Chapter 21 ST7

[Adithyan]

I had been through chapter 21 (Capital modelling and allowance for diversification) in ST7. I have put the page no. and the paragraph from the page.
I have highlighted the lines that didn't make sense to me.

Kindly help me with these.

I have put my question in italics and highlighted below the paragraph from the book.

1.3 Allowing for the cost of allocated capital for pricing ( Page in book 10)
For expanding or contracting portfolios, the capital needed to support the
reserves that would be held until all claims from the specific underwriting year
are fully paid may differ from the reserve risk component of the allocated capital.
This would be based on the size of the total reserves brought forward.

My question: I don't get the meaning of the sentence in bold in the paragraph above.
2.2 Assessing correlation (Pg in book 15)
Two alternative approaches are for us to consider causes and effects to assess
the key drivers of correlation, or to consider the likely scenarios in which the
particular risks will occur at the same time.

A cause and effect reasoning considers the underlying logical links between different
events, using for example, scientific theory. For example, the risk of a tidal wave of a
certain magnitude can be assessed using flood models, and then the effects of that tidal
wave on the land can be assessed using mapping techniques

My question: Could you tell me how cause and effect reasoning helps in finding correlation?
These were the stuff that hindered my understanding of the chapter. Kindly assist.
Thank you in advance for the help!

 

[Hemant Rupani]

This would be based on the size of the total reserves brought forward.

Reserves brought forward is total of reserves brought forward related to all past Underwriting year, with expanding or contracting portfolios amounts related to each past Underwriting year will not be consistent.

Could you tell me how cause and effect reasoning helps in finding correlation?

Cause and effect just means Y depends on X, so there must be correlation, except some rare cases where correlation is 0 for dependent variables.

 

[Adithyan]

Thank you very much for the response. They have been extremely helpful in my learning.

For expanding or contracting portfolios, the capital needed to support the
reserves that would be held until all claims from the specific underwriting year
are fully paid may differ from the reserve risk component of the allocated capital.
This would be based on the size of the total reserves brought forward.

Similar differences may arise with the underwriting risk component. Where
material differences arise, we should discuss with the underwriter and the
management of the company the implications of setting pricing loads with
reference to the allocated capital.

In the above paragraphs are they trying to say that reserves held for underwriting years and the capital held for reserve risk together make the capital allocated? And that these differ?

And if you could explain the 2nd paragraph here in connection with the first, I can get the whole picture here!

Thanks for being very helpful and considerate!

 

[Hemant Rupani]

In the above paragraphs are they trying to say that reserves held for underwriting years and the capital held for reserve risk together make the capital allocated? And that these differ?

Reserves held are called reserves only. Capital allocated for reserve risk is over and above reserves held(you can take reference of Section 2.3 of Chapter 20).

And if you could explain the 2nd paragraph here in connection with the first, I can get the whole picture here!

As far as I understand -
On Written basis, Underwriting risk is for future. So it is not sum like Reserve risk. Whatever written - capital allocation goes to reserve risk.
Similar loguc for Earned basis capital allocation, But Underwriting risk may have part from risk from past Underwriting years but unearned.

Now for contacting or expanding portfolio, there will likely different concentration risk. So allocation proportion depends on how the portfolio is changing. We would discuss with the underwritters or management, who has better information of sales target and budget to decide in allocated capital (thus Cost of capital) to load.