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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
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Capital measures - Risk-adj(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
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Risk measures
- percentile: achieve given prob of ruin
- CTE = conditional tail expectation: mean XS loss = TVaR
- EPD ratio
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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
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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
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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
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Risk Aggregation Techniques
- closed form solutions
- approximation methods: set dist like (log)normal
- simulation methods
- square root rule
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Capital Allocation Methods
- proportional based on risk measure: eg VaR
- incremental allocation: effect of adding entire line
- marginal allocation: effect of increasing exposure
- Co-measure: avg measure when avg firmwide loss > percentile
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RAROC calculation
- economic profit = P - E - L + Inv return
- RAROC = econ profit / allocated capital
- highly sensitive to sel C allocation method
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Multiperiod RAROC
 - R = cost of risk capital
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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)
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