Brehm 4 CF Only Flashcards
Briefly describe seven types of operational risk loss events. For each event, provide one insurer specific
example.
⇧ Internal fraud – acts by an internal party that defraud, misappropriate property or circumvent the law or company policy (ex. claim falsification)
⇧ External fraud – acts by a third party that defraud, misappropriate property or circumvent the law (ex. claim fraud)
⇧ Employment practices and workplace safety – acts that are inconsistent with employment, health or safety laws (ex. repetitive stress)
⇧ Clients, products and business practices – unintentional or negligent failure to meet a professional
obligation to specific clients (ex. bad faith)
⇧ Damage to physical assets – loss or damage to physical assets from natural disasters (ex. physical damage to insurer’s office building)
⇧ Business disruption and system failures – disruption of business operations due to hardware and software failures, telecommunication problems, etc. (ex. processing center downtime)
⇧ Execution, delivery and process management – failed transaction processing or process management, and relationships with vendors (ex. policy processing errors)
Identify three causes of P&C company impairments.
⇧ Deficient loss reserves
⇧ Underpricing
⇧ Rapid growth
An actuary believes the root reason for insurer failures is reserve deficiency. State whether or not the actuary is correct. If the actuary is incorrect, provide the root reason for insurer failures.
⇧ The actuary is incorrect. The root reason for insurer failures is the accumulation of too much exposure for the supporting asset base
A company’s plan loss ratio determination process is considered the “fulcrum” of operational risk. Fully describe a bridging model that could lead to the financial downfall of the company. In your discussion, include three explanations for the company’s downfall and explain how they are related to operational risk.
⇧ The plan loss ratio is a forecast of the loss ratio for the upcoming underwriting period. A bridging model determines the plan loss ratio by bridging forward more mature prior-year ultimate loss ratios using year-over-year loss cost and price level changes. If the Bornhuetter/Ferguson (BF) method is used for immature prior years with an ELR equal to the initial plan loss ratio for the year, the prior-year ultimate loss ratio will remain close to its planloss ratio. Once older prior years begin to deteriorate, the BF ELRs for the more recent prior years will increase via the bridging. This could lead to a booked reserve deficiency, a possible rating downgrade, and a large exodus of policyholders
⇧ One explanation for the issues described above is that the plan loss ratio and reserve models could not accurately forecast the loss ratio and reserves. If competitors were NOT facing similar problems in forecasting loss ratios or reserves, then this explanation still implies that operational risk exists. Another explanation is that the plan loss ratio and reserve
models could have accurately forecasted the loss ratio and reserves, but the models were not properly used. This represents an operational risk due to people failure. The final explanation is that the plan loss ratio and reserve models did accurately forecast the loss ratio and reserves, but the indications were ignored. This represents an operational risk due to process and governance failure
a) Briefly describe cycle management.
b) Provide an example of naive cycle management.
c) Describe four areas that a company should focus on to ensure effective cycle management.
Part a:
⇧ Cycle management is the management of underwriting capacity as market prices change with the underwriting cycle
Part b:
⇧ An example of naive cycle management would be if a company decreased prices and expanded coverage in order to “maintain market share” during a soft market. As a result of these actions, price adequacy would drop. As the underwriting cycle hits bottom, the company would begin to recognize increased losses from its increased exposure. This could eventually lead to a rating downgrade, which may drive customers away and lead to stability and availability problems. The company may also become insolvent, which would lead to reliability and affordability problems
Part c:
⇧ Intellectual property
• An insurer’s franchise value is driven by intangible assets (i.e. intellectual property). Managers must focus on retaining top talent during periods of capacity retraction and continue to develop their skills. Managers must also maintain a presence in their core market channels
⇧ Underwriter incentives
• Cycle management requires adaptability and responsiveness. Oftentimes, underwriter incentives are written once a year and are tied to “making the plan.” The problem is that the plan is based on one assumed market situation. Instead, plans should be fluid and change based on the market condition. If prices drop to an unacceptable level, underwriters should be able to stop writing new business without fearing that their
bonuses will be in jeopardy
⇧ Market overreaction
• The insurance industry tends to overreact to the underwriting cycle. For example, market prices and coverage tend to soften below reasonable levels. Eventually, market prices and restrictions overcorrect to the other extreme. Firms can take advantage of this overreaction by better managing their underwriting capacity. In general, firms with the most available capacity during the hard market will reap huge profits that can offset several years of underwriting losses
⇧ Owner education
• Owners must understand what their financial figures mean AND what to do with that information. Under effective cycle management, financial figures may look out of line when compared with other companies. For example, premium volumes will drop under cycle management. For most firms, this is a bad sign. For an insurer practicing effective cycle management, this is perfectly fine. It’s important that owners NOT make calls
for increased market share during the worst possible point in the cycle
a) Briefly explain how agency theory relates to operational risk.
b) Describe a situation where the interests of the firm’s owners and management may not be aligned.
c) Quantifying this operational risk can be extremely difficult. Provide an alternative solution for managing this risk.
Part a:
⇧ When the interests of management and the interests of a firm’s owners diverge, management may make decisions that are not supported by the firm’s owners. This is an operational risk
Part b:
⇧ A company can agree to pay management a percentage of the increase in its market cap after five years. Although this ties manager compensation to the firm’s performance, management may be more willing to take on risky investments. In their mind, they could either end up incredibly wealthy or right where they are now. This allows them to gamble with the owner’s money
Part c:
⇧ Rather than trying to quantify this risk, we should study the incentive plan and make adjustments if necessary
a) Briefly describe control self-assessment.
b) Identify the primary objectives of internal controls.
Part a:
⇧ Control self-assessment is a process through which internal control effectiveness is examined and assessed. The goal is to provide reasonable assurance that all business objectives will be met
Part b:
⇧ The reliability and integrity of information
⇧ Compliance with policies, plans, procedures, laws, regulations and contracts
⇧ The safeguarding of assets
⇧ The economical and efficient use of resources
⇧ The accomplishment of established objectives and goals for operations or programs
a) Briefly describe key risk indicators.
b) Briefly explain the difference in review frequency between self-assessments and key risk indicator
measurement.
c) Briefly explain the difference in key risk indicators and historical losses.
d) Provide four insurer-specific examples of key risk indicators.
Part a:
⇧ Risk indicators are measures used to monitor the activities and status of the control environment of a particular business area for a given operational risk category
Part b:
⇧ While typical control self-assessment processes occur only periodically, key risk indicators can be measured daily
Part c:
⇧ Key risk indicators are forward-looking indicators of risk, whereas historical losses are backward-looking
Part d:
⇧ Production – hit ratios
⇧ Internal controls – audit results
⇧ Staffing – employee turnover
⇧ Claims – frequency
a) Describe the six sigma management framework.
b) Provide three insurer processes that might benefit from the six sigma management framework.
Part a:
⇧ Six sigma is a management framework that focuses on process redesign, project management, customer feedback, internal communication, design tradeoffs, documentation and control plans. For the financial services industry, six sigma can help firms identify and
eliminate inefficiencies, errors, overlaps and gaps in communication and coordination
Part b:
⇧ Underwriting – exposure data verification, exposure data capture, price component monitoring, classification and hazard selection
⇧ Claims – coverage verification, ALAE, use of outside counsel and case reserve setting
⇧ Reinsurance – treaty claim reporting, coverage verification, reinsurance recoverables, disputes,
letters of credit and collaterization
Definitions of strategic risk focus on either strategic risk-taking OR strategic risks. Explain the
difference.
⇧ 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
Briefly describe four categories of strategic risk. For each category, provide an insurance-related example.
⇧ Industry
• Capital intensiveness, overcapacity, commoditization, deregulation, cycle volatility
• Example – Insurers suffer from capital intensiveness
⇧ Technology
• Shift, patents, obsolescence
• Example – Insurers may experience technological advancement in internet distribution (issuing policies over the internet, adjusting claims over the internet)
⇧ Brand
• Erosion or collapse
• Example – Insurance products are fairly homogeneous. At the end of the day, the
primary feature of an insurance product is the ability to pay the claim. However, insurers can differentiate themselves on price and service. A reputation for fair claims handling and low prices can certainly improve franchise value
⇧ Competitor
• Global rivals, gainers, unique competitors
• Example – Pricing below the market in order to grab market share is a significant risk to rival insurers
A firm is setting next year’s plan for a LOB.
a) Describe the traditional planning approach based on “plan estimates.”
b) Briefly describe two issues that may be caused by using the traditional approach.
c) Describe the scenario planning approach.
d) Briefly describe two advantages of the scenario planning approach.
Part a:
⇧ The traditional planning approach is based on “plan estimates” (single point estimates). These estimates are often overly optimistic due to the need to meet overall corporate profit or premium volume targets. When actuals 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
Part b:
⇧ The firm may have an unforeseen reserve deficit
⇧ The overall portfolio mix (combination of written premium and corresponding written loss ratios) may not be what is intended. For example, if leadership had known that the loss ratio would be xx.x% during the planning phase, the target premium volume may have
differed
Part c:
⇧ In contrast to the traditional planning approach, scenario planning expands the single point estimates to includes various scenarios. The likelihood and response plans for each scenario must be decided in advance. For each option, the firm would need to develop detailed plans that would be activated depending on how market conditions play out
Part d:
⇧ The firm thinks through responses beforehand. It can prescreen and agree on the best response. It can also save time during crises by having strategic action plans laid out and ready for use
⇧ Organizational inertia is reduced (i.e. the plan is more flexible). The unrealistic urge to make the numbers at all costs is reduced
a) Briefly describe advanced scenario planning.
b) Describe how advanced scenario planning is used in asset management.
c) Provide two examples of insurer-related action rules that could be applied in response to environment changes in advanced scenario planning.
Part a:
⇧ In basic scenario planning, scenarios and strategies are manually generated. In advanced scenario planning, the best strategy for each scenario is found by maximizing some performance metric and reducing downside risk
Part b:
⇧ For each scenario, various asset strategies are tested by simulating the returns of portfolios selected by different strategies
⇧ Each strategy is represented as a set of asset selection rules, where the rules are repeatedly applied to rebalance the portfolio in response to the environment changes as the scenario progresses
⇧ Rebalancing measures include selling bonds, changing investment allocations and buying tax-exempt investments in response to the portfolio tax position
⇧ The selected portfolio is the one that maximizes a performance metric (ex. net income, economic value) and reduces downside risk (ex. TVaR)
Part c:
⇧ Hold price in response to market price decreases. This reduces premium volume and market share
⇧ Allocate underwriter capacity in various ways based on anticipated price adequacy levels
a) Briefly describe how the interaction between multiple firms might be handled in scenario planning.
b) Provide an example of how one firm’s strategy might conflict with another firm’s strategy.
Part a:
⇧ In order to capture the interactions between firms during scenario planning, firms must employ agent-based modeling (ABM). ABM is a method for studying systems of interacting “agents.” These “agents” are independent entities capable of assessing the environment, selecting courses of action and using those selections to effect change on the environment
Part b:
⇧ One firm might plan (in isolation) to target a market segment identified as profitable. The firm would create detailed plans outlining the target premium volume and loss ratio. However, they fail to recognize the fact that other competitors have also noticed the profitable
segment. When all of the competitors attempt to grow in the same segment, prices drop and the profitability of the line decreases
