Ray.DeJaco@jmagroup.com on 01/06/99 03:19:49 PM
To: studygroup10@lists.casact.org
cc: (bcc: Ann Bok/BOCA/NCCI)
Subject: Can anyone out there shed some light on this one: (this is a
question from last year's test)
Can anyone out there shed some light on this one: (this is a question from
last year's test)
Last year's test question #3 is as follows:
"You are given the following information:
The expected loss from the policy is $100
30% of the loss is paid at the end of year 1.
70% of the loss is paid at the end of year 2
The funds generating coefficient is 1.5
The risk free rate is 5%
The market risk premium is 12%
The systematic risk of loss payments is 1.2
The non-systematic risk of loss payment is 1.00
Using the discounted Cash Flow (DCF) method outlined in D'Arcy and Doherty,
"The financial Theory of Pricing Property- Liability Insurance Contracts,"
calculate the premium net of expenses, that will produce a competitive
return on equity."
The answer to this one according to the CAS is "at least $70, but less than
$75". I feel this amount is much too low. They seem to have discounted
the ($30 & $70) cashflows at r= 5% + 1.2 (12%)= 19.4% (the discounted
cash flow model is described on page 80-83 of the reading). If this what
they did, wouldn't this say that the higher the systematic risk of loss
payments the lower the required premium. It seems to me that the loss
payment cashflows should be discounted at a rate less than the risk free
rate (less than risk free to reflect risk) leaving a significantly higher
premium.
What do you think?
Is my problem caused by an unrealistic value for the systematic risk of
loss payments- would 1.2 mean that losses tend to be above average when
market return are above average? In other words, this risk would be
desirable because it would tend to counteract the risk of the market
therefore it's premium would be lower than if it were risk free. [what
type of coverage would exhibit this kind of systematic risk of loss
payment? - stop loss coverage on shorted stock purchases?]. It seems that
a normal "systematic risk of loss payment" per Darcy/Doherty formulas would
be negative (losses tend to be above average when market returns are below
average) or near zero which would calculate to a discount rate less than or
equal to risk free.
Any comments?