Kreps - Investment Equivalent Reinsurance Pricing Flashcards
Why the risk loads derived using Kreps method will in general result in larger risk loads?
The constract is priced on a stand-alone basis, i.e. assume it is the reinsurer’s only business. The risk loads derived here are maximal because reinsurers generally have an ongoing book of business. This book is mutually supporting, in that usually not all of it goes bad at the same time. Pricing on a stand alone basis is equivalent to assuming that the whole book is correlated.
Briefly describe Kreps paradigm.
when the reinsurer accepts a contract, it arrages to have available at every time of loss sufficient liquifiable assets to cover possible losses up to some safety level. These assets arise from premium and assets allocated from surplus, both of which are invested in appropriate financial instruments. The reinsurer wishes to have at least as favourable return and risk over the period of the contract as it would when doing its target investment with the underlying allocated assets.
This paradigm looks at risk load as an opportunity cost and represent it as a cost of liquidity.
Explain why intuitively the total risk load may be reduced by pooling?
Both safety level and variance constraint will be primarily sensitive to the tail of loss distribution. When two contracts are imperfectly correlated, the bulk of the tail results from one or the other contracts going bad, and not both. The effect is shorten the tail relative to mean.
What are the practical use of Krep’s technique, since it should not be followed through (produces risk load that is too large for a book of business).
Take the financial target and allocated assets as input. The two constrants then become requirement on loss distribution. The corresponding risk loads will emerge. Knowing the desired loss characteristic and the necessary risk load, market knowledge can be used to do selective underwriting and keep the overall distribution within acceptable risk levels at the target rate of return.
