ERA 2 TIA Flashcards
What are the major differences in the 1st and 2nd
evolutionary step in Decision Analysis?
- Use of Distributions for the inputs instead of
fixed amounts - Output is also a Distribution
What is the major difference between the 2nd and 3rd
evolutionary step in Decision Analysis?
Use a Risk Preference (Utility) function to value
the possible outcomes
What is the argument that the 3rd evolutionary step
in Decision Analysis is Unnecessary
Firms only compensate owners for systemic risk,
since the firm-specific risk is averaged out.
therefore, no need for formulations of corporate risk preferences; only systemic risk should be managed
Name some reasons why companies should pay
attention to firm-specific risk (3)
- Management cannot easily separate firm-specific
vs. systemic risk - Some risks are instantaneous, and can’t be
managed through discounting - market based information is too noisy to use for
cost-benefit analysis
Owners and Management want corporate policy that
makes risk management decisions more (4):
- Objective
- Consistent
- Repeatable
- Transparent
Spetzler parameterizes a Utility function for
management. What are the benefits of using a Utility function to
make decisons? (3)
- Transparent
- Objective
- Mathematical
Walls identifies an efficient set of portfolios for the
firm to invest in. Why is this not sufficient to select the best portfolio?
We need the company risk preference to select the
optimal portfolio along the efficient frontier
According to Mango what 3 questions does Walls ask?
- How much risk are we willing to tolerate
- How much reward are we willing to give up for a given
reduction in risk - Are the risk-reward tradeoffs along the efficient frontier
acceptable to us?
The first two come from the parameterized utility function
It’s possible there are no options on the efficient frontier that
are acceptable
Why is allocating capital considered irrelevant? (2)
- All of the company’s capital supports each policy
- Allocating cost of capital is preferred
What risk sources should capital be allocated to?
- Risk taking sources (eg. products)
- Non Risk taking sources (eg. credit risk)
What is RORAC?
Return On Risk Adjusted Capital
1. Allocate Capital on a risk adjusted basis
2. Apply a company wide hurdle rate to determine
the cost of capital in $
3. This is a form of cost of capital
How do Merton & Perold define the cost of capital?
Amount to purchase a guarantee that the firm will
meet its obligations
How do we use Cost of Capital to determine if a
course of action is suitable?
EVA = NPV − [Cost of Capital] > 0
Economic Value Added
Under Capital Allocation, how do we determine if a
course of action is suitable?
for example a purchase of additional reinsurance
NPV > Cost of Capital
[Net Reinsurance Cost] < −∆ Capital · [Hurdle Rate]
That is the benefit to cost of capital should be greater than the reinsurance cost
Reinsurance Premium 30m Expected Reinsurance Benefit 20m Net Reinsurance Cost 10m
```
∆ Capital -100m
Hurdle Rate 12%
``` 10m < 12m Cost < Benefit
What is Value at Risk VaRα?
The loss at the αth percentile.
VaRα = E[Y|F(Y) = α]
What is Tail Value at Risk TVaRα?
The average loss excess of the percentile α
TVaRα = E[Y|F(Y) > α]
What is Excess Tail Value at Risk XTVaRα?
Conceptually, the expected losses are funded by premium.
The excess is funded by capital - This is what XTVaR
represents.
XTVaRα = E[Y | F(Y) > α] − E[Y]
= TVaRα - Mean
What is Expected Policyholder Deficit EPD?
If capital is set as VaRα then EPD is the expected loss given default, times the probability of default.
EPD = (TVaRα − VaRα) · (1 − α)
Why does Venter not recommend VaR as a risk
measure for insurance companies?
It is too simplistic for insurers, which tend to use a number of
risk measures, many of which are more informative than VaR
Why shouldn’t we use a 1-in-3000 year risk metric? (3)
- Not able to accurately measure the losses so deep in the tail
- Selection of 1-in-3000 is arbitrary
- Better to choose probability levels that are less remote, but still impact the company
What features does the following risk measure have? (2)
E[Y · e^(cY/EY)]
- Captures all the moments
- Usually only exists if there is a maximum loss
What is the Value of the Default Put Option?
The market cost of purchasing insurance to cover any losses, when in default.
If VaRα is the capital level, then EPD is the expected unconditional loss, and the Default Put is the Market Value.
What is a Probability Transform?
How can we use it to calculate risk measures?
- A probability transform changes the density function -
usually increasing the the density of worse losses - A risk measure (such as mean) can be calculated on the
transformed probabilities
What is the Esscher Transform?
f^*(y) = k · e^y/c · f(y)