ERM Chapter 7

Question 1

What is the main shortcoming of credit ratings?

Answer 1

While viewed as a valuable source of information on creditworthiness by third parties, it is important to realise that rating agencies are paid by the debt issuer.
As a better credit rating will lead to cheaper borrowing, rating agencies are often pressured to assign good rating by the entities that pay their bills.
This conflict of interest is offset by the need for credit rating agencies to maintain a good reputation.

Question 2

What are the three risk elements of S&P’s rating framework?

Answer 2

1. Sovereign risk analysis e.g. taxation, currency control
2. Business risk analysis e.g. industry prospects, lack of diversification, diseconomies of scale, competitor strength, operational risks, management quality and structure
3. Financial risk analysis e.g. profit level, cashflow, capital structure and flexibility

Question 3

What two features of an insurers business determine the significance of the categorisation of ERM capability within its overall credit rating?

Answer 3

1. How complex the risks that the insurer accepts are

2. The amount of available capital and the ease of access to it i.e. capability to absorb risk

Question 4

What are the five main areas that S&P assess to determine ERM capability, and
how are these areas assessed?

Answer 4

1. Risk management culture: positive indicators of risk management culture include:
   - communication of risks through all levels of the company
   - documentation and analysis of past errors
   - consistency of RM across all parts of the business
   - incentivising good RM practices across the firm
   - governance structure, risk tolerance statement and capabilities of individual risk managers
2. Risk control: control mechanisms for key risks will be assessed, including:
   - how well the company’s risk identification procedures are carried out
   - how well risks are monitored on an ongoing basis
   - the limits set for retained risks, how well these limits will be adhered to, and the consequences or actions taken when they are not met
   - the execution of the RM processes
3. Extreme event management: these events are low frequency and high impact, and can seriously affect a company’s financial health. Companies must prove they consider various possible events such as terrorism, natural disaster, reputational damage etc. and adopt an appropriate course of action to measure the potential impact and prepare for such an event. Stress tests and scenario analysis may be used, and early warning indicator reporting and catastrophe insurance are potential risk mitigators.
4. Risk models and capital models: used to determine how much capital a company should have to withstand a shock. If without a model, companies can use certain published, standardised formulae to perform calculations. S&P assess risk and capital models by:
   - reviewing the model, inputs, assumptions and modelling formulae
   - regarding a good model as one that is consistent across all business areas and all business regions
   - look at modifications of any standardised formula used for appropriateness to the particular business lines in which the company operates
5. Strategic risk management: S&P will assess the focus that the organisation puts on the risks to its corporate goals. Namely looking for the following six positive features:
   - clear decision-making with regards to the retained risks, and whether the company’s business should be refocused to avoid or diversify these risks
   - a clear strategy for investing assets owned by the company, with particular focus on the allocation across broad categories and across countries
   - pricing of products reflect the risk/return payoff, and clear standards are set for the risk/reward profiles that are acceptable to the company
   - appropriate allocation of capital across business units based on the capital model
   - an appropriate dividend policy, which is influenced by the level of risk-adjusted return on retained capital - a strong company will be able to discuss how the dividend decision was made
   - good risk-adjusted returns should be rewarded within the company

Question 5

What are the strengths of the S&P approach?

Answer 5

• overall emphasis on ERM e.g. managing all important risks together rather than a silo approach
• focus on the use of economic capital aka risk capital measures
• consideration of operational performance in light of the risk choices and tolerances
• useful breakdown into components of ERM analysis, which can be helpful to organisations when implementing their own ERM processes
• encouragement of greater transparency of ERM practices
• introduction of a classification system that should make outcomes of rating agencies easier to communicate
• same criteria is applied to all insurance companies, but also tailored to each one
• a high rating may help companies attract and retain increasingly sophisticated customers

Question 6

What are the weaknesses of the S&P approach?

Answer 6

• it is limited to insurance and reinsurance companies only
• limited description is given on the actual procedures, details of how investigations will be carried out, and how certain aspects will be measured
• no explicit mention of agency risk
• reference to complicated and powerful simulation models, which may be highly subjective and problematic
• RM was already considered when eating companies, so it is unsure whether this additional formalised approach has a significant impact on the views of insurance and reinsurance companies
• reliance should not be placed solely on the opinion of ratings agencies, and risks may be missed that a company takes, and the company itself may have missed. It may also be the case that the company has a better understanding of its risks than the rating agency

Question 7

What are examples of extreme events?

Answer 7

• terrorism
• natural disaster
• IT system failures
• power failures
• stock market crashes
• severe interest rate changes