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Old 06-11-2018, 08:32 PM
joshren joshren is offline
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Default MCEV / AFR -Cost of Nonhedagble Risk

In MCEV framework, the cost of nonhedgable risk (i.e. mortality, longevity , behavior etc) are estimated based on a capital charge * economic capital * duration

I believe this is needed because those risks are not modeled stochastically like financial risks.

However, if i were to model those risks stochastically, the cost of option and guarantee is much smaller vs the proposed approach above. This is because the cost of O&G is trying to capture deviation around the mean, while the approach above is calibrated based and extreme tail event like 2.57x standard deviation.

In my opinion, this creates a significant dis-adavange for Insurance risk given there is not such deduction for financial risk, only O&G

Is anyone aware if this issue was discussed at the MCEV forum or any reasoning behind such different treatment for risks?

Thanks
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Old 06-13-2018, 09:17 AM
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Eddie Smith
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The cost of nonhedgable risk is a cost of capital measure that reflects the capital owners' (e.g. shareholders) willingness to bear the risk that insurance experience will be worse than the best estimates that go into the value of inforce (i.e. the PV of distributable earnings on a best estimate basis).

The cost of nonhedgable risk exists because there is no way to hedge away non-financial risk using tradable market instruments, so it's based on an economic capital approach that allows the framework (as a whole) to remain market-consistent (because the the cost of nonhedgable risk is like a market measure of the uncertainty in non-financial risks like mortality, etc.) The EC base that goes into the cost of nonhedgable risk calculate can certainly be based on stochastic simulations for mortality tail risk, but you could also use equivalent 1-year VaR shocks for the mortality, etc. components (a la Solvency II).
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