Term
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Definition
Risk Adjusted Return on Capital
RAROC = Income/Risk-Adjusted Capital
accounts for riskiness of returns |
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Term
| (4) income measures that can be used in RAROC calculation |
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Definition
GAAP Net Income: convenient when RAROC is used in management decisions
Statutory Net Income: calculated using Statutory accounting rules
IASB Fair Value - Remove the biases of various accounting conventions
Economic Profit - change in "economic value" of firm over period |
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Term
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Definition
1)ignores franchise value
2)may make less sense to management since differs from GAAP
3)hard to justify to external parties |
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Term
| (2) unadjusted measures of Capital |
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Definition
1)Actual Committed Capital
2)Market Value of Equity |
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Term
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Definition
1)Percentile - capital required to achieve a certain prob of ruin
2)Conditional Tail Expectation (CTE)- Mean loss of all losses that exceed a certain percentile (also TVar or Tail conditational expectation)
3)Expected PolicyHolder Deficit Ratio |
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Term
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Definition
1) Bond Default prob - must select which credit rating/ doesn't account for risk of downgrade
2) Management risk preferences
3) Arbitrary default probability |
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Term
| (5) main categories of risk |
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Definition
1) Market Risk
2) Credit Risk
3) Insurance Underwriting Risk
4) Operational Risk
5) Strategic Risk |
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Term
| Risk Adjusted Measures (4) |
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Definition
1)Regulatory Required Capital
2)Rating Agency Required Capital
3)Economic Capital: the amount necessary for a particular objective
4) Risk Capital: Amount required to cover the risk liabilities may exceed funds provided |
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Term
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Definition
| Risk to investments due to changes in market variables |
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Term
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Definition
Risk of loss due to credit events
such as Reinsurance recoverables
Marketable Securities/swaps
Receivables |
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Term
| Insurance Underwriting (3) |
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Definition
Loss reserves on prior years
Underwriting Risk for current policy year
Property catastrophe Risk |
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Term
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Definition
Operational risks (failure of systems/people)
Strategic risks (related to competitors)
hard to quantify/ignored in paper |
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Term
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Definition
1) Empirical Analysis of Histroical Data - usually insufficent data
2) Subjective Estimate - + Can reflect tail/user intuition - as # of risk categories increase, so do dependency parameters required
3) Explicit Factor models - link variability of risks to common factors |
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Term
| Aggregate distributions (4) |
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Definition
1)closed form
2)Approximation
3)Simulation Methods
4)Square root rule |
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Term
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Definition
1) Proportional Allocation
2) Incremental Allocation
3) Marginal Allocation
4) Co-Measures |
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Term
| Myers Read Capital Allocation |
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Definition
Marginal Method - allocate capital s.t. the marginal impact of each business is equal on the value of the put option
si=s - (dp/ds)-1 * (dp/dσ) * [(σiL- σL2)-(σiV - σLV)]/σ
- (dp/ds) = partial der of put value vs s
- s = agg cap to liability ratio
- σiL = cov of line to agg losses all lines
- σiV = cov of line to assets
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Term
| Proportional allocation based on risk measure |
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Definition
| Calculate stand-alone values by risk and allocates into proportion to Sum. |
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Term
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Definition
| this method determines the impact that each risk source has the agg risk measure and allocates total in proportion |
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Term
| Co-Measures approach (kreps,ruhm-mango) |
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Definition
| This method allocates based on the contribution each risk source has to the total risk measure |
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Term
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Definition
1)Developed to allocate frictional costs, not risk adjusted requirements
2)Relies on Default option framework, tougher calculation
3)Mathematical limitations - assumes adding/subtracting risk doesn't change the distribution of risk. Not the case insurance applications. |
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Term
| (5) Applications of methods |
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Definition
Most important:
1) Risk adjusted Performance Measurement
2)Insurance Policy Pricing
others:
3)Assesing Capital Adequacy
4)Setting Risk Management Priorities
5)Evaulating Alternative Risk Management Strategies |
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Term
| Additional risk load to attain RAROC |
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Definition
RAROC ={ [P +∏ - E](1+i) - PV(L) }/
Allocated Risk Capital
∏ = risk load |
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Term
| Multiperiod capital requirement |
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Definition
| Risk Capital may be required for more than 1 period. Can calculate the PV of the entire amount required in the future |
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Term
| Cost of risk capital issues |
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Definition
Definition of risk - shouldn't mix RAROC with CAPM, based on totally different approaches
Leverage - RAROC is artifacially leveraged because it doesn't match market value or actual capital. Losses in a business unit are also not limited by the amount of RC allocated.
Investment income on allocated capital:
not included. Need to select rate and should then consider EXCESS risk adjusted return above market returns. |
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