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Exam 7 > Brehm > Flashcards

Brehm Flashcards

1
Q

Define ERM

A

The process of systematically and comprehensively identifying critical risks, quantifying their impacts and implementing integrated strategies to maximize enterprise value.

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2
Q

Four Aspects of ERM

A
  1. Should be a regular process
  2. Risks should be considered on an enterprise basis
  3. Focused on risks that have significant impact to the value of the firm
  4. Risks must be quantified as best as possible. Calculate risk impacts on an overall, portfolio basis. Consider correlations.
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3
Q

Four Risks an Insurer Faces

A
  1. Insurance hazard - Risk assumed by insurer in exchange for a premium
  2. Asset - Volatility in interest rates, forex, equity prices, credit quality, and liquidity
  3. Operational - Execution of company business
  4. Strategic - Making right/wrong strategic choices given current and expected market conditions
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4
Q

Three Categories of Insurance Hazard Risk

A
  1. Underwriting - Non-CAT risk from in-force exposures
  2. Accumulation/CAT - CAT risk from in-force exposures
  3. Reserve deterioration - Deterioration of past exposures
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5
Q

Four Steps in ERM Process

A
  1. Diagnose - Determine risks that exceed a defined threshold
  2. Analyze - Model those risks as best as possible
  3. Implement - Implement risk management strategies
  4. Monitor - Monitor actual outcomes against expectations
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6
Q

Five Implementations of Risk Management Strategies (Traditional Risk Management)

A
  1. Avoidance
  2. Reduction
  3. Mitigation
  4. Elimination (Transfer)
  5. Retention
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7
Q

Three characteristics of a good ERM model and what a bad model leads to

A
  1. Model shows balance between risk and reward from different strategies
  2. Model reflects relative importance of risks to business decisions
  3. Model includes mathematical techniques to reflect the relationships among risks (dependencies)

A bad model can lead to overly aggressive or overly cautious corporate decision making

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8
Q

Five Types of Parameter Risk

A
  1. Estimation - Misestimation of model parameters due to imperfect data
  2. Projection - Uncertainty in projections of changes over time
  3. Event - Large unpredicted events can affect the model
  4. Systematic - Risks that operate simultaneously on a large number of individual policies (non-diversifying); e.g. inflation
  5. Model
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9
Q

Three Categories of Risks in Diagnosing Phase

A
  1. General Environment
  2. Industry Uncertainties (supply/demand, competition)
  3. Firm-Specific
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10
Q

Types of Operational Risk

A
  1. Internal Fraud
  2. External Fraud
  3. Employment Practices/Workplace Safety
  4. Damage to Physical Assets
  5. Business Disruption/System Failure
  6. Process Management - Policy process, claim processing, data entry
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11
Q

Three Explanations of Bridging Model Failure

A
  1. Could Not - Process and system failure
  2. Did (improperly used) - People failure
  3. Did Not (ignored) - Process and governance failure
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12
Q

Four Underwriting Cycle Performance Metrics

A
  1. Stability
  2. Availability
  3. Reliability
  4. Affordability
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13
Q

Four Areas of Focus for Underwriting Cycle Management

A
  1. Intellectual Property
  2. Underwriter Incentives
  3. Market Overreactions (maintain discipline)
  4. Owner Education (premium volume and expense ratio)
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14
Q

Three Types of Uncertainties in CAT Models

A
  1. Probabilities of events
  2. Severities of events
  3. Data quality
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15
Q

Goals of Agency Theory

A

Align management and business owner’s interests and understand the impacts when they are not.

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16
Q

Operational Risk Management Strategies

A
  1. Monitor (lawsuits, IT failure)
  2. Control (reputation, IT failure, misc HR risks)
  3. Quantify (pension funding)
  4. Contingency Planning (IT failure)
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17
Q

Goals of Control Self Assessments

A

Assess effectiveness of internal controls:

  1. Reliability of information
  2. Compliance with strategies/laws
  3. Safeguarding assets
  4. Efficient resource use
  5. Accomplishment of firm objectives
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18
Q

Key Risk Indicators

A

Monitor operational risk categories:

  1. Production (hit ratios, retention ratios)
  2. Internal Controls (audit frequency)
  3. Staffing (turnover, premium per employee)
  4. Claims (frequency, severity)
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19
Q

Six Sigma

A

Eliminate inefficiencies, data errors, gaps in communication:

  1. Underwriting (exposure verification, classification selection)
  2. Claims (coverage verification, ALAE)
  3. Reinsurance (coverage verification, reinsurance recoverables)
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20
Q

Seven Types of Strategic Risk

A

High to Low

  1. Industry (underwriting cycle, available capital)
  2. Project (M&A, R&D, IT)
  3. Stagnation (weak pricing - trying to maintain volume in soft market)
  4. Brand
  5. Competitor
  6. Customer (priority shifting)
  7. Technology (technology shifting, patents)
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21
Q

Scenario Planning for Strategic Risk

A
  • Company thinks through responses to certain events ahead of time
  • More flexibility when compared against just trying to “make plan”
  • Define desirable goals to optimize (net income, minimize TVaR)
  • Keep in mind that competitors will also be carrying out strategic plans (agent-based modeling)
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22
Q

Five Key Elements of ERM Model Quality

A
  1. Reflects relative importance of risks
  2. Created with deep knowledge of risk fundamentals
  3. Reflects dependencies between risks
  4. Created by modelers with a trusted relationship with senior management
  5. Reflects model uncertainty from all sub-models (CAT, macroeconomic)
23
Q

Four Considerations when Implementing ERM Model

A
  1. Staffing/Scope
  2. Parameter Development (inputs, correlations, software)
  3. Implementation (priority, impact, education)
  4. Integration/Maintenance (cycle, controls)
24
Q

ERM Model Staffing/Scope Recommendations

A
  1. Fair and balanced team leader
  2. Full-time employees
  3. Full control of input and outputs
  4. Initial scope should be about prospective underwriting year and variance around the plan
25
Q

ERM Model Parameter Development Recommendations

A
  1. Consider expertise of the team when deciding on building model components or using pre-built
  2. Include expert opinion from all insurance departments
  3. Correlations should be owned at a corporate level and recommended by the modeling team
  4. Validate and test an extended period
26
Q

ERM Model Implementation Recommendations

A
  1. Top management should set priority
  2. Regular communication to broad audiences
  3. Pilot test to prepare shareholders for a big change
  4. Bring leadership to a base-level of understanding
27
Q

ERM Model Integration/Maintenance Recommendations

A
  1. Integrate into the corporation calendar
  2. Major updates no more than semi-annually
  3. Centralized control of inputs, outputs, and templates
28
Q

Four Aspects of Underwriting Risk

A
  1. Frequency/severity distribution modeling
  2. Pricing risk (underpricing)
  3. Parameter risk
  4. CAT model uncertainty
29
Q

Four ERM Model Elements

A
  1. Underwriting Risk
  2. Reserving Risk (losses develop differently than expected)
  3. Asset Risk (macroeconomic model giving higher probabilities to more likely scenarios)
  4. Dependencies (macroeconomic conditions, CATs, underwriting cycle)
30
Q

Three Models of Projection Risk

A
  1. Simple Trend (trend line that ignores the fact that history may not yet be settled)
  2. Severity Trend and Inflation (sum of general and superimposed inflation)
  3. Time Series (capture the most uncertainty)
31
Q

Modeling Estimation Risk

A

Fit a lognormal (or normal) model to the MLE parameters’ covariance matrix. Use this to simulate the parameters for difference loss model iterations.

32
Q

Modeling Model Risk

A

Assign probabilities of each model being correct. Use these to select which model to use for the losses at each iteration.

33
Q

Four Underwriting Cycle Stages

A
  1. Emergence (competition)
  2. Control (data lags and competition)
  3. Breakdown (data lags and competition)
  4. Reorganization (competition)
34
Q

Four Theories of Underwriting Cycle Drivers

A
  1. Institutional Factors - data lags causing everyone to always be behind the actual market
  2. Competition - underwriting strategies drive price into the ground until market starts to harden
  3. Supply/Demand - shocks to capital change market capacity
  4. Economic Linkages - macroeconomics and the overall market as a whole drive profitability and cost of capital
35
Q

Possible Underwriting Cycle Model Predictors

A
  1. Previous time period profitability
  2. Internal financial variables (reserves, income, capital flows)
  3. Regulatory variables (rating upgrades/downgrades)
  4. Reinsurance sector financials
  5. Macroeconomic variables (inflation, unemployment)
  6. Financial market variables (interest rates, forex)
36
Q

Three Soft Approaches to Underwriting Cycle Modeling

A

Competitor intelligence:

  1. Scenarios
  2. Delphi Method
  3. Competitor Analysis
37
Q

Three Approaches to Underwriting Cycle Modeling

A
  1. Soft
  2. Technical
  3. Behavioral (Econometric)
38
Q

Six Strategic Decisions ERM Modeling Helps

A
  1. Setting capital requirements
  2. Identify sources of significant risk (+ supporting capital)
  3. Selecting reinsurance strategy
  4. Planning growth
  5. Managing asset portfolio
  6. M&A valuation
39
Q

Three Types of Risk/Return Metrics

A
  1. Statutory Accounting (little hedging)
  2. GAAP Accounting (little hedging)
  3. True Economics (duration matching used to lower interest rate risk)
40
Q

Asset-Liability Management vs Asset-Liability Matching

A

Matching simply looks at the durations of the asset and liabilities (interest rate risk). Management is a more comprehensive process that also looks at inflation risk, credit risk, and market risk.

Management drives decisions in changing the asset portfolio, reinsurance purchasing, or underwriting changes.

41
Q

Layers of Complexity in Asset-Liability Management

A
  1. Variable liability cash flows (timing and amount)
  2. Variable underwriting cash flows
  3. Tax considerations
  4. Equity investments
42
Q

Three Steps in the Evolution of Corporate Decision Making

A
  1. Deterministic Project Analysis - Single, deterministic forecast used to project future cash flows to calculate PV or IRR. Judgement used to consider uncertainties.
  2. Risk Analysis - Distribution set for uncertain variables. Distributions used to simulate cash flows.
  3. Certainty Equivalent - Similar to Risk Analysis, but uses corporate risk preferences to quantify risk judgements.
43
Q

Three Elements of Using ERM Model Output

A
  1. Corporate Risk Tolerance - How much risk is the firm willing to tolerate?
  2. Cost of Capital Allocation
  3. Cost-Benefit Analysis for Mitigation - Determining whether or not to undergo a risk mitigation project (e.g. EVA)
44
Q

Three Reference Points for Setting Capital Requirements

A
  1. Probability of default is remote (risk avoidance)
  2. Support renewal business
  3. Thrive after a CAT
45
Q

Why allocate Cost of Capital instead of Capital?

A

All lines of business have full-access to the entire capital. You aren’t actually doling out capital - it makes more sense to give every LOB a minimum profit target.

46
Q

Three Practical Models for Setting Capital

A
  1. Leverage Ratios - e.g. NWP-to-Surplus (IRIS ratios). Simple way that regulators monitor capital adequacy, but only cares about underwriting risk of firm overall.
  2. RBC and Rating Agency Capital - More comprehensive than Leverage Ratios, but still doesn’t distinguish between LOBs.
  3. Scenario Testing - Stochastic modeling reviewed by a regulator. 1-5 year projection taking into account various uncertainties and correlations.
47
Q

Theoretical Modeling for Setting Capital

A

ERM Models! Should focus on probability of impairment rather than probability of insolvency (economic capital) because probability of insolvency is so remote.

This provides a unifying measure of all risks and is more meaningful than practical models. Forces quantifying of all risks and using the ERM framework.

48
Q

Formula for Total Firm Cost of Capital

A

Required Capital x Hurdle Rate

49
Q

Risk-Adjusted Profitability

A

Ratio of the profit of a LOB to its risk measure

50
Q

Three Paradigms for Measuring Reinsurance Value

A
  1. Reinsurance Provides Stability - protects surplus, improves earnings predictability, protects insureds
  2. Reinsurance Reduces Capital Requirements
  3. Reinsurance Adds Value - this is talking about market value, since the cost of reinsurance is actually usually negative. This paradigm is largely theoretical and hard to quantify.
51
Q

Six Indications of Reinsurance Stability

A

Significant judgement needed when evaluating these:

  1. Financial Measures - combined ratio, net income
  2. Summary Statistics - mean/sd of reinsurance cost
  3. Probability Distributions - want to avoid limiting profitable scenarios too much
  4. Box/Space Needle View - shows probability in different ranges (bad scenarios vs good scenarios)
  5. Cost-Benefit Diagram
  6. Efficient Frontier
52
Q

Two Methods for Quantifying Reinsurance as Capital

A
  1. Net Benefit - Cost of Capital Reduction minus Net Reinsurance Cost
  2. Marginal ROE - Net Reinsurance Cost over Change in Required Capital

Can measure change in required capital using either theoretical (ERM) or practical models (easier, but uses risk proxies).

53
Q

Why use As-If Loss Reserves?

A

When quantifying reinsurance as capital, we evaluate the change in capital for a given year. However, long-tailed lines need significant capital to support older years’ reserves (accumulated risk). We add these old reserves to the current year to get the as-if loss reserves.

We can then apply reinsurance and correlated risk factors to this year to evaluate the effect on accumulated risk. This better captures the reduction in required capital from reinsurance.

54
Q

Five Reasons for Holding Sufficient Capital

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

Exam 7 (1 decks)

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