Chapter 22: Capital modelling methodologies Flashcards
(21 cards)
1
Q
Types of capital:
A
- Available capital
- Required capital
o Regulatory capital
o Economic capital
2
Q
Reasons insurers hold more capital than the minimum specified by their regulators:
A
- To reduce the risk that the available capital falls below the regulatory requirement, which would hamper the firm’s business activities
- To give a greater degree of security to policyholders than implied by the relatively weak regulatory minimum
- To maintain its credit rating
- To meet the requirements of other stakeholders such as debt providers, whose interests may be subordinated to those of the policyholders
- To maintain a level of working capital for investment in business development and other opportunities
- To allow a buffer between the actual profitability of the business and the dividend stream paid to shareholders, who prefer less volatile returns
3
Q
Capital models can be categorised by three core features:
A
- A risk profile
- A risk measure
- A risk tolerance
4
Q
The uncertainty in cashflows is usually split into the following risk categories:
A
- Insurance risk (including underwriting and reserving risk)
- Market risk
- Credit risk
- Operational risk
- Group risk
- Liquidity risk
5
Q
Insurance risk may be affected by:
A
- The underwriting cycle
- Parameter error
- Multi-year policies
- Management actions
- Reinsurance terms in future years
6
Q
Sources of general market risk include movements in:
A
- Interest rates
- Exchange rates
- Equity prices
- Real estate prices
7
Q
Types of credit risk
A
- Counterparty credit risk
- Investment credit risk
8
Q
Stages in building a stochastic model to model the capital requirement:
A
- Select appropriate model structure
- Decide which variables to include and their interrelationships
- Determine the types of scenarios to develop and model
- Collect, group and modify data
- Choose a suitable density function for each of the variables to be modelled stochastically
- Estimate the parameters that should be used for each variable
- Test and validate the reasonableness of the assumptions and their interactions. If the goodness of fit is not acceptable then fit a different density function(s)
- Ascribe values to the variables that aren’t modelled stochastically
- Construct a model based on the chosen density function(s), e.g. calculating the net profit based on the simulations
9
Q
Advantages of stochastic models for capital modelling
A
- Test a wider range of scenarios and scenarios we may not have thought about
- We can derive a probability distribution from the outcomes of a stochastic model and calculate confidence levels
- Even though assumptions and hence output are subject to parameter error, the model is at least explicit about the assumptions being made
- A stochastic approach explores all possible combinations of stressors and can rank them against the chosen risk measure
10
Q
Advantages of deterministic models for capital modelling
A
- Model is easier to design and quicker to run
- By reducing the computational power necessary to generate many simulations, we can introduce more detail in other dimensions. May aid the intelligent selection of a limited number of scenarios
- By showing the effect of a limited range of stresses and scenarios, some of which may have been developed in consultation with the users, we can make results more comprehensible to them
- Can be easier to communicate the results of stress and scenario tests to senior management and give them comfort as to the reasonableness of the overall capital value
- We can link the capital model to the risk register and help integrate capital and risk management
- It is clearer what economic scenarios have been tested
- Commonly used for risks that cannot easily be modelled quantitatively and where more subjective judgment is required. This allows us to concentrate more on the more important areas of the distribution of outcomes for the key risks when a full specification of the distributions is impossible
- Potential cause and effect relationships between risks may be modelled better using deterministic relationships rather than statistical correlations
- Deterministic models are useful to check/validate stochastic models for reasonableness and help to calibrate assumptions.
11
Q
In aggregation methodologies, the types of correlation to allow for include:
A
- Between underwriting classes
- Between risk types
- Between successive years
- Between legal entities within a group
12
Q
Correlation assumptions will typically be subjective and should be set while considering:
A
- Historic events
- An acceptable range of considerations
- The subsequent impact on the capital models
13
Q
We might be interested in the capital requirements of:
A
- A single policy
- A particular product
- A class of business
- An insurer’s whole portfolio of business
14
Q
Allocating total capital between classes, products or individual policies may be necessary for:
A
- Performance measurement
- Business planning and strategy setting
- Pricing
15
Q
Capital allocation methods:
A
- Percentile method
- Marginal capital method
- Shapely method
- Proportions method
16
Q
Main items of data needed for capital modelling are:
A
- Unexpired premiums (gross and net), split by class of business
- Planned premiums (gross and net), split by class of business
- Gross and unpaid claims, split by class of business
- Claims payment profiles
- Claim limits
- Future reinsurance costs
- Reinsurance programmes for gross unpaid claims and unexpired business
- Planned reinsurance programmes
- Expenses
- Asset values
- Details of risks, such as credit exposures and operational risks
17
Q
Assumptions that need to be set when capital modelling:
A
- Gross written premium
- Ceded premium
- Ultimate gross claims (including claims management costs)
- Catastrophe claims
- Claims payment profiles
- Gross reserve movements, split by class of business
- Reinsurer’s share of ultimate claims and the proportion of this the firm may not be able to recover
- Reinsurance exhaustion and reinsurance downgrade assumptions
- Expenses
- Inflation
- Investment returns, split by asset class
- Operational losses
- Tax and dividends
- Correlation assumptions
18
Q
Features of a good model:
A
- Reflects the risk profile of the classes of business being modelled
- Parameter values used are appropriate for class of business and investments being modelled
- Outputs and degree of uncertainty surrounding them are capable of independent verification for reasonableness and easy to communicate
- The model balances detail and simplicity
- Model is flexible and adaptable – capable of development and refinement
19
Q
Additional features of a good stochastic model:
A
- Has all parameters clearly identified and justified
- Structured and documented so that it can be understood by non-actuarial members
- Capable of being run with changed parameters for sensitivity testing
- Uses a large number of simulations
- Has a robust software platform
20
Q
General modelling considerations:
A
- All parties involved should understand the whole process
- The model developers should have a deep understanding of the business
- The objectives of the model relate to an increased understanding of risk and capital by management, and decisions including the impact on risk and capital
- There are a number of decisions a capital model can inform
- Thorough testing should be conducted to understand the extent of the uncertainty and it should be communicated appropriately to those using the output of the model in decision making
- The principle of proportionality and practicability should be considered when deciding on the level of detail to model
- A detailed audit trail should be kept of the whole process, with special care to document the process of selecting key assumptions and other key decisions
21
Q
Key objectives of any capital requirement regime are to ensure that:
A
- Senior management focus on risk management – a risk management framework should be central to this process
- There is a link between risk and capital setting
- The capital model is being used within the decision-making process
