Question

1. As you know, one of the regulations on banks relates to Capital Adequacy. Compare and contrast the Capital-to-Assets Ratio requirement with Risk-based Capital Ratios. In this connection, also discuss some of the key enhancements prescribed as part of Basle III.

2. a) In the context of Property and Liability insurance, explain the differences between low-severity, high-frequency lines and high-severity, low-frequency lines. For which of these lines will insurance companies charge a higher premium and why?

b) In the context of Property and Liability insurance, explain the differences between long tail and short tail lines. For which of these lines will insurance companies charge a higher premium and why?

3. a) With respect to life insurance, what additional flexibilities are provided by variable and universal life policies as compared to a standard whole life policy?

b) Two of the main types of mutual fund trading abuses mentioned in the text are market timing and late trading. Explain in your own words how each of these practicesmay have adversely impacted other investors.

4. What is insolvency risk? How can liquidity risk and credit risk cause insolvency? What actions can a financial institution take to best protect itself against insolvency?

Answer 1

A1. One of the central concepts in banking regulation is capital adequacy. It refers to the extent to which the assets of the bank exceeds its liabilities and is thus a measure of the ability of the bank to withstand a financial loss. Bank regulators care about capital adequacy because their mandate is to prevent bank panics and contagions. A bank with high ratio of capital to assets will, all else equal, be better able to withstand a sudden loss than a bank with a low capital asset ratio.

Capital assets ratio is also known as capital to risk weighted assets ratio, it is used to protect depositors and promote the stability and efficiency of financial systems around the world.

Tier 1 risk based capital is the rqtio of a bank's core capital to its risk weighted assets. It measures how much buffer a bank has a percentage of its riskiness. It excludes more exotic elements from the calculation of capital and so serves as a better approximation of an adequate capital ratio.

Key enhancements under basel 3: Under Basel 3, the minimum capital adequacy ratio that banks maintain is 8%. The basel III regulations based on three mutually pillars I.e minimum capital requirements, supervisory review of capital adequacy and market discipline of basel II capital adequacy framework.

Scope of application of capital adequacy framework- a bank shall comply with the capital adequacy ratio requirements at two levels.

A. The consolidated (group) level capital adequacy ratio requirements, which measure the capital adequacy of a bank based on its capital strength and risk profile after consolidating the assetsand liabilities of its subsidiaries.

B. The standalone level capital adequacy ratio requirements, which measure the capital adequacy of a bank based on its standalone capital strength and risk profile.

The reserve bank will take into account the relevant risk factors and the internal capital adequacy assesments of each bank to ensure that the capital held by the bank is commensurate with the bank's overall risk profile. This include effectiveness of the bank risk management system in identifying, assesing, measuring, monitoring, and managing various risks including intrest rate risk in banking book, liquidity risk, concentration risk and residual risk.

A2.

A. The most commonly purchased form of property and liability insurance are insurance for your home and its contents and insurance for your use and ownership of vehicles.

Estimation of risk and losses- Frequecy of loss is the likely number of times that a loss might occur over a period of time. Severity of loss describes the potential magnitude of a loss.

Many people wonder whether they should buy insurance when loss frequency is low, for example, if they are young and healthy or they live in a safe neighbourhood. This is not a good way to think about potential losses, because they still could occur and if the loss frequency is low, the cost of insurance would be small.

Insurance companies charge a higher premium for low frequency and high severity lines.

The bottom line is that high severity and low frequency losses should be insured against and low severity and high frequency losses should be prepared for in your budget and savings plannings.

B. Grouping lines into long and short tail categories is a standard procedure in the insurance economics literature because long and short tail losses and profits often behave differently whereas intra category differences are much less pronounced.

Lines of business that generally pay 90% of claims within 3 years were considered short tail lines,

While lines that take longer to close are considered long tailed lines.

Insurance companies charged higher premium for long tailed lines.

Short tail business describes product lines for which losses are usually known and paid shortly after the loss actually occurs.

Long tail business describes lines of business for which specific losses may not be known for some period and claims can take significant time to report and settle.

A3.

a. A universal life insurance policy might be a good choice if we want:

1. The flexibility to adjust the premiums and coverage amounts.

2. Cash value that you may be able to borrow from while you are still alive

3. Parmanent life insurance protection and access to cash values.

4. Since there is a cash value component, it may able to skip premium payments as long as the cash value is enough the required expenses for that month.

5. Some policies may allow to increase or decrease the death benefits to match your particular circumstances

6. The intrest that may have earned overtime accumulates tax deferred.

The flexibilty that a universal life policy provides is a key differentiator over whole life. As a result, universal life insurance premiums are typically lower during periods of high intrest rates than whole life.

The intrest paid on universal life insurance is often adjusted monthly, intresr on a whole life insurance policy is normally adjusted annually.

B. Late trading is an illegal activity. Trades are placed after the market close yet the trader gets to buy in at the days net asset value per share.

Although market timing is not fradulent or illegsl, many fund companies discourage the practice because it can disrupt portfolio investment strategies and harm fund performance through increased potfolio turnover, trading and transaction costs.

A4. Insolvency risk is the risk that a firm will be unable to satisfy its debts. Also known as bankruptcy risk.

Steps to protect itself against insolvency.

1. Reducing the risks

2. Take early action

3. Aiming for a rescue

4. Bankruptcy

5. Alternatives to bankruptcy.