Could some one please respond to the following queries? Sep 2009 q 2 (v) Describe the additional research you would conduct and the likely changes you would make to your answer in (iv) once you have been given the extra information that in each of the past three years the very poor claims experience has been the result of systemic losses. Answer: Systemic losses mean that the assumption that claims are independent from one another is not correct. In order to test this assumption it would be necessary to conduct a survey of a random selection of claims to determine whether they are related in any way. Assuming that the factor of 3.5 standard deviations to reach the 99.5th percentile of the aggregate claims cost distribution was made assuming that claims were independent from one another then it would be necessary to develop the assumption to allow for positive correlation between claims and possibly very strong positive correlation in the extreme cases My response would have been along the lines of something that affected the entire industry. eg. A regulation that was misinterpreted by the IFAs ended up them doling out incorrect advice. If this was expected to be set right in the future then the claim distribution might have to be revisited and probably the last 3 years experience should be given less weightage. As a result capital could reduce. Is that a fair reading of the situation? Compare and contrast the ways in which mutual insurance and proprietary insurance companies are taxed in the UK. [5] Which part of the core reading does this pertain to? Was the response to this question ever a part of SA5? (vii) Describe a suitable initial capital structure for CM. Your answer should consider the main sources of capital including bank debt, capital market debt, reinsurance and AIFA’s internal surplus. The response to this question also follows from the earlier one. Is a candidate expected to know this? Q1 (IV) Outline the principal investment and business risks of both XYZ Capital and RockSolid. Part of the response Mismatching risk: hedge will likely between probable short Treasuries or corporate bonds index and long distressed securities Operational risk of marking portfolio and timely valuation, leading to loss of customer goodwill Are they saying that treasuries could not be used to hedge these bonds, since the margin over the Risk free rate might vary and so these bond prices will fluctuate (however, Treasury prices will be unaffected if risk free rates stay the same)? Also, what does the operational risk imply? Incorrect communication of portfolio values to customers? What does "marking portfolio" mean? Discuss how RockSolid could mitigate any of the risks identified in (iv) without significantly compromising expected investment returns or business results Part of the response: Volatility: portfolio is short vol so could have long options however these are not very well matched at all due to idiosyncratic nature of portfolio positions Could some one please elaborate upon the response?
Hi Ivanhoe Wow, lots of questions! Perhaps in future try setting up a separate thread for each one? It will make it a lot easier for other forum users to post responses if they know that they can respond to just one question and so you are more likely to get help. Also, do bear in mind that this is the 'exam discussions' forum, which is intended to enable students to discuss their last exam. The 'subject discussions' forum, which covers anything to do with a particular subject, (including past questions) tends to be more widely read, so it is probably better to post there. Apologies if I sound rather grumpy , I'm not - I'm just trying to maximise the chance of you getting responses. Anyway, to your first query: I think the key thing here is to note that the question asks you to do two things: 1) Describe the additional research you would conduct 2) Describe the likely changes you would make to your answer in (iv). Looking at the Examiners' answer, we can see they definitely do that. I don't teach SA5, but I'm not sure that points you make definitely do those two things? Also, given that (iv) focused on calculations and this 99.5th percentile, I would have been tempted to refer to that in my answer to part (v) - just playing a game here of trying to use relevant information from the question in my answer. Gresham
I don't have access to the 2009 CMP at present. But I can see that the 2012 CMP contains more information about the differences between mutual and proprietary insurance companies than the 2014 CMP and the 2012 material seems quite similar to the examiners' answer. So I suspect that the regulations have changed and the Core Reading has been changed and the examiners' original question and answer are now out of date. Similarly, given the change in legislation regarding reserving / capital requirements since 2009, I suspect the examiners' answer may now be out of date.
Mismatching risk: I think the examiners were simply saying here that XYZ is going long in some (distressed) bonds and wants to hedge out the risk of a movement in interest rates eg the risk free rate. It can do this by going short in some (close to) risk-free bonds eg Treasuries. However, this hedge may not be perfect since the treasuries and the distressed bonds may not have exactly the same sensitivity to movements in interest rates? Operational risk: I'm guessing here, but I think that the 'marking' is a reference to 'marking to market'. These distressed bonds may be pretty illiquid and the hedge fund may not be able to mark to market / or value the assets very frequently or accurately. Investors in the hedge fund may be upset by this, particularly if they try to redeem their investment and get much less than they were expecting because of inadequacies in the frequency or accuracy of the process the hedge fund was using to value its investments. Certainly, around the time that this paper was set we saw several high profile cases where hedge funds tried to sell their underlying investments and got much much less for them than the funds' models had suggested they were worth. Gresham
Thank you for your responses! I will post my queries as you suggested. I understand your explanations. I was just wondering however that if as a principle, hedging eliminates risk and the upside gain, then why would a hedge fund investing in distressed securities ever hedge?For a hedge fund, the transactions are often in the nature of taking on more risk in the form of leverage. Thanks anyway
Hi Ivanhoe Hedge funds will hedge out the risks that they don't want to take, leaving the risk on which they want to bet. So here for example, I think the hedge fund wants to bet that the distressed securities will rise in value (i.e. the fund manager thinks that others currently have overestimated the degree of "distress" and so the value of the securities is too low), but doesn't want to be exposed to general changes in the risk free rate. Gresham
Makes sense! However, treasuries are a best bet to hedge the changes in the risk free rate. If the hedge funds wants to hedge the change in the risk free rate, and they have treasuries, it is favourable. Why should it be a mismatching risk?
I guess because the treasures and the distressed securities may have different sensitivities to the risk free rate - in which case the hedge wouldn't be perfect? Gresham
