Brehm #4

Question 1

Operational risk

Answer 1

risk of loss from failed internal processes, people, and systems or from external events

> > includes legal risk, but excludes strategic and reputational risk

Question 2

Categories of operational risk (7)

Answer 2

1. internal fraud
2. external fraud
3. employment practices and workplace safety
4. clients, products, and business practices
5. damage to physical assets
6. business disruption and system failures
7. execution, delivery, and process management

Question 3

Explanation of internal fraud and examples (3)

Answer 3

attempts to defraud, misappropriate property, or circumvent rules/regulations from an inside source

ex:
1. intentional misreporting
2. employee theft
3. insider trading

Question 4

Explanation of external fraud and examples (3)

Answer 4

attempts to defraud, misappropriate property, or circumvent rules/regulations from an outside source

ex:
1. robbery
2. forgery
3. damage from computer hacking

Question 5

Explanation of employment practices and workplace safety operational risk and examples (3)

Answer 5

acts inconsistent w/ health and safety laws/standards, result in personal injury, or diversity and discrimination issues

ex:
1. WC claims violation of health and safety rules
2. discrimination claims
3. GL claims

Question 6

Explanation of clients, products, and business practices operational risk and examples (3)

Answer 6

unintentional or negligent failure to meet a professional obligation

ex:
1. misuse of confidential customer info
2. improper trading activities
3. money laundering

Question 7

Explanation of damage to physical assets operational risk and examples (5)

Answer 7

physical damage from natural disaster or other events

ex:
1. terrorism
2. vandalism
3. EQ
4. fire
5. flood

Question 8

Examples of business disruption and system failure operational risk (3)

Answer 8

1. hardware/software failures
2. telecommunications problems
3. utility outages

Question 9

Explanation of execution, delivery, and process management operational risk and examples (3)

Answer 9

failed transaction processing or process management and relationships w/ partners or vendors

ex:
1. data entry errors
2. incomplete legal documentation
3. vendor disputes

Question 10

Primary cause of insurer failures

Answer 10

operational risks

Question 11

Explanation of bridging process for plan LR determination

Answer 11

mature prior year ultimate LRs are bridged forward based on estimates of yr-over-yr LC and price level changes

ultimates for immature prior years are set using the BF method w/ELR = initial plan LR

Question 12

Operational risk problem with the bridging process for plan LR determination

Answer 12

high degree of interdependence b/w prior yr ultimate LRs

optimistic prior year LRs roll forward and lead to optimistic plan LRs, producing a string of optimistic forecasts

as older years deteriorate, BF ELRs increase, producing reserve conflagration

Question 13

Management options when facing reserve conflagration as a consequence of optimistic planning process (2)

Answer 13

1. book reserve deficiency and suffer rating downgrade

2. change reserving process

Question 14

Possible explanations for failed LR planning bridging process (3)

Answer 14

1. inherent uncertainty - plan LR / reserve review model could not accurately forecast the LR / reserves
2. people failure - plan LR / reserve review model could accurately forecast the LR / reserves, but was improperly used
3. process and governance failure - plan LR / reserve review model did accurately forecast LR / reserves, but indications were ignored

Question 15

UW cycle management

Answer 15

management of UW capacity as market pricing changes w/ the UW cycle

Question 16

Types of problems resulting from inefficient UW cycle management (2)

Answer 16

1. stability and availability problem - increases losses from increased exposures increases risk of ratings downgrades which could drive customers away
2. reliability and affordability problem - risk of insolvency from recognition of mounting exposures and potential partial claim payments to policyholders

Question 17

Key components of effective UW cycle management (4)

Answer 17

1. intellectual property (aka intangible assets) - focus on retaining and developing top talent and investment in systems, models, and databases while maintaining presence in core market channels
2. adaptable UW incentives - should be tied to supporting portfolio goals and adapt to changing market conditions
3. preparation for market overreaction - firms with most available capital during price improvements will see profits that can offset years of UW losses
4. owner education - owners must understand how to interpret results and what to do with that information

Question 18

Examples of KPIs that may seem out of line under effective UW cycle management (2)

Answer 18

1. drop in premium volume - understand that premium is result of amount of exposures and price per exposures - management should not make calls to increase market share at worst possible point in UW cycle
2. overhead expense ratio - high expense ratio could indicate capital investments in intellectual property vs. operational inefficiency

Question 19

Key concept of agency theory

Answer 19

considers management agents of a firm’s owners, whose interests are not always aligned (which creates operational risk)

Question 20

Goals of agency theory (2)

Answer 20

1. align management and owner interests (reduce operational risk)
2. understand impacts of potential divergence

Question 21

Potential issues with management incentives under agency theory (2)

Answer 21

1. if management incentives are tied to company performance, managers may be more willing to take on risk than owners b/c they are allowed to “gamble with the owner’s money”
2. if management incentives are firm stock options, managers may be less diversified (and more risk averse) than owners

Question 22

Additional operational risks in banking and manufacturing (5)

Answer 22

1. pension funding - financial and HR component
2. IT failure
3. other HR risks incl. loss of important staff, fraud, inadequate training, rule-breaking, or incompetence
4. reputational risk
5. lawsuits

monitoring and control more important than quantifying and funding

Question 23

Examples of reputational risk (3)

Answer 23

1. products tampering
2. bad press coverage
3. off-hours employee behavior

Question 24

Primary objectives (5) of control self-assessments (CSA)

Answer 24

1. reliability and integrity of info
2. compliance w/ policies, laws, and regulation
3. safeguarding assets
4. economical and efficient use of resources
5. accomplishment of established objectives/goals for operations

Question 25

Critical component of key risk indicators (KRIs)

Answer 25

must have trigger levels that require management action

Question 26

Main categories of KRIs (4)

Answer 26

1. production 2. internal controls 3. staffing 4. claims

Question 27

Examples of production KRIs (4)

Answer 27

1. hit ratio 2. retention ratio 3. pricing level 4. rate per unit of exposure

Question 28

Examples of internal control KRIs (2)

Answer 28

1. audit results | 2. audit frequency

Question 29

Examples of staffing KRIs (4)

Answer 29

1. employee turnover 2. training budget 3. premium per employee 4. policies per employee

Question 30

Insurer processes that could benefit from six sigma management framework process improvements (3)

Answer 30

1. UW 2. claims 3. reinsurance

Question 31

Steps for operational risk modeling (5)

Answer 31

1. identify exposure base for each operational risk source (ex: payroll, policy count, CC, premium volume) 2. measure exposure level for each business unit 3. estimate loss potential (frequency and severity) for each unit reflecting internal controls and process effectiveness 4. produce modeled frequency and severity distributions by business unit 5. estimate impact of mitigation, process improvement, or risk transfer

Question 32

Strategy and two things strategy is NOT

Answer 32

long term series of actions designed to take a company from its current state to its desired future state and aims to provide a sustainable competitive advantage over other companies in the same market NOT: 1. pure business planning - goes beyond understanding market position and how to outperform 2. tactics = short term and detailed vs. strategy = long term and broad ** often overlaps w/operational risk definitions

Question 33

Strategic risk vs. strategic risk taking

Answer 33

strategic risk = unintentional risks that occur as a result of strategic planning/execution strategic risk-taking = intentional risk-taking as part of strategic execution

Question 34

Strategic risk categories for insurers (7)

Answer 34

1. industry 2. technology 3. brand 4. competitor 5. customer 6. project 7. stagnation

Question 35

Highest (3) and lowest (1) strategic risk categories for insurers

Answer 35

highest: industry, project, and stagnation lowest: technology

Question 36

Examples of industry strategic risk (5)

Answer 36

1. capital intensiveness 2. overcapacity 3. commoditization 4. de-regulation 5. cycle volatility

Question 37

Examples of technology strategic risk (2)

Answer 37

1. technological advancement in internet distribution | 2. data management

Question 38

Example of customer strategic risk

Answer 38

concentration risk for large commercial insurers

Question 39

Examples of project strategic risk (3)

Answer 39

1. failure of mergers and acquisitions 2. underinvestment in research and development 3. underinvestment in IT

Question 40

Examples of stagnation strategic risk (4)

Answer 40

1. redeployment of intellectual assets (highly task-specific) 2. extensive reporting lags 3. mismatch in timing of revenue and expenses 4. poor insurer response to market price cycles

Question 41

Key distinction b/w scenario planning (in strategic risk management) and simulation

Answer 41

scenario planning involves subjective interpretations of factors that cannot be modeled

Question 42

Plan or actual LR calculation using traditional planning forecast methods

Answer 42

LR = [ base LR * ( 1 + cost trend ) ] / ( 1 + price change )

Question 43

Potential problems stemming from management reluctance to deviate from plan results (2)

Answer 43

1. unforeseen reserve deficit | 2. overall portfolio mix may not be what was intended

Question 44

Components of scenario planning for strategic risk management (3)

Answer 44

1. scenarios (price changes) 2. likelihoods 3. response plans

Question 45

Advantages of scenario planning (2)

Answer 45

1. company considers scenarios and responses ahead of time, getting consensus on best response and saving time during crisis 2. reduced organizational inertia (= more flexible plan)

Question 46

Considerations when combining scenario planning for multiple LOB (3)

Answer 46

1. consistency 2. correlations 3. UW capacity/allocation across LOB

Question 47

Advanced scenario planning

Answer 47

simulates large sets of scenarios and allows for re-balancing of the portfolio to find the best strategy best strategy maximizes a performance metric (ex: net income or economic value) and reduces downside risk (ex: TVaR)

Question 48

Example of portfolio re-balancing actions in advanced scenario planning (2)

Answer 48

1. sell bonds | 2. change investment allocations

Question 49

Agent-based modeling

Answer 49

considers impact of strategic interactions b/w companies ("agents")

Question 50

Control self assessment (CSA)

Answer 50

A process for examining and assessing internal control effectiveness

Question 51

Examples of brand strategic risk (2)

Answer 51

Erosion or collapse from 1. Bad press 2. Class action suits

Question 52

Example of competitor strategic risk (3)

Answer 52

1. Predatory pricing 2. Entrance into new lines/territories with inadequate expertise, systems, or capabilities 3. Multiple competitors simultaneously targeting the same market segment