Brehm #2

Question 1

The evolutionary process of decision making using ERM (3)

Answer 1

1. deterministic project analysis - single deterministic forecast where uncertainty is handled judgmentally
2. dynamic financial analysis (DFA)/risk analysis - uses simulation to produce forecasts of distributions where uncertainty is handled judgmentally &laquo_space;current state
3. certainty equivalent - extends DFA and formalizes judgment by quantifying corporate risk preferences using a utility function

Question 2

Argument for moving towards step 3 in the evolutionary process (certainty equivalent)

Answer 2

both shareholders and managers want to maximize market value

Question 3

Franchise value

Answer 3

= PV (future earnings growth)

*risk management aims to protect franchise value

Question 4

Market value

Answer 4

market value = book value + franchise value

Question 5

Advantages of the certainty equivalent (3)

Answer 5

1. objective
2. consistent
3. repeatable

Question 6

Corporate risk tolerance

Answer 6

combination of factors such as organization size, financial resources, and ability and willingness to tolerate volatility

Question 7

Efficient frontier graph

Answer 7

plots risk (x) against return (y)

Explore options that either:

• reduce risk without sacrificing return
• increase return without increasing risk
• or scenarios in between

Question 8

Economic value added (EVA) formula

Answer 8

EVA = NPV (return) - cost of capital

positive EVA = value added
negative EVA = value destroyed

Question 9

Economic capital

Answer 9

economic capital = VaR at a remote probability (such as 1-in-3000)

Question 10

Advantages of allocating capital using economic capital (4)

Answer 10

1. unifying measure for all risks across org
2. more meaningful to management (vs. RBC/capital adequacy ratios)
3. forces firms to quantify risks and combine them into probability distributions
4. provides framework for setting acceptable risk levels for the organization as a whole and individual business units

Question 11

Main categories of risk measures (3)

Answer 11

1. moment based
2. tail based
3. probability transforms

Question 12

Description and examples (2) of moment-based risk measures

Answer 12

probabilistic expectations of random variables

ex: variance or standard deviation, semi-standard deviation

Question 13

Disadvantages of moment-based risk measures (2)

Answer 13

1. favorable deviations are treated the same as unfavorable ones
2. may understate risk because lower moments do not adequately capture market attitudes

Question 14

Alternatives to moment-based risk measures that better capture market attitudes (2)

Answer 14

1. skewness

2. exponential moments - reflects all losses but is more responsive to large losses E [ Y * exp ( c * Y / E [ Y ] ) ]

Question 15

Disadvantage of using tail-based risk measures

Answer 15

emphasize large losses only

Question 16

Types of tail-based risk measures (5)

Answer 16

1. VaR
2. TVaR
3. XTVaR
4. expected PH deficit (EPD)
5. value of default put option

Question 17

XTVaR tail-measure and idea behind it

Answer 17

XTVaR = TVaR - overall mean

idea: if the mean is financed through other funding, capital is only required for losses above the mean

Question 18

Expected PH deficit (EPD) tail-measure

Answer 18

EPD = ( TVaR - VaR ) * probability of default

where probability of default = 1 - probability level

gives the unconditional expected value of defaulted losses

Question 19

Value of default put option tail-measure

Answer 19

market value of risk for firm’s right to put claims back to the policyholders if capital or reinsurance is exhausted

Question 20

Description of probability transform risk measures and examples (2)

Answer 20

measures risk by shifting more probability towards unfavorable outcomes and computing a risk measure with the transformed probabilities

ex: expected loss under transformed probabilities, weighted TVaR

Question 21

Meaning of marginal risk decomposition

Answer 21

change in overall company risk b/c of change in business unit volume should be attributed to that business unit

Question 22

Characteristic of marginal decompositions and examples of common marginal decompositions (2)

Answer 22

sum up to company risk measure

ex: standard deviation and TVaR

Question 23

Requirements for marginal decomposition (2)

Answer 23

1. ability to change volume in a homogeneous fashion (ex: quota share)
2. scalable risk measures - rho ( a * y ) = a * rho ( y )

Question 24

Co-measure

Answer 24

sum of covariances = variance

Question 25

Risk factors analyzed in Asset Liability Management (ALM) (4)

Answer 25

1. change in interest rate 2. inflation risk 3. credit risk 4. market risk

Question 26

Paradigms for measuring value in reinsurance (3)

Answer 26

reinsurance: 1. provides stability 2. frees up capital 3. adds market value to the firm

Question 27

Marginal ROE

Answer 27

marginal ROE = change in cost of reinsurance / change in required capital When releasing capital (buying reinsurance) want low marginal ROEs that are below the cost of capital When consuming capital (switching to less expensive reinsurance) want a higher marginal ROE above the cost of capital

Question 28

Method to reduce standard deviation and cost

Answer 28

eliminate favorable distributions cost = lower profitability in the good years

Question 29

Interpretation of the mean when comparing programs

Answer 29

avg income/loss difference = net cost of reinsurance

Question 30

Interpretation of the safety level for comparing programs

Answer 30

best case performance in a good year for a given probability level (higher = better)

Question 31

Interpretation of the smallest simulated event for comparing programs

Answer 31

worst case loss in a bad year

Question 32

Measuring efficiency in UW results comparison graphs

Answer 32

plots loss amounts vs. cost at various probability levels to be efficient, must have lower loss at a given probability

Question 33

Sources of required capital (2)

Answer 33

1. theoretical models (ex: VaR, TVaR, XTVaR, WXTVaR) | 2. practical models (ex: BCAR, RBC, S and P)

Question 34

Disadvantage of using practical models to set capital requirements

Answer 34

relies on risk proxies (such as premiums or reserves) rather than the risk itself

Question 35

As-if loss reserves

Answer 35

loss reserves that would have existed at the beginning of AY if business had been written in a steady state in all prior years (b/c loss reserves absorb capital)

Question 36

Proxy for amount of capital absorbed by AY

Answer 36

proxy for capital absorbed by AY = current reserves + as-if loss reserves

Question 37

Reason combined ratio is a bad cost measure for reinsurance

Answer 37

gives a distorted picture of effects of reinsurance on earnings because of impact of high ceded costs on the expense ratio

Question 38

Good cost measure for reinsurance

Answer 38

NPV ( expected earnings )

Question 39

Disadvantages of allocating capital (2)

Answer 39

1. Arbitrary- different risk measures give different allocations 2. Artificial - each business unit has access to insurers total capital

Question 40

Methods to allocate capital (2)

Answer 40

1. Proportional allocation - allocate the total risk measure proportionally using individual business unit risk measure 2. Marginal decomposition - calculate the overall risk measure and then calculate marginal co-measures for each business unit (Marginal decomposition is preferable b/c it reflects how the risk from each BU impacts the total risk profile)

Question 41

Benefit to the insurer from purchasing reinsurance for CBA

Answer 41

Reduced cost of capital (Cost of capital = k * required capital) and measure the amount reduced with each option

Question 42

Meaning of stability for measuring value in reinsurance (3)

Answer 42

1. Protects surplus 2. Improved predictability of earnings 3. Customers’ assured recovery of losses

Question 43

Asset liability management definition

Answer 43

Comprehensive analysis and management of asset portfolio in light of current liabilities and future cash flows of a going-concern company

Question 44

Difference between asset liability management and duration matching

Answer 44

Duration matching only considers risk of interest rate changes whereas ALM considers additional risk factors

Question 45

Challenge with duration matching for insurance

Answer 45

Variable amount and timing of cash flows

Question 46

Approach (steps) for asset liability modeling (6)

Answer 46

1. Start with models of asset classes, existing liabilities, and current business operations 2. Select a risk metric (e.g. standard deviation) 3. Select a return metric (e.g. earnings or ROE) 4. Determine time horizon and constraints (e.g. regulatory limits on asset classes) 5. Run model on variety of investment strategies, UW strategies, and reinsurance options 6. Create an efficient frontier