11_Brehm Flashcards

Question

V@R

Answer 1

V@R Percentile of the probability distribution Pro - Emphasizes large losses Con - Only looks at one point in the distribution

Answer 2

TV@Rp% = E[Loss | Loss > V@Rp%] Expected loss given a loss is equal or greater than a specified probability level Pro - Reflects losses that exceed V@R Con - Losses are reflected linearly in the tail

Answer 3

XTV@Rp% = TV@Rp% −Mean The mean loss might be funded by other means (such as premium). Capital is needed for losses above the mean.

Answer 4

EPD = (TV@Rp%-V@Rp% )⋅(1− p%) For EPD, the probability level is set so that capital is V@R at that level

Answer 5

The market value of the remaining default risk after reinsurance. This would be estimated based on options pricing.

Answer 6

* Shifts the probability distribution towards larger losses, then computes risk measure Examples: * Expected loss with transformed probabilities * Minimum martingale transform and minimum entropy martingale transform, Wang transform * Weighted risk measures: WV@R, WTV@R, WXTV@R [TVaR is linear in the tail (a loss twice as large is considered twice as bad). Under transformed probabilities, TVaR becomes WTVaR, this is not linear in the tail and consider a loss that is twice as large to be more than twice as bad]

Answer 7

Expected values that aren’t simply powers of the variable. Example: Blurred V@R, which adds weight to losses around the percentile (not just looking at the loss percentile)

Answer 8

Some insurance customers are concerned about capital levels, reflecting the “quality of the insurance guarantee.” * Rating increases can slowly increase growth * Rating decreases can result in a rapid decline in business (Rating is agency rating)

Answer 9

Capital allocation shows the contribution of each business unit to the overall risk. Capital allocation can be used for calculating risk-adjusted profitability and setting capacity controls by line of business.

Answer 10

Proportional Capital Allocation Allocates total risk down to business units. First calculate the risk measure for each business unit. Then allocate the overall risk measure proportionally.

Answer 11

Risk Decomposition Decomposition uses co-measures to calculate the contribution of each business unit to the overall risk measure. -> e.g. Co-TV@R It is desirable for a risk decomposition method to be marginal All marginal decompositions are also co-measures. Common risk measures that can be expressed as marginal decompositions are TVaR and standard deviation

Answer 12

Marginal Allocation 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.

Answer 13

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

Answer 14

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. risk-adjusted profitability ratio = Profit_j/Risk Measure_j

Answer 15

Allocating the cost of capital to business units sets a minimum profit target for each unit. * If a business unit’s profit exceeds the minimum profit target, this excess is value 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 16

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 17

* Leverage ratios generally compare a ratio to surplus (e.g. Net Written Premium-to-Surplus) to a threshold for testing capital adequacy. -> 12 IRIS ratios [4+ ratios does not fall within their corresponding reasonable ranges are considered to be at risk and warrant regulatory scrutiny Advantages * Easy to calculate and monitor Disadvantages * Doesn’t distinguish between lines of business * Ignores risks other than underwriting risks

Answer 18

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

Answer 19

Different Model Uses * Rating agency models (AM Best, S&P) focus on long-term viability * Regulatory models (like US RBC) 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) o The covariance adjustment will reflect independence between risks so that the overall capital is less than the sum of individual risks

Answer 20

An insurer may do its own risk assessment using scenario testing or stochastic modeling, which would be reviewed by a regulator. Scenario Testing Requires * A 1-5 year financial projection model * Probability distributions for sources of uncertainty * Correlations between risks * Management responses to adverse financial results

Answer 21

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.

Answer 22

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

Answer 23

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

Answer 24

* Analysis of the asset portfolio in isolation (risk vs. return) * Adding fixed liabilities to the analysis o Reinvestment risk if asset duration is shorter o Risk of selling depressed assets if asset duration is longer * Adding variability to the amount/timing of liability cash flows * Adding variable underwriting cash flows * Adding tax considerations and equity investments -> With real-world complexity, a true enterprise-risk model is needed. all above are increasing complexity

Answer 25

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

Answer 26

1) Model assets, existing liabilities and current business operation 2) Define risk metrics - income or balance sheet-based, accounting basis 3) Define return metrics - income or balance sheet-based 4) Set the analysis time horizon - single or multi-year 5) Include model constraints – e.g. regulatory constraints 6) Run the model with different investment, underwriting, and reinsurance strategies, calculating risk-return metrics 7) Plot an efficient frontier based on the different portfolios 8) Test the effects of different reinsurance structures 9) Review simulations where portfolios performed poorly - hedging strategies or new policies may reduce downside risks

Answer 27

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

Answer 28

Reinsurance Provides Stability * 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. (Cost of this stability) But still requires significant judgment to evaluate the stability benefit

Answer 29

Reinsurance is a Substitute for Risk Capital * Increased stability lowers the required risk capital ROE cost of reinsurance = ReinsuranceCost/Capital Freed If the ROE cost of reinsurance is less than the company’s target return, getting reinsurance is a good deal.

Answer 30

Reinsurance Adds Value Ideally, we could measure the value of reinsurance by the incremental increase in market value to the company. There’s no clear way to measure the marginal impact of reinsurance on firm value

Answer 31

Disadvantage Significant judgment is needed to evaluate the benefit of stability against the net cost of reinsurance for different programs.

Answer 32

Look for: * Which option protects best 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 33

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

Answer 34

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 options perform best at different probability levels * If a program is more costly but has worse loss outcomes at each probability level, it’s inefficient and shouldn’t be considered.

Answer 35

Efficient Frontier Graphs the risk-return of different reinsurance programs at various probability levels. * Programs that are below the efficient frontier are inefficient.

Answer 36

Theoretical Models Required capital is calculated with risk measures using an enterprise risk model. * Advantage -> Required capital is more consistent with management’s views about risk Practical Models Required capital is calculated using rating agency or regulatory models (e.g. 175% of BCAR) * Advantage -> Easier to implement * Disadvantage -> Uses proxies for risk (e.g. premium) to measure capital instead of modeling risks directly

Answer 37

* The cost of buying more reinsurance is NPV(Ceded Premium – Ceded Loss) compared to the current program (negative) * This should release capital (negative) Marginal ROE(cost) = delta(Ceded Prem - Ceded Loss)/delta(Capital) If the marginal ROE (cost) is less than the cost of capital, buying reinsurance is a good deal.

Answer 38

* The benefit of buying less reinsurance is NPV(Ceded Premium - Ceded Loss) compared to the current program (positive) * This should consume capital (positive) Marginal ROE(benefit) = delta(Ceded Prem - Ceded Loss)/delta(Capital) If the marginal ROE (benefit) is greater than the cost of capital, buying less reinsurance is a good deal.

Answer 39

* 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.

Answer 40

As-If Loss Reserves Loss reserves that would exist at the beginning of a new accident year if that business had been written in a steady state for all prior years. We can approximate the present value of required capital for an accident year over time by modeling the capital needed for both: * The current year for the current accident year * The as-if loss reserves

Answer 41

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

Answer 42

Staffing/Scope * Organization Chart (modeling team reporting, …) * Functions Represented (actuarial, finance, …) * Resource Commitment (mix of skill set, full vs. part-time, …) * Critical Roles and Responsibilities (control of inputs/outputs, …) * Purpose * Scope

Answer 43

Staffing/Scope Recommendations * Reporting Relationship - Team leader should have a reputation of fairness and balance * Resource Commitment - The team should have a full-time commitment to the implementation * Inputs and Outputs - Should be controlled similarly to the general ledger * Initial Scope - Prospective underwriting period, variation around plan

Answer 44

Parameter Development * Modeling Software (software capabilities, integration with systems, …) * Developing Input Parameters (data driven, requires expert opinion, …) * Correlations (corporate-level ownership of correlations) * Validation and Testing

Answer 45

Parameter Development Recommendations * Modeling Software - Capabilities of the modeling team should determine how much is pre-built and how much the team builds * Parameter Development - Include expert opinion from underwriting, claims, planning and actuarial * Correlation - Modeling team recommends assumptions, which are owned at the corporate level (CRO/CEO/CUO) * Validation - Validate and test over an extended period

Answer 46

Implementation * Priority Setting (priority/timeline driven from the top, …) * Interest and Impact (visibility and interest, communication plans, …) * Pilot Test * Education Process

Answer 47

Implementation Recommendations * Priority setting - Top management should set the priority for implementation * Communications - Regular communication to broad audiences * Pilot Testing - Do pilot testing to prepare stakeholders for the magnitude of the change * Education - Bring leadership to a base level of understanding about the model

Answer 48

Integration and Maintenance * Cycle (integrating into corporate calendar for decision-making, …) * Updating (frequency/magnitude of updates, …) * Controls (control of inputs/outputs, control of analytical templates, …)

Answer 49

Integration and Maintenance Recommendations * Cycle - Integrate into the corporate calendar (at least for planning) * Updating - Major updates to inputs no more frequently than semiannually * Controls - Maintain centralized control of inputs, outputs and templates

Answer 50

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 51

Projection Risk The risk in projecting past trends into the future. Estimation Risk The risk that parameter estimates used are not the “true” parameter estimates for the underlying process. Model Risk Uncertainty about which fitted distribution form is the “correct” distribution (e.g. Gamma vs. Weibull).

Answer 52

A trend line is fit to historical loss costs to project future severities. Disadvantages * Loss cost data is based on historical claims that haven’t settled, which adds uncertainty. * Assumes a single constant trend for historical data that will continue into the future.

Answer 53

Models the trend as the sum of general inflation and “superimposed inflation.” Advantage * An ERM model can reflect the dependency between trend and inflation.

Answer 54

Advantages * Reflects more uncertainty than a simple trend model * Models trend as a time series as opposed to assuming a single, constant trend Disadvantages * A substantial number of data points is needed * If the data is limited, the model will understate the uncertainty

Answer 55

1) Parameter estimates are calculated using the MLE 2) Fit a joint lognormal (or normal) 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.

Answer 56

1) Assign probabilities of being “correct” to each of the better-fitting distributions. 2) For each simulation: a) Select a distribution from the set of distributions. b) Select the parameters from the lognormal distribution of parameters (to add estimation risk). c) Use this fixed distribution for all losses in the simulated scenario.

Answer 57

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 58

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 59

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 60

* Light-tailed copula * R(1) = 0

Answer 61

* Heavier tail than Frank * Asymmetric with more weight in the right tail *R(1) > 0

Answer 62

* Low correlation in left tail, heavy right tail * R(1) > 0

Answer 63

* Heavier tail than the Frank copula * Lighter tail than Gumbel or HRT * R(1) = 0 * Can be used for more than two variables

Answer 64

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

Answer 65

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. R(z) = Pr(U > z|V > z) L(z) = Pr(U < z|V < z)

Answer 66

Upper tail dependence coefficient The limit of R(z) as z -> 1 If this limit is greater than zero, 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 67

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 68

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 69

Operational Risk The risk of loss during the execution of the company due to: Inadequate or failed internal processes, people and systems External events Includes legal risk, but excludes strategic and reputational risk

Answer 70

Types of Operational Risk * Internal Fraud * External Fraud * Employment Practices and Workplace Safety * Clients, Products and Business Practices * Damage to Physical Assets * Business Disruption and System Failures * Execution, Delivery and Process Management

Answer 71

Internal Fraud Acts involving people within the company intended to defraud, misappropriate property or avoid regulations, the law, or company policy (excluding diversity/discrimination). Examples include: * Employee theft * Claim falsification

Answer 72

External Fraud Acts by a third party intended to defraud, misappropriate property or avoid the law. Examples include: * Claims fraud * Falsifying application information * Damage from computer hacking

Answer 73

Employment Practices and Workplace Safety Acts inconsistent with employment, health, or safety laws/agreements, or acts resulting in the payment of personal injury claims, or claims relating to diversity/discrimination. Examples include: * Workers Compensation claims * Violation of employee health/safety rules * Organized labor activities * Discrimination claims * General liability (e.g. customer slip and fall at a branch office)

Answer 74

Clients, Products and Business Practices Unintentional or negligent failure to meet a professional obligation to specific clients or from the nature or design of a product. Examples include: * Client privacy * Bad faith claims * Red-lining

Answer 75

Damage to Physical Assets Loss or damage to the company's physical assets from natural disaster or other events (such as terrorism/vandalism). This excludes policyholder losses (which is insurance hazard risk). Examples include: * Damage to own office * Damage to own auto fleet

Answer 76

Business Disruption and System Failures Disruption of business or system failures. Examples include: * Processing center downtime * Hardware/software failures * Telecommunication problems * Utility outages

Answer 77

Execution, Delivery and Process Management Failed transaction processing or process management, and relations with trade counterparties and vendors. Examples include: * Policy processing * Claim payment errors * Data entry errors

Answer 78

Bridging Model * Ultimate loss ratios from mature years are trended forward to set the new plan loss ratio. * Ultimate loss ratios for immature prior years are calculated with the BF method using ELRs set to the initial plan loss ratio for each prior year. Problem with a 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 AYs to deteriorate.

Answer 79

* The model could not have accurately forecasted the loss ratio (or reserves). o Operational Risk: Process and system failure (or inherent uncertainty and no operational risk if all competitors were wrong) * The model could have accurately forecasted the loss ratio (or reserves), but was improperly used. o Operational Risk: People failure * The model did accurately forecast the loss ratio, but the indications were unpopular and ignored. o Operational Risk: Process and governance failure

Answer 80

Underwriting Cycle Management The management of underwriting capacity as market pricing fluctuates due to the underwriting cycle. Assess different cycle management strategies based on: * Stability * Availability * Reliability * Affordability

Answer 81

Naïve 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 o Failure of stability/availability * Insurer may go insolvent with partial recoveries on claims for policyholders o Failure of reliability/affordability

Answer 82

Effective Cycle Management Disciplined Underwriting: * Soft Market - Decrease Written Premium volume (don’t write inadequately priced business) * Hard Market - Increase Written Premium volume To implement, must overhaul underwriting decision processes, including: * Planning * Underwriting * Objective Setting * Incentive bonuses

Answer 83

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 Underwriter Incentives * Incentive plans should be flexible so underwriting decisions are aligned with corporate objectives, which change with market conditions. Example: If prices drop too low, underwriters may need to stop writing new business, but their bonuses & employment shouldn’t be at risk. Market Overreaction * When prices fall too low in a soft market, the insurer should maintain underwriting discipline and write less. * When the market hardens and prices overcorrect, the insurer will have the capacity to write significantly more business profitably. 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.

Answer 84

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 85

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 (“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 * Management has a large portion of their wealth tied to the company

Answer 86

* Pension Funding Issues - Quantify this risk with models that include financial risk and firm demographics * IT Failure Risk - Monitor and control with contingency planning. The remaining risk could be quantified and funded * Other HR Risks - Identification and control of these risks is most important * Reputational Risk - Identification and control of these risks is most important * Lawsuits - Monitoring of this risk is most important

Answer 87

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. 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 - the economical and efficient use of resources - accomplishment of established objectives and goals for operations or programs

Answer 88

Primary objectives of internal controls * 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 89

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.

Answer 90

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 91

Six Sigma Six Sigma 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

Answer 92

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

Answer 93

Strategic Risk Strategic Risk is the risk to the company from 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 94

Industry (Very high) - Capital intensiveness, overcapacity, commoditization, deregulation, cycle volatility eg: Underwriting Cycle, Insurance as a commodity Project (High) - Failure of R&D, IT, business development or M&A eg: Value-destroying M&A, underinvesting in R&D and IT Stagnation ( High) - Flat or declining volume, price decline, weak pipeline eg: Response to changes in the underwriting cycle Brand (Moderate) - Erosion or collapse eg: Reputation loss through bad press or class action lawsuits Competitor (Moderate) - Global rivals, gainers, unique competitors eg: Predatory pricing from competitors, Entrance into new markets with inadequate expertise or systems Customer (Moderate) - Priority shift, power, concentration eg: This is an issue with large commercial insurance business Technology (Low)- Technology shift, patents, obsolescence eg: Data Management, Innovations in distribution over the internet

Answer 95

1) Define the scope of the analysis - Time frame, business segments, ... 2) Identify the major stakeholders - Customers, competitors, employees, shareholders 3) Identify basic trends 4) Identify key uncertainties 5) Construct initial scenario themes - Combine key elements to create scenarios 6) Check for 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 decisions scenarios - Scenarios used to test different strategies

Answer 96

Advantages 1. Company thinks through responses beforehand – Can select the best strategic response to different market conditions 2. Reduces organizational inertia – Provides more flexibility compared to trying to “make plan” even if market conditions change Disadvantage: The insurer is going to have to design and implement an approach to monitor the market conditions, which could be difficult

Answer 97

Underwriting Cycle “The recurring pattern of increases and decreases in insurance prices and profits.”

Answer 98

Emergence * For a new line, there is a cycle between soft and hard markets: o Price wars between competitors -> price corrections when weak competitors leave -> period of profitability -> new competition to restart the cycle * Competition drives pricing dynamics Control * Stabilization as rating bureaus and state DOIs regulate prices. * Statistical data lags drive pricing dynamics Breakdown * Controls breakdown due to technological and societal changes * Competition and data lags drive pricing dynamic Reorganization * A new “version” of the line of business or marketplace emerges, returning to the emergence phase. * Competition drives pricing dynamics

Answer 99

Institutional Factors 体制因素 The cycle is driven by time lags involved in pricing. Time lags due to reporting and regulatory delays also contribute to the underwriting cycle. (Immature losses for estimation, and delay with regulatory approval) Competition The cycle is driven by competition between insurers toward lower rates - to unprofitable levels for market share leading to crisis and price correction Underwriting strategies fluctuate between growth and price maintenance. (Not all competitors have the same view of the future. Inexperienced firms may have poorer loss forecasts than mature firms. As a result, inexperienced firms may drop prices based on poor forecasts. This eventually pushes the market toward lower rates) Supply and Demand, Capacity Constraints and Shocks Shocks to capital (catastrophes, …) reduce capacity, causing price increases. Economic Linkages Insurance profitability and cost of capital are driven by macroeconomics. – An insurer’s investment income impacts its profitability – The cost of capital is based on the state of the economy – Expected losses are influenced by economic factors such as inflation/ GNP growth/ unemployment

Answer 100

* Previous time period profitability * Internal financial variables (e.g. reserves, investment income, catastrophe losses, capital flows) * Regulatory and rating variables (rating upgrades/downgrades) * Reinsurance sector financials * Macroeconomic variables (inflation, unemployment, GNP) * Financial market variables (interest rates, equity returns)

Answer 101

Soft Approaches Soft approaches focus on gathering data and doing competitor intelligence, which analysts look at to gauge the state of the underwriting cycle. eg. Scenarios/ Delphi Method/ Competitor Analysis 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 or for strategic planning. Econometric Modeling (Behavioral Modeling) Balances soft approaches, which seek to understand the structure of the underwriting cycle, and technical modeling, which seeks to create a statistical model. It models changes in supply and demand of insurance and how those changes influence equilibrium price of insurance

Answer 102

Supply and Demand Curves * Shocks to capital (e.g. catastrophes) decrease supply (and potentially decreases demand if quality decreases) * Increased competition increases supply (and potentially increases demand if insurance quality rises) * Supply curve could be modeled with a minimum and maximum price.

Answer 103

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 a steady outflow of capital

Answer 104

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 modeled at the intersection of supply and demand * Premiums and losses affect capital * Profitability impacts capital flows

Answer 105

Although deficient reserves are normally cited as the primary cause of insolvency the root reason for insurer failure is the accumulation of too much exposure for the supporting asset base.

Answer 106

In the simple trend model, the prediction intervals widen with time due to the uncertainty in the estimated trend rate. In the time series model, the prediction intervals widen with time as well, but the effect is more pronounced and the prediction intervals are wider. This is due to the additional uncertainty of the auto-regressive process

Answer 107

-Assign probabilities of being right to all of the better-fitting distributions. These probabilities can be based on the Hannan-Quinn Information Criteria (HQIC) metric or a Bayesian analysis -Use a simulation model to select a distribution from the better-fitting distributions -Select the parameters from the joint log-normal distribution of parameters for the selected distribution -Simulate a loss scenario using the parameterized distribution -Start the process over again with the next scenario

Answer 108

1) The standard deviations of the parameters can be high enough to produce negative parameter values with significant probability 2) The distribution of the parameters may be heavy-tailed (the bi-variate normal is not heavy-tailed)

Answer 109

To assess estimation risk, we use the covariance matrix that results from the standard MLE procedure (based on second partial derivatives of the parameters), but we assume the parameters follow a joint log-normal distribution with that covariance matrix (works for both large and small datasets)

Answer 110

The best-fitting parameters can be difficult to determine if the likelihood "surface" is very flat near the maximum. When the surface is flat near the maximum, a wide range of parameter sets have almost the same likelihood. Thus, the set that maximizes the likelihood might not be any better than one that has slightly smaller likelihood

Answer 111

DFA< ERM< Cat model DFA: difficult to implement as it requires an internal champion (that most insurers lacked) in order to work with the different silos of the insurer. There was insufficient pressure to move to DFA to overcome this obstacle ERM: this is also difficult to implement as it requires working with the different parts of the insurer. However in this case there is increasing pressure to use it, one reason being because the ERM program will be assessed by the rating agencies Cat models: high pressure to use these as insurers suffered huge losses from Hurricane Andrew

Answer 112

including operational risks such as IT hardware & software exposures, pension funding inadequacy, loss of key executives, fraud, etc... One option is to model operational risks in bulk using judgment. The issue is that this will have a high degree of uncertainty * A more reasonable alternative is to just use the model for risks that it can quantify reasonably well, and recognize that there are operational risks that are not handled well by the model that need some other management method

Answer 113

It is difficult to model scenarios at this level of confidence Tail events are poorly understood There is little available data to help derive the tail TVaR at 80%: this is far enough in the tail to still generate significant issues for the insurer. However, because this scenario is further away from the tail, it should be easier for the insurer to model (and should be understood better by the modelers).

Answer 114

⋄ Holding enough capital to continue to service renewals (since renewals tend to be more profitable) ⋄ Holding enough capital so that the insurer not only survives a major cat but thrives in its aftermath ⋄ Holding enough capital so that the probability of default is remote. However, it is very conservative and mainly protects the policyholder ⋄ Holding enough capital to maximize the insurer’s franchise value. Franchise value includes an insurer’s balance sheet, customer base, agency relationships, reputation, etc. Maximizing franchise value protects both the policyholder and the shareholder

Answer 115

Diversified investors only care about systematic risk since firm specific risk is diversified away in a diversified portfolio. Therefore, firm managers should also be indifferent to firm-specific risk in order to maximize shareholder value. Thus unnecessary. Its assumptions are unlikely to apply in practice. For example: * It is difficult for management to determine which risk is firm specific versus systematic * The risk-adjusted rate is often used to be a proxy for the risk level. However this rate mainly reflects risks that will arise in the future, but the insurer is also concerned about risks that may arise before that * The market based data is so noisy and so it would be difficult for management to conduct a proper cost-benefit analysis

Answer 116

1 Startup: Staffing & Scope 2 IRM Parameter Development 3 Implementation 4 Integration & Maintenance

Answer 117

1. Corporate Risk Tolerance 2. Cost of Capital Allocated 3. Cost-Benefit Analysis for Risk Mitigation

Answer 118

1. Calculate total trend from the claims data, and then net out inflation to generate the social inflation 2. Use general inflation metrics to adjust the data, and then model the residual superimposed inflation

Answer 119

1. Control Self assessment A process to examine and assess the effectiveness of internal controls to provide reasonable assurance that all business objectives will be met 2. Key Risk Indicator 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 3. Six sigma can help firms identify and eliminate process issues such as inefficiencies, errors, overlaps and gaps in communication

Answer 120

plan loss ratio determination The authors believe that "insufficient reserves" are a symptom of poor company analyses/managerial decisions They are a lagging indicator of either: – insufficient reserving initially (due to optimistic plan loss ratios); or – premature reserve releases

Answer 121

The issue is that it is static, having just one inflexible plan, and may not be appropriate if there are changes in the market. For example if the rate level drops, it may make more sense to reduce the premium goal accordingly.

Answer 122

There is a minimum price which reflects the expected losses and marginal costs of writing the business. It would not make sense to sell policies below this price. * Up to a certain quantity level, all business will sell at this minimum price * After this level, the industry has reached capacity and will therefore need to obtain more capital in order to write more business. It will need to charge for the incremental cost of capital, causing the supply curve to slow upward * Towards the right of the curve, the premium itself is providing enough margin to support this cost of capital, and so it reaches a maximum level

Answer 123

1) reinsurance provides stability 2) reinsurance frees up capital 3) reinsurance adds market value to the firm

Answer 124

1. Correlation requires lots of data to estimate, and is thus difficult to quantify 2. The correlation may change across the distribution, which requires a complex method such as copulas model 3. Correlation of 2 distributions can be done with a wide array of copulas. The options are limited when combining many classes.

Answer 125

Experts are given background information and asked for their opinions in a questionnaire. The answers are aggregated and then summaries are given back to the participants. Based on the summaries, participants can change their answers are articulate their reasons for disagreeing. This process is repeated until consensus is reached

Answer 126

1. Similarity to soft approach - econometric modeling includes the recognition of human factors impacting the UW cycle 2. Similarity to technical approach - econometric modeling requires mathematical rigor

Answer 127

During soft market, invest more in high yielding assets such as equity and high-yield corporate bonds during soft market. Because during soft market, company is taking on less insurance risk by reducing market share, so it makes sense to take on more asset risk, and extra investment income would help offset the reduction in UW income However, asset risk would increase during soft market. Equities are riskier than bonds. There is a risk that market price would decline after you invest more heavily in equities

Answer 128

1. When actual deviate from the overly optimistic plan, managers are reluctant to deviate from the plan numbers. This results in booked numbers that are unrealistic for far too long 2. Underwriters do whatever is necessary to meet their plan numbers (even if what they are doing is bad for the company)

Answer 129

Using an optimistic planned loss ratio as an ELR can lead to: 1. Reserve deficiencies 2. Inadequate rates

Answer 130

It’s difficult to determine if the forecasting model could not accurately predict the loss ratio (underwriting risk) or if the model was simply not used/implemented appropriately (operational risk)

Answer 131

Because if an estimated parameter does not accurately reflect the true underlying parameter, the projected results may be significantly understated or overstated

Answer 132

A copula can have significant right tail dependence even if R(1) = 0. This is due to the fact that the function decreases rapidly as z approaches 1. A solution is to look at the function at values slightly below 1 and assess the strength of the dependence at those values

Answer 133

The right tail concentration function calculates the probability density of a copula in the right tail. R(z) = P(U>z, V>z)/(1-z) = [1 - 2z + C(z,z)]/(1-z) L(z) = P(U

Answer 134

1. Support growth 2. Sustain current underwriting 3. Satisfy regulators, rating agencies, and shareholders 4. Provide for adverse reserve changes 5. Provide for declines in assets

Answer 135

1. The model shows the balance between risk and reward from different strategies (such as changing the asset mix or reinsurance program) 2. The model recognizes and reflects its own imperfection, including parameter uncertainty, simplistic assumptions or poor data quality And the 4 model qualities Models without the characteristic above often exaggerates certain aspects of risk while underestimating others. This can lead to overly aggressive or overly cautious corporate decision.

Answer 136

Proportional allocation Calculate risk measure for the insurer and each business unit separately. Allocate the total risk measure for the insurer proportionally using the individual risk measure Marginal decomposition Calculate the overall risk measure for the insurer. Then calculate the marginal co-measures for each business unit. The marginal co-measures sum to the company risk measure. Marginal decomposition is better since it reflects how the risk from each business unit impacts the total risk profile as opposed to looking at them in isolation

Answer 137

Purpose: to evaluate capital adequacy 1. Leverage ratios 2. Risk-Based Capital Models 3. Scenario Testing

Answer 138

Short-term: Reinvestment risk: if interest rate drop, bonds will be reinvested at lower interest rates and investment income may be too low to cover the liabilities Long term: If interest rate increase, the value of the bonds fall and they may need to be liquidated at depressed prices to fund liabilities

Answer 139

1. Insurance liabilities are variable in amount and timing, making duration matching impossible 2. The company can pay claims from premium cash flows, so an enterprise-wide model is needed 3. Tax considerations will also impact the optimal investment strategy

Answer 140

Model the capital absorbed in the current year using the combination of current accident year and as-if reserves. The as-if reserves are the loss reserves that would exist at the start of an accident year if the business currently being written had been written in a steady state for all prior years.

Answer 141

Adding accumulated risk spreads out the distribution and results in a fatter tail. This will cause TVaR to be significantly higher, resulting in a higher required capital

Answer 142

An efficient frontier plot shows risk on the y-axis and reward (or return in this case) on the x-axis. The curve graphs the portfolios that maximize return for a given risk level. If the current portfolio has the same return as one of the efficient portfolios but more risk, then it is sub-optimal. In order to select one of the efficient portfolios, firms must decide how much risk they are willing to tolerate and how much reward they are willing to give up for a reduction in risk 左上角的points更好，但是要consider company preferences and budget constraints,有多少additional cost 才能lower the probability of making plan

Answer 143

1. Works when business units can change volume in a homogeneous fashion 2. Works when the risk measure is scalable. This means that multiplying the random variable by a factor multiplies the risk measure by the same factor Rho(aY) = a*rho(Y) Also known as homogenous of degree 1

Answer 144

Static scenarios are pre-defined scenarios (defined by the firm). Stochastic scenarios are generated through a stochastic process

Answer 145

If a reinsurance has slightly stronger underwriting results but far more ceded premium, then the combined ratio will actually be worse (even though the absolute underwriting income is better) （对于insurer来说，ceded premium多了，所以net premium变少了，所以combined ratio变少了）

Answer 146

Historical data is often based on estimates of past claims which have not yet settled. In the projection period, the projection uncertainty is a combination of the uncertainty in each historical point AND the uncertainty in the fitted trend line. Thus, the actuary’s prediction intervals may be too narrow due to the missing uncertainty associated with the historical data

Answer 147

1. Deficient loss reserves 2. Underpricing 3. Rapid growth 4. Alleged fraud 5. overstated asset 6. Catastrophe 7. Reinsurance failure

Answer 148

Strategic risk-taking refers to intentional risk-taking as an essential part of a company’s strategic execution. Strategic risks are unintentional risks that occur as a result of strategy planning or execution

Answer 149

A Delphi process can create a set of scenarios and scenarios can form the input to a Delphi assessment about the likelihood of each scenario

Answer 150

1) how do economic factors (interest rate, inflation, cost of capital) influence the supply and demand curves? 2) how does capital influence the supply and demand curve? 3) how does the supply demand curve jointly determine price and quantity? 4) how does profitability affect external capital flows?

Answer 151

An econometric model is comprised of various components such as supply curves, demand curves, capital flows, inflation, etc. Each component influences the equilibrium price in specific ways. Various component changes can be simulated to create an empirical distribution of possible future equilibrium prices.

Answer 152

Dimension 1 - data quantity, variety and complexity: soft > behavioral > technical Dimension 2 - recognition of human factors: soft > behavioral > technical Dimension 3 - mathematical formalism and rigor: technical > behavioral > soft

Answer 153

Sources of information include 1. Customer surveys 2. Trade publication 3. News scanning 4. Rate filling

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