Goldfarb - risk adj performance

Question 1

standard measurements of return (ROE, ROA, etc) do not account for

Answer 1

risk

these measurements may provide misleading conclusions about performance of different areas of firm

Question 2

alternate diagnostics aka risk adjusted performance measures can

Answer 2

explicitly reflect the risks to which a business is exposed by adjusting either the numerator or denominator of the return calculation

Question 3

Risk-adjusted return on capital, RAROC

Answer 3

risk adjusted performance that adjusts the denominator

Question 4

several different measures of income that can be used in the RAROC calculation:

Answer 4

1. GAAP net income: convenient when RAROC will be used in management decisions as GAAP is catered towards management
2. statutory net income
3. IASB fair value: based on fair value accounting; removes the accounting biases of various accounting conventions
4. economic profit

Question 5

economic profit & issues

Answer 5

change in economic value of firm over a period (assets are recorded at market value and liabilities are discounted)

• ignores franchise value
• may make less sense to management because economic values often do no reconcile to GAAP accounting
• management may have difficulty justifying their decisions to external parties as these parties only have access to statutory & GAAP accounting

Question 6

goldfarb paper calculations based on

Answer 6

RAROC & economic profit

Question 7

several different capital measures are available

Answer 7

some of these measures are adjusted to reflect the level of risk and some are not

Question 8

capital measures that are not risk adjusted

Answer 8

1. actual committed capital: actual capital provided by shareholders
2. market value of equity: market capitalization

includes the franchise value

Question 9

book value & advantages and disadvantages

Answer 9

• the book value is just the value of capital at a particular point in time. It is not a prospective value that is helpful in predicting performance.
• actual capital is a volatile number that is based on past underwriting performance
• Since book value is available in financial statements, it is more reliable and readily available

Question 10

Risk adjusted measures include

Answer 10

1. regulatory required capital
2. rating agency requited capital: amount of capital necessary to achieve a specific credit rating
3. economic capital:
4. risk capital:

Question 11

economic capital:

Answer 11

amount of capital necessary to provide the firm with a certain probability of achieving a specific objective over the time horizon; objectives include:

• solvency objective=firm can meet its existing obligations to policyholders -> policyholders need economical capital to achieve this objective
• capital adequacy objective=firm can continue to pay dividends/grow premiums/maintain a certain financial strength -> Shareholders need economical capital to achieve this objective

Question 12

risk capital & how it differs from economic capital

Answer 12

amount of capital that needs to be provided by shareholders to cover the risk that the liabilities may exceed the funds already provided in form of loss reserves or premiums

• amount of capital to protect the firm from the risks that it is exposed to
• Risk capital is highly dependent on the selected risk metric

differs from economic capital in that it is reduced to extent that liabilities are overly conservative and/or if risk margin exists

Question 13

risk based measures of required capital are often

Answer 13

much lower than market value of firm’s equity

Question 14

problem of using risk-adjusted capital to determine the cost of capital

Answer 14

may result in an understated number

-Goldfarb’s procedure accounts for this by allocating the actual capital using risk based approach

Question 15

risk measures can be

Answer 15

used to assess the risk associated with a given LOB

Question 16

insurers can derive the necessary amount of capital required to produce a specific

Answer 16

probability of ruin

percentile risk measure, VaR: loss at a particular percentile

conditional tail expectation, CTE: mean loss of all losses that exceed certain percentile; also known as TVaR or tail conditional expectation

expected policyholder deficit ratio

Question 17

probability of ruin

Answer 17

Default: assets are insufficient to settle liabilities

Credit rating dropping below a certain level

Question 18

risk measures are usually compared to

Answer 18

a threshold level

Question 19

common thresholds

Answer 19

1. bond default probabilities @ selected credit rating level:
2. management’s risk preferences: threshold based on risk tolerance of management
3. arbitrary default probability

Question 20

bond default probabilities @ selected credit rating level

Answer 20

maintain enough capital that would result in probability of default of firm = probability of default of a bond with specific credit rating

disadvantages: does not address which credit rating should be targeted, does not account for risk of downgrade

Question 21

management’s risk preferences disadvantages

Answer 21

will be difficult to get management to articulate and agree on threshold

preferences of managers will often differ to preferences of directors and shareholders

does not factor in risk which is important consideration to compare to reward

managers will likely be focused on several issues that concern policyholders

may be hard to isolate the estimate of the threshold to just the probability of default

Question 22

arbitrary default probability advantages

Answer 22

arbitrary percentile that is relatively easy to measure

insurer does not have to estimate values at very low probability of occurrences where a lot of uncertainty exists