1. (a) Western Insurance Company has assets at fair market value of $100 million

Question

1. (a) Western Insurance Company has assets at fair market value of $100 million. The present value of Western’s liabilities is $85 million. The market value margin is $5 million. What is Western’s MVS? (b) Using probability models, Western Insurance determines that its value at risk (VaR) is $8 million. Western may be expected to incur $8 million or greater loss of capital at a .5% probability over the next one-year period. What is Western’s economic capital? (c) Does Western have excess capital or a deficiency in capital?

2. What constitutes an insurer’s most significant credit risk?

3. What is the purpose of the National Association of Insurance Commissioners’ (NAIC) risk-based capital (RBC) system?

4. The composition of Western Insurance Company’s capital is as follows: • 10% market value of debt • 30% market value of common stock • 60% reserves The after-tax cost of debt is 3%, the cost of common stock is 4% and the cost of reserves is 5%. Calculate the weighted Average cost of Capital (WACC)

Explanation / Answer

1(a) Western's MVS = Fair market value of assets - (present value of liabilities + market value margin)

= $100 million - ($85 million + $5 million)

= $10 million

1(b) Economic capital = $7.96 million ($8 million - 0.5% probability of loss)

1(c) western have deficiency in capital. As the assets are valued at $ 100 million and liabilities are valued at $85 million and the value of the capital should be $15 million whereas it is $7.96 million

2. Insurer's most significant credit risk is that the insured will fail to meet its obligations in accordance with the agreed terms.Credit risk consists of default risk which means non-compliance with the exact specification of a contract and spread risk which means reduction in the matket value of the contract due to changes in the credit quality of the counterparty.

3. Risk-Based Capital (RBC) is a method of measuring the minimum amount of capital appropriate for a reporting entity to support its overall business operations in consideration of its size and risk profile. RBC limits the amount of risk a company can take.RBC is intended to be a minimum regulatory capital standard and not necessarily the full amount of capital that an insurer would want to hold to meet its safety and competitive objectives.

4. WACC = 0.1 x 3 + 0.3 x 4 + 0.6 x 5

= 4.5%

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