Goldfarb

Question 1

Allocate capital based on stand-alone percentile risk measure (VaR)

Answer 1

VaRx% = Net Loss at x%

Capitali = Risk Capital x (Risk Measurei /Summation(Risk Measurei))

Question 2

Allocate capital based on stand-alone CTE

Answer 2

CTEx% = Summation(Losses > VaRx%) / # Losses > VaRx%

Capitali = Risk Capital x (Risk Measurei /Summation(Risk Measurei))

Question 3

Allocate capital base on co-CTE

Answer 3

Co-CTEx% = Summation(Lossesi) / # Losses using the aggregate distribution

Capitali = Risk Capital x (Risk Measurei /Summation(Risk Measurei))

Question 4

Economic Profit Formula

Answer 4

Economic Profit = (Premium - Expenses) x (1 + Investment Return %) - Premium x Loss Ratiodisc

RAROCi = Economic Profiti / Capitali

Question 5

Adjusted RAROC for mulit year commitment

Answer 5

RAROCadj = R x Summation(Ci / (1 + r)^(t-1)) / C where

R = target rate of return

Ci = Ci-1 - Allocated Capital x % Paid
C1 = Allocated Capital

Economic profit at t=1 and capital allocated at t=0

Question 6

Objectives of policy/shareholders in regards to economic profit

Answer 6

Policyholders - are concerned with solvency, i.e. the economic capital is there so insurers can meet existing policyholder obligations.

Shareholders - are concerned with the capital adequacy objective, which uses economic capital to pay dividends, grow, and maintain financial strength.

Question 7

Strategic Decisions guided by RAROC performance

Answer 7

1) Assessing Capital Adequacy - Firms capable of performing these calculations should be in a better position to demonstrate their claims paying ability and should have the tools they need to understand what drives the risk in their business.
2) Setting Risk Management Priorities - Identifying opportunities that require the greatest risk capital.
3) Evaluating Alternative Risk Management Strategies - Calculating RAROC before and after certain risk strategies to see if they have improved.
4) Risk Adjusted Performance Measurement - The use of a risk adjusted performance metric such as RAROC may allow these business units to be more fairly compared. The explicit risk adjustment may also be an improvement over judgmental premium to surplus ratios.
5) Insurance Policy Pricing - Setting a price that can result in target returns. This may include using a risk load to reach target returns.

Question 8

Theory behind Meyers-Read Method

Answer 8

Evaluates the company’s default option. This is the value the company has for the righ to default on their obligations to policyholders if liabilities are greater than assets.

Unlikely to be asked on exam (same with formula)

Question 9

Risk Capital

Answer 9

Capital provided by equity holders to the company to cover the risk that liability may exceed the funds provided by the policyholders in form of loss reserves and UEPR.

Question 10

Practical Considerations

Answer 10

• Time horizons
• Alternative return measures
• Diversification adjustments
• Risk based allocation