax changes are also examples of external risk.
In general, external risk is systematic (ie non-diversifiable) risk.
Risk appetite
Expression of an entity’s (individual or companies) WILLINGNESS and ABILITY to take on risk and is set by the board in order to meet their objectives
Risk profile
A complete description of the CURRENT and FUTURE RISK EXPOSURES that does and can affect an organisation
Risk limits
Guidelines that set the limits on the acceptable actions that can be taken today.
If adhered to then each individual unit of business is deemed to be working within its permitted risk tolerances. Regarded as a component of risk capacity
Risk capacity
The VOLUME of the risk that an organisation can take, according to some consistent measure, such as economic capital
Risk tolerance
A statement on an entity’s attitude towards risk, describes the LEVEL(S) of risk that an insurer is willing to bear that is QUANTIFIABLE and NON-QUANTIFIABLE
Risk tolerance limits
Translate risk tolerance levels into operational limits for each risk category and their limits, taking into account any links between these categories
Risk metrics
MEASUREMENTS to determine if the company is operating within its risk tolerance limits.
Proportional reinsurance
A reinsurance arrangement where the reinsurer and cedant share the claims proportionally. Usually, premiums follow the same proportions but commission rates may differ. Two types commonly arise; quota share and surplus
Non-proportional reinsurance
Reinsurance arrangements, where the claims are not shared proportionately between the cedant and reinsurer. The reinsurer covers the loss suffered by the insurer that exceeds the excess/retention point
Quota share reinsurance
A form of proportional reinsurance where the proportions used in apportioning claims and premiums between the insurer and reinsurer are constant for all risks covered by the treaty
Surplus reinsurance
A form of proportional reinsurance where the proportions are determined by the cedant for each individual risk covered by the treaty, subject to limits defined in the treaty
Excess of loss (XL or XOL)
reinsurance
A form of non-proportional reinsurance whereby the reinsurer indemnifies the cedant for the amount of a loss above a stated excess point, usually up to an upper limit. The excess point and upper limit may be fixed, or indexed as specified in a stability clause. Usually this type of reinsurance relates to individual losses, but it can be a form of aggregate excess of loss reinsurance covering the total of all losses in a period and subject to a total aggregate claim limit
Aggregate excess of loss reinsurance
A form of excess of loss reinsurance that covers the aggregate of losses, above an excess point and subject to an upper limit, sustained from a single event or from a defined peril (or perils) over a defined period, usually one year
Stop loss reinsurance
An aggregate excess of loss reinsurance that provides protection based on the total claims, from all perils, arising in a class or classes over a period. The excess point and the upper limit are often expressed as a percentage of the cedant’s premium income rather than in monetary terms
Catastrophe reinsurance
A form of aggregate excess of loss reinsurance providing coverage for very high aggregate losses arising from a single event, that may be spread over a number of hours;
24 or 72 hour periods that are commonly used.
Integrated risk covers
Written as multi-year, multi-line covers and will give premium savings due to cost savings and to greater stability of results over long time periods and across more and (uncorrelated) lines
Securitisation
The transfer of insurance risk to the banking and capital markets
Post lost funding or contingent capital
A way of raising capital to cover the losses from of a risk after the risk event has happened
Swaps
Organisations with matching but negatively correlated risks can swap packages of risk so that each organisation has a greater risk diversification
Risk management process
The process of ensuring that the risks to which an organisation is exposed are the risks to which it thinks it is exposed and to which it is prepared to be exposed
Underwriting
- The process of consideration of an insurance risk. This includes assessing whether the risk is acceptable and, if so, the appropriate premium, together with terms and conditions of the cover. It may also include assessing the risk in the context of the other risks in the portfolio.
- The provision of some form of guarantee. In investment, underwriting is where an institution gives a guarantee to a company issuing new shares or bonds that it will buy any remaining shares or bonds that are not bought by other investors.
Claims control systems
mitigate the consequences of a financial risk that has occurred by guarding against fraudulent or excessive claims.
Provisions
Amounts set aside to meet future liabilities
Best estimate basis
The set of assumptions that has equal probability of overstating and understating the values
Optimistic basis
Assumptions are chosen which result in a higher value of assets and or a little value of liabilities
Cautious basis
Assumptions are chosen which result in a lower value of assets and or a high value of liabilities
Going concern basis
The accounting basis are normally required for an insurer’s published accounts that is based on the assumption that the insurer will continue to trade as normal for the long-term future
An equalisation reserve
may be set up to smooth results from year to year, where there are low probability risks with a high and volatile financial outcome.
Valuation of liabilities: market-based reflecting assets held
Discounted outgo using expected return on assets held (i.e. current implied market discount rates), weighted by proportions held of each asset class
Valuation of liabilities-
fair value: replicating portfolio
Market value of assets in the theoretical replicating portfolio
Valuation of liabilities-
fair value: risk-neutral market-consistent
Discounted cashflows using risk-free rates
A schemes funding level
Value of assets divided by value of benefits
Solvency II
Sets out regulatory capital requirements for insurance companies
Minimum capital requirement (MCR)
The threshold at which companies will no longer be permitted to trade
Solvency capital requirement (SCR)
The target level of capital below which companies may need to discuss remedies with their regulators
Basel Accords
Set a regulatory capital requirements for Banks
Economic capital
The amount of capital that are provider determines is appropriate to hold (in excess of liabilities) to cover its risks under adverse outcomes, generally with a given degree of confidence over a given time horizon
Surplus arising
Change in the surplus
= Change in assets - Change in liabilities
Levers
Factors that management can affect through management control systems to influence the amount of surplus/profit: sources within the providers control
Community banks
Membership based, decentralised and self-help financial institutions
Development banks/ Development Financial Institutions (DFI)
provides credit through high risk loans to both public & private
sector initiatives
Trading book
Consists of instruments that are actively traded and marked-to-market daily by the bank
Banking book
Consist primarily of loans and is not marked-to-market daily
Expectations theory
• The expectations theory describes the shape of the yield curve as being determined by economic factors which drive the market’s expectations for future short-term interest rates.
• we expect future short-term interest rates to fall (rise), then we would expect gross redemption yields to fall (rise) and the yield curve to slope downwards (upwards).
Liquidity preference theory
—The liquidity preference theory is based on the generally accepted belief that investors prefer liquid assets to illiquid ones.
— Investors require a greater return to encourage them to commit funds for a longer period.
— Long-dated stocks are less liquid than short-dated stocks, so yields should be higher for long-dated stocks.
— According to liquidity preference theory, the yield curve should have a slope greater than that predicted by the pure expectations theory.
Inflation risk premium theory
— Under the inflation risk premium theory the yield curve will tend to slope upwards …
— … because investors need a higher yield to compensate them for holding longer-dated stocks which are more vulnerable to inflation risk than shorter-dated stocks.
Market segmentation
— The market segmentation (or preferred habitat) theory says that vields at each term to redemption are determined by supply and demand from investors with liabilities of that term.
— Demand for short bonds comes from banks, which compare their yields with short-term interest rates.
— Demand for long bonds comes from pension funds and life assurance companies, whose main objective is protection against future inflation.
— The supply of bonds of different terms will reflect the needs of borrowers …
— … for example, the government may issue short-term bonds if it has a short-term need for cashflow.
— The two areas of the bond market may move somewhat independently.
A copula
A function, which takes as inputs marginal cumulative distribution functions, and outputs a joint cumulative distribution function
Factor sensitivity approach
Determines the degree to which an organisation’s financial position (e.g. solvency or funding) is affected by the impact that a change in a single underlying, risk factor (e.g. short-term interest rates) has on the value of assets and liabilities.
Scenario sensitivity approach
Similar to the factor sensitivity But rather than changing a single underlying risk factor of the effect of changing a set of such factors is considered
Tracking error
Where deviation is measured relative to the benchmark rather than the mean
Value at risk
The maximum potential loss on a portfolio over a given future period with a given degree of confidence
E.g., A VaR of R10m over the next year with a 95% confidence interval means that there is only a 5% expected probability of underperformance being greater than R10m over the next year
Moral hazard
— The action of a party who BEHAVES DIFFERENTLY or less carefully,
— from the way they would if they were FULLY EXPOSED to the consequences
of their actions.
— leaving the organisation/insurer etc. to bear some of the CONSEQUENCES of that action.
Example: policyholder claims for more expensive procedures than necessary claims for new glasses every year, even if there is nothing wrong with existing glasses, policyholder not making an effort to seek out more affordable healthcare if scheme will pay for the more expensive option
Community rating
Individual rating factors that are not used to determine premiums and therefore lead to cross subsidy
Liability insurance
Provides indemnity
where the insured, owing to some form of negligence,
is a legally liable
to pay compensation to a THIRD party
Property damage insurance
To indemnify the insured
against loss of or damage to
their own material property
Financial loss insurance
Indemnity
against financial losses arising from a perils covered by the policy
Deterministic model
- Parameters are fixed at outset
- Results of running model is a single outcome
- Potential variability is assessed by sensitivity analysis and scenario testing
Stochastic model
- At least one parameter is estimated…
…by assigning it a probability distribution - Model is run a large number of times…
…with value of stochastic parameters randomly selected from the distribution on each run - Outcome is a range of values
Capital management
Involves ensuring that a provider has:
• sufficient solvency and
• liquidity
to enable both its
•existing liabilities and
• future growth aspirations to be met in all reasonably foreseeable circumstances.
It involves maximising the reported profits of the provider
Required return vs Expected return
Required return = required risk-free real rate of return + expected inflation + risk premium
Therefore, an investor will expect that the value of their investment does not decrease in real terms, and that they are compensated for the risk taken.
Expected return = initial income yield + expected capital growth
Therefore, the expected return is what the investor expects to achieve on the asset, given
— the price paid for the asset
— the price for which he/she expects to sell/redeem the asset,
— the expected income whilst the asset is held
Underwriting cycle
• The process whereby relatively high and thus profitable premium rates that often result in an increase in the supply of insurance are followed by lower and less profitable premium rates usually associated with increased competition.
• These in turn may be followed by a decrease in supply as companies leave the less profitable market, reduced competition and a return to higher premium rates.
• This process is complex but appears to occur in all types of insurance and reinsurance, though at different speeds and to different degrees.
