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Exam 9 > Goldfarb: Risk-Adjusted Performace > Flashcards

Goldfarb: Risk-Adjusted Performace Flashcards

1
Q

Goldfarb issue with general return metrics (ROE, ROA)

A

Do not distinguish between varying degrees of risk

Can sometimes result in misleading indications of performance

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2
Q

RAROC equation

A

Income / RAC

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3
Q

Alternate measures of income to use in RAROC calculation

A

GAAP NI

SAP NI

IASB Fair Value

Economic Profit

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4
Q

Three issues with using economic profit for net income in RAROC equation

A
  1. Ignores franchise value
  2. Complicates reconciliation to GAAP; makes less sense to management
  3. External parties (only have access to GAAP)
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5
Q

6 alternate measures of capital

A

Actual committed capital

Market value of equity

Regulatory required capital

Rating agency required capital

Economic capital

Risk capital

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6
Q

Actual committed capital

A

Actual capital provided by shareholders

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7
Q

Economic capital

A

Amount of capital necessary to provide firm with certain probability of achieving a specific objective over time horizon

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8
Q

Risk capital

A

Amount of capital needed to be provided by shareholders to cover risk that L > A

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9
Q

2 objectives to derive economic capital

A

Solvency objective

Capital adequacy objective

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10
Q

Solvency objective

A

That firm can meet existing obligations

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11
Q

Capital Adequacy Objective

A

That firm can continue to grow/pay dividends/maintain rating

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12
Q

Stranded capital

A

Excess of actual capital over the risk capital (usually driven by regulation or rating agency)

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13
Q

3 ways to derive thresholds used to compare risk measures

A
  1. Bond default probabilities at selected credit rating level
  2. Management risk preference
  3. Arbitrary default probability
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14
Q

Weaknesses of choosing bond default probabilities for risk measure

A
  1. Does not address which credit rating should be targeted
  2. Does not account for risk of downgrade (AA-rating is based on ability to maintain that level with high probability)
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15
Q

Three points to keep in mind if using bond default probabilities

A
  1. Historical vs. current estimates (stability vs. reflective)
  2. Different sources may indicate different numbers
  3. Time horizon (default probabilities are annual vs. lifetime)
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16
Q

Disadvantages to using management risk preferences as threshold

A
  1. Getting management to articulate/agree
  2. Differing views from directors/shareholders
  3. Does not factor in risk, which needs to be considered to compare to reward
  4. Managers focused on number of issues, difficult to estimate threshold to just probability of default
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17
Q

5 main categories of risk to an insurer

A
  1. Market risk
  2. Credit risk
  3. Insurance UW risk
  4. Operational risk
  5. Strategic risk
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18
Q

Market risk

A

Potential loss in value that results form impact that changes in equity indices, interest rates, foreign exchange rates, etc. have on current investments

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19
Q

Credit risk

A

Potential loss in value due to counterparty default, changes in counterparty credit rating, or changes in rating-specific yield spreads

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20
Q

Three most important credit-related risk exposures

A
  1. Marketable securities/derivatives/swap positions
  2. Insureds contingent premiums/deductibles receivable
  3. Reinsurance recoveries
21
Q

Uniqueness of reinsurance recoveries for credit risk

A
  1. Definition of default (death spiral)
  2. Substantial contingent exposure (may increase with adverse loss development)
  3. Reinsurance credit risk is highly correlated with underlying insurance risk
22
Q

Insurance UW risk (3 categories)

A
  1. Loss reserves on prior PYs
  2. UW risk for current period PY
  3. Property CAT risk
23
Q

3 components of total risk that impact loss reserve risk

A
  1. Process risk
  2. Parameter risk
  3. Model risk
24
Q

Process risk

A

Risk that actual results will deviate from expected value due to inherent random variation of claim development process

25
Q

Parameter risk

A

Risk that actual deviates from estimate due to inaccurate parameter estimates in models

26
Q

Model risk

A

Risk that you used the wrong model

27
Q

Three methods to quantify UW risk

A
  1. Loss ratio distribution model
  2. Freq/Sev model
  3. Inference from reserve risk models
28
Q

5 advantages of Freq/Sev models over loss ratio distribution models

A
  1. Easier to account for growth
  2. Reflects inflation more accurately
  3. Changes in limit and deductibles reflected
  4. Impact of deductibles on frequency can be accounted for
  5. Treatment of split of loss can be mutually consistent
29
Q

4 methods to derive aggregate distribution from Freq/Sev distributions

A

Analytical solution (based on freq/sev parameters)

Numerical method (approximation)

Approximation (based on mean, variance of collective risk model)

Simulation

30
Q

Reasons historical CAT losses not best measure of future losses

A
  1. Frequency
  2. Changes in exposures
  3. Changes in severities (building materials)
31
Q

3 modules of CAT models

A
  1. Stochastic/Hazard module - generate events
  2. Damage (vulnerability) module - based on exposure information
  3. Financial analysis module - applies terms of contracts to determine impact
32
Q

Correlation vs. dependency

A

Correlation: measure of linear dependency

Dependency: more general measure of the degree to which different random variables depend on each other

Perfect dependency does not imply perfect correlation

33
Q

3 methods to quantify dependency between risks

A
  1. Empirical analysis of historical data
  2. Subjective estimates
  3. Explicit factor models (link variability of risks to common factos)
34
Q

Disadvantages of empirical analysis to quantify dependency between risks

A

Data required does not exist

Historical data contains very little insight into correlation/dependency when tail events occur

35
Q

Advantages/disadvantages to using subjective estimates to quantify dependency between risks

A

A: Reflects dependency during tail events

A: Reflects user intuition

D: As number of risk categories increases, number of dependency parameter estimates increases exponentially

36
Q

Four techniques to aggregate the distributions of different risks

A
  1. Closed form solutions
  2. Approximation methods (assume distributions, derive parameters)
  3. Simulation methods (favored due to intuitiveness, brute forcing of results)
37
Q

Available methods to allocate capital (Goldfarb)

A
  1. Proportional allocation
  2. Incremental allocation
  3. Marginal allocation (i.e. Meyers-Read)
  4. Co-measures
38
Q

Shortcomings of Meyers-Read

A

Not developed as a mean for determining risk-adjusted capital requirements

May require more quantitative resources compared to other methods

Significant mathematical challenges

39
Q

Five applications of risk adjusted performance metrics

A
  1. Assessing capital adequacy
  2. Setting risk management priorities
  3. Evaluating alternative risk management strategies
  4. Risk adjusted performance measurement
  5. Insurance policy pricing
40
Q

Economic profit, equation

A

Economic profit = P - E - L / (1 + y) + Investment return

41
Q

Inconsistent time horizons when assessing aggregate risk profile

A

Market risk often based on one-year period, whereas insurance risks are based on ultimate liability

42
Q

Target RAROC when capital is committed for multiple periods

A
43
Q

Problems with looking at insurance risks over only one year

A

Few data/methods to estimate timing of recognition of adverse development

Change in value perspective of loss reserves not consistent with market risk

Likely results in small change in liability valuation, though potential risk over long term (significant)

44
Q

Problem with quantifying market risk over longer than one-year period

A

Investment strategies change

Difficult to derive parameters

45
Q

Importance of economic capital to policyholders and shareholders

A

Policyholders: Need economic capital to achieve solvency objective

Shareholders: need economic capital to achieve capital adequacy objective

46
Q

Target RAROC when given cost of capital

A

Target RAROC = [cost of capital * PV(capital held)] / initial capital

47
Q

Premium risk

A

Risk that the expected premium collected will not be enough to pay for expected losses

48
Q

Interest rate risk vs. tail of business

A

Longer tail line has more interest rate risk (longer duration)

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