Brehm 1 CF Only

Question 1

a) Briefly define enterprise risk management.

b) Briefly describe four aspects of the definition above.

Answer 1

Part a:
⇧ Enterprise risk management is defined as the process of systematically and comprehensively identifying critical risks, quantifying their impacts and implementing integrated strategies to maximize enterprise value
Part b:
⇧ An effective ERM program should be a regular process, not just a one-time event
⇧ Risks should be considered on an enterprise basis
⇧ ERM focuses on risks that have a significant impact to the value of a firm
⇧ Risks must be quantified as best as possible. The impact of each risk should be calculated on an overall, portfolio basis and correlations with other risks should be considered

Question 2

Briefly describe four risks that an insurer faces.

Answer 2

⇧ Insurance hazard – risk assumed by insurer in exchange for a premium. Consists of underwriting risk, accumulation/cat risk, and reserve risk
⇧ Asset – risk in the insurer’s asset portfolio related to volatility in interest rates, foreign
exchange rates, equity prices, credit quality and liquidity
⇧ Operational – risk associated with the execution of the company’s business. For example, risks include the execution of IT systems, policy service systems, etc.
⇧ Strategic – risk associated with making the wrong or right strategic choices. In other words, it is the risk of choosing the wrong plan, given the current and expected market conditions

Question 3

Briefly describe the four steps in the ERM process.

Answer 3

⇧ Diagnose – company conducts a risk assessment to determine material risks that exceed a company-defined threshold
⇧ Analyze – risks that exceed a company threshold are modeled as best as possible
⇧ Implement – implement various activities to manage the risks
⇧ Monitor – monitor the actual outcomes of the plans implemented in the previous steps against expectations

Question 4

a) Provide four characteristics of a good enterprise risk model.
b) Briefly explain what may happen if a firm employs a weak enterprise risk model.

Answer 4

Part a:
⇧ The model shows the balance between risk and reward from different strategies (such as changing the asset mix or reinsurance program)
⇧ The model reflects the relative importance of various risks to business decisions
⇧ The model includes mathematical techniques to reflect the relationships among risks (dependencies)
Part b:
⇧ Models without the characteristics listed above often exaggerate certain aspects of risk while underestimating others. This can lead to overly aggressive or overly cautious corporate decision making

Question 5

Briefly describe four types of parameter risk.

Answer 5

⇧ Estimation risk – misestimation of model parameters due to imperfect data
⇧ Projection risk – refers to changes over time and the uncertainty in the projection of these changes
⇧ Event risk – refers to situations in which there is a causal link between a large unpredicted event (outside of the company’s control) and losses to the insurer
⇧ Systematic risk – refers to risks that operate simultaneously on a large number of individual
policies. Thus, they are non diversifying and do not improve with added volume

Question 6

a) Provide an example of event risk.

b) Provide an example of systematic risk.

Answer 6

Part a:
⇧ Latent exposures such as asbestos
Part b:
⇧ Inflation

Question 7

Provide three sources of uncertainty in catastrophe models.

Answer 7

⇧ Uncertainty relating to the probabilities of various events
⇧ Uncertainty relating to the amount of insured damage caused by each event
⇧ Uncertainty related to data quality

Question 8

Briefly describe a key aspect of asset modeling.

Answer 8

A key aspect of asset modeling is modeling scenarios consistent with historical patterns. When generating scenarios against which to test a insurer’s strategy, the more probable scenarios should be given more weight

Question 9

Provide four reasons for holding sufficient capital

Answer 9

⇧ Capital must be sufficient to:
• Sustain current underwriting
• Provide for adverse reserve changes
• Provide for declines in assets
• Support growth
• Satisfy regulators, rating agencies, and shareholders

Question 10

Briefly describe four common approaches for setting capital requirements.

Answer 10

⇧ Holding enough capital so that the probability of default is remote.
⇧ Holding enough capital to maximize the insurer’s franchise value. Franchise value includes an insurer’s balance sheet, customer base, agency relationships, reputation, etc.
⇧ Holding enough capital to continue to service renewals
⇧ Holding enough capital so that the insurer not only survives a major cat but thrives in its aftermath