“Analysis of Incremental Returns of Canadian Mutual Funds”, J. F. Carrière; C. F. Hill,April 2001

Abstract

The determination and allocation of economic capital is important for pricing, risk management, and related insurer financial decision making. This paper considers the allocation of economic capital to lines of business in insurance. We show how to derive closed-form results for the complete markets, arbitrage-free allocation of the insurer default option value, or insolvency exchange option, to lines of business for an insurer balance sheet. We assume that individual lines of business and the surplus ratio are joint log-normal although the method we adopt allows other assumptions. The allocation of the default option value is required for fair pricing in the multiline insurer. We discuss and illustrate other methods of capital allocation, including Myers-Read, and give numerical examples for the capital allocation of the default option value based on explicit payoffs by line.     

基于Copula函数的保险公司经济资本配置研究

经济资本的度量及配置是风险管理的核心内容。本文利用Copula函数构建保险公司总体风险的联合分布函数,结合TCE方法来度量保险公司经济资本,并利用动态规划方法对经济资本最优配置模型求解。最后结合中国人民财产保险股份有限公司的数据进行实证。通过研究发现,我国财险公司内部偿付能力状况较好,但险种结构有待优化。     

Capital Allocation for Insurance Companies—What Good IS IT?

In their 2001 Journal of Risk and Insurance article, Stewart C. Myers and James A. Read Jr. propose to use a specific capital allocation method for pricing insurance contracts. We show that in their model framework no capital allocation to lines of business is needed for pricing insurance contracts. In the case of having to cover frictional costs, the suggested allocation method may even lead to inappropriate insurance prices. Beside the purpose of pricing insurance contracts, capital allocation methods proposed in the literature and used in insurance practice are typically intended to help derive capital budgeting decisions in insurance companies, such as expanding or contracting lines of business. We also show that net present value analyses provide better capital budgeting decisions than capital allocation in general.     

Bank Failure,Mark‐to‐market and the Financial Crisis

This paper is concerned with the allegation that fair value accounting rules have contributed significantly to the recent financial crisis. It focuses on one particular channel for that contribution: the impact of fair value on the actual or potential failure of banks. The paper compares four criteria for failure: one economic, two legal and one regulatory. It is clear from this comparison that balance sheet valuations of assets are, in two cases, crucial in these definitions, and so the choice between ‘fair value’ or other valuations can be decisive in whether a bank fails; but in two cases fair value is irrelevant. Bank failures might arise despite capital adequacy and balance sheet solvency due to sudden shocks to liquidity positions. Two of the most prominent bank failures cannot, at first sight, be attributed to fair value accounting: we show that Northern Rock was balance sheet solvent, even on a fair value basis, as was Lehman Brothers. The case study evidence is augmented by econometric tests that suggest that mark‐to‐market accounting has had only a very limited influence on the perceived failure risk of banks.     

Solvency II und Rechnungslegung — Diskussion einer solvabilitätsorientierten Bilanzierung von Versicherungsunternehmen

A modern stochastic solvency model for insurance companies is also based on the balance sheet like a traditional factor-based solvency model. Therefore the importance of the interactions of Solvency II and the IASB-project to develop a new standard for the accounting of insurance contracts is frequently stressed in the Solvency II discussion. The following article is discussing the deduction of an adequate accounting framework for solvency purposes of insurance companies. Thereby different theoretical options are considered and compared with the purpose of a solvency balance sheet. In a second step the resulting accounting framework is compared with existing accounting standards.     

Biometric Solvency Risk for Portfolios of General Life Contracts. I. The Single-Life Multiple Decrement Case

Abstract

Solvency II splits life insurance risk into seven risk classes consisting of three biometric risks (mortality risk, longevity risk, and disability/morbidity risk) and four nonbiometric risks (lapse risk, expense risk, revision risk, and catastrophe risk). The best estimate liabilities for the biometric risks are valued with biometric life tables (mortality and disability tables), while those of the nonbiometric risks require alternative valuation methods. The present study is restricted to biometric risks encountered in traditional single-life insurance contracts with multiple causes of decrement. Based on the results of quantitative impact studies, process risk was deemed to be not significant enough to warrant an explicit calculation. It was therefore assumed to be implicitly included in the systematic/parameter risk, resulting in a less complex standard formula. For the purpose of internal models and improved risk management, it appears important to capture separately or simultaneously all risk components of biometric risks. Besides its being of interest for its own sake, this leads to a better understanding of the standard approach and its application extent. Based on a total balance sheet approach we express the liability risk solvency capital of an insurance portfolio as value-at-risk and conditional value-at-risk of the prospective liability risk understood as random present value of future cash flows at a given time. The proposed approach is then applied to determine the biometric solvency capital for a portfolio of general life contracts. Using the conditional mean and variance of a portfolio’s prospective liability risk and a gamma distribution approximation we obtain simple solvency capital formulas as well as corresponding solvency capital ratios. To account for the possibility of systematic/parameter risk, we propose either to shift the biometric life tables or to apply a stochastic biometric model, which allows for random biometric rates. A numerical illustration for a cohort of immediate life annuities in arrears reveals the importance of process risk in the assessment of longevity risk solvency capital.     

Capital and risk in property-liability insurance markets

This paper investigates the capital and portfolio risk decisions of property-liability insurance firms. A theoretical model based on option pricing theory is developed which predicts a positive relationship between insurer capital and risk, as firms balance these two factors to achieve their desired overall insolvency risk. The implications of the model are then tested empirically using a simultaneous equations methodology. The results support the predictions of the model. They also provide evidence that managerial incentives play a role in determining capital and risk in insurance markets. The findings have significant implications for insurance solvency regulation.     

CONTINGENT CAPITAL: INTEGRATING CORPORATE FINANCING AND RISK MANAGEMENT DECISIONS

Financial executives of companies that face a sharp increase in business or financial risks have two basic ways of protecting the solvency and strategic viability of their organizations: they can transfer those risks using insurance or derivatives; or they can raise additional capital, typically by issuing equity, to cushion the firm against the higher expected volatility. But CFOs now also have a third means of managing risk, known as "contingent capital," that effectively combines capital raising and risk management.
A contingent capital facility gives a company the right to raise capital after the realization of a loss arising from one or more specified risks, thus ensuring access to capital in potentially difficult times. For example, Swiss Re recently granted Michelin a five-year right to issue ten-year subordinated debt at a fixed spread over LIBOR, though only under conditions in which the tire maker expects its own earnings to be down. To the extent that it eliminates the need to keep more capital on the balance sheet, the use of such contingent capital has the potential to increase shareholder value by reducing a company's overall cost of capital. This article provides an introduction to some recent innovations in contingent capital, along with discussion of their role in integrating corporate finance and risk management.     

Allocate Capital and Measure Performances in a Financial Institution

This paper provides a model for allocating capital and measuring performances for financial institutions. The methodology relates the economic valuation of the balance sheet to the market value of the firm. In so doing, each business unit is evaluated on an economic basis, and the capital allocated to these units is related to the risk premiums that the market demands. The paper's results have broad applications for corporate managers, risk managers, and other market participants in managing financial institutions to increase shareholders' value.     

Allocation of Capital in the Insurance Industry

ABSTRACT: This article discusses and critiques the methods that have been proposed for allocating capital in financial institutions, with an emphasis on applications in the insurance industry. The author discusses the rationale for allocating capital by line of business and explains how capital allocation can be used to maximize firm value. The implications for capital allocation of regulatory risk-based capital and the capital asset pricing model are discussed. The advantages and disadvantages of using value-at-risk and insolvency put option criteria in capital allocation are analyzed. Finally, recently proposed methods of marginal capital allocation are evaluated. One conclusion is that using the insolvency put option is superior to value-at-risk for allocating capital but that both methods fail to account for diversification across lines in the multi-line firm. The primary conclusion is that marginal capital allocation methodologies based on option-pricing models that recognize the effects of diversification are the best approach for allocating capital in the financial industry.     

MEASURING THE PROFITABILITY OF UK PROPRIETARY LIFE INSURERS

This paper compares and evaluates various legal and economic methods to measure and report UK life insurance company profitability in terms of their (i) treatment and recognition of profits emerging from life insurance business over time; and (ii) compliance with «true and fair view» requirements of the Companies Act and the concepts set out in the Accounting Standards Board («ASB») proposedStatement of Principles. A simple life insurance policy model is used to demonstrate the differential impact of each method on the pattern of profit recognition over time. Legal methods of reporting «profit» used by the UK industry to comply with conservative UK solvency regulations fail to provide inventors with insight into the value of the business. Economic methods provide a more «realistic» basis for reporting to shareholders by incorporating discounted future profits into the value of life insurance business, but these do not accord with the European Union Insurance Accounts Directive («IAD»). A legal «earned profits» method, although not endorsed by the industry, is the only one that appears to provide a «true and fair view» as envisaged by the Companies Act and meet the objectives of the ASB. Various outstanding issues between the industry-endorsed economic methods and the ASB's requirements are discussed.     

Economic crisis and determinants of solvency in the insurance sector: new evidence from Spain

This paper analyses the factors that determine the solvency of insurance companies operating in Spain. The selected time span, from 2008 to 2015, encompasses a period of economic instability characterised by record low interest rates and low or even negative economic growth. Using a dynamic panel data model, we conclude that actual solvency margins are positively related to profitability, underwriting risk and a mutual-type organisation but inversely related to size, reinsurance use, longer-tailed business and life insurance specialisation. We also find that less concentrated markets and the context of an economic crisis decrease solvency margins.     

Financial Intermediary Versus Production Approach to Efficiency of Marketing Distribution Systems and Organizational Structure of Insurance Companies

An examination of the efficiency of the marketing distribution channel and organizational structure for insurance companies is presented from a framework that views the insurer as a financial intermediary rather than as a “production entity” which produces “value added” through loss payments. Within this financial intermediary approach, solvency can be a primary concern for regulators of insurance companies, claims‐paying ability can be a primary concern for policyholders, and return on investment can be a primary concern for investors. These three variables (solvency, financial return, and claims‐paying ability) are considered as outputs of the insurance firm. The financial intermediary approach acknowledges that interests potentially conflict, and the strategic decision makers for the firm must balance one concern versus another when managing the insurance company. Accordingly, we investigate the efficiency of insurance companies using data envelopment analysis (DEA) having as insurer output an appropriately selected (for the firm under investigation) combination of solvency, claims‐paying ability, and return on investment as outputs. These efficiency evaluations are further examined to study stock versus mutual form of organizational structure and agency versus direct marketing arrangements, which are examined separately and in combination. Comparisons with the “value‐added” or “production” approach to insurer efficiency are presented. A new DEA approach and interpretation is also presented.     

The Financial Modeling of Property-Casualty Insurance Companies

This paper describes a financial model currently being used by a major U.S. multiline property-casualty insurer. The model, which was first developed for solvency monitoring purposes, is now being employed for a variety of internal management purposes as well, including (1) the allocation of equity to corporate units, thereby allowing measurements of profitability by business segment and policy year, as well as analysis of the progression of “free surplus,” (2) the analysis of major risks–such as inflation risks, interest rate risks, and reserving risks–that have heretofore been difficult to quantify, and (3) consideration of varying scenarios on the company’s financial performance, both of macroeconomic conditions as well as of the insurance environment.

Many aspects of financial modeling do not differ significantly between life and property-casualty insurers, and these are not discussed in the paper. Rather, the paper focuses on the following topics:

1. Surplus allocation and profitability: how economic surplus and the returns on this surplus are determined by line of business, separately for new business and for the runoff of existing business, and how the progression of free surplus is viewed.

2. Multifaceted risks: how to model risks that affect multiple components of the insurer’s operations, such as economic risks and financial risks. The multiple effects of macroeconomic conditions and changing inflation rates on workers’ compensation claim frequencies and severities complicate the basic interest rate path modeling of life insurance products and annuity contracts.

3. Scenario building: how to construct scenarios of macroeconomic conditions or industry cyclical movements to test the resilience of the company to changing external conditions.     

Evaluating Liquidation Strategies for Insurance Companies

In this article, we examine liquidation strategies and asset allocation decisions for property and casualty insurance companies for different insurance product lines. We propose a cash‐flow‐based liquidation model of an insurance company and analyze selling strategies for a portfolio with liquid and illiquid assets. Within this framework, we study the influence of different bid‐ask spread models on the minimum capital requirement and determine a solution set consisting of an optimal initial asset allocation and an optimal liquidation strategy. We show that the initial asset allocation, in conjunction with the appropriate liquidation strategy, is an important tool in minimizing the capital committed to cover claims for a predetermined ruin probability. This interdependence is of importance to insurance companies, stakeholders, and regulators.     

Creating Value Through Best‐In‐Class Capital Allocation1

With the economy showing signs of recovery, companies are shifting their focus from liquidity and balance sheet concerns back towards capital allocation and value creation. This article provides a comprehensive framework to examine shareholder value creation through capital allocation, and discusses important capital allocation lessons that have re‐emerged over the last few years. Notable among the key lessons are the following:

• ? Growth alone does not guarantee value creation, which suggests that companies should allocate capital based on the economic value of each investment opportunity.
• ? The limits of diversification in a financial crisis should be considered when allocating capital and managing liquidity.
• ? Companies should be conservative with base‐case cash flow projections and incorporate the possibility of downside scenarios into their projections.
• ? It is important to incorporate all forms of capital when managing liquidity.
• ? Whether using a long‐term or current‐market approach, companies should be consistent throughout the cycle in their cost of capital methodology.
• ? Companies should continually rethink investments and allocate capital in an attempt to maintain a competitive advantage.
• ? Evaluate returns relative to risk and cost of capital, and not against the company's average ROIC.
• ? Comparing the IRR of share repurchases to new investments is not an apples‐to‐apples comparison.

Finally, companies should concentrate on the strategic uses and value of particular assets and not allow their decisions to be driven by the value they might receive relative to their initial cost.     

Housing,Illiquidity, and Wealth

This article develops a model of asset allocation relevant for the representative consumer. Consumption is composed of two items: housing, and other goods and services. The representative household's balance sheet consists largely of a house and a mortgage. Its income statement is dominated by labor earnings, constraining cash expenditures. Housing-market behavior thus underlies intertemporal wealth and consumption allocation. With a housing-dominated portfolio and a maximizing plan, a plausible bound on the intertemporal marginal rate of substitution in consumption can be estimated for a typical household. The model takes account of idiosyncratic characteristics of housing returns and finance. Underwriting standards oblige borrowers to secure mortgage debt with a housing asset and with cash flow, usually from labor income. Access to the mortgage market depends on the loan-to-value ratio, or leverage and debt size, and the debt-coverage ratio, or cash solvency. If there are seasonals or predictable patterns in house returns, their magnitude is amplified for the typical liquidity-constrained household. Empirical results for the aggregate U.S. market confirm predictability and serial correlation in house capital gains. There are seasonals in housing returns. While there is no January effect, above-average returns are obtained during the summer months.     

我国财产保险公司承保业务线经济资本的度量

承保风险是保险公司面临的主要风险之一,合理地计量其经济资本有助于提高公司的资本管理能力。采用多元Copula理论对我国某财险公司主要业务线的相依结构进行建模,选择拟合较好的GaussCopula,在此基础上,使用凹扭曲风险度量测度主要业务线的经济资本。结果显示:凹扭曲风险度量中的Wang风险度量能够根据风险的整体水平灵活地调整所需的经济资本。     

Flight to liquidity and the Great Recession

This paper argues that counter-cyclical liquidity hoarding by financial intermediaries may strongly amplify business cycles. It develops a dynamic stochastic general equilibrium model in which banks operate subject to agency problems and funding liquidity risk in their intermediation activity. Importantly, the amount of liquidity reserves held in the financial sector is determined endogenously: Balance sheet constraints force banks to trade off insurance against funding outflows with loan scale. A financial crisis, simulated as an abrupt decline in the collateral value of bank assets, triggers a flight to liquidity, which strongly amplifies the initial shock and induces credit crunch dynamics sharing key features with the Great Recession. The paper thus develops a new balance sheet channel of shock transmission that works through the composition of banks’ asset portfolios.     

我国财产保险公司偿付能力最低资本标准实证研究

以风险度量为基础确定偿付能力最低资本标准正成为国际保险业偿付能力监管的趋势。本文以我国财产保险公司的经验数据为基础,通过对财产保险公司面临的保险风险进行度量,确定对应的偿付能力最低资本标准,并对我国建立以风险度量为基础的偿付能力最低资本标准面临的挑战进行分析。