Chapter 19

Question 1

Discuss further ways of managing risks using capital management

Question 2

Describe the use of sensitivity analysis or the assessment of variances

Question 3

Describe the use of models for pricing, assessing the return on capital, assessing the profitability of existing business, projecting future supervisory solvency position

Question 4

Solvency margin

Answer 4

The excess of the value of its assets over the value of its liabilities.
Insurance supervisory authorities may have requirements as to the minimum level of solvency margin that a company must have

Question 5

List the disadvantages of capital intensive business

Answer 5

• It would lead to a problem with supervisory solvency
• Even if solvency is not immediately threatened, the reduction of capital could weaken the company’s resilience to falls in the value of assets
• It will reduce the company apparent financial strength (often measured simply as free assets relation to the reserves)
• It represents an opportunity cost, in that the company could use the same amount of capital to write more business which is less capital intensive
• It could lead unexpectedly to a problem with supervisory solvency if the company sells much more of the business than anticipated
• Putting eggs in one basket – or rather too small a number of baskets. In theory, the company will be less at risk to adverse experience if it uses caporal to finance a large number of non-capital intensive policies than if it uses it for a smaller number of more capital intensive policies

Question 6

What assumptions does the statement “An investor should choose the investment with the higher NPV, that choice would be optimal.” depend on?

Answer 6

• This statement holds because it shows to invest into the investment that maximises the worth of the company

But it holds if the following assumptions hold:
* The capital market is perfectly efficient and free= this means that investors can lend and borrow and lend unlimited amounts at market rates and there are no restrictions on trade. It also means that all assets are perfectly priced to reflect all asset-related information. The implies that the market rates are correctly pricing risk!!!
* When two risky investments are compared each is discounted at a risk discount rate appropriate to its riskiness. This ensures that you’re comparing investments on a risk-adjusted basis.

Question 7

List some practical points to bear in mind when using NPV

Answer 7

• Subject to law of diminishing returns
• Says nothing about competition
• Assumptions must hold for it to be the best profit criteria:
• capital market must be perfectly free and efficient
  -when two risky investments are being compared, each is discounted at a rdr appropriate to its riskiness

Question 8

Why might the NPV i.t.o. sales costs be a better measure than IRR and DPP

Answer 8

IRR:
* may not be unique (more than 1 -ve)
* may not exist (only +cfs, so profits from outset, unusual in reality)
* no information on company worth, their market share or their sales effort
* no information about competition (but same for NPV)

DPP:
* ignores cfs after DPP
* no information about competition

Question 9

Net present value

Answer 9

Discounting the profit signature at the risk discount rate produces a net present value

Question 10

Internal rate of return

Answer 10

The rate at which the discounted value of the cashflows is zero

Question 11

Discounted payback period

Answer 11

The policy duration at which the profits have emerged so far have present value zero at the risk discount rate

Question 12

How can the suitability of a model point be assessed for profitability?

Answer 12

• Where the profitability is being assessed at the same time as supervisory reserves are being calculated (policy data used), use model points to determine the supervisory reserves and then compare that value with the published value

Question 13

Estate of a life insurance company

Answer 13

The excess if the realistic value of its assets over its liabilities = internal realistic determination of solvency

Question 14

List some of the uses of capital

Answer 14

• The main use of capital is so that the company can withstand adverse, unexpected conditions
  The amount of capital affects the company’s ability to:
• write new business = development costs and capital requirements
• adopt a less restrictive investment strategy to meet the company’s investment aims
• Smooth surplus distributions = paying out more than the asset share when returns fall and vice versa
• Reduce the need for reinsurance
• Smooth dividend payments to shareholders
• Allow the company to seize profitable business opportunities as they present themselves like a merger or an acquisition

Downside: can reduce return on capital if not used efficiently

Question 15

List some sources of capital

Answer 15

• Free assets
• rights issue
• selling off assets
• selling off a subsidiary
• raising loan capital
• demutualising