Capital 2 Flashcards Preview

CP1 Flashcards > Capital 2 > Flashcards

Flashcards in Capital 2 Deck (27)
Loading flashcards...
1
Q

What are the risks in companies that we need capital to manage?

A
  • Asset risks -> Events that may cause a reduction in the mkt value or income from the assets
  • Liability risks -> Events that may increase liabs.
  • Asset/Liability risks -> Events that move both asset/liab values st. the outcome is negative
  • Operational risks -> Events that cause losses as result of inadequate/failed internal processes, people & systems or from external events
2
Q

What are the ASSET related risks in insurance companies?

A
  • Default risks
  • Market movements risk
  • Concentration risk
  • Liquidity risk
  • Risk of losses from assets that do not have intrinsic value
3
Q

Default risks

A
  • Risk that investor does not receive the expected return on asset or risk of total loss of the asset
    • > Includes default of reinsurer
    • > Credit risk (default on loans) is major risk for banks
4
Q

Market movements risk

A
  • Financial statements show assets at mkt value, so fall in asset value reduces available capital
5
Q

Concentration risk

A
  • Significant proportion of funds invested in ONE asset
    eg. large loan to ONE client, large holding in ONE property. If something goes wrong with the asset eg counterparty defaults => large losses incurred wrt one asset
6
Q

Liquidity risk

A
  • Asset is difficult to sell for cash to meet immediate liabilities
    -> Only way to obtain cash for the asset would be to
    sell it at a loss
    -> Company may be forced to borrow money
7
Q

Risk of losses from assets that do not have intrinsic value examples

A

Examples:

  • > Works of fine art, wine, vintage cars etc.
  • > Loans to related parties eg. subsidiaries
  • > Goodwill (asset value additional to mkt value)
  • Allowed in company accounts after acquisition or due to company reputation
  • —> These assets may need to be excluded from statutory valuations
8
Q

What are the LIABILITY related risks of a insurance company?

A
  • Pricing risk
  • Concentration of liability risk
  • Valuation risk
  • Unexpected external event risks
9
Q

Pricing risk

A
  • Risk that premiums will not cover liabilities taken on ie. risk that the experience (claims/expenses) is worse than expected. Risks from
    • > Fixed premiums of life insurance products
    • > Loan repayments based on fixed-interest rates
10
Q

Concentration of liabilities risk

A
  • Liabilities are concentrated with a particular client, portfolio or geographic area
    => higher risk from bad events for that client or in that particular geographic area
11
Q

Valuation risk

A
  • Risk that reserves are not large enough to meet claims & expenses
  • May need to increase the size of the reserves hence reducing the free capital available
12
Q

What do reserves need to cover?

A
  • Future claims wrt premiums received
  • Outstanding claims
  • Incurred but not reported (IBNR)
  • Unearned premiums or unexpired risk
    -> Premiums received to provide cover for period
    which has not yet expired
  • Options in contracts eg. guaranteed insurability or
    guaranteed premium rates
13
Q

Unexpected external event risks

A
  • Risk of events occurring that significantly change the context of the insurance problem:
    • > Change in regulations
    • > Court decisions increasing eligible claims
    • > Major change in economic conditions
    • > Terrorist attacks
14
Q

What are the ASSET/LIABILITY risks related to an insurance company?

A
  • Market risk

- Operational risk

15
Q

Market risk

A
  • Risk that change in mkt values or economic variables results in value of assets changing unfavourably relative to liabs
  • > Major risk for pension schemes where liabs typically have longer duration than available assets eg. if interest rates fall liabs increase more than assets
16
Q

Operational risk

A
  • Risk of financial loss from inadequate or failed internal processes , people or systems or from external events

Examples:

  • > Admin errors such as overpayment of a benefit
  • > Failure of IT systems leading to closure of a part of operations
  • > Fraud or mismanagement
  • > Compliance problems leading to fines

o Some internal risks can be reduced by improving controls
o Difficult to calculate likelihood of operational risk due to lack of relevant data however financial firms are still required to consider operational risks in detail

17
Q

Capital required may be based on different criterion for example:

A

(1) Amount of capital needed st. probability of losses from risks will not exceed the capital w prob. x%
x% -> accepted level of confidence
Need stochastic model of risk to calculate capital req.

(2) Amount of losses from risk based on stress tests
- > Stress tests based on risk related adverse events

(3) Regulatory capital requirements (may change from country to country)

18
Q

Diversification benefits for capital requirements:

A
  • Total required capital for a business UNIT (line) is likely to be less than the sum of capital needed for each of the business units’ individual risks
  • Because the risks will not be 100% correlated with each other
  • Similarly, capital req. for a company is likely to be less than the sum of capital required for individual business units eg. Consider a life company that sells both life cover + pension benefits (risks offset each other)
19
Q

Wrt. the impact of diversification, what are questions that the company should address?

A
  • Given the capital needs for each business unit, what is the capital need for the company overall?
    • > What allowance is made for diversification?
    • > How does the company allocate the overall capital to business units?
20
Q

How does economic capital compare with regulatory capital?

A
  • Economic capital may be higher or lower than regulatory capital
    eg. If regulator is concerned w reducing prob. of failure, regulatory cap. req. might be higher than economic cap. req.
21
Q

Rationale behind capital allocation:

A
  • Organisation aims to make return on capital (profit)
  • Need to analyse return on capital for each business unit
    -> Need to notionally allocate capital to each business
    unit to analyse return on capital
  • Might allocate less capital to business unit than on a standalone basis to reflect diversification benefits
  • This increases return on capital for each business unit
22
Q

What tools does an insurer have to manage the amount of capital it holds?

A
  • Reinsurance
  • Financial Reinsurance
  • Securitisation
  • Issuing debt or equity
  • Internal restructuring eg. changing assets, weakening valuation basis, deferring surplus/dividend distribution to members/shareholders and retaining profit
23
Q

How reinsurance effects on capital requirements:

A
  • Reduces the amount of variability/size of claims

- Reduces new business strain as reinsurer pays commission to insurer upon acquisition of business

24
Q

What is Financial reinsurance (FinRe)?

A
  • Arrangement that provides capital usually by exploiting regulatory, solvency & tax arbitrages
25
Q

What is securitisation?

A
  • Involves converting an illiquid asset into tradable cashflows eg. insurers may transfer underwriting risk to capital markets by bundling insurance policies and securitising them
  • Provides liquidity for the company
26
Q

Competing objectives of capital management that actuaries will need to consider when providing advice:

A

(1) Model both existing & projected new business to assess cap. reqs. for the provider’s business plans to be achieved at a given ruin probability while considering statutory & regulatory requirements throughout lifetime of the business
(2) Consider the cost of holding capital to shareholders and to the company such that capital is not held unnecessarily (less inefficiency)

27
Q

Regulatory restrictions on calculating capital requirement:

A
  • Regulator may prescribe rules concerning how provisions are calculated wrt future liabs.
  • Future is difficult to predict => calculation of provisions/capital reqs will contain margins for prudence
  • Prudence achieved by setting cautious assumptions for provisions; or requiring additional capital to be held; or a combination of both