7. Proprietary risk frameworks

Question 1

What is a credit rating?

Answer 1

• Rating issued by credit rating agency as indication of creditworthiness or lack thereof
• Assigned for issuers and the issue

Question 2

What is a drawback of credit ratings?

Answer 2

Paid for by companies the credit agency is assessing so under pressure to give good ratings to companies.

Question 3

Whar are factors thart affect the assessment of ERM capability?

Answer 3

• Complexity of insurer’s risks
• Available capital and ease of access

Question 4

How does the S&P work?

Answer 4

• Assign one person to each firm that it assigns ratings for
• Subjective combination of factors arising from the rating framework

Question 5

Which 3 risk elements are in the S&P framework?

Answer 5

• Sovereign risk analysis
• Business risk analysis
• Financial risk analysis

Question 6

What are the elements of soverign risk analysis?

Answer 6

• Tax
• Currency controls

Question 7

What are the elements of business risk analysis?

Answer 7

• Industry prospects
• Lack of diversification
• Diseconomies of scale
• Operational risks
• Management quality and structure

Question 8

What are the elements of financial risk analysis?

Answer 8

• Profit level
• Cashflow
• Capital structure and flexibility

Question 9

What are the 5 areas the S&P considers when measuring ERM capability

Answer 9

• Risk management culture
• Risk control
• Extreme event management
• Risk and capital models
• Strategic risk management

Question 10

Define risk management culture

Answer 10

Degree to which risk and risk management are NB considerations across all business decision-making

Question 11

What are the dimensions of risk management culture

Answer 11

o Risk and risk appetite philosophy
o Governance and organisational structure of RMF
o External and Internal risk and risk management disclosures + communication
o Degree to which there is understanding and participation in RM across company

Question 12

How does S&P assess risk management culture?

Answer 12

• Has developed suite of favourable and non-favourable indicators
• Only assess as effective if they judge every manager to contribute to RM culture without direction from RM staff

Question 13

How does S&P assess risk control?

Answer 13

• Assess by considering:
  o How well risk identification procedures are carried
  o How well risks are managed on an ongoing basis
  o Limits set for retained risks, how limits are adhered to and consequences or actions taken when limits not met
  o Execution of RM process

Question 14

What are extreme events?

Answer 14

Low frequency, high impact events that can seriously affect org’s financial health

Question 15

How does S&P assess extreme event management

Answer 15

• S&P looks for evidence of:
  o Org considers different events e.g., terrorism, natural disasters …
   And adopts appropriate way to measure impact (reputation, liquidity, financial strength)
  o May look at stress testing and scenario analysis
  o Early warning-indicators and cat insurance can be risk mitigators
  o “Post-mortem” analyses of problems and risk mitigators that feeds into contingency plans

Question 16

How would S&P assess risk capital models

Answer 16

• S&P might assess:
  o Range, quality and use of indicative, predictive and sensitivity risk measures
  o Degree to which chosen risk measure is consistent with complexity of risk and intended usage
   Indicative may be suited for simple risks and/or low cost and time constraints
   More complex risks/usage»_space; more sophisticated techniques to produce range of risk measures
  o Appropriateness of choice of projection approach. Single scenario vs stochastic simulation
  o Degree to which models reflect all of org’s NB risks
  o Associated operational issues:
   Assumptions used
   Treatment of risk mitigation activities in models
   Infrastructure to feed data to models
   Procedures followed to run models
   Validation of models
  o If models assess risk and capital consistently throughout org»_space; enables aggregate capital requirements to be determined
  o If single or separate models are used and how they’re co-ordinated
  o Modification of any standard formulae used for appropriateness to particular business lines in which org operates
  o Degree to which economic capital is used in day-to-day management, business planning and strategic decision making
  o Amount and quality of available capital held against economic capital requirement

Question 17

What are the 6 positive features of strategic risk management?

Answer 17

o Clear decision-making wrt org’s retained risks and if company’s business must refocused to avoid or diversify risks
o Clear investment strategy for company’s assets, focusses on broad categories (equity/bonds) and across countries
o Risk/return payoff is reflected in product pricing and clear standards set risk/reward payoffs acceptable to company
o Appropriate capital allocation between diff business units based on capital model
o Appropriate dividend policy, which is influenced by risk-adjusted return on retained capital- a strong company will be able to discuss how dividend decision was made
o Good risk-adjusted returns must be rewarded within company

Question 18

What are the strengths of S&P

Answer 18

• Overall emphasis on ERM, ie managing all NB risks together instead of having separate silo for each risk
• Focus on use of economic capital or “risk” capital measures
• Consideration of operational performance in light of risk choices and tolerances
• Useful breakdown into components of ERM analysis, which can be helpful to organisations when implementing their own ERM processes
• Encourages greater transparency of ERM processes
• Introduction of a classification system that should make outsomes of rating agency analysis easier to communicate
• Same criteria applied to all insurance companies, but also tailored ‘The paper argues that a high rating may help orgs attract and retaining increasingly sophisticated customers

Question 19

What are the weaknesses of S&P?

Answer 19

• Paper relates only to view of Standard & Poor’s – not credit ratings in general
• Limited to insurance and reinsurance companies
• Document is part of company’s marketing literature, and yone could be argued to be overly optimistic
• Limited description is given on actual procedures, or details of how investigations will be carried out and how certain aspects will be measured
• No explicit mention of agency risk
• There is reference to “complicated and powerful simulation models”; this is highly subjective and may be problematic
• Risk management was already considered in S&Ps when rating companies. Unclear if additional formalised approach had significant impact on their views of insurance and reinsurance models
• Reliance should not be placed solely on opinion of rating agencies; may have missed risks that a company takes and that co may have also missed. Company may have better understanding of risks than rating agency