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IAI Actuarial Core Principles · Business Management · Issues and challenges in each main practice area

Kaveri Assurance writes long-term savings products and holds capital against several risks. When the Appointed Actuary aggregates capital requirements for market risk, insurance risk and operational risk, she uses a correlation matrix so that the total is lower than the simple sum. Which statement best describes the main challenge in this approach?

The main challenge is that correlation assumptions are hard to estimate from limited data and tend to move towards one in extreme stress, so the diversification credit may disappear exactly when capital is most needed. Aggregation is a judgement, not a legal fixed rule.

  1. ADiversification credit is unreliable because correlations are hard to estimate and may rise towards one in extreme stress conditionsCorrect
  2. BAggregation always gives a total equal to the simple sum, so the matrix has no effect
  3. CCorrelation matrices can only be used for operational risk, not for market or insurance risk
  4. DDiversification benefits are prohibited under every regulatory framework
  5. Correlations between risks are fixed by law and need no judgement

Explanation

Diversification credit depends on correlation assumptions that are difficult to calibrate from limited data and tend to rise in tail events, so the benefit may vanish when most needed. The other statements are factually wrong.

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