Past Exam Questions: April 2012 Flashcards
Discuss when it would be helpful to distinguish between upside and downside risk and when it would not.
Many companies are relatively risk averse and so will be more willing to commit limited time and resource to
- identifying
- estimating
- mitigating
- and transferring
the risks of not making the expected returns or financial objectives.
They will be interested to know that there are scenarios that result in higher than expected returns, but they won’t spend much time analysing them and seeking to optimise them.
For these companies, the risk reporting, risk quantification including scenario testing, mitigation and transfer strategies will all be concerned with downside risk only.
A possible exception is the calculation of the best case return which would be concerned with upside risk.
Also the comparison of different transfer strategies may include determination of the lost potential for upside risk under each alternative.
However, less risk averse companies would be likely to separate and analyse upside risk in order to feed it into strategic decision-making, particularly the identification of potential opportunities to exploit.
The separation of upside and downside risk is not a useful concept for stochastic modelling and for calculating expected returns.
In this case, risk is typically defined as the variation from the expected result.
For example, this approach is necessary to calculate confidence levels, probability of capital sufficiency and diversification credits.
Outline 5 different types of supervisory body
- Professional bodies
- Professional regulators
- Industry regulators
- Industry bodies
- Government
Outline how different types of supervisory body carry out their controlling functions:
Professional bodies
Ensure that their members dealing with the regulatory process are thoroughly trained and their knowledge is kept up to date.
This is usually done through an examination system and Continuous Professional Development requirements.
Outline how different types of supervisory body carry out their controlling functions:
Professional regulators
Set the standards to which the professions must adhere and monitor how well the members are doing so.
They also discipline cases of non-adherence.
Outline how different types of supervisory body carry out their controlling functions:
Industry regulators
Limit and monitor firms.
They can control which companies can enter a particular industry and which individuals can hold particular roles.
They can monitor companies by requiring standard information to be provided at frequent intervals.
They can also require oversight of strategic plans, e.g. controlling the features on new products and by interacting with senior members of a company to understand the strategic direction of a company.
They can take sanctions against companies and individuals breaking the rules.
Outline how different types of supervisory body carry out their controlling functions:
Industry bodies
Can require standards from member companies.
However, they do not carry the same weight as industry regulators and usually represent the interests of the industry.
Outline how different types of supervisory body carry out their controlling functions:
Government
Can establish legislation to provide the framework for industry regulators.
This may also include the levels of capital requirements for the particular industry.
List 4 Archimedean Copulas
- Gumbel
- Frank
- Clayton
- generalised Clayton
Explain different situations in which it would be appropriate to use:
The Gumbel copula
The Gumbel copula has upper tail dependence, but no lower tail dependent.
It is therefore suitable for modelling dependency where association increases for extreme positive values, e.g. losses from a credit portfolio measured as a positive.
Or property / liability claims aggregation.
Explain different situations in which it would be appropriate to use:
The Frank copula
Has neither upper tail nor lower tail dependencies.
It is therefore suitable for modelling the relationship between stock indices and bond returns.
Stocks and bonds do not usually show tail dependence because their returns are not directly dependent on each other.
Explain different situations in which it would be appropriate to use:
The Clayton copula
The Clayton copula has heavy concentration of probability near (0,0) and depending on the parameters the Clayton copula can have either:
- Only lower tail dependency
making it suitable to use if extreme negative events are thought to happen together - for example returns from a portfolio of shares.
Share market crashes of the past have demonstrated this type of behaviour. - No upper tail or lower tail dependence - therefore similar to the Frank copula
Explain different situations in which it would be appropriate to use:
The generalised Clayton copula
The generalised Clayton copula has an additional parameter which allows both upper and lower tail dependencies.
It would be suitable for modelling where fat tails occur at both extreme high and low values - e.g. risks subject to contagion such as country credit risk.
4 Main uses of copulas
- insurance loss aggregation
- default loss modelling
- operational risk
- market risk
Explain why the management of a Marine insurer might believe that an internal model would be more appropriate for its business than the standard formula.
Marine insurance is a fairly specialised form of insurance and a standard approach is unlikely to provide an appropriate description of the risk.
An internal model provides the insurer with an option to develop an economic capital model that, subject to regulatory minimum standards, is tailored to its actual risk profile.
This model may also allow the company to perform more sophisticated analysis for risk management and decision-making purposes.
The insurer may believe that the standard model would result in an unreasonably high capital requirement, so the internal model would allow it to use capital more efficiently.
It may already have some form of economic capital model that it could use as the starting point for the internal model build.
Outline the process an insurer should undertake to develop its internal model
Developing an internal model could involve the following steps:
- Specify the objectives of the model, ensuring that it is consistent with Solvency II requirements.
- Collect and validate the data
- Group or modify it as necessary
- Choose the form of the model and the distributions to use,
… including any copula if used. - Identify and estimate all parameters and variables
- Estimate any correlations between variables
- Check that the goodness of fit is acceptable and attempt to fit a different model if not.
- Ensure that the model is able to project all required cashflows and other outputs…
… including the interactions between them, which may be modelled dynamically. - Run the model using the selected estimated variables.
- For stochastic models, this would require a large number of simulations using a random sample from the density function(s) chosen for the stochastic parameters.
- Output the results in an appropriate format (e.g. summarised for stochastic models)
- Assess the sensitivity of results to different deterministic variable values.
- Perform appropriate validations on the outputs.
- Produce thorough documentation.
