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Exam 7 > ERM Ch.2 > Flashcards

ERM Ch.2 Flashcards

1
Q

3 steps in the evolutionary process

A
  • Deterministic Project Analysis
  • Risk Analysis
  • Certainty Equivalent
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2
Q

Risk Management Decisions should be

A
  • Objective
  • Consistent
  • Repeatable
  • Transparent
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3
Q

Steps to allocate cost of risk

A
  • Estimate an Aggregate Loss Distribution
  • Quantify the impact of the loss outcomes on the organization
  • Assign a cost to each amount of impact
  • Attribute (allocate) the cost back to each risk source
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4
Q

Corporate risk tolerance depends on

A
  • Organization’s size
  • Financial resources
  • Abiltiy & willingness to tolerate volatility
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5
Q

Advantages of Economic Capital

A
  • Provides a unifying measure for all risks across an organization
  • More meaningful to management than formulaic RBC or capital adequacy ratios
  • Forces firm to quantify the risks it faces & combine them into a probability distribution
  • Provides a framework for setting acceptable risk levels for the organization as a whole & for individual business units
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6
Q

Asset Liability Modeling Approach

A
  • Start w/ models of asset classes, liabilities & current business operations
  • Define risk metrics
  • Define return metrics
  • Time Horizon
  • Constraints
  • Simulations
  • Efficient frontier graph
  • Liabilities, in particular future loss reserves, can be modified
  • Results should be reviewed to identify the simulations that the preferred portfolio performed poorly
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7
Q

Value of Reinsurance

A
  • Provides stability
  • Frees up captial
  • Adds to the value of the firm
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8
Q

Deterministic Project Analysis

A

Singe deterministic forecast of cash flows. Calculate a NPV or IRR. May do sensitivity analysis by varying some of the input assumptions. Uncertainity is handled judgementally.

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9
Q

Risk Analysis

A

The critical inputs have a distribution. These are fed into the model, and the output is a distribution of outcomes. Can be NPV or IRR. Uncertainty is handled judgementally, though a good portion has been moved into the distributions.

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10
Q

Certainty Equivalent

A

Has the additional step of running the output through a utility function. Formalizes some of the risk assessment so it can be applied consistently.

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11
Q

Should we strive for certainty equivalent?

A

Argument 1: Since the investors in the company are only compensated for systemic risk, and not compensated for firm-specific risk; the company shouldn’t be concered with firm-specific risk.

Argument 2: Hard to identify systemic vs. firm-specifc risk. Market-based information is too noisy for management to be able to do a proper CBA and make tradeoff decisions.

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12
Q

Market Value

A

Book Value + Franchise Value

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13
Q

2 papers analyzed by Mango - Spetzler

A
  • Measure the utility curve for managers of a firm
  • Which minimum level (p) would you accept a project
  • Compared risk tolerance of different managers within a firm
  • Create a transparent, objective mathematical expression of the corporation’s risk/reward tradeoffs
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14
Q

2 papers analyzed by Mango - Walls

A
  • Focused on oil projects - Upfront investment -> Project may either succeed or fail
  • Certainty Equivalent - The fixed amount that the firm is indifferent between taking the risky portfolio or the fixed amount
  • Calculates the efficient frontier of portfolios & then uses the risk tolerance of the firm to select where on the frontier to select the best portfolio
  • Questions:
    • How much risk are we willing to tolerate?
    • How much reward are we willing to give up for a given reduction in risk & vice versa?
    • Are the risk-reward tradeoffs available along the efficient frontier acceptable to us?
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15
Q

One method to allocate the cost of risk capital

A
  • Allocate Capital in a risk adjusted way
  • Apply a hurdle rate to determine the cost of captial for each business unit
  • Called Return on Risk-Adjusted Capital - RAROC
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16
Q

Economic Value Added

A

NPV - Cost of Capital

17
Q

Why do we prefer skewness over standard deviation?

A

There is evidence that standard deviation does not capture market attitudes to risk, so we can add higher moments

18
Q

XTVaR - Excess Tail Value at Risk

A

TVaR - Mean

19
Q

EPD - Expected Policyholder Deficit

A

(TVaR - VaR) * (1- alpha)

20
Q

Transforms - Why & Types

A

Want a way to recognize that large losses are worse for the firm, in more than a linear way

  • Types:
    • Minimum Martingale Transform (reins. prices)
    • Minimum Entropy Martingale Transform (reins. prices)
    • Wang Transform (market prices for bonds/CAT bonds)
21
Q

Allocating the company risk measure to each business unit…

A
  • Allows the company to measure the amount of risk each business unit contributes to the company
  • Can be used to set capacity & policy limits for each business unit
  • Can be used to calculate risk-adjusted profitability
22
Q

3 ways to allocate a risk measure of a firm to its business units:

A
  • Proportional Method
    • Calculate the risk measure for each business unit, p(Xj), & allocate the risk measure for the company, p(Y), in proportion to p(Xj)
  • TVaR
    • Calculate the average losses in unit j, when the firm has losses excess of the (alpha)th percentile
  • VaR
    • Calculate the expected value fo the losses in unit j when the firm has losses at the (alpha)th percentile
23
Q

Scalable Risk Measure

A

Risk measure are scalable if increasing (or decreasing) the size of the business by a small factor also increases (reduces) the risk measure by the same factor

24
Q

Marginal Allocation

A

An allocation is marginal if the change to the company’s risk measure from a small change in a single business unit is attributed to that business unit.

25
Q

Can get proportional growth (shrinkage) in two ways:

A
  • Reinsruance
  • Growth
26
Q

How to measure the risk adjusted profit of a business unit

A

Profits of the unit/Allocation

Pj/r(Xj)

27
Q

Allocate cost of capital

A
  • Set equal to the value fo the righ to call upon the capital of the firm
  • Charge the market valeu of a stop-loss for the business unit
    • Start w/ the expected value of the stop-loss
    • Use a probability transform & the theory of pricing in incomplete markets (Min. Entropy Martingale Transform)
28
Q

Allocating capital is ___ and ___

A

Arbitrary & Artificial

29
Q

3 accounting methods & effect on hedging

A
  • Statutory Accounting:
    • Little hedge from duration matching
    • Bonds are amortized not marked to market
    • LIabilities are not discounted
  • GAAP Accounting:
    • Duration matching is not effective
    • Bonds are marketed to market
    • Liabilities are not discounted
  • Economic Balance Sheet:
    • Duration matching results in low interest rate risk
    • Assets are marked to market
    • Liabilities are discounting
      *
30
Q

Net Benefit of Reinsurance

A

= | Change in Cost of Capital| - |Net Cost of Reinsurance|

If >0 then Accept

31
Q

ROE - Reinsurance

A

= Net Cost of Reinsurance / Change in Capital

Accept if less than the cost of capital

32
Q

Theoretical Models vs. Practical Models

A

Theoretical - from a risk model (Ex: VaR, TVaR)

Practical - use capital requirements from rating agencies or regulators (Ex: BCAR, S&P)

33
Q

Pro & Con of Practical Model

A
  • Pro: Easier to implement, since it doesn’t require modeling the distribution of lossses & their correlations
  • Con:Not accurate though, because the measurement of risk is based on proxies, not the actual risk itself
    • Solution: Have a model that looks a year out. It would take the current state & projections for nex year. Predict the probability of falling below certain thresholds. The capital could then be set so that the proability of this is less than 10%
34
Q

As-If Reserves

A

Calculate the reserves, as if the company has been writing the same book the last several years

Need to adjust for inflation

35
Q

As-If Reserves Advantages

A
  • It can measure the impact of accumulated risk caused by correlated risk factors
  • The reinsurance can be applied to the current AY & the as-if reserves providing a more valid measure of the accumulated risk & captial used over the full-life of the AY
36
Q

Capital Consumed

A

=-PV(Premium + Reserves - Losses - Expenses)

Exam 7 (25 decks)

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