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Capital (Risks (Operational risk (governance (low quality management…
Capital
Risks
Insurance risk
risk of loss from inherent uncertainty of
occurrence
amount
timing
insurance liabilities
premiums
expenses
Gross underwriting risk
relates to risks yet to be written/earned
Sources
attritional loss frequency
large loss frequency and severity
catastrophes
poor aggregate management of CAT exposures
mis-pricing risk
anti-selection risk
claims inflation
legislation / court awards
volumes/mix of business
underwriting cycle
latent claims
propensity to claim
macroeconomic conditions
capital charge
UW result at chosen risk tolerance
for business written/earned
divide firm's business
classes
territories/currencies
data required
estimates of future business volumes and mix
firm's BE business plan
claims and expense ratios for each class
historic performance
market experience
adjust for differences
assess variability of claims and expenses
fit statistical distributions
use stress tests
split claims
attritional
below reinsurance retention
model in aggregate based on past experience
use mildly-skewed distribution
2 more items...
if SD small % of mean use N distribution
if insufficient data use loss ratios
large
model separately to attritional
allow for reinsurance recoveries
use F-S approach based on past experience
2 more items...
catastrophes
cannot model using past experience (too rare)
natural cats
1 more item...
man-made cats
1 more item...
future latent
treat separately
not modelled based on past experience (heterogeneity)
claims made during extreme conditions
e.g. severe recession
stochastic model (possibly)
1 more item...
scenario-based approach
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bespoke model
1 more item...
UW result on a realistic basis
any expected profit should be excluded
if large
writing significant volumes of business
writing capital-intensive business e.g. CAT risks
correct price uncertain
lack of data
uncertain claims experience
uncertain mix
uncertain T&Cs
heterogeneity of business
Gross reserving risk
relates to risks already written/earned
i.e. claims yet to be reported/settled
capital charge
ultimate cost of settling claims
at firm's chosen risk tolerance
from business written/earned before modelled period
current BE reserves
approach analogous to that for UW risk
assess variability in firm's claims settling
bootstrapping
Mack method
using stress tests
data required
firm's actual BE reserves
initial loss ratios for B-F method
earlier year results
benchmarks
if large
less (risky) business than previously
medium to long-term business
Net insurance risk
significant if
low levels of reinsurance
uncertain recoveries
nature of the cover e.g. v. high layer
events causing losses v. volatile
high reinsurance exhaustion risk
Aggregate insurance risk
should allow for correlations between
classes
UW and reserving risks
if large
write large amounts of (volatile) business
significant accumulations of risk
may be affected by
underwriting cycle
model should reflect movements in
rates
T&Cs
parameter error
include margin for variability to
allow for less than full credibility of past data
reinsurance of unexpired risk
allow for cost of purchasing reinsurance on LOD basis
to cover future period being modelled
multi-year policies
capital charge should suffice for
all risks taken on during modelled period
management actions
following UW losses firm will increase rates
unless not shared by market
discounting
does not add to insurance risk
unless profits are prematurely anticipated as a result
Market risk
risk of fluctuations
in value of assets
in the income from assets
market movements
Sources
interest rates
market value of investments
value of liabilities (if discounting)
investment income levels
exchange rates
market value of overseas investments
size of foreign currency claims
value of repatriated profits
equity risk
property risk
spread risk
non-constant credit spreads
concentration risk
lack of diverse portfolio
mismatching risk
can lead to liquidity risk
systemic risk (contagion)
other risks
inflation risk
if assets held not real
reinvestment risk
if duration of assets < liabilities
economic conditions
severe economic downturn
adverse interest rates
fall in equity market
higher taxes
extreme events
assets valued incorrectly
Correlations are important aspect of prudent management of market risk
Modelling
simple stress tests
standard investment portfolios
sense check more complicated model
consider relationships between risks
ESG
generates values for economic variables
can be very complex
output should be scrutinised for reasonableness
express chosen confidence level
stress and scenario-type benchmarks
examine scenarios around chosen scenario
to understand drivers of capital charge
examine individual variables
within overall economic scenario
identify those to which balance sheet most sensitive
examine implied correlations within the output
gives joint probability distribution of outcomes
point is chosen reflecting desired confidence level
defines form variables can take
and relationship between them
Capital charge
if small % of overall requirement
shorter-tail liabilities
invested in stable assets
well-matched portfolio
Liquidity risk
unable to meet obligations as fall due
timing mismatch between assets and liabilities
Factors to consider
uncertainty of liability cashflows
size
timing
extent of mismatch between A & L
amount of liquid, marketable assets
changes in market conditions
affecting ability to liquidate promptly
failure to forecast CF requirements accurately
unplanned changes in funding sources
process weaknesses
poor credit control
management of disputes
minimum level of free assets required
across UW cycle
impact of a large loss
correlations with
insurance risk
market risk
Modelling
possible stress tests
increase in attritional claims
delay between large loss and making recovery
CAT loss
reduced level of NB
Capital charge
if low
investing in stable assets
significant reinsurance in place
to meet CAT losses
significant stream of future income
to fund short-term cashflow needs
Credit risk
risk of loss due to 3rd party failure
investment credit risk
Factors to consider
probability of default
financial strength rating of investments
probability of moving from one grade to another
size of loss given default occurs
degree of exposure
spread risk
correlations between asset classes
likelihood of systemic financial risk
cannot be diversified
potential correlations within
financial and economic modelling factors
used within assessment of market risk
e.g. from holding non-gov't bonds
counterparty credit risk
Factors to consider
probability of default
for each counterparty
by reference to credit ratings
level of risk in different environments
size of loss
correlations between counterparties
hidden costs of adverse credit scenarios
potential non-recoveries
reinsurance/broker disputes
any collateral held
e.g. letters of credit
Examples
e.g. balances with intermediaries
e.g. reinsurer default
e.g. premium debtors
Modelling
stochastic model may be used
stress tests needed
to check for reasonableness
help calibrate the assumptions
failure of largest reinsurer/intermediary
one notch downgrade of all reinsurers
existing or future disputes relating to reinsurance contracts
default of largest corporate investment
Capital charge
if high
significant reinsurance in place
use of low-grade reinsurers
significant debtors
Operational risk
inadequate or failed
internal processes
people
systems
administration
higher where
recent acquisition
new classes written
business written cross-territory
governance
dominance risk
loss of key personnel
new CEO
Board restructure
low quality management processes
no focus on risk management processes
lack of individual responsibility
lack of diversity in expertise
biased judgements
conflicts of interest
significant outsourcing
weak systems and controls
should reflect
nature/scale/complexity of business
diversity of business written
e.g. geography
nature/volume/scale of transactions
compliance
legislative requirements
internal requirements
higher where new class written
fraud
may increase following management change
strategy
inability to
implement appropriate business plans
make decisions
allocate resources
adapt to changes in business environment
higher where entering new market
technology
risk higher where
high quote volumes
reliance on technology
website sales
quote systems
rating engine
claims reporting
less infrastructure
pension scheme provision
requirement to rectify a funding shortfall
risk higher following an acquisition
poor claims controls
claims leakage
poor underwriting
claims handling systems unable to cope
external events
natural disaster
difficulty sourcing skilled labour
Modelling
difficult
uncertain and subjective nature
require considerable judgement
overlap with other risk types
avoid double-counting
identify all material scenarios
specific to firm's business
compile/maintain risk register
brainstorming session with stakeholders
Capital charge
not defined % of other risk charges
stochastic model infrequent
insufficient past experience of extreme failures
use deterministic scenario-based approach
degree of loss from each risk
type of event causing loss
frequency of such a loss
net and gross of mitigating controls
if low
model error
inadequate assessment
Group risk
being part of group structure
ownership structure of the firm
how it is funded by parent company
Forms
reputational risk
group reinsurance risk
concentrated credit risks
reliance on parent for centralised functions
e.g. accounting
mitigants
capital not a good mitigant
ERM policy
Modelling
stochastic model unlikely
scenario-based approach more likely
consider
likelihood
financial consequences
insolvency
downgrading of parent company
Political risk
political change alters
outcome/value of economic action
important for firms operating in emerging markets
may be correlated to insurance risk
regulatory changes may stem from a cat
Modelling
stress testing using a known example
Capital model
Validation
Stress tests
effect of changing single parameter
good corporate governance
model future cat claims
additional tests on uncertain assumptions
Scenario tests
effect of changing multiple parameters
understand relationships between risks
allow for interactions between variables
within stochastic models
explore scenarios not deemed important
calibrate assumptions
validate output
scenario planning
link between
capital model
risk register
risks not easily modelled quantitatively
communication tool
Sensitivity testing
make small change to each assumption in turn
identify most critical assumptions
part of stochastic modelling process
help select assumptions
part of validation and sign off process
Back testing
actual experience
model output
reflect risk profile of business?
reflect reality?
identify model shortcomings
e.g. erroneous parameter
past performance good indicator of future?
Model documentation
should provide clear audit trail
model itself
key assumptions/approximations
details of
prudential risks
processes
controls
key risks issues considered
how considered
reasons behind
conclusions
findings
any concerns over data
business classification used
rationale for selecting assumptions
indicative movements in the capital requirement
Peer review
by independent person
Market benchmarking against
other measures of CR
standard formula
ICA
market data
competitors
Lloyd's
balance sheet items
Analysis of change
identify key causes of any changes
Reverse stress testing
identify scenarios leading to failure
Deterministic model
validate a stochastic model
General model reasonableness checks
assumptions produce sensible outputs
manual spot checks
Governance procedures
approval from oversight committee
Regulatory requirements
annual validation
requirement for certain
experience
qualifications
use of prescribed
methods
standard formula
specific validation tests
stresses
scenarios
validation of
data inputs
external models
external validation of model
regular reviews of validation approach
by regulator
to address previous issues
specific documentation
public disclosure
selecting insurers' models for review
choose proportion each year
not very targeted
perform cursory reviews to decide
balances
budget constraints
risk identification
more in early years, less later
identify high-risk areas sooner
stratified sampling
more targeted
target high-risk firms
e.g. new insurers
subjective
impose periodic reporting requirements
may be complex/onerous
increased costs
based on independent actuarial report
use skills available in market
Data needed
products
exposure measure/volumes
risk appetite
mix of business
net written premiums
planned exposures
mix of business
conversion
lapses
retention
future rate changes
reinsurance rates
for losses-occurring cover
cost of reinstatements
expenses
acquisition costs
administration costs
claims handling
expense inflation
claims
large
frequency
severity
latent
PPOs
triangles
by product
gross/net of reinsurance
CAT risk
distribution of exposure
claim ratios
distribution
mean
standard deviation
technical provisions
including IBNER
split by class
claims inflation
best estimate reserve
outstanding reported claims
estimated IBNR
historical movements
ratios of net to gross claims
claims handling
expense inflation
investment portfolio
gilt yields
corporate bond yields
equity/property returns
exchange rates
underwriting results
business plan
reinsurance covers in place
probability of reinsurer default
historical failures
expected loss
probability of exhaustion
credit ratings
downgrading probability
operational risk losses
firms' risk register
potential risks
likelihood
expected costs
variability
financial statements
tax
tax rules
dividends
board policy
Impact of regulation
type of model
standard formula
internal model
basis to be used
prudent + modest SM
BE with substantial SM
method used to value liabilities
discounting permitted?
method used to value assets
market value
discounted cashflow
assumptions used
restrictions
acceptable ranges
level of detail/granularity
model validation
prescriptive
guidance
monitoring/reporting
Diversification
Sources of correlation
between/within asset classes
economic downturn
equity market fall
falling bond prices
between risk types
market and insurance
economic downturn
fraudulent claims
valid claims
rise in interest rates
increase in MIG claims
exchange rate movements
higher cost of foreign claims
fall in equity markets
high creditor claims
catastrophe
fall in investment markets
underwriting and reserving
latent claim
reserve deteriroation
new business
operational risks
resource stretch
process failures
group risks
concentrated credit risk
captive default
insurance and credit
large loss
reinsurer failure
liquidity risk
between loss types
poor underwriting controls
increase exposure to
attritional claims
large losses
CATs
between/within geographical areas
different countries exposed to similar
social changes
economic changes
regulatory changes
between classes
by peril
PD or theft claims
seasonal effects
weather events
catastrophe risk
large individual loss
underwriting risk
biased underwriting standards
reserving risk
poor internal claims controls
economic risk
inflation risk
changes in size of claims
investment credit risk
defaults
counterparty credit risk
reinsurer default
liquidity risk
inability to pay claims
poor investment returns
currency risk
if business written overseas
operational risks
IT failure
legal risk
loopholes in policy wording
external risk
changes in legislation
behavioural trends
propensity to claim
new type of claim
latent claims
underwriting cycle
similar rate changes across classes
between counterparties
large CAT
default of multiple reinsurers
following M&A
Methods of estimating
assume none when bidding
retain the upside
assume x% when combining business
look at capital intensity by risk
apply to premiums of acquired firm
benchmark against
similar transactions
announced synergies
plug in volumes/data into existing model
produce a range
via sensitivity anlysis
Uses
underwriting
determining risk appetite
monitoring aggregate exposures
pricing
assess return on capital for
performance measurement
reserving
setting technical reserves
quantifying uncertainty in reserves
optimise reinsurance purchase
choose retention to maximise savings on
reinsurance premiums
capital required
monitoring performance
actual vs expected
investment
setting strategy
impact of change in asset mix
risk management
design process
identify key risks
impact of mitigation controls
capital allocation
planning
compare plans in terms of
risks
expected profits
strategy
assess for new strategies
risks
diversification benefits
e.g. acquisitions, new classes
performance-related salary or bonuses
Required capital
Regulatory capital
protect policyholders interests
minimum requirement
hold more to
reduce risk of available capital < minimum
greater security for policyholders
meet requirements of other stakeholders
e.g. debt providers
maintain credit rating
maintain buffer between
actual profitability
dividend stream
Economic capital
assets
liabilities
business objectives
more realistic basis
internal capital model
risk profile of assets and liabilities
correlation of the risks
desired level of overall credit deterioration
risk measure
features
risk profile
risks being modelled
key outcome to measure success
risk measure e.g. VaR
links outcome to capital needed
given degree of confidence
given time horizon
risk tolerance
required confidence level within chosen risk measure
diversification
if no credit total CR =
sum of risk charges
if risks perfectly independent total CR =
sqrt of sum of risk charges squared
Factors affecting
regulatory requirements
model used
internal capital model
time available
IMAP
standard formula
credibility of estimated requirements
may hold margin if low
basis used
run-off
going concern
windup
desired level of ruin probability
i.e. risk tolerance
time horizon of calculation
one-year
ultimate
risk appetite
probability of adverse events/cats
probability of breaching MCR
expected line size to MCR
output of stochastic model/DFA
size of risks
adding a small business to large
may have minimal impact
opportunity cost of capital
start-up costs need to be funded up-front
market perceptions
increasing CR could be perceived badly
achieve desired credit rating
capital required to attract policyholders
desired flexibility
risk selection
reinsurance strategy
level of prudence
investment strategy
ability to withstand changes in
legislation
tax
judicial inflation
business plan
growth increases CR
profitability
profit commission arrangements
can be volatile
will reduce profits
may improve liquidity
if less return commission payable upfront
reliance on retained profits may be limited
new business strain
soft market
dividend policy
new class of business
product development costs
product design
marketing costs
new business strain
administrative expenses
paying commission
setting up reserves
including solvency margin
Modelling
create model points
reflecting expected business mix
build cashflow model projecting
premiums
claims
expenses
investment return
reinsurance
premiums
recoveries
tax
allow for required solvency margin
discount cashflows to determine reserves
discount rate should reflect
regulation
purpose of exercise
liabilities
uncertainty
currency
nature
extent of asset mismatching
assets
nature
expected return
non-investible
investment expenses
tax
delay before receiving premiums
risk-free yield curve
at valuation date
any margin
reflecting riskiness of class
inflation assumptions
for consistency
last year's rate
those used by competitors
arguments for
more realistic picture
long-tailed classes less profitable ow
easier to compare classes
arguments against
negligible difference for short-tail class
may be prohibited
discount rate subjective
not discounting
provides implicit margin
defers profit and tax
sign of weakness
assuming claims inflation as per interest earned on assets
choose appropriate basis
realistic
economic capital
prudent
regulatory capital
Consider
type of model
deterministic
easier to design
quicker to build/run
clearer what stresses/scenarios tested
easier to understand
provide check on overall CR
integrate capital and risk management
dialogue mechanism with senior management
for subjective risks
more readily explicable
test stochastic models
detrimental scenarios may be omitted
scenario modelling can extend to
scenario planning
'what-if' analysis
better model potential cause and effect
stochastic
tests wider range of scenarios
explore 'ripple effects'
can rank all combinations of inputs
can apply multiple risk measures
assess financial guarantees
computationally more intensive
subjective distribution functions
communicating results difficult
spurious accuracy
time horizon
lifetime of business
accuracy required
number of simulations
correlations between variables
consistency between assumptions
allowance for any guarantees
future tax position
scenario and sensitivity testing
Available capital (free reserves)
removing shortfall
depends on size of deficit
Underwriting risk
reduce business volumes
fixed costs still need to be covered
write less capital-intensive business
shorter-tail classes
fewer liability risks
less volatile direct risks
e.g. smaller commercial properties
less volatile reinsurance business
working layer vs. high layer
regions not cat-exposed
increase diversification
write different business to previous years
write more classes
purchase more reinsurance
lower attachment points
higher upper limits
lower aggregate deductibles
unlimited reinstatements
Reserving risk
purchase run-off reinsurance
e.g. LPT
Market risk
invest in lower risk assets
cash
short-term gilts
exit classes exposed to currency risk
Credit risk
use more highly-rated reinsurers
require reinsurers to post collateral
tighter control of broker balances
Liquidity risk
match liabilities more closely
increase premium income
Operational risk
discuss areas of concern
implement controls to mitigate concerns
Access to further capital
shareholders (proprietary)
unwilling?
may demand high returns
Names (syndicate)
parent company
group risk
financial reinsurance
if permitted by PRA
e.g. financial QS
other finance provider
guarantees from government
implicit
explicit
retained profits
Excess capital