Learning & Memorizing Key Topics and Formulas ILA Life ...€¦ · ACTEX Learning Section 1 –...
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Flashcards Learning & Memorizing Key Topics and Formulas ACTEX Learning ILA Life Risk Management John Aprill, FSA, MAAA Fall 2017 Edition
Transcript of Learning & Memorizing Key Topics and Formulas ILA Life ...€¦ · ACTEX Learning Section 1 –...
FlashcardsLearning & Memorizing Key Topics and Formulas
ACTEX Learning
ILA Life Risk Management
John Aprill, FSA, MAAA
Fall 2017 Edition
Copyright © 2017, ACTEX Learning, a division of SRBooks Inc.
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ISBN 978-1-63588-139-4
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Section 1
Principles of Risk Management
ACTEX Learning Section 1 – Page 1 Life Risk Management
Operations of Principal Financial Firms
ACTEX Learning Section 1 – Page 2 Life Risk Management
Characteristics of Principal Financial Firms:
Customers are liability holders and thus sensitive to credit rating
Opaqueness of asset stricture and business activities
o High costs of risk capital
o Highly liquid balance sheet
o High information and agency costs
Operate in competitive financial markets
o Profitability very sensitive to cost of risk capital
o Difficult to allocate COC to lines of business
o Must correctly charge for guarantees provided to each line of
business
LRM-100-14, pp 16-17
ACTEX Learning Section 1 – Page 3 Life Risk Management
Definition of Risk Capital
ACTEX Learning Section 1 – Page 4 Life Risk Management
Risk Capital = the smallest amount that can be invested to insure the
value of the firm’s net assets against loss in value relative to rf,
where
Net Assets = Gross Assets – Customer Liabilities
Riskiness of net assets depends on
o riskiness of gross assets
o liability riskiness
o covariance between assets and liabilities
Net asset value is the most important determinant of risk capital level
LRM-100-14, page 17
ACTEX Learning Section 1 – Page 5 Life Risk Management
Risk Capital – Asset and Liability Guarantees
ACTEX Learning Section 1 – Page 6 Life Risk Management
Asset Guarantees
If a parent company provides risk capital, repayment of the risk capital depends
on underlying asset (under subsidiary’s control) not losing value
Value of insurance purchased or borrowed should be balance sheet asset
If liabilities are risk free, Risk capital = shareholder equity
Liability Guarantees
Parent company provides liability insurance by guaranteeing payment
Guarantee is an off-balance sheet asset
Payoff makes liability cashflows equivalent to asset insurance
Risk capital = value of guarantee
Liability Guaranteed with Default Risk
Risky Debt = Risk-Free Note – Insurance on Note
Net Assets = Assets – Value(Default-Free Guarantees) – Value(Customer
Liabilities)
LRM-100-14, pages 18-20
ACTEX Learning Section 1 – Page 7 Life Risk Management
Risk Capital – Balance Sheet Accounting
ACTEX Learning Section 1 – Page 8 Life Risk Management
Accounting Balance Sheet
Assets = investment portfolio + 3rd party insurance value
Liabilities = MV(liability) + MV(debt)
Risk Capital Balance Sheet
Assets = investment portfolio + asset insurance from policyholders, debt
holders, and shareholders
Net equity capital = cash capital + risk capital – value of insurance
provided
Summarizes basic functions of capital providers:
o provide cash capital
o sell asset insurance
o provide risk capital
LRM-100-14, pp 20-24
ACTEX Learning Section 1 – Page 9 Life Risk Management
Risk Capital – Asset Insurance Accounting
and Income Statements
ACTEX Learning Section 1 – Page 10 Life Risk Management
Accounting for Asset Insurance
from outside insurer guarantee is balance sheet asset
from parent guarantee is [incorrectly] considered off-balance sheet
asset
Income Statements
should reflect cost of asset guarantees as an expense, payments from
guarantor are revenue
same treatment for purchased guarantees as provided guarantees
if don’t account for costs of asset guarantees, then profits are:
o overstated if no guarantee payment made
o understated if guarantee payment made
LRM-100-14, pp 24-25
ACTEX Learning Section 1 – Page 11 Life Risk Management
Risk Capital – Economic Cost
ACTEX Learning Section 1 – Page 12 Life Risk Management
Reasons Why Costly
1. adverse selection
2. moral hazard
3. agency costs
Cost Determinants
1. opaqueness of issuing firms
2. form purchased – debt or equity
Expected Profitability
cost of cash capital = fr cash capital
cost of risk capital = bid/asked spread * risk capital
full insurance premium should be deducted to calculate profits
Use of Derivatives
hedging reduces risk and risk capital
speculation increases risk and risk capital
Firm-Level Risk Capital
consider marginal amount of risk capital after diversification
full allocation of risk capital distorts unit profitability
LRM-100-14, pp 25-26
ACTEX Learning Section 1 – Page 13 Life Risk Management
Goals for Risk Management
ACTEX Learning Section 1 – Page 14 Life Risk Management
Variance minimization
Elimination of lower-tail outcomes
Value maximization
Substitute for equity capital
LRM-104-14 pp 8-9
ACTEX Learning Section 1 – Page 15 Life Risk Management
Costs Associated with Higher Volatility
ACTEX Learning Section 1 – Page 16 Life Risk Management
Bankruptcy costs
Higher contracting costs
Higher taxes due to tax convexity
LRM-104-14 pp 12-14
ACTEX Learning Section 1 – Page 17 Life Risk Management
Risk Management Integration with Corporate Objectives
ACTEX Learning Section 1 – Page 18 Life Risk Management
Bear risks when you have a comparative advantage
Comparative advantage from information superiority, cost structure,
or distribution
Can use information superiority for selective hedging
Risk management decision depends on capital structure and
ownership structure
Management should be compensated on marginal risk-adjusted
returns
LRM-104-14 pp 14-24
ACTEX Learning Section 1 – Page 19 Life Risk Management
S & P
Risk Management Culture
ACTEX Learning Section 1 – Page 20 Life Risk Management
Risk management culture
ERM is well entrenched in the organization with a formal
ERM framework
Insure has a clear vision f enterprise risk profile and risks
are managed within risk tolerances
Insurer risk management framework is clearly
communicated and linked to risk limits
Insurer has a culture of risk communication and information
sharing
Incentive compensation supports ERM goals
LRM-123-15
ACTEX Learning Section 1 – Page 21 Life Risk Management
S & P
Risk Controls
ACTEX Learning Section 1 – Page 22 Life Risk Management
Risk controls
All material risk identified
Insure has a comprehensive risk limit system and formal
breach policies
Insurer uses multiple risk management strategies to manage
exposure within limits
Generally scored positive no controls negative
LRM-123-15
ACTEX Learning Section 1 – Page 23 Life Risk Management
S & P
Risk Models
ACTEX Learning Section 1 – Page 24 Life Risk Management
Risk models
All material risks captured
Insure models have robust validations
Model limitations are understood and compensated for
Models perform stochastic and deterministic scenarios
Insure uses model results in decision making
LRM-123-15
