
Income measures
 GAAP Net Income: convenient for mgt decisions
 Statutory Net Income
 IASB Faire Value: removes accntg bias
 *Economic Profit: chg in econ value of firm () ignores franchise () mgt can't justify, doesn't reconcile w GAAP

Capital measures  Riskadj(Y) or not (N)
 N  Actual committed C: from shareholders
 N  Mkt value of equity: mkt capitalization
 Y  Regulatory req C
 Y  Rating agency req C
 Y  Economic C: objectives = solvency & C adequacy
 *Y  Risk C: amt of C from shareholders to cover risk that P > L + R

Risk measures
 percentile: achieve given prob of ruin
 CTE = conditional tail expectation: mean XS loss = TVaR
 EPD ratio

Setting risk measure threshold level
 bond default prob: sel cr rating () which cr rating? () ignores risk of downgrade
 mgt risk pref: () diff to get consensus () differs from directors, investors
 arbitrary default prob: (+) easy to measure, bypass very low lvl where more uncertainty

Risk sources
 mkt risk: chg in inv value; annualize (usually ST)
 cr risk: counterparty default; inv position; prem receiv; reins recov (def of default  death spiral; contingent exposure; high corr w insr risk)
 UW risk: loss res on prior yrs, UW curr yr, property CAT
 others: operational, strategic; hard to quantify

Aggregating dependencies
 empirical analysis: () insufficient data () how corr chg in tail events
 subjective estimates: (+) accnt for tail (+) reflects intuition () as # incr, exponential incr in estimates
 explicit factors models: link variability of risk to common factors

Risk Aggregation Techniques
 closed form solutions
 approximation methods: set dist like (log)normal
 simulation methods
 square root rule


Capital Allocation Methods
 proportional based on risk measure: eg VaR
 incremental allocation: effect of adding entire line
 marginal allocation: effect of increasing exposure
 Comeasure: avg measure when avg firmwide loss > percentile

RAROC calculation
 economic profit = P  E  L + Inv return
 RAROC = econ profit / allocated capital
 highly sensitive to sel C allocation method

Multiperiod RAROC
 R = cost of risk capital

Disadv of CAPM & Fama Fench to derive RAROC
 "risk" in CAPM = systematic inv risk. RAROC = diff in CF exp value & tail value
 denominator of RAROC understated (no franchise)

