FINA FINAL EXAM TH & QUIZES CH 6-10
interest rate risk
"Matching the book" or trying to match the maturities of assets and liabilities is intended to protect the FI from
As of 2012, assets of property-casualty insurers totaled approximately ________, which was ______ of the assets of the life insurance industry.
$1,600 billion; 30 percent
net short €10 million
A U.S. bank has €40 million in assets and €50 million in CDs. All other assets and liabilities are in U.S. dollars. This bank is [Net position = Asset value - Liability value]
Compensating Balance
A percentage of a loan that a borrower is required to hold on deposit at the lending institution.
Insolvency risk
A small local bank failed because a housing market collapse following the departure of the area's largest employer. What type of risk applies to the failure of the institution?
Stock Companies excluding Mutual Holding Companies
About 75% of Life Insurers are which type of structure?
(-$200,000); +$2,000
An FI finances a $250,000 2-year fixed-rate loan with a $200,000 1-year fixed-rate CD. Use the repricing model to determine (a) the FI's repricing (or funding) gap using a 1-year maturity bucket, and (b) the impact of a 100 basis point (0.01) decrease in interest rates on the FI's annual net interest income? 1-year CGAP = RSA - RSL ∆NII = (CGAP) × ∆R
foreign exchange risk
An FI that finances a euro (€) loan with U.S. dollar ($) deposits is exposed to
decreases in net interest income and decreases in the market value of equity when interest rates rise.
An FI that finances long-term fixed rate mortgages with short-term deposits is exposed to
firm-specific credit risk
An advantage FIs have over individual household investors is that they are able to diversify away credit risk by holding a large portfolio of loans to different entities. This reduces
if dividends paid to policyholders is $10 million and income generated on investments is $14 million.
An insurance company collected $31.0 million in premiums and disbursed $28 million in losses. Loss adjustment expenses amounted to $5.0 million. The firm is profitable
variable life.
An insurance policy in which fixed premium payments are invested in mutual funds of stocks, bonds, and money market instruments is called
Universal Life
An insurance policy that allows both the premium amount and the maturity of the life contract to be changed by the insured is called
term life
An insurance policy that often is the least expensive to the insured because of the policy does not include a savings plan is called
whole life.
An insurance policy that protects an individual over an entire lifetime as long as the premiums are paid is called
(asset value - liability value) = net position (¥100 - ¥80) = +¥20 million is the only option in which the value of assets is more than the value of liabilities.
Any FI is considered to be "net long" when the value of the assets is more than the value of liabilities.
market risk
As commercial banks move from their traditional banking activities of deposit taking and lending and shift more of their activities to trading, they are more subject to
state insurance commissions.
As of 2012, the primary regulator of both the life and property-casualty insurance industry is/are the
Refinancing risk and Interest rate risk.
Bank of the Atlantic has liabilities of $4 million with an average maturity of two years paying interest rates of 4.0 percent annually. It has assets of $5 million with an average maturity of 5 years earning interest rates of 6.0 percent annually. To what risk is the bank exposed?
**PMT= $298,058.98.** because PV=2,000,000 FV=0 I=8 N-10
Calculate the annual cash flows of a $2 million, 10-year fixed-payment annuity earning a guaranteed 8 percent annually if the payments are to start at the end of this year.
**PMT = $59,638.51.** because PV=500,000 FV=0 I=6 N=12
Calculate the annual cash flows of a $500,000, 12-year fixed-payment annuity earning a guaranteed 6 percent per year if annual payments are to begin at the end of the current year.
A The spread between bid prices and ask prices on securities B The spread between borrowing rates and lending rates C The spread income model D**Both B and C** E None of the above
Deposit taking Financial Institutions make money PRIMARILY via?
may or may not occur. if the contingency does occur, the asset or liability is transferred onto the FI's balance sheet. impact the economic value of the equity. if the contingency never occurs, there is virtually no economic meaning to the OBS activity. Correct! **All of these.**
Economically speaking, OBS activities are contractual claims that
lower its average costs of operations by expanding its output of financial services.
Economies of scale refer to an FI's ability to
unexpected increases in inflation. the frequency and severity of loss. the concept of long-tail risk. property versus liability coverage. **All of the above.**
Factors that affect the predictability of claims loss exposure include
Complete default on principal and interest
For an FI investing in risky loans or bonds, the probability is relatively the lowest for which of the following occurrences?
low-severity high-frequency events.
For property-casualty insurers, loss rates are more predictable for
long tails and high inflation
For property-casualty insurers, losses are higher for lines that are exposed to
invest in more short-term assets than life insurance firms.
Higher uncertainty of losses forces property-casualty firms to
default risk and interest rate risk.
Holding corporate bonds with fixed interest rates involves
(- $25,000)
If interest rates decrease 50 basis points for an FI that has a gap of +$5 million, the expected change in net interest income is
0.88 implying that this line of insurance is profitable. The line is profitable because the loss ratio is less than one.
If losses on a particular line of fire insurance were $430 million, premiums earned were $595 million, and loss adjustment expenses were $95 million, the combined ratio would be
1.13 implying that this line of insurance is unprofitable. The line is unprofitable because the loss ratio is greater than one.
If losses on a particular line of medical malpractice insurance were $650 million and premiums earned were $575 million, the loss ratio would be
1.13 implying that this line of insurance is unprofitable.
If losses on a particular line of medical malpractice insurance were $650 million and premiums earned were $575 million, the loss ratio would be [Loss Ratio = Payouts (losses) / Premiums earned]
The loans' negative correlations will decrease the bank's credit risk exposure because lower than expected returns on some loans will be offset by higher than expected returns on other loans.
If the loans in the bank's portfolio are all negatively correlated, what will be the impact on the bank's credit risk exposure?
commissions and other expenses are 16 percent and investment yields are 20 percent
If the loss ratio on a line of insurance is 70 percent and loss adjustment expenses are 33 percent, then the line is profitable before dividends if the ratio of
¥80 million in liabilities.
In which of the following situations would an FI be considered net long in foreign assets if it has ¥100 million in loans?
liabilities, because the insurance company may have to pay out the benefits.
Insurance policy benefits are classified on an insurance company's balance sheet as
limiting the mismatches on the institution's balance sheet
Interest rate risk management for financial intermediaries deals primarily with
are sponsored by state insurance regulators
Life insurance guaranty funds
Losses + Adjustment Expense = 70 + 33 = 103
Need a net investment yield of at least 3 percent to reach profitability. That is, investment yields have to be at least 3 percent higher than commissions and other expenses. The only selection that meets this criteria is [commissions and other expenses are 16 percent and investment yields are 20 percent]
sovereign country risk
Politically motivated limitations on payments of foreign currency may expose an FI to
Investment income must be at least $2 million higher than dividends paid. The only selection where this is the case is [if dividends paid to policyholders is $10 million and income generated on investments is $14 million]
Premiums collected − (Losses + Adjustment Expense) + Investment income − Dividends paid to policyholders > 0 to generate a profit Premiums collected − (Losses + Adjustment Expense) > −(Investment income − Dividends paid) 31.0 - (28.0 + 5.0) = -2
A. insurance coverage related to the loss of real and personal property. B. insurance protection against legal liability exposure. **C. Answers A and B only**
Property-casualty insurance involves
Expected Return on Loan
Recall, the promised return on a loan is (1 + k). The expected return on a loan [E(r)] is a function of the probability of complete repayment (p) the the promised return on the loan (1 + k). E(r) = p(1 + k) + (1 - p)0 - 1 , which reduces to E(r) = p(1 + k) - 1
The only selection that represents a net short position exposed to refinancing risk is: "An FI issues $10 million of liabilities of one-year maturity to finance the purchase of $10 million of assets with a two-year maturity."
Refinancing risk occurs when maturing liabilities may have to be replaced at higher rates than those of the maturing liability. Refinancing risk is present when the FI is "net short".
Credit risk
Regulation limits FI investment in non-investment grade bonds (rated below Baa or non-rated). What kind of risk is this designed to limit?
a fund established separately from the other funds of the insurance company and invested without regard to the usual diversification restrictions.
Separate accounts business of a life insurance company represents
TRUE
Since liabilities are of shorter term (maturity) than the assets, this bank is exposed to both refinancing risk (the ability to replace the same amount of funds) and interest rate risk (the risk that they may have to pay higher rates on liabilities in order to replace them at maturity).
1.915
Suppose that the financial ratios of a potential borrowing firm take the following values: Working capital/total assets ratio (X1) = 0.75 Retained earnings/total assets ratio (X2) = 0.10 Earnings before interest and taxes/total assets ratio (X3) = 0.05 Market value of equity/book value of long-term debt ratio (X4) = 0.10 Sales/total assets ratio (X5) = 0.65 Calculate the Altman's Z-score for the borrower in question.
Operational risk and technology risk
The BIS definition: "the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events," encompasses which of the following risks?
10.03%
The current 1-year and 2-year spot rates are 5.0% and 7.5% respectively. What is the 1-year forward rate?
corporate bonds
The largest asset category on the balance sheet of U.S. life insurance companies as of 2012 was
bonds
The largest asset on property-casualty insurers' balance sheet as of 2012 was
net policy reserves
The largest liability category on the balance sheet of U.S. life insurance companies as of 2012 was
loss reserve and loss adjustment expenses.
The largest liability on property-casualty insurers' balance sheet as of 2012 was
ordinary life
The largest line of life insurance in terms of total contract value in the U.S. is
Longer
The lower the level of interest rates (i.e. market rates), the _ the duration of a fixed income instrument?
market value of assets and the market value of liabilities.
The net worth of a bank is the difference between the
combined ratio after dividends minus the investment yield.
The operating ratio for a PC insurer equals
protect policyholders from adverse events.
The primary function of insurance companies is to
causes insurance underwriters to alter the health statistics of the general population when determining appropriate premiums.
The problem of adverse selection
market risk
The risk that a debt security's price will fall, subjecting the investor to a potential capital loss is
foreign exchange risk
The risk that a foreign government may devalue the currency relates to
insolvency risk
The risk that an FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities is referred to as
reinvestment risk
The risk that an investor will be forced to place earnings from a loan or security into a lower yielding investment is known as
credit risk
The risk that borrowers are unable to repay their loans on time is
interest rate risk
The risk that interest income will increase at a slower rate than interest expense is
liquidity risk
The risk that many depositors withdraw their funds from an FI at once is
the cash value paid to the policyholder if the policy is terminated before it matures.
The surrender value of an insurance policy is
Systematic credit risk
This risk of default is associated with general economy-wide or macro conditions affecting all borrowers.
technology risk.
Unanticipated diseconomies of scale or scope are a result of
increases in loss rates
Underwriting risk faced by property-casualty insurance companies may result from unexpected
allow both the premium and benefit payout to vary with investment returns.
Variable universal life insurance policies
Operational Risk
Wells Fargo recent business problems are Primarily a result of
Convexity
What causes pricing errors using duration
Payouts on policies to premiums earned.
What does the loss ratio measure in any particular year?
Marginal Default Probabilities
What is meant by the phrase marginal default probability? How does this term differ from cumulative default probability? How are the two terms related? Marginal default probability is the probability of default in a given year, whereas cumulative default probability is the probability of default across several years. For example, the cumulative default probability across two years is given below, where (p) is the probability of nondefault in a given year. Cp = 1 - (p1) (p2)
0.08
What is the expected return on a loan that has a probability of default of 10% (1 - p), and a promised return of 120%? E(r) = p(1+k) - 1
Off-balance sheet risk.
What type of risk focuses upon future contingencies?
Interest rate risk.
What type of risk focuses upon mismatched asset and liability maturities and durations?
Foreign exchange rate risk.
What type of risk focuses upon mismatched currency positions?
-$150,000
What will be the change in Net Interest Income for buckets of 12 months or less if interest rates increase by 1%? Recall, Delta NII = (CGAP) Delta R
not exactly matching the maturities of assets and liabilities
When the assets and liabilities of an FI are not equal in size, efficient hedging of interest rate risk can be achieved by
Unearned premiums.
Which account refers to the reserve set-aside that contains the portion of a premium that has been paid before insurance coverage has been provided.
Asset transformation
Which function of an FI involves buying primary securities and issuing secondary securities?
A The Coupon B The level of interest rates C The maturity of the bond **D All of these**
Which of the following affect price sensitivity of a bond with respect to interest rates?
Credit Life
Which of the following insurance products protects a lender against a borrower's death prior to repayment of the debt?
Variable Life
Which of the following involves fixed premium payments and a benefit payout at the time of death that will depend on investment returns over the life of the policy?
Publicly held companies have access to equity markets for additional capital for future business expansion.
Which of the following is an advantage of converting from a mutual insurance company to a stockholder-controlled company?
endowment life.
Which of the following is pure life insurance with a savings element built in
Existing policies.
Which of the following is used as collateral when an insurance company issues policy loans?
Economies of scope
Which of the following refers to an FI's ability to generate cost synergies by producing more than one output with the same inputs?
An FI issues $10 million of liabilities of one-year maturity to finance the purchase of $10 million of assets with a two-year maturity.
Which of the following situations pose a refinancing risk for an FI?
Endowment Life
Which of the following types of life insurance should you purchase if you want to be insured for 10 years?
Bonds, equities, and derivatives
Which of the following would one typically find in the trading portfolio of an FI?
Refinancing risk
Which term refers to the risk that the cost of rolling over or re-borrowing funds will rise above the returns being earned on asset investments?
Property & Casualty Insurance
Which type of insurance would you purchase if your wanted to transfer the risk of losing the total value of your automobile in the event of an accident?
PMT= $119,277.03. because PV=1,000,000 FV=0 I=6 N=12 Ordinary Annuity cash flow
You start an annuity with $1million and expect to receive 12 equal payments beginning at the end of the first year. The guaranteed annual interest rate is 6 percent. The annual payments that you expect to collect are
Altman's Z Score
Z < 1.81 considered a high default risk firm Z > 2.99 Low default risk firm 2.99 ≥ Z ≥ 1.81 Indeterminant risk firm Default risk indicator, NOT direct probability of default measure
