Flashcards in Section D Deck (59):
Describe the treatment of covariance under shapley value and covariance share methods
Shapley value: Allocates the mutual covariance equally between accounts
Covariance Share method: Allocates mutual covariance according to weights selected by the user (proportion to loss size)
List the different risks that surplus can protect an insurer from
- Asset risk: chance assets will depreciate
- Pricing risk: chance that losses & expenses are ultimately greater than initially expected
- Reserving risk: risk that reserves are insufficient
- Asset-liability risk: chance that changes in interest rates will affect the market value of assets
differently to liabilities
- Catastrophe risk
- Reinsurance risk: risk that reinsurance recoverables won’t be collected
- Credit risk: risk that agents/insureds won’t remit premium
Explain two ways that u/w profit provisions and what method is preferred by Robbin
- Rate of return approach: rates should be regulated to ensure that companies are able to achieve an adequate return
- Constrained free market theory: the premiums will move to an optimal level, via market forces
Robbin argues that the structure of the insurance industry is greatly different than utility companies: there are a large number of firms, with relatively low market shares.
What is the objective of the method PVI/PVE
Aims to determine an U/W profit provision which in the ratio of PV of Income to PV of Equity equal to a target rate of return.
Briefly describe 2 assumptions made by the insurance IRR model
1. Amount of surplus requirement:
- Difficult to determine since no foxed relation between premium and surplus
- Need to be allocated by LOB
2. Timing of surplus commitments/release:
- Can be related to UEPR, Loss reserve or both
Give 3 advantages of using return on sales to assess rate equity
- Achieves true rate equity
- Similar to the concept of markup (understandable to policyholder)
- No need to allocate surplus (artificial)
Explain added complication in determining the optimal capital structure for an insurer
- Higher level of reserves implies a higher level of written premium, which could possibly increase diversification. This would partially offset the increase in variability of results. It is not as straightforward as : higher debt = higher risk
- Also, loan interest (u/w loss) is not known until many years
Give advantages and disadvantages of the PV CF Return Method
- The present value of U/W cash flows is what most people think about with regards to U/W profit
- It is not clear what sort of profit is being measured. The cash flows do not have the same timing as GAAP income
Give a few examples of parameter selection questions
o What discount rate should be used?
o What is the right target return?
List market characteristics that could affect the company ability to earn a reasonable return
- Size/composition residual market
- Number of insurers (degree of competition)
- Degree of product diversity and innovation
Give 3 advantages of calendar year data and a disadvantage
- Data is easily obtained and verified (annual statement)
- Since the figures are reported in filed documents, less manipulable by insurer
- The CY investment portfolio yields are relatively stable
-CY results are prospective, not totally applicable to prospective ratemaking
What is the objective of the method IRR on equity flow
Select an U/W profit provision to achieve a target rate of return on the equity flows.
What is the interest cost incurred by the insurer to use the reserve?
U/R (in the case of U/W losses) can be thought of as an “interest cost” incurred by the firm to use the reserves, which were contributed by the policyholders.
Describe renewal additivity in risk load methodology
Sum of renewal risk loads of each risk is equal to the risk load for the aggregate portfolio.
Describe why insurer's CF patterns are different than most companies
Insurers collect money at inception (inflow) and pay it out during the policy period (outflow). Most industries have the opposite patterns.
List and briefly describe 5 types of u/w profit
- Provision included in manual rates/filings to change manual rates
- Corporate target U/W profit provision: generate an expected return similar to that provided by investments with similar risk
- Breakeven U/W profit provision: rate of return to stockholders equal to the rate of return on risk free investments. No compensation for the risk
- Charged U/W profit provision: the rate achieved after applying experience and schedule rating modifications, as well as other adjustments to the manual rate
- Actual U/W profit: these will differ from the charged provisions, as the provisions for losses and expenses most likely won’t be accurate; and also because the actual catastrophe loss in a year most likely won’t match the provision
List regulator's desired properties of the riskiness leverage ratio
- Be 0 until the capital is seriously impacted
- Not decrease (for excess that significantly exceeds capital) because of the risk to the state guaranty fund
Explain why insurer's management has the ability to influence the results in the financial statement
Since there is a lot of uncertainty in the estimation of losses, management can either strengthen (good year, to increase loss and reduce return) or weaken the reserves (reduce u/w loss to increase return).
Why should the CY investment income offset procedure requires many iterations
PLR is used in the determinant of profit provision but it also is impacted by the profit provision
List management's desired properties of the riskiness leverage ratio
- Be a down side measure
- Be roughly constant for excess that is small compared to capital
- Become much larger for excess that significantly impacts capital
- Reduces to 0 (at least doesn’t increase) for excess that significantly exceeds capital. Once capital is exceeded, bankruptcy so no need to consider past that point.
Give advantages and disadvantages of the PV Offset Method
- Accounts for investment income in a simple manner
- Not distorted by rapid growth/decline (uses PLR)
- No need to select a target return, or allocate surplus
- Have to choose discount rate
- Have to choose payment pattern
- Lack of economic theory to support calculation
List and briefly describe examples of leverage models to determine risk loads
1. Risk neutral: Risk load is 0. Appropriate when in most probable scenarios, liabilities are small compared to available capital.
2. Variance: Whole distribution is relevant
3. TVaR: riskiness leverage ratio is 0 up to a point and then constant
4.VaR: Insurer is only concerned by particular level of losses that threatens its surplus
5.Semi-Variance: Only relevant for bad results (worse than average)
6.Mean downside deviation: Most naive measure. Assigns capital for bad results in proportion to how bad they are.
7. Assigns capital pro-rata to its contribution to the excess over the mean
What is the main difference between SAP and GAAP accounting frameworks
SAP Incurred expenses are incurred according to a fixed pattern, whereas in GAAP the expenses are incurred as the premium is earned.
Name 3 key inputs to which premiums are sensitive
- Surplus (Higher surplus = higher profit, since investors demand higher return for more investment)
- Interest (Higher interest = lower profit margin, since investment income will finance a part of the return)
- Payout pattern (Higher duration = lower profit margin, again more investment income)
Describe relation between I/A and U/R in Ferrarri non-equity capital formula in decision to keep writing business or not
- If U/R > 0, the term in parenthesis is positive, so it makes
sense for the insurer to keep writing business
- If the U/R < 0), but the absolute value is less than I/A, the term in parenthesis
is still positive, implying that is still profitable to keep writing business.
- Finally, if U/R < 0 and (I/A + U/R) < 0, at this point, it
makes sense for the insurer to stop writing business, since writing business will reduce the ROE.
Contrast profit and rate of return as a profitability measure
- Absolute number
- Used to pay dividends or grow company
- Hard to compare companies
Rate of Return
- % of a particular base (Equity, Asset and Sales)
- Measure of efficiency
- Used to compare companies
List reasons why alternative pricing models have been proposed for the fixed profit margin
- Lack of theoretical justification of the fixed margin
- High interest rates (implying the fixed margins may be too low)
- Increasing competitiveness of the insurance industry (insurers may therefore have periods of reduced profit margins)
List some risk sources than can generate surplus need
- Risk of not making plan
- Risk of serious deviation from plan
- Risk of not meeting the investor analysts’ expectations
- Risk of a downgrade from the rating agencies
- Risk of triggering a regulatory notice
- Risk of going into receivership
- Risk of not getting a bonus
List factors that will influence the amount of capital allocated to a new member of the group in the game theory
- Stability/incentive to split from the group
- Bargaining power
- Marginal impact to the group’s characteristic function value
List a few features of cooperative games with tranferablw utilities
- Participants that have benefits or costs to share
- Opportunity to share the benefits/costs due to the cooperation of all the participants
- Ability of the players to enter into negotiations
- Conflicting player objectives, where each wants to maximize his/her share of the benefits
Describe how the financial market impacts the product market in insurance transactions
- Higher cost to obtain capital will lower the supply of insurance
- Higher returns achievable will increase the supply of insurance
Why is the opportunity cost calculated at risk free rate?
Policyholder is not exposed to any of the risk of the insurer’s investment: if the insurer speculates and
loses money, the policyholders do not have to provide for this shortfall.
Describe 2 factors that drives the relation between P/S and I/A
- A higher portion of the surplus is from current business, and is therefore in the form of uninvestable balances.
- A higher ratio of P/S results in more risk to Owners Equity. To compensate, insurers will need to follow more conservative investment policies.
Contrast the possible options of rate to discount losses in the PV Offset method
There are a few options of rates at which to discount the losses:
- Portfolio yield from a recent year
- Estimated portfolio yield for the year in which the rates will be in effect
- New money yield
New money yields are more suited to the prospective nature of ratemaking. However, historical
prospective yields are more stable & verifiable.
Give advantages and disadvantages of the Risk-adjusted discounted CF method
- Great intuitive appeal
- Grounded in modern financial theory (CAPM)
- Not necessary to determine a target rate of return
- It is hard to determine beta for liabilities: no active market where liabilities are traded and little data exists from which to calculate parameters
Give reasons why expense projection less accurate than premium and losses projection
- Data: companies often do not monitor the expense payment patterns
- Vary widely by company
- Risk size: unlike losses, not all expenses are proportional to premium
- Policy year: several expenses are higher in the first policy year than future years
Give a few examples of model construction questions
o Should surplus be included in the model?
o How should the surplus requirement be determined?
o How should risk be incorporated into the model?
o It is better to use cash flows or incomes flows?
o How to reflect income taxes?
Give advantages and disadvantages of the CY investment income offset procedure
- Easy to get the numbers
- Calculation is short & relatively straight forward
- Lack of economic theory supporting the calculation
- Results distorted if large change in volume or reserve adequacy (based on retro numbers)
Explain one problem with the IRR assumption and reasons why it is rarely an issue in pricing
IRR assumes that revenues are reinvested at IRR, which is rarely the case.
- If IRR > cost of capital, insurers can write more policies and grow at IRR. The “reinvestment rate” of revenue is equal to the IRR, and therefore assumption holds.
- Policies are usually priced using an underwriting profit provision which sets the IRR equal to the
cost of capital. Again this would mean that the assumptions hold, since IRR = CC = Reinv Rate.
List 2 factors affecting current underwriting results
- Current reserving decisions
- Amortization of past reserving decisions
Name 2 factors influencing the opportunity cost
1. Line of business: Payment pattern
2. Cash needed to support the infrastructure: This cannot be invested
List 2 situations where NPV and IRR analysis results could differ
- Projects with unusual cash flows
- Projects with budget constraints/mutually exclusive projects
Describe how the product market impacts the financial market in insurance transactions
- Higher demand for insurance will increase the return to investors
- Inadequate rates will pull ressources from the industry
According to game theory, what are a few rules for allocation
- The allocation methods must be renewal additive
- Coalition should be stable (Fair). There should be no possibilities where a subgroup is better on
Define the insurance leverage factor
It looks at the relationship between the money borrowed from the policyholders (reserve) and the owner investment in the company (surplus).
Describe the factor that drives the relation between U/P and I/A
- Higher U/W profit means that the insurer can engage in more aggressive investments
- More money to invest from the additional premiums
Explain why both marginal surplus and marginal variance methods are not renewal additive
- In the MS method, Σ Renewals Risk Loads < Risk Load for the portfolio. Accounts will be undercharged due to sub-additivity of square root.
- On the other hand, the MV method will overcharge the accounts, as Σ Renewal Risk Loads > Risk Load for Portfolio due to double counting the Covariance.
Give advantages and disadvantages of pricing method IRR on equity flow
-Simple to interpret: Expected interest earned on shareholders loan of surplus to the company
- Nicely captures the impact that accounting rules and regulatory capital restrictions directly impacts shareholders
-Need to assume a particular surplus requirement which may not make sense on a LOB/policy basis
- Need to identify a target IRR
- Assumes reinvestment rate = IRR
List 2 factors that affect the value of the firm
- Expected Earnings stream
- Rate at which this stream is discounted by the market
What are Robbin's 2 general goals for price of policies?
- Should be consistent & sensitive to risk.
- Should reflect management’s risk return preferences.
What will be the consequences on the market if insurer perceive rates as inadequate (unreasonable rate of return)
- Increasing size of residual market
- Reducing degree of product diversity
- Reduced innovation
List the different desired qualities for an allocatable risk load
- It can be able to be allocated down to any level
- The risk load of any sum of random variables should equal the sum of the risk loads allocated individually
- The same additive formula can be used to calculate the risk load for any subgroup or group of groups
List and briefly describe the 3 problems with using ROE in regulation
1. Focuses on return on equity instead of rate equity
2. Surplus allocation is artificial since 100% of surplus is available to support each risk. Regulation based on ROE requires surplus allocation.
3.ROE regulation is a complicated method of regulating ROS, because of the usage of target ratios of premium to surplus to assign surplus
Describe opportunity cost
Lost investment income because premiums are paid by the policyholder before the losses and expenses are paid by the insurer.
Why should investment income from surplus be excluded from the opportunity cost?
- Surplus is not owned by the policyholders, but rather the owners of the insurer
- Including surplus will penalize high surplus insurers, as they will need to charge lower premiums
List the different parties involved in insurance industry and which metric interests them
1. Investors are interested in ROE
- Which company to invest in
- Prefer companies that generate a higher return from a given equity investment
2. Society is interested in ROA
- Which companies are best using resources
- Prefers that companies use the assets efficiently
3. Regulators/Actuaries are interested in ROS
- Make sure rates are not excessive, inadequate, unfairly discriminatory
Describe a practical criticism of the IRR model in relation to regulation and a reason why insurers are more likely to run into this problem
Regulators may believe that insurer is profitable if IRR is greater than investment yield or even only positive. Having IRR lower than cost of capital is a clear sign of unprofitability.
Insurer's capital is not fixed (based on reserves for example). This means that fluctuating results will make surplus requirement move as well (investment income on surplus), offsetting u/w results.
Describe the riskiness leverage ratio
Arbitrary selection by management, allowing their views towards risk to be incorporated