Flashcards in Goldfarb Deck (76)

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1

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General form of return on capital (ROC)

(Goldfarb)

### ROC = income / capital

2

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Issue with the general form of return on capital (ROC)

(Goldfarb)

### fails to recognize varying degrees of risk

3

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Measures of income to use in ROC (4)

(Goldfarb)

###
1. GAAP net income

2. statutory net income

3. IASB fair value basis net income

4. economic profit

4

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Methods to reflect risk in ROC (2)

(Goldfarb)

###
1. implicitly by using premium-to-surplus or reserve-to-surplus ratios

2. explicitly by adjusting income, capital, or both

5

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Measures of capital to use in ROC that are not risk-adjusted (2)

(Goldfarb)

###
1. actual committed capital

2. market value of equity

6

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Measures of risk-adjusted capital to use in ROC (4)

(Goldfarb)

###
1. regulatory required capital

2. rating agency required capital

3. economic capital

4. risk capital

7

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Difference between IASB fair value income vs. GAAP/statutory income

(Goldfarb)

### IASB fair value removes biases in country-specific accounting standards (e.g. discounts loss reserves and includes a risk margin)

8

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Economic profit

(Goldfarb)

### economic profit = (premium - expenses) * (1 + investment return %) - premium * LR discounted to t=1

9

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Limitations of using economic profit as an income measure (3)

(Goldfarb)

###
1. does not consider changes in firm value from future profits (franchise value)

2. difficult to reconcile to GAAP

3. decision rationale may not be clear to external parties if decision-making is based on economic profit but reporting is based on GAAP accounting

10

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Actual committed capital

(Goldfarb)

### actual committed capital = contributed capital + retained earnings

11

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Market value of equity

(Goldfarb)

### considers franchise value, so generally > committed capital

12

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Economic capital

(Goldfarb)

### capital required to ensure probability of achieving a given objective

13

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Possible objectives used for economic capital requirements (2)

(Goldfarb)

###
1. solvency - hold enough capital that firm can meet future obligations to PH

2. capital adequacy - hold enough capital to reach other objectives such as paying dividends, gaining premium, or maximizing franchise value

14

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Risk capital

(Goldfarb)

### capital contributed by shareholders to absorb the risk that liabilities will exceed premium & loss reserves

15

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Risk-adjusted return on capital (RAROC)

(Goldfarb)

### RAROC = economic profit / risk-adjusted capital

16

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Issue with RAROC

(Goldfarb)

### different capital allocation methods can lead to different conclusions

17

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Common risk measures (4)

(Goldfarb)

###
1. probability of ruin

2. percentile risk measure (VaR)

3. conditional tail expectation (CTE, aka TVaR)

4. expected policyholder deficit (EPD) ratio

18

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Probability of ruin risk measure

(Goldfarb)

###
estimated probability that a ruin scenario will occur

ex: insurer default or ratings downgrade

19

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Percentile risk measure (VaR)

(Goldfarb)

### amount of capital required to achieve a specific probability of ruin target (= loss amount exceeded X% of the time)

20

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Conditional tail expectation (CTE, aka TVaR) risk measure

(Goldfarb)

### average loss out of losses that exceed a given percentile

21

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Approx. default probability using TVaR

(Goldfarb)

### approx. default probability = (1 - TVaR %) / 2

22

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Expected policyholder deficit (EPD) ratio risk measure

(Goldfarb)

###
avg value of shortfall b/w assets and liabilities relative to expected liabilities

(denominator is total # of scenarios/simulations, not just those generating a deficit)

23

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Methods for selecting risk measure thresholds (3)

(Goldfarb)

###
1. bond default probabilities for credit rating level

2. management's/shareholder's risk preferences

3. arbitrary default probability, percentile, or EPD ratio

24

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Bond default probabilities for credit rating level risk measure threshold

(Goldfarb)

### set the threshold such that the probability of default = probability of default of bonds with the desired credit rating (e.g. AA-rated)

25

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Weakness of the bond default probability method for selecting a risk measure threshold

(Goldfarb)

### does not address which rating firm's should target

26

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Considerations for selecting bond default probabilities for selecting a risk measure threshold (3)

(Goldfarb)

###
1. historical (more stable) vs. current (more responsive) default rates

2. can get different estimates from different rating agencies - should use the most reflective of current estimates

3. default probabilities should be adjusted to reflect the time horizon

27

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Weakness of using management's risk preferences to determine risk measure threshold

(Goldfarb)

### management may have difficulty agreeing or preferences that clash with board/shareholders

28

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Risk sources (aka risk distributions, 4)

(Goldfarb)

###
1. market risk

2. credit risk

3. insurance UW risk

4. other risk sources: operational & strategic

29

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Market risk

(Goldfarb)

###
potential loss in value of current investments from

- changes in equity indices

- interest rates

- FX rates

- and other market variables

30