Last minute Qs Flashcards
4 SOURCES of operational risk
not operational risks, but sources of risk
- inadequate or failed internal processes, people or systems
- reliance on a single individual over the running of the business
- reliance on 3rd parties to carry out various functions for which the organisation is responsible
- failure of plans to recover from an external event
What is the incentive for self-regulation?
The incentive is the fact that regulation is:
- an ECONOMIC GOOD
- that consumers of financial services are WILLING TO PAY for and
- which will BENEFIT all participants.
An alternative incentive is the threat by government to impose statutory regulation,
especially if a satisfactory self-regulatory system isn’t implemented.
Corporate Bonds:
Security
Corporate bonds are generally much LESS SECURE than government bonds.
The level of security depends upon the type of debt security considered, the company that has issued the bond and the term of the bond.
Corporate Bonds:
Yields: Running yields
Historically, running yields on conventional bonds have typically been HIGHER than running yields on equities and property.
This is because income on equities and property is expected to grow over time, creating capital gains.
Conversely, since the income stream on a conventional bond is flat and the scope for capital gains is limited (if the bond is held to maturity), income levels tend to be higher.
Corporate Bonds:
Yields: Real vs nominal
If bonds are held until redemption (with no default risk materialising), the monetary amounts of income and capital are known and fixed. To this extent, the expected nominal returns are known at outset. The actual return achieved might, however, be uncertain:
- If an investor bought an n-year bond to meet an n-year liability, the coupon payments would have to be REINVESTED on terms that are not known at the outset.
- If an investor plans to sell before redemption, the SALE PRICE IS NOT KNOWN at the outset.
- Any DEFAULTS from the issuer will also impact the actual return achieved.
- The REAL RETURN IS UNCERTAIN. If inflation turns out to be higher than expected at outset, the real returns from conventional bonds will be lower than originally anticipated.
Corporate Bonds:
Yields: Expected return relative to government bonds
The gross redemption yields on corporate bonds are higher than for similar government bonds, compensating for the
- lower marketability and the
- perceived additional default risk.
The lowest yield margins will be for larger issues from companies with high credit ratings.
Corporate Bonds:
Spread – volatility of capital values
Market values will fluctuate from day to day if there are changes in the supply and/or demand. Quite large shifts in market value are possible with less liquid, long-dated stocks.
The risk of falling market values may be a problem for:
• investors who need to prove financial strength by reference to the market value of assets (e.g. general insurers);
• investors who have to sell at the lower market prices (e.g. if an investor is required to meet a liability earlier than anticipated).
Corporate Bonds:
Term
Bonds can be classified as: • shorts (< 5 years) • medium-dated (5-15 years) • long-dated (> 15 years) • undated or irredeemable (no redemption date).
Corporate Bonds:
Expenses
For corporate bonds, the margins between buying and selling prices are typically wider than for conventional government bonds.
Corporate Bonds:
Exchange rate – currency risk
There will be a currency risk for an investor who is investing in bonds denominated in one currency but who has liabilities denominated in another.
Corporate Bonds:
Marketability
Corporate bonds are typically much less marketable than government bonds,
primarily because the SIZE OF ISSUE IS SMALLER.
Corporate Bonds:
Tax
The taxation of the income and capital gains will depend on the tax regime of the country concerned.
There will typically be both an income component (coupons) as well as capital gain (redemption value or sale price).
7 Sources of capital
- Share capital
- Policyholders
- Reinsurers (through financial reinsurance)
- Securitization
- Subordinated debt (into a holding company)
- Derivatives
- Past profits
Reasons why an insurance company might need capital
- Cushion for unexpected events
- Pay for future liabilities as they fall due
- To grow or expand / Finance new business
- As start up capital (will finance costs before revenue comes through)
- Required by regulator
- To finance known losses (for example to finance a loss leader product) or to finance losses incurred (for example due to adverse claims experience)
- To write business containing guarantees as it requires higher solvency margins
- To obtain a good credit rating (demonstrates financial strength)
- In order to have more investment freedom including the ability to mismatch to obtain higher returns
Why might the central bank increase interest rates?
- government may want to CONTROL INFLATION
Higher real interest rates mean a decreased quantity of money is demanded which is met by a decrease in the money supply.
This can lead to reduced inflation. Higher real interest rates can assist in any inflationary pressures by decreasing demand in the real economy. - government may want to STRENGTHEN THE DOMESTIC CURRENCY
If interest rates in one country are high relative to other countries, international investors will be more inclined to deposit money in that country. This increases demand for the domestic currency and tends to increase the exchange rate. - High real interest rates reduces investment spending by firms and decrease the level of consumer spending.
So increasing interest rates reduced the rate of growth in the short term.
The government may want to increase rates for political reasons. Eg to increase savings rates, strengthen financial institutions, or make future rate decreases possible (as hard to go below zero)
Effect of increased short-term interest rates on the EQUITY market
Equity markets should be REASONABLY INDIFFERENT towards high nominal interest rates and high inflation.
If the rate of inflation is high, the rate of dividend growth would be expected to increase.
Higher interest rates should REDUCE ECONOMIC ACTIVITY
… reducing corporate profitability
… reducing the general level of the equity market.
RATE OF RETURN REQUIRED by investors should be higher, so the present value of the future dividends will be lower.
The increase interest rates are also likely to REDUCE CAPITAL AVAILABLE to invest, leading to lower company growth.
CURRENCY MAY STRENGTHEN, doing damage to export-based industries.
IMPORTERS of raw materials will be better off.
Effect of increased short-term interest rates on the BOND market
Yields on short-term bonds are closely related to returns on money market instruments, so an increase in short-term interest rates will almost certainly reduce prices of short bonds.
However, the yield on long bonds might increase by a smaller amount, or even fall due to investors expecting deflation in the longer term.
Inflation-linked bonds may be more affected if the expectation is that inflation falls.
A significant part of the demand for government bonds in many markets comes from overseas. Increased expectations of future increases in the exchange rate will affect the demand from overseas investors. It will also alter the relative attractiveness of domestic and overseas bonds for local investors.
Describe factors other than interest rates which could influence the country’s investment markets
How attractive are ALTERNATIVE INVESTMENTS?
General MARKET SENTIMENT and investment FASHIONS
COMMODITY PRICES (and other input costs) will affect many companies
POLITICAL events or REGULATORY/TAX changes
ECONOMIC GROWTH OUTLOOK, expected improvements may generate market increases in anticipation of future growth.
EQUITY RISK PREMIUM - this is the additional return that investors require from equity investment to compensate for the risks relative to risk-free rates of return.
Set out what minimal underwriting may consist of.
- Personal details
- Age
- Gender
- Smoker status and other lifestyle issues (eg alcohol)
- Height/weight/BMI data
- Brief health questions (diagnosis / treatment)
- Alternatively require a catch-all health declaration.
Outline the practical problems that may arise due to the lack of data held by a brand new insurer.
great difficulty in determining
- appropriate PREMIUM rates
- expected MORTALITY rates
- what the key RATING FACTORS are, or how they will affect their target market.
- expense loadings
- capital requirements
- difficult to predict BUSINESS VOLUMES
- need data from OTHER SOURCES
- – which will cost money
- – may not be relevant / credible
Describe the commercial implications of a new insurer not having any past data / experience.
- the uncertainty will lead to LARGE CONTINGENCY MARKETS.
- they will rely heavily on REINSURANCE data and expertise (but this comes at a cost).
Leading to high premium rates vs competitors. - the alternative is having low contingency markets, but could lead to premiums being too low for actual claims (ie large losses).
- incorrect pricing structure could see the company ACCEPTING POOR RISKS.
they will be vulnerable to ANTI-SELECTION (owing to light underwriting standards).
Discuss the circumstances leading to a risk
BEING RETAINED
The risk would be material if it arose.
However, the company may think that the risks are unlikely to bite.
Or, they might have SUFFICIENT FUNDS to cover any potential losses.
Suitable alternatives (transferrance) might be prohibitively expenses.
The company may be happy to take extra measures to deal with the risk.
The company may want to retain any UPSIDE OF THE RISK.
Discuss the circumstances leading to a risk
BEING FULLY TRANSFERRED
- The company is risk averse.
They believe that insurance is necessary, since - even if the risk is unlikely - the impact will be to great for them to cover themselves.
Alternatively, they may believe that they will be taking on significant risk but the premium represents value (and/or they can afford it).
It may be a LEGAL REQUIREMENT.
Describe how the costs of a policyholder protection scheme could be met.
- POLICYHOLDERS
Higher premiums or charges applied to policyholder funds. - CAPITAL PROVIDERS
The ranking of capital provided on insolvency. - COMPANIES
Surcharges on surviving companies to provide benefits on insolvent schemes. There could be levies on all companies; these could be related to risk. - STATE
May step in directly. Could provide direct insolvency support or underwriting support, eg to provide confidence in benefit schemes. This could be funded through general taxation.
Outline how the actuarial control cycle could be used to manage the launch of a new insurance product:
SPECIFYING THE PROBLEM
Include an analysis of risks, including mitigations, and the problem seen from each stakeholder’s perspective.
Need to know the AIMS AND OBJECTIVE of the insurance company for this product.
We need to know its SUCCESS MEASURE.
Analyse the market to ensure the product is VIABLE.
Understand the NEEDS OF CONSUMERS
Understand who the COMPETITION IS
Understand COMPETITIVE ADVANTAGES
