Brehm Ch 1

Question 1

Define Enterprise Risk Management (ERM)

Answer 1

Process of systematically and comprehensively:
1. Identifying critical risks
2. Quantifying their impacts
3. Implementing integrated strategies
to maximize enterprise value.

Question 2

Describe 4 desirable characteristics of ERM

Answer 2

1. An effective ERM program should be a regular process, not just a one-time event
2. Risks should be considered on an enterprise basis. It should consider risks other than insurance risk.
3. ERM focuses on risks that have a significant impact to the firm value.
4. Strategies must be implemented to avoid, mitigate and exploit risks.
5. Risks must be quantified as best as possible. Impact should be calculated on an overall portfolio basis and correlations with other risks should be considered.
6. Risk management strategies are evaluated for trade-off between risk and return to maximize firm value.

Question 3

Identify the 4 types of risks faced by insurers.

Answer 3

1. Insurance hazard risk
2. Financial (Asset) risk
3. Operational risk
4. Strategic risk

Question 4

Describe Insurance hazard risk

Answer 4

Risk assumed by insurer in exchange for a premium.

Question 5

Briefly describe the 3 sub-categories of insurance hazard risk.

Answer 5

1. Underwriting risk
   Risk due to non-cat losses from current exposures.
2. Accumulation/Cat
   Risk due to cat losses from current exposures.
3. Reserve deterioration
   Risk due to losses from past exposures.

Question 6

Briefly describe Financial (Asset) risk.

Answer 6

Risk in the insurer’s asset portfolio related to volatility in
1. Interest rates
2. Foreign exchange rates
3. Equity prices
4. Credit quality
5. Liquidity

Question 7

Identify the 4 steps of the ERM process.

DAIM

Answer 7

1. Diagnose
2. Analyze
3. Implement
4. Monitor

Question 8

Describe the 1st step of the ERM process (Diagnose)

Answer 8

Company conduct a risks assessment to determine material risks that exceed company-defined thresholds.

Question 9

Identify the 3 risks found in the diagnose step.

Answer 9

1. General environment
2. Industry
3. Firm specific

Question 10

Briefly describe the General environment type of risk.

Answer 10

Include:

1. Political uncertainties
   Ex: democratic changes, war, revolution
2. Government policy changes
   Ex: fiscal, monetary changes, regulation
3. Macroeconomic changes
   Ex: inflation, interest rates
4. Catastrophes
   Ex: earthquake, hurricane

Question 11

Briefly describe the industry type of risk.

Answer 11

Include:
1. Input market changes (supply)
2. Product market changes (demand)
3. Competitive uncertainties (new entrants, rivalry)

Question 12

Briefly describe the Firm specific type of risks.

Answer 12

Include:
1. Operating changes (labor)
2. Liability changes (products, pollution)
3. Research & Development
4. Credit
5. Behavioral

Question 13

Describe the 2nd step of ERM process (Analyze)

Answer 13

Risks that exceed company threshold are modelled as bess as possible:

1. Risks are quantified by creating probability distributions of potential outcomes.
2. Correlations among risk factors are recognized and distributions must be integrated across individual risks.
3. Risk metrics are calculated using combined distribution of outcomes.
4. Risk factors that contribute the most to the risk metrics must be prioritized.

Question 14

Describe the 3rd step of ERM process (Implement)

Answer 14

Implement various activities to manage the risks.

Question 15

Provide 4 examples of traditional implementation of ERM

Answer 15

1. Risk avoidance
   Ex: exit market
2. Reduce risk occurrence
3. Risk mitigation
   Ex: increase deductible
4. Risk transfer
   Ex: buy reinsurance
5. Retention of risk
   Ex: retain exposure

Question 16

Describe the 4th step of ERM process (Monitor)

Answer 16

Monitor the actual outcomes of plans implements in previous steps against expectations.

Should not be viewed as a project to be completed.

Company will frequently update for:
1. New risks to address
2. New ways to control them
3. New options for treating them
4. New ways of transferring them

Question 17

Provide 4 firm functions facilitated by enterprise risk models.

Answer 17

1. Determining capital needed to support risk, maintain ratings, etc.
2. Identifying sources of significant risk and cost of capital to support them.
3. Setting reinsurance strategies.
4. Planning growth
5. Managing asset mix.
6. Valuing companies for mergers and acquisitions.

Question 18

Provide 3 characteristics of a good Enterprise Risk model.

Answer 18

1. Model shows balance between risk and reward from different strategies (such as changing asset mix or reinsurance program)
2. Model recognizes and reflects its own imperfections.
   Imperfections include parameter uncertainties, simplistic assumptions and poor data quality.
3. Model reflects relative importance of various risks to business decisions.
4. Modelers have a deep knowledge of the fundamentals of those risks.
5. Model includes mathematical techniques to reflect the relationship among risks (dependancies/correlations)
6. Modelers have a trusted relationship with senior management of the company.
7. Model reflects the uncertainty of the output of other models being incorporated (such as cat models or macroeconomic models)

Question 19

What happens if enterprise risk model is weak?

Answer 19

Models without the characteristics of a good model often exaggerate certain aspects of risk while underestimating others.

This can lead to overly aggressive or overly cautious corporate decisions.

Question 20

Identify the 4 essential elements of a mathematical enterprise model.

Answer 20

1. Underwriting risk
2. Reserving risk
3. Asset risk
4. Dependencies/correlations

Question 21

Briefly explain why operational and strategic risk are often excluded from mathematical enterprise model.

Answer 21

Operational and strategic risks do not lend themselves to quantification and other methods are often needed to manage these risks (such as copulas).

Question 22

Briefly describe the Underwriting Risk (in the context of mathematical enterprise risk model)

Answer 22

Consists of:
1. Loss frequency and loss severity
2. Pricing Risk
3. Parameter Risk
4. Cat modeling uncertainty

Question 23

Briefly describe how Loss Frequency and Loss severity uncertainty is taken into account in underwriting risk.

Answer 23

Variety of distributions provide a decent fit of insurance data.

Statistical methods exist to estimate distribution parameters, test the quality of the fit and understand the remaining uncertainty.

Best modelers have best control of those issues.

Question 24

Briefly describe pricing risk.

Answer 24

Instability in underwriting results arising from variations in premiums as well as losses.

Underwriting cycle contributes heavily to pricing risk and needs to be modeled over multiple periods.

Question 25

Identify the 5 types of Parameter Risk.

Answer 25

1. Estimation risk 2. Projections risk 3. Event risk 4. Systematic risk 5. Model risk

Question 26

Describe estimation risk

Answer 26

Misestimation of model parameters due to imperfect data.

Question 27

Describe projection risk.

Answer 27

Refers to changes over time and uncertainty in projection of those changes. Examples: 1. Trending frequency and severity of future periods. 2. Loss development Unexpected changes in risk conditions also contribute to projection risk and include: 1. Increase in driving due to cheaper fuel 2. Criminals attach security vehicles because banks are more secure 3. Long-term shift to more extreme weather events aggravates property damage.

Question 28

Describe event risk

Answer 28

Refers to situations in which there is a causal link between a large unpredicted event (outside of company's control) and losses to the insurer.

Question 29

Provide 2 examples of event risk

Answer 29

1. Class-action lawsuits 2. Latent exposures (asbestos) 3. New cause of loss emerges while previously regarded as not covered (mold, construction defect) 4. New entrants into market reduces rates to grab market share. 5. Legal decisions on policy wording (court decides to ban a policy exclusion)

Question 30

Briefly describe systematic risk

Answer 30

Refers to risks that operate simultaneously on a large number of individual policies. Thus, are non diversifiable and do not improve with added volume. Ex: 1. Inflation 2. All previously discussed parameter risk.

Question 31

Provide 3 sources of cat modelling uncertainty

Answer 31

1. Cat exposure is incorporated into enterprise risk models by incorporating proprietary cat models. 2. These models often differ from each other and change over time as modelling firms release model updates. 3. Each model includes considerable uncertainty relating to the probabilities of various events and relating to the amount of insured damage caused by each event. 4. Data quality and assumptions also contribute to cat model uncertainty. !!! Enterprise risk models need to incorporate this uncertainty into cat model results.

Question 32

Describe Reserving Risk

Answer 32

Risk of reserves developing other than as anticipated. Affects both amount of required capital and time for which capital must be held. Traditional reserving techniques are deterministic and do not provide a means of understanding reserve variability. Stochastic reserving is becoming more popular and is used to develop reserve ranges.

Question 33

Identify 4 important classes of assets to model

Answer 33

1. Bonds 2. Equities 3. Real estate 4. Exchange rates

Question 34

Identify a key aspect of asset modelling.

Answer 34

Modelling scenarios consistent with historical patterns. When generating scenarios agains which to test an insurer's strategy, the mode probable scenarios should be given more weight.

Question 35

How do asset, underwriting, insurance and investment risk interact in a good model.

Answer 35

Good enterprise risk model help balance asset and underwriting risk. Insurers can optimize their use of capital by offsetting insurance risks with investment risk (aka duration matching) since liabilities and assets often have different durations.

Question 36

Provide 3 sources of dependancies

Answer 36

1. Inflation rates, interest rates, equity values are correlated and should be modelled as such in a macroeconomic model. 2. Underwriting cycles, insurance loss trends and reserve development are correlated across LOBs and with each other. 3. Cats and other kinds of event risk are often correlated across LOBs.

Question 37

Briefly explain why insurers tend to focus on tail dependency.

Answer 37

Because extreme events such as large earthquake can create simultaneous large losses for multiple LOBs (prop, workers comp, auto). Tail dependency is often modelled using copulas.

Question 38

Provide 4 reasons for holding sufficient capital.

Answer 38

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

Question 39

Briefly describe 4 common approaches for setting capital requirements.

Answer 39

1. Default avoidance: holding enough capital so that probability of default is remote. Very conservative approach and mainly protects the PH. 2. Holding enough capital to maximize insurer's franchise value (BS, customer base, agency relationships, reputation, etc). Protects both PH and shareholder. 3. Holding enough capital to continue to service renewals (since renewals tend to be more profitable). 4. Holding enough capital so that insurer not only survives a major cat but thrives in its aftermath.

Question 40

True or False? An enterprise risk model is best reliable in the extremes.

Answer 40

False. ER model is least reliable in the extremes. Extreme reference points are difficult to model accurately and it is better to focus on more manageable probability levels.

Question 41

Once probability level for model is selected, how do you calculate amount of loss?

Answer 41

Need to choose risk measure. Examples include VaR and TVaR.

Question 42

Identify a positive consequence of risk modelling.

Answer 42

Ability to measure risk-adjusted performance of various business segments. Done by allocating capital to business segments using risk measures and then measuring the risk-adjusted return on the allocated capital.