Section C: ERM Flashcards

Question

Brehm Chapter 2: Corporate Decision Making using ER Model **Internal** **Risk Model (IRM): Corporate Risk Tolerance**

Answer 1

**_Corporate Risk Tolerance_** * Corporate Risk Tolerance is needed to **quantify** the impact of possible aggregate loss outcomes and **assign** a cost to each amount (impact) * Combination of the following factors is Corporate Risk Tolerance: * organization size * financial resources * ability and willingness to tolerate volatility

Answer 2

**_Cost of Capital Allocated_** * Cost of risk capital is allocated to the individual risk sources (e.g. line of business) * RAROC = Risk-Adjusted Captial • Hurdle Rate*

Answer 3

**_Cost Benefit Analysis for Risk Mitigation_** * Any risk mitigation effort with a positive EVA is worth doing. This means the reduction of capital cost is greater than the cost of risk-mitigation. * EVA = NPV Return - Cost of Capital* * Cost of Capital = Risk Capital • Hurdle Rate * Using the EVA approach determines the cost of capital directly * If we use the capital allocation approach (where we have allocated capital) we would pursue activities where the decrease in capital required exceeds the cost of implementation.

Answer 4

**_Advantages of Economic Capital_** 1. Provides **unifying** measure for all risks across an organization 2. More **meaningful** to management than risk-based capital or capital adequacy ratios 3. Forces the firm to **quantify** the risks it faces and combine them into a probability distribution 4. Provides a **framework** for setting acceptable risk levels for an organization as a whole AND for individual business units

Answer 5

Moment-Based Measures - use the moment of a random variable * random variable could be change in capital over an accounting period * measured by variance, standard deviation, skewness, etc. **_Advantages_** * Reflects all losses in the distribution **_Disadvantages_** * Standard Deviation treats favourable deviations the same as unfavourable ones * Exponential Moment - responds better to large losses* * Semi-Standard Deviation - only uses unfavourable deviations* * Skewness or higher moments may reflect market attitude better*

Answer 6

VaR - percentile of the probability distribution **_Advantages_** * Emphasizes large losses **_Disadvantages_** * Only looks at one point in the distribution

Answer 7

TVaR - expected loss given a loss above a selected percentile of the probability distribution * VaR uses one point as the expected loss (e.g. 99th percentile) while TVaR uses the average of all the losses above the 99th percentile) **_Advantages_** * Reflects losses that exceed VaR **_Disadvantages_** * Losses are reflected linearly in the tail

Answer 8

XTVaR_p% = TVaR_p% - Mean * The mean loss might be funded by other means (other than capital such as premium) so capital is only needed for losses above the mean.

Answer 9

**EPD = (TVaR_p% - VaR_p%)• (1-p%)** * For EPD, the probability level is set so that the capital is VaR at that level. * The (TVaR_p% - VaR_p%) term is the expected value of default conditioned on that a default occurs. * The second term, (1-p%), makes the first term unconditional so it becomes the expected value of default.

Answer 10

**Value of Default Option** When capital and/or reinsurance is exhausted, the firm has the right to default on its obligations and put the claims to the policyholders. The market value of this risk is the value of the default put option which can be estimated based on option pricing.

Answer 11

* Probability transforms measure risk by **shifting** the probability towards the unfavourable outcomes and then computing a risk measure with transformed probabilities Examples: * Expected loss with transformed probabilities * Minimum martingale transform and minimum entropy martingale transform, Wang transform * Weighted risk measures: WVaR, WTVaR, WXTVaR * losses twice as large are twice as bad - for example, removes the linearity in the tail for TVaR which assumes that each loss above the tail gets the same weight (simple average in tail)

Answer 12

Generalized Moments - expectations of a random variable that are NOT simply powers of that variable. Example: * Blurred VaR, which adds weight to losses around the percentile so we are not just looking at the loss percentile

Answer 13

The amount of capital an insurance is required to hold is a function of several things: * **Customer Reaction** - some care about insurers ratings so if the rating drops there could be a decline in business (more likely to see greater impact when rating decline vs. improve) * **Capital Requirements of Rating Agencies** - different requirements differ by agency * **Comparative Profitability of New and Renewal Business** - renewal business tends to be more profitable due to more informed pricing and underwriting * e.g. if renewals comprise 80% of the book then the insurer should be able to maintain 80% of its capital (coming from renewal business which is more profitable). Therefore, in a bad year if the company wishes to maintain this, then they should hold enough capital so that 20% of its capital could cover the adverse event.

Answer 14

_Purpose of Capital Allocation_ * helps to show the **contribution** of each business unit to the overall risk * can be used for calculating the risk-adjusted **profitability** by line of business and also **setting capacity controls** for those lines

Answer 15

1. Allocate the overall risk to the individual business units 2. Estimate the contributions of the individual units to the overall risk

Answer 16

**Proportional** **Capital Allocation** * Allocates total risk down to business units _Steps:_ 1. Calculate overall risk measure 2. Calculate the risk measure for each individual business unit 3. Allocate the overall risk measure to the individual business units in proportion to their individual risk measures

Answer 17

**Risk Decomposition** * Decomposition uses co-measures to calculate the contribution of each business unit to the overall risk measure. * e.g. Co-TVaR

Answer 18

**Marginal Allocation** * Measures the change to the total risk measure for the company if there is a small change in a business unit's volume * The change to the total risk measure is assigned to the business unit. Marginal Impact of the j^th business component: r(X_j) = lim as ε→0 {[⍴(Y+εX_j) - ⍴(Y)] / ε}

Answer 19

**Advantages** * Marginal allocation also produces co-measures * Marginal attributions sum to the total risk measure * Leads to consistent strategic implications * e.g. growing a business with an above average profit-to-risk ratio increases the company's profit-to-risk ratio

Answer 20

If the risk measure is proportional to the market value of risk, then a higher risk-adjusted profitability ratio means a business unit is more profitable relative to its risk. ## Footnote *Risk-Adjusted Profitability Ratio = Profit / Risk Measure*

Answer 21

Allocating the cost of capital to business units sets a _minimum profit target_ to each unit. * If a business unit's profit exceeds the minimum profit target, this excess is added to the firm The cost of capital reflects the risk that a business unit has the right to access the insurer's entire capital.

Answer 22

**_Disadvantages of Allocating Capital_** * it's **arbitrary** because different risk measures allocate capital differently * it's **artificial** because each business unit has access to the entire company's capital

Answer 23

* Leverage ratios are generally a per dollar of surplus measure such as premium to surplus or reserve to surplus * Can be used to compare to a threshold for testing capital adequacy (12 IRIS ratios) **_Advantages_** * Easy to calculate and monitor **_Disadvantages_** * Doesn't distinguish between lines of business * Ignores risks other than underwriting risks

Answer 24

Risk-based capital models combine multiple aspects into a single number. _Included Risk Aspects:_ * Invested Asset Risk * Credit Risk * Premium Risk * Reserve Risk * Accumulation/CAT Risk (not in US or S&P models) * Covariance Adjustment (in some models US and AM Best)

Answer 25

**_Different Model Uses_** * Rating agency models (AM Best, Moody's, S&P) focus on long-term viability of the firm * Regulatory models (MCT, US RBC, etc.) focus on 1-year solvency so these models will have relatively lower factors **_Covariance Adjustment_** * Models with a covariance adjustment (like AM Best) will have relatively higher factors than models without it (like S&P) * the covariance adjustment will reflect that not all risks will occur at the same time: reflects the independence between risks so that that overall capital is less than the sum of the individual risks

Answer 26

An insurer may do its own risk assessment using scenario testing or stochastic modeling which would be reviewed by a regulator. _Requirements:_ 1. A one to five year financial projection model 2. Probability distributions for sources of uncertainty 3. Correlations between risks 4. Management responses to adverse financial results

Answer 27

**Asset Liability Management** - the analysis and management of the asset portfolio, reflecting current liabilities, future cash flows, future premium flows, and the existing asset and liability portfolios. The GOAL of ALM is to help the insurer make better risk-return decisions. \*more extensive than just asset-liability matching

Answer 28

**Asset-Liability Matching** - setting an investment portfolio to have the same duration as the duration of the liability portfolio to protect the firm from changing interest rates.

Answer 29

Beyond interest rate risk, ALM considers: * Inflation Risk * Credit Risk * Market Risk * Equities and Reinsurance as methods for hedging

Answer 30

Each item below adds complexity - we start off with just the asset portfolio then start adding the liabilities, timing and then UW cashflows. * Analysis of the asset portfolio in isolation (risk vs. return) * Adding fixed liabilities into the analysis * reinvestment risk if asset duration is shorter * risk of selling depressed assets if asset duration is longer (interest rates high) * Adding variability to the amount/timing of liability cash flows * Adding variable underwriting cash flows With the above real-world complexities, a true enterprise-risk model is needed.

Answer 31

**Statutory** **Accounting Metrics** Since bonds are amortized and liabilities are not discounted, this approach show little hedging from duration-matching. **GAAP Accounting Metrics** Bonds are valued at market value, but this also shows little hedging form duration-matching. **True Economic Metrics** Duration-matching lowers interest rate risk, but including cash flows complicates the analysis.

Answer 32

**Step 1:** Model assets, existing liabilities and current business operations **Step 2:** Define risk metrics, can be income based or balance sheet based **Step 3:** Define return metrics - income or balance sheet based (should be consistent with step 2) **Step 4:** Set the analysis time horizon - single year or multi-year **Step 5:** Include Model Constraints - regulatory restraints **Step 6:** Run the model - with different investment, underwriting and reinsurance strategies, calculating risk-return metrics **Step 7:** Plot an efficient frontier based on the different portfolios **Step 8:** Test the effects of different reinsurance structures **Step 9:** Review simulations where portfolios performed poorly * hedging strategies or new policies may help to reduce downside risk

Answer 33

Comparing ceded premium (cost of reinsurance) to reinsurance recoveries and ceding commissions (benefit) over many years typically shows a negative benefit. Reinsurance expect to make a profit, so simple cost-benefit analysis is a **poor** way to assess reinsurance value.

Answer 34

**_Reinsurance Provides Stability (Paradigm 1)_** * _Protects surplus_ from adverse results * _Improves predictability_ of earnings and growth * _Improves customer confidence_ that they'll recover insured losses * Ceded Premium - Recoveries* * is a better cost measure under this paradigm

Answer 35

**_Reinsurance is a Substitute for Risk Capital (Paradigm 2)_** * Increased stability lowers required risk capital * ROE Cost of Reinsurance = Reinsurance Cost / Capital Freed* If the ROE cost of reinsurance is less than the company's target return, getting reinsurance is a good deal (i.e. want a small ratio).

Answer 36

**_Reinsurance adds value (Paradigm 3)_** * Ideally, we could measure the value of reinsurance by the incremental increase in market value to the company.

Answer 37

**_Disadvantage_** Significant judgement is needed to evaluate the benefit of stability against the net cost of reinsurance for the different programs.

Answer 38

Look for: * Which option protects against the worst losses * Options that don't limit profitable scenarios too much * Compare which options produce better results in different areas of the probability distribution

Answer 39

* Shows the probability in different ranges Compare programs based on: * which program protects from the most unfavourable scenarios * which sacrifices profitable good years

Answer 40

**_X-axis_** Cost of reinsurance = ceded premium - expected recovery **_Y-axis_** Loss Amount = Net Premium - Net Loss * Plot multiple probability levels (e.g. 1-in-10, 1-in-100, 1-in-250) Look for: * which option(s) perform best at the different probability levels * if a program is more costly but has worse loss outcomes at each probability level, its inefficient and shouldn't be considered

Answer 41

**_Efficient Frontier_** Graphs the risk-return of different reinsurance programs at various probability levels. * Programs that are _below_ the efficient frontier _are inefficient_

Answer 42

**_Theoretical Models_** Required capital is calculated with risk measures using an enterprise risk model * *Advantage* - required capital is more consistent with management's view about risk **_Practical_** **_Models_** Required capital is calculated using rating agency or regulatory models or actual capital (e.g 200% of BCAR) * *Advantage* - easier to implement * *Disadvantage* - uses proxies for risk such as premium to measure capital instead of modeling risks directly

Answer 43

* The cost of buying more reinsurance is NPV of Ceded Premium less Ceded Loss compared to the current program which should be negative * This should release capital which also is negative **Marginal ROE (cost) = Δ(Ceded Premium - Ceded Losses) / ΔCapital** If the marginal ROE (cost) is _less_ than the cost of capital, then buying reinsurance is a good deal.

Answer 44

* The benefit of buying less reinsurance is NPV (Ceded Premium less Ceded Loss) compared to the current program which should be _positive_ * This should _consume_ capital which also is positive **Marginal ROE (benefit) = Δ(Ceded Premium - Ceded Losses) / ΔCapital** If the marginal ROE (benefit) is _more_ than the cost of capital, then buying less reinsurance is a good deal.

Answer 45

* Marginal ROEs for measuring reinsurance value are based on capital for a single year. * Long-tail lines have loss reserves and accumulated risk that must be supported by capital for multiple years. * Can use as-if loss reserves to account for multi-year

Answer 46

**_As-if Loss Reserves_** For an accident year of new business, the as-if loss reserves are the reserves that would exist at the beginning of the accident year if that business had been written in a steady state in all prior years. We can approximate the present value of required capital for an accident year over time by modelling the capital needed for both: * the current year for the current accident year * the as-if loss reserves (represents the accumulation of reserves from prior years)

Answer 47

**_Advantages_** 1. This approach can measure the impact that correlated risk factors have on the accumulated risk 2. It can fully measure the impact of reinsurance by applying reinsurance to the accident year and as-if reserves

Answer 48

**_Staffing & Scope_** * Organization Chart - modeling team reporting line, solid line vs. dotted line reporting * Functions Represented - reserving, pricing, finance, planning, UW * Resource Commitment - mix of skill set, full-time or part-time * Critical Roles & Responsibilities - control of input parameters, control of output data, analyses and uses of output * Purpose - is the goal of the model to quantify variation around the plan? * Scope - prospective UW year only, or including reserves, asset, operational risks?

Answer 49

**_Staffing & Scope Recommendations_** * Reporting Relationships - team leader should have reputation of fairness and balance * Resource Commitment - the team should have full-time commitment to the implementation * Inputs & Outputs - should be controlled similarly to the general ledger * Initial Scope - prospective underwriting period, variation around plan

Answer 50

**_IRM Parameter Development_** * _Modeling Software_ - what are the capabilities, scalability, learning curve, integration with current systems * _Developing Input Parameters_ - data driven, requires expert opinion, involve functional areas of the firm * _Correlations_ - line of business representatives cannot set cross-line parameters, need to have corporate-level ownership of these parameters * _Validation & Testing_ - as this is new, there is no existing IRM to compare

Answer 51

**_IRM Parameter Development Recommendations_** * _Modeling Software_ - compare existing vendor software with user-built options, ensure final software choice align with capabilities of the IRM team * _Developing Input Parameters_ - include product expertise from UW, claims, planning and actuarial; develop systematic way to capture expert opinion * _Correlations_ - modeling team recommends correlation assumptions which are ultimately owned at the corporate level (CRO/CEO/CUO) * _Validation & Testing_ - validate and test over extended period, provide basic education on probabilities and statistics

Answer 52

**_IRM Implementation_** The following details need to be addressed: * _Priority Setting_ - priority and timeline must be driven from the top executives * _Interest and Impact_ - implement communication and education plan across the enterprise * _Pilot Test_ * _Education Process_ - run parallel with pilot test to bring leadership to the same point of understanding regarding probability and statistics

Answer 53

**_IRM Implementation Recommendations_** * _Priority Setting_ - top management should set priority for implementation * _Interest and Impact_ - plan for regular communication to broad audiences * _Pilot Test_ - do pilot testing to prepare stakeholders for the magnitude of the change as a result of using the IRM * _Education Process_ - target training to bring leadership to similar BASE level of understanding

Answer 54

**_Integration and Maintenance_** * _Cycle_ - integrate model runs into corporate calendar and ensure that IRM output supports major company decisions * _Updating_ - determine frequency and magnitude of updates * _Controls_ - ensure there is centralized storage and control of inputs and outputs, control of analytical templates

Answer 55

**_Integration and Maintenance Recommendations_** * _Cycle_ - integrate into the corporate calendar at minimum * _Updating_ - major updates to inputs no more than semi-annually * _Controls_ - maintain centralized control of inputs, outputs and templates

Answer 56

**_Small Company_** A small insurer already has significant uncertainty so the added impact of parameter risk isn't too large. **_Large Company_** Without parameter risk, the loss ratio modeled for a large insurer is *unrealistically* stable. **Parameter risk isn't diversified away with more insureds,** so it significantly increases uncertainty for a large insurer.

Answer 57

The risk of assuming incorrect distributions or parameters for those distributions manifests itself in the following ways: 1. **Estimation Risk** - arises from using only a sample of the universe of possible claims to estimate the parameters * risk that parameter estimates used are not the "true" parameter estimates for the underlying process 2. **Projection Risk** - arises from projecting past trends into the future 3. **Model Risk** - arises from having the wrong models to begin with

Answer 58

A trend line is fit to historical loss costs to project future severities. **_Weaknesses_** * Loss cost data is based on historical claims that haven't settled which adds uncertainty * adds uncertainty to frequency and severity * Assumes a single constant trend for historical data that will continue into the future (same factor applied)

Answer 59

Models the trend as the sum of the general inflation and "superimposed inflation" (social inflation) **_Advantage_** * An ERM model can reflect the dependency between trend and inflation

Answer 60

This accounts for the trend changing over time and not being constant **_Advantage_** * Reflects **more uncertainty** than a simple trend model * Models trend as a time series as opposed to assuming a single, constant trend **_Disadvantage_** * A substantial number of data points is needed * If the data is limited then the model will **understate** the uncertainty

Answer 61

To assess estimation risk, we use the covariance matrix that results from the standard MLE procedure, but the parameters are assumed to follow a joint log-normal. * *_Process:_** 1. Parameter estimates are calculated using **MLE** 2. Fit a joint lognormal distribution to the **covariance matrix** from the MLE 3. In the ERM model, each simulation draws a random sample from the joint lognormal distribution to be the parameters for the loss distribution This approach adds variability to the parameters used in the model. **Note:** Lognormal preferred over normal as it works for large and small datasets.

Answer 62

_Recommendations to help guide model selection_ 1. Assign probabilities of being "correct" to each of the better-fitting distributions. 2. For each simulation: i. Select a distribution form the set of distributions ii. Select the parameters from the lognormal distribution of parameters (to add estimation risk) iii. Use this fixed distribution for all losses in the simulated scenario.

Answer 63

Each individual model may be realistic, but if dependencies between different lines and risks are unrealistic, then the ERM model in aggregate will be unrealistic.

Answer 64

**Correlation** uses a single value (the correlation coefficient) and doesn't differentiate between different levels of dependency in different parts of the distribution. **Dependency** between different risks and lines may be higher in the tail than the rest of the distribution. * This is better modeled with a copula

Answer 65

Copulas are a way to aggregate different distributions into a combined multivariate distribution. Different copulas reflect _different levels of dependency_ at different parts of the distribution.

Answer 66

* Light-tailed copula - produces wark correlation in the tails * R(1) = 0

Answer 67

* More tail concentration that Frank's copula * Asymmetric with more weight in the right tail * R(1) \> 0

Answer 68

* HRT copula produces less correlation in the left tail and more correlation in the right tail * R(1) \> 0

Answer 69

**_Advantages_** * Easy simulation method * Generalized to multi-dimensions (\> than 2 dimensions) * Heavier tail than Frank copula but lighter tail than Gumbel or HRT * R(1) = 0

Answer 70

* Multivariate copula which can be used for more than two variables * Has an additional parameter for the heaviness of the tail

Answer 71

R(*z*) = Pr(U\>*z*|V\>*z*) L(*z*) = Pr(U\<*z*|V\<*z*) The right tail concentration function, R(*z*), shows the probability that losses from one distribution will be large given that losses from another distribution are large.

Answer 72

**_Upper Tail Dependence Coefficient_** The limit of R(*z*) as *z*→1 If this limit is greater than zero, then there is high tail dependency. There still can be significant dependence near the limits so it's useful to look at R(*z*) when *z* is near 1.

Answer 73

The joint probability distribution of two distributions combined with a copula shows **areas with high joint probability densities**. This can be used to compare how different copulas behave; especially in the tail.

Answer 74

**_Left and Right-Tail Concentration Functions_** Look near the limit of R(*z*) as *z*→1 **_J Function_** Compare the fitted J to the empirical J function to evaluate which copula fits the data best. **_Chi Function_** Compare the fitted Chi function to the empirical Chi function.

Answer 75

**_Operational Risk_** The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. * Includes legal risk * Excludes strategic and reputational risks

Answer 76

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

Answer 77

**_Internal Fraud_** Acts by **internal** party that defraud, misappropriate property (i.e. unfairly take) or circumvent the regulations (either the law or company policy). * employee theft * insider trading * claim falsification

Answer 78

**_External Fraud_** Acts by a third-party that defraud, misappropriate property or circumvent the law. * Robbery, forgery, and computer hacking * Claims fraud and falsifying application information

Answer 79

**_Employment Practices & Workplace Safety_** Acts that are inconsistent with employment, health and safety laws * WC claims, * Violation of employee health and safety rules * Discrimination claims * Organized labor activities * General Liaiblity (e.g. customer slip and fall at branch office) * Repetitive Stress (insurer specific)

Answer 80

**Clients, Products and Business Practices** Unintentional or negligent failure to meet a professional obligation to specific clients or the nature/design of product. _Insurer Examples_ * Client Privacy * Bad Faith Claims * Red-lining _General Examples_ * Fiduciary breaches * Misuse of Confidential Customer Information * Money Laundering * Sale of Unauthorized Products

Answer 81

**_Damage to Physical Assets_** Loss or damage to physical assets from natural disasters or other evens such as terrorism/vandalism. This excludes policyholder losses which is an insurance hazard risk. _Insurer Examples_ * Damage to insurer's office building and its own automobile fleets _General Examples_ * Terrorism * Vandalism * Earthquakes * Floods

Answer 82

**_Business Disruption & System Failures_** Disruption of business or system failures _Insurer Examples_ * Processing centre downtime * System interruptions _General Examples_ * Hardware and software failures * Telecommunication problems * Utility outages

Answer 83

**_Execution, Delivery & Process Management_** Failed transaction processing or process management, and relationships with vendors _Insurance Examples_ * Policy Processing Errors * Claim Payment Errors _General Examples_ * Data Entry Errors * Incomplete Legal Documentation * Unapproved Access given to Claimant Accounts * Vendor Disputes

Answer 84

* Deficient Loss Reserves (1st) * root reason for insurer failure is the accumulation of too much exposure for the supporting asset base * Rapid Growth (2nd) * Underpricing * Alleged Fraud * Overstated Assets * Catastrophes * Reinsurance Failure * Reckless Management

Answer 85

Operational risk should be unbundled from UW risk and analyzed separately as these can be significant sources of risk. Supported by capital risk charges applied to premium, reserves and growth (operational risk is implicitly included in the capital charges)

Answer 86

The _plan loss ratio determination process_ is considered the fulcrum of operational risk. * Deficient carried reserves are indicators of deficient initial reserving, which is driven by optimistic plan ratios, OR premature reserve releases

Answer 87

**_Bridging Model_** * Ultimate losses from mature years are trended forward (using loss cost trend and price level changes) to set the new plan loss ratio * Ultimate loss ratios of immature prior years are calculated with the BF method using ELRs set to the initial plan loss ratio for each prior year. **_Problem with Bridging Model_** * Prior year ultimate loss ratios become _highly correlated_. * If the older prior year loss ratios were too optimistic, the plan loss ratios would be set too low. This causes many of the prior year ultimate loss ratios to be too low. * Eventually, older years deteriorate, causing many AY's to deteriorate * Reserve conflagration which is represents the pure operational risk

Answer 88

* The model *_could not have accurately forecasted_* the loss ratio (or reserves) * Operational Risk → **Process and System failure** * Not Operational Risk → inherent uncertainty and all competitors were wrong with their estimates as well * The model *_could have accurately forecasted_* the loss ratios (or reserves) but was improperly used. * Operational Risk → **People failure** * The model *_did accurately forecast_* the loss ratio, but the indications were unpopular and ignored * Operational Risk → **Process and governance failure**

Answer 89

**_Underwriting Cycle Management_** The management of UW capacity as market pricing fluctuates due to the underwriting cycle. Assess different cycle management strategies based on: * stability * availability * reliability * affordability

Answer 90

**_Naive Cycle Management_** Writing business at inadequate prices during a soft market in order to *_maintain market share_*. _Possible Results:_ * Insurer may be downgraded, causing policyholders to switch insurers * Failure of stability/availability * Insurer may go insolvent with partial recoveries on claims for policyholders * Failure of reliability/affordability

Answer 91

**_Effective Cycle Management_** Disciplined UW: 1. **Soft Market** - decrease written premium (don't write inadequately priced business) 2. **Hard Market** - increase written premium volume To implement, must overhaul UW decisions and processes simultaneously which can be difficult. The following area are affected: * Planning * Underwriting * Objective Setting * Incentive Bonuses

Answer 92

An insurer can implement by focusing on 3 key areas: 1. Intellectual Property 2. Underwriter Incentives 3. Market Overreaction 4. Owner Education

Answer 93

**_Intellectual Property_** * Retain and continue to develop top talent through soft markets * Maintain a presence in the core marketing channels * Maintain consistent investment in systems, models and databases Note: Intellectual property is an intangible asset and can drive the company's franchise value.

Answer 94

**_Underwriter Incentives_** * Incentive plans should be flexible so underwriting decisions are aligned with corporate objectives which change with market conditions * E.g. if prices drop too low, UWs may need to stop writing new business, but their bonuses and employment should be at risk

Answer 95

**_Market Overreaction_** * When prices fall too low in a soft market, the insurer should maintain underwriting discipline and write less. (i.e. not over-react) * When the market hardens and prices overcorrect, the insurer will have the capacity to write significantly more business profitably.

Answer 96

**_Owner Education_** * Some financial figures may diverge from those of peer companies such as: * **Premium Volume** - will drop during soft markets * **Overhead Expense Ratio** - maintaining intellectual property during a premium decline will cause the expense ratio to rise * Practicing effective UW cycle management means owners should not over-react when their ratios diverge from their competitors

Answer 97

Agency theory is important because there are potential _operational risks_ when management and owner interests are misaligned. **_Goals of Agency Theory_** * How to align management and owner interests * Understanding the impacts when management and owner interests are different

Answer 98

**_Incentive_** - Percentage of the increase in market cap after n years **Result** - Management may take *_too much risk_* to increase firm value because * High upside benefit - big payoff if there's a major increase in firm value * Low downside risk - don't lose anything as they are gambling with someone else's money **_Incentive_** - Stock grants or stock options **Result** - Management may become *_too risk averse_* because: * Shareholders may have diversified portfolios but management does not since their compensation is tied directly to the firm * Management has a large portion of their wealth tied to the company so they will be less willing to take on risk

Answer 99

1. **Pension Funding Issues** - quantify this risk with models that include financial risk and firm demographics 2. **IT Failure Risk** - monitor and control with contingency planning. The remaining risk could be quantified and funded. 3. **Other HR Risks** - identification and control of these risks is most important (more important than quantifying them) * e.g. loss of important staff, employee fraud, etc. 4. **Reputational Risks** - identification and control of these risks is most important (more important than quantifying them) * product tampering, bad press coverage, etc. 5. **Lawsuits** - monitoring of this risk is most important

Answer 100

**_Control Self Assessment_** A process to examine and assess the effectiveness of internal controls with a goal of providing reasonable assurance that all business objectives will be met.

Answer 101

**_Primary Objectives of Internal Controls are to ensure:_** * Reliability and integrity of information * Compliance with policies, plans, procedures, laws, regulations and contracts * Safeguarding of assets * Economical and efficient use of resources * Accomplishment of established objectives and goals for operations or programs

Answer 102

**_Key Risk Indicators_** Measures used to monitor the activity and status of controls in a business area for a given operational risk category. KRIs are *leading indicators of risk* and can be measured frequently to flag attention if a threshold is hit. * KRIs are **forward-looking** indicators of risk unlike historical losses which are backward looking

Answer 103

Examples of Insurer Key Risk Indicators: * **Production** - hit ratios, retention ratios, pricing levels, rate per unit of exposure * **Internal Controls** - audit results, audit frequency * **Staffing** - employee turnover, training budget, premium per employee, policies per employee * **Claims** - frequency, severity, new classes of loss

Answer 104

**_Six Sigma_** - its a management framework; based on customer-specified tolerances for product defects are +/- 3σ from the mean * in insurance, can help firms identify and eliminate process issues such as inefficiencies, errors, overlaps and gaps in communication Examples of insurer processes to improve with six sigma: * **Underwriting** - exposure data verification/capture, classification/hazard selection * **Claims** - coverage verification, ALAE, use of outside counsel to set initial case reserves * **Reinsurance** - treaty claim reporting, coverage verification, reinsurance recoverables, disputes, LOC and collaterization

Answer 105

**Operational Risk Modeling Steps:** 1. Identify exposure base - payroll, head count, policy count, premium volume 2. Measure exposure level 3. Estimate the loss potential (frequency and severity) per unit of exposure 4. Create loss frequency and severity distributions by combining step 2 and step 3 above 5. Estimate the impact of risk mitigation, process improvement or risk transfer on the frequency and

Answer 106

**_Strategic Risk_** - is the risk to the company form making the right or wrong strategic decisions, not making a decision or not recognizing that a strategic decision needs to be made. It's the risk of choosing the wrong plan given market conditions.

Answer 107

_Types of Strategic Risks:_ 1. Industry 2. Technology 3. Brand 4. Competitor 5. Customer 6. Project 7. Stagnation

Answer 108

**_Industry_** - capital intensiveness, overcapacity, commoditization, deregulation, cycle volatility _Insurer Risk_ - very high Examples - UW cycle, insurance as a commodity

Answer 109

**_Technology_** - technology shift, patents, obsolescence _Insurer Risk_ - low Examples - data management, innovation in distribution over the internet

Answer 110

**_Brand_** - erosion or collapse _Insurer Risk_ - moderate Examples - reputation loss through bad press or class action lawsuits

Answer 111

**_Competitor_** - global rivals, gainers, unique competitors _Insurer Risk_ - moderate Examples - predatory pricing from competitors, entrance into new markets with inadequate expertise or systems or multiple competitors targeting the same market segment poses a risk as well

Answer 112

**_Customer_** - priority shift, power, concentration _Insurer Risk_ - moderate Examples - risk is worse for commercial insurance companies (can be concentrated in certain areas rather than spread over the country)

Answer 113

**_Project_** - failure of R&D, IT, business development or M&A _Insurer Risk_ - high Examples - value-destroying M&A (don't contemplate integration costs, timelines, reserve deficiencies, etc), under-investing in underwriting in R&D and IT

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**_Stagnation_** - flat or declining volume, price decline, weak pipeline _Insurer Risk_ - high Examples: * response to changes in the UW cycle is poor, * difficulty in redeploying assets * insurer's assets are largely intellectual assets (people) which have a large degree of specificity) * extensive reporting lags * mismatched revenue/expenses

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Steps: 1. Define the scope of the analysis - time frame, level of analysis such as geographic, product segments 2. Identify major stakeholders - customers, suppliers, competitors, employees, shareholders, regulators 3. Identify basic trends - include their influence on the organization 4. Identify key uncertainties 5. Construct initial scenario themes - combine key elements to create scenarios 6. Check consistency and plausibility - scenarios should be realistic and internally consistent 7. Develop learning scenarios - identify themes that are strategically relevant (e.g. "soft market" scenario) 8. Identify research needs - better understand the trends and uncertainties 9. Develop quantitative models 10. Evolve toward decision scenarios - scenarios used to test different strategies

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**_Advantages_** 1. Company thinks through responses beforehand * Can select the best response to different market conditions 2. Reduces organizational inertia * Provides more flexibility compared to trying to "make plan" even if the market conditions change

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**_Underwriting Cycle_** The recurring pattern of increases and decreases in insurance prices and profits.

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1. Emergence 2. Control 3. Breakdown 4. Reorganization

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**_Emergence_** - for a new line, there is a cycle between soft and hard markets: * Price wars between competitors price corrections when weak competitors leave→period of profitability→new competition to restart the cycle * Competition drives pricing dynamics

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**_Control_** * Stabilization as rating bureaus and state DOIs regulate prices * Statistical data lags drive pricing dynamics

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**_Breakdown_** * Controls breakdown due to technological and societal changes * Competition and data lags drive pricing dynamic

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**_Reorganization_** * A new version of the line of business or marketplace emerges, returning to the emergence phase * Competition driving pricing dynamics

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**_Theories of what Drives the Underwriting Cycle_** 1. **Institutional Factors -** the cycle time is driven by time lags involved in pricing. Time lags due to reporting and regulatory delays also contribute to the underwriting cycle. 2. **Competition -** the cycle is driven by competition between insurers toward lower rates. Underwriting strategies fluctuate between growth and price maintenance. 3. **Supply and Demand, Capacity Constraints and Shocks -** shocks to capital (catastrophes, etc.) reduce capacity causing price increases. 4. **Economic Linkages** - insurance profitability and cost of capital are driven by macroeconomics.

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**_Potential Predictor Variables for Modeling the Underwriting Cycle_** 1. Previous time period profitability 2. Internal financial variables * reserves, investment income, catastrophe losses, capital flows 3. Regulatory and rating variables * rating upgrade/downgrade 4. Reinsurance sector financials 5. Macroeconomic variables * inflation, unemployment, GNP 6. Financial market variables * interest rates, equity returns

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**_Soft Approaches_** - focus on gathering data and doing competitor intelligence, which analysts look at to gauge the state of the UW cycle The following techniques are used: * Scenarios * Delphi Method * Competitor Analysis

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**_Technical Modeling_** - the underwriting cycle is modeled as a time series such as an autoregressive model. The model can then create forecasts for the future, which can be used in an ERM model for strategic planning.

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**_Economic Modeling (Behavioural Modeling)_** *_Balances soft approaches_*, which seek to understand the structure of the UW cycle, *_and technical modeling_*, which seeks to create a statistical model.

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**Supply & Demand Curves** * Shocks to capital (such as catastrophes) *_decrease supply_* which potentially decrease demand if quality decreases * Increased competition *_increases supply_* which potentially increases demand if insurance quality rises * Supply curve could be modeled with a minimum and maximum price

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**_Capital Flows_** * High expected profits result in capital inflows (new competitors, capital infusions) * Low profits result in capital outflows (firms exiting the market) * Normal dividends result in steady outflows of capital

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**_Assembling the Econometric Model_** * Economic factors influence supply and demand curves * Capital flows impact supply and demand curves * Current level of prices and losses influence supply * Price and quantity of insurance is modelled at the intersection of supply and demand * Premiums and losses affect capital * Profitability impacts capital flows

Section C: ERM Flashcards

(154 cards)