Panning

Question 1

Franchise value (F) definition

Panning

Answer 1

economic value of future renewals to the firm

Question 2

Total economic value (TEV, aka market value or market capitalization)

(Panning)

Answer 2

TEV = current economic value (C) + franchise value (F)

Question 3

Objective of Asset Liability Management (ALM)

Panning

Answer 3

measure & manage the degree to which the economic value of an insurer is adversely exposed to changes in interest rates

Question 4

Franchise value and ALM and accounting rules

Panning

Answer 4

franchise value is not recognized in ALM or accounting rules

Question 5

Goal of firm’s according to Panning

Panning

Answer 5

minimize exposure to interest rate risk while limiting exposure to accounting rules that can adversely impact solvency/ratings

Question 6

Simplified assumptions of the Panning model (original version, 6)

(Panning)

Answer 6

1. all premiums are collected & expenses paid on 1/1
2. true value of losses & LAE is known and paid on 12/31
3. constant surplus, expenses, and expected losses in each year
4. no taxes
5. flat term structure of interest rates
6. all calculations are as of 1/1 immediately after business is written

Question 7

UW income

Panning

Answer 7

UW income = premium - loss - expense

Question 8

Investment income

Panning

Answer 8

investment income = (surplus + premium - expense) * risk-free rate

Question 9

Premiums required to achieve target return on surplus

Panning

Answer 9

premium = [(surplus * (target ROS - risk-free rate) + loss) / (1 + risk-free rate)] + expense

Question 10

Current economic value (C) definition and formula

Panning

Answer 10

balance sheet value on 1/1

C = surplus + premium - expense - loss discounted to time 0

Question 11

Franchise value formula (fixed version) & assumptions (3)

Panning

Answer 11

F = (premium - expense - loss discounted to time 0) * (d / (1 - d))

where d = client retention / (1 + risk-free rate)

assumes constant:

1. client retention
2. interest rates
3. target return on surplus

Question 12

Market value to book value ratio

Panning

Answer 12

market value to book value = total economic value / current economic value

Question 13

Relationship between client retention (cr), franchise value (F), and market value to book value ratio (3)

(Panning)

Answer 13

As client retention increases:

1. franchise value increases
2. market value to book value ratio increases
3. franchise value as a % of TEV increases

Question 14

Target return on surplus (k) assumptions (2)

Panning

Answer 14

1. k = a (constant target return on surplus) - original version
2. k = a + by = target returns are a function of the risk premium (a) and the risk-free rate (y)&raquo_space; setting b<>0 allows premium to vary with interest rates

Question 15

Franchise value formula with varying interest rates

Panning

Answer 15

F = [client retention * surplus * (a + (b - 1) * risk-free rate] / [(1 + risk-free rate) * (1 + risk-free rate - client retention)]

Question 16

Dollar duration

Panning

Answer 16

Dollar duration = PV * D

Question 17

Duration of franchise value (D(F))

Panning

Answer 17

D(F) = [(a - b + 1) / ((1 + y) * (a + by - y))] + (1 / (1 + y - cr))

D = dF/dy
y = risk-free rate
cr = client retention

Question 18

Duration of total economic value (D(TEV))

Panning

Answer 18

D(TEV) = (D(C) * C + D(F) * F) / (C + F)

= weighted average duration of franchise value and current economic value

Question 19

Reason that the duration of franchise value (D(F)) is greater than the duration of losses and expenses

(Panning)

Answer 19

because premium CFs are sensitive to interest rates

Question 20

Impacts of an increase in interest rates with fixed k (2) and how to mitigate

(Panning)

Answer 20

1. PV(premium) decreases (unavoidable)
2. Dollar value of future premiums decreases (minimize by using a pricing strategy that allows interest rates to vary, k = a + by)

Question 21

Reason that firms want to reduce duration of invested assets

Panning

Answer 21

to minimize exposure to interest rate risk

Question 22

Ways firms can reduce the duration of invested assets (2)

Panning

Answer 22

1. changing the composition of the investment portfolio

2. purchasing derivative security’s that modify the asset portfolio

Question 23

Problems with reducing the duration of invested assets (2)

Panning

Answer 23

1. with larger franchise value, it is more difficult to manage interest rate risk by reducing duration
2. regulators and rating agencies will not be able to see the benefits (b/c they only see accounting numbers), which may lead them to believe the firm is in distress

Question 24

Panning’s recommended pricing strategy

Panning

Answer 24

optimize a and b parameters in k = a + by to retain a given target return and reduce duration (D(TEV)) to acceptable levels

Question 25

Limitation of Panning's recommended pricing strategy | Panning

Answer 25

desired combination of target return on surplus and target duration of TEV can only be maintained for a narrow range of interest rates (b/c price-interest rate relationship is non-linear) *standard ALM has the same limitation

Question 26

Advantage of Panning's recommended pricing strategy | Panning

Answer 26

dynamic pricing policy is invisible to external audiences, so it avoids potential regulator or rating agency risks from reducing duration

Question 27

Implications of Panning's model on ALM (3) | Panning

Answer 27

1. franchise value is real 2. franchise value is exposed to interest rates due to discounting of future CFs 3. despite importance, franchise value tends to be invisible and unmanaged

Question 28

Duration of current economic value, D(C) and simplifying assumption (Panning)

Answer 28

D(C) = [D(Assets) * PV(Assets) - D(Liab) * PV(Liab)] / C ``` where PV(Assets) = S + P - E PV(Liab) = L / (1 + y) ``` simplifying assumption: D(C) = 1

Question 29

Relationship between duration and interest rate risk | Panning

Answer 29

higher duration of TEV = higher interest rate risk