Capital 2

Question 1

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

Answer 1

• 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

Question 2

What are the ASSET related risks in insurance companies?

Answer 2

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

Question 3

Default risks

Answer 3

• 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

Question 4

Market movements risk

Answer 4

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

Question 5

Concentration risk

Answer 5

• 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

Question 6

Liquidity risk

Answer 6

• 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

Question 7

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

Answer 7

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

Question 8

What are the LIABILITY related risks of a insurance company?

Answer 8

• Pricing risk
• Concentration of liability risk
• Valuation risk
• Unexpected external event risks

Question 9

Pricing risk

Answer 9

• 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

Question 10

Concentration of liabilities risk

Answer 10

• 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

Question 11

Valuation risk

Answer 11

• 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

Question 12

What do reserves need to cover?

Answer 12

• 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

Question 13

Unexpected external event risks

Answer 13

• 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

Question 14

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

Answer 14

• Market risk

- Operational risk

Question 15

Market risk

Answer 15

• 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

Question 16

Operational risk

Answer 16

• 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

Question 17

Capital required may be based on different criterion for example:

Answer 17

(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)

Question 18

Diversification benefits for capital requirements:

Answer 18

• 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)

Question 19

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

Answer 19

• 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?

Question 20

How does economic capital compare with regulatory capital?

Answer 20

• 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.

Question 21

Rationale behind capital allocation:

Answer 21

• 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

Question 22

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

Answer 22

• 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

Question 23

How reinsurance effects on capital requirements:

Answer 23

• Reduces the amount of variability/size of claims

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

Question 24

What is Financial reinsurance (FinRe)?

Answer 24

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

Question 25

What is securitisation?

Answer 25

- 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

Question 26

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

Answer 26

(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)

Question 27

Regulatory restrictions on calculating capital requirement:

Answer 27

- 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