Panning Flashcards

1
Q

Franchise value (F) definition

Panning

A

economic value of future renewals to the firm

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2
Q

Total economic value (TEV, aka market value or market capitalization)

(Panning)

A

TEV = current economic value (C) + franchise value (F)

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3
Q

Objective of Asset Liability Management (ALM)

Panning

A

measure & manage the degree to which the economic value of an insurer is adversely exposed to changes in interest rates

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4
Q

Franchise value and ALM and accounting rules

Panning

A

franchise value is not recognized in ALM or accounting rules

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5
Q

Goal of firm’s according to Panning

Panning

A

minimize exposure to interest rate risk while limiting exposure to accounting rules that can adversely impact solvency/ratings

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6
Q

Simplified assumptions of the Panning model (original version, 6)

(Panning)

A
  1. all premiums are collected & expenses paid on 1/1
  2. true value of losses & LAE is known and paid on 12/31
  3. constant surplus, expenses, and expected losses in each year
  4. no taxes
  5. flat term structure of interest rates
  6. all calculations are as of 1/1 immediately after business is written
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7
Q

UW income

Panning

A

UW income = premium - loss - expense

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8
Q

Investment income

Panning

A

investment income = (surplus + premium - expense) * risk-free rate

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9
Q

Premiums required to achieve target return on surplus

Panning

A

premium = [(surplus * (target ROS - risk-free rate) + loss) / (1 + risk-free rate)] + expense

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10
Q

Current economic value (C) definition and formula

Panning

A

balance sheet value on 1/1

C = surplus + premium - expense - loss discounted to time 0

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11
Q

Franchise value formula (fixed version) & assumptions (3)

Panning

A

F = (premium - expense - loss discounted to time 0) * (d / (1 - d))

where d = client retention / (1 + risk-free rate)

assumes constant:

  1. client retention
  2. interest rates
  3. target return on surplus
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12
Q

Market value to book value ratio

Panning

A

market value to book value = total economic value / current economic value

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13
Q

Relationship between client retention (cr), franchise value (F), and market value to book value ratio (3)

(Panning)

A

As client retention increases:

  1. franchise value increases
  2. market value to book value ratio increases
  3. franchise value as a % of TEV increases
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14
Q

Target return on surplus (k) assumptions (2)

Panning

A
  1. k = a (constant target return on surplus) - original version
  2. k = a + by = target returns are a function of the risk premium (a) and the risk-free rate (y)&raquo_space; setting b<>0 allows premium to vary with interest rates
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15
Q

Franchise value formula with varying interest rates

Panning

A

F = [client retention * surplus * (a + (b - 1) * risk-free rate] / [(1 + risk-free rate) * (1 + risk-free rate - client retention)]

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16
Q

Dollar duration

Panning

A

Dollar duration = PV * D

17
Q

Duration of franchise value (D(F))

Panning

A

D(F) = [(a - b + 1) / ((1 + y) * (a + by - y))] + (1 / (1 + y - cr))

D = dF/dy
y = risk-free rate
cr = client retention
18
Q

Duration of total economic value (D(TEV))

Panning

A

D(TEV) = (D(C) * C + D(F) * F) / (C + F)

= weighted average duration of franchise value and current economic value

19
Q

Reason that the duration of franchise value (D(F)) is greater than the duration of losses and expenses

(Panning)

A

because premium CFs are sensitive to interest rates

20
Q

Impacts of an increase in interest rates with fixed k (2) and how to mitigate

(Panning)

A
  1. PV(premium) decreases (unavoidable)
  2. Dollar value of future premiums decreases (minimize by using a pricing strategy that allows interest rates to vary, k = a + by)
21
Q

Reason that firms want to reduce duration of invested assets

Panning

A

to minimize exposure to interest rate risk

22
Q

Ways firms can reduce the duration of invested assets (2)

Panning

A
  1. changing the composition of the investment portfolio

2. purchasing derivative security’s that modify the asset portfolio

23
Q

Problems with reducing the duration of invested assets (2)

Panning

A
  1. with larger franchise value, it is more difficult to manage interest rate risk by reducing duration
  2. regulators and rating agencies will not be able to see the benefits (b/c they only see accounting numbers), which may lead them to believe the firm is in distress
24
Q

Panning’s recommended pricing strategy

Panning

A

optimize a and b parameters in k = a + by to retain a given target return and reduce duration (D(TEV)) to acceptable levels

25
Q

Limitation of Panning’s recommended pricing strategy

Panning

A

desired combination of target return on surplus and target duration of TEV can only be maintained for a narrow range of interest rates (b/c price-interest rate relationship is non-linear)

*standard ALM has the same limitation

26
Q

Advantage of Panning’s recommended pricing strategy

Panning

A

dynamic pricing policy is invisible to external audiences, so it avoids potential regulator or rating agency risks from reducing duration

27
Q

Implications of Panning’s model on ALM (3)

Panning

A
  1. franchise value is real
  2. franchise value is exposed to interest rates due to discounting of future CFs
  3. despite importance, franchise value tends to be invisible and unmanaged
28
Q

Duration of current economic value, D(C) and simplifying assumption

(Panning)

A

D(C) = [D(Assets) * PV(Assets) - D(Liab) * PV(Liab)] / C

where PV(Assets) = S + P - E 
PV(Liab) = L / (1 + y)

simplifying assumption: D(C) = 1

29
Q

Relationship between duration and interest rate risk

Panning

A

higher duration of TEV = higher interest rate risk