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CAS Exam 9 > Brehm Ch 1 > Flashcards

Brehm Ch 1 Flashcards

1
Q

Define Enterprise Risk Management (ERM)

A

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

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2
Q

Describe 4 desirable characteristics of ERM

A
  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.
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3
Q

Identify the 4 types of risks faced by insurers.

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

Describe Insurance hazard risk

A

Risk assumed by insurer in exchange for a premium.

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5
Q

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

A
  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.
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6
Q

Briefly describe Financial (Asset) risk.

A

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

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7
Q

Identify the 4 steps of the ERM process.

DAIM

A
  1. Diagnose
  2. Analyze
  3. Implement
  4. Monitor
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8
Q

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

A

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

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9
Q

Identify the 3 risks found in the diagnose step.

A
  1. General environment
  2. Industry
  3. Firm specific
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10
Q

Briefly describe the General environment type of risk.

A

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
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11
Q

Briefly describe the industry type of risk.

A

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

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12
Q

Briefly describe the Firm specific type of risks.

A

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

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13
Q

Describe the 2nd step of ERM process (Analyze)

A

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.
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14
Q

Describe the 3rd step of ERM process (Implement)

A

Implement various activities to manage the risks.

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15
Q

Provide 4 examples of traditional implementation of ERM

A
  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
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16
Q

Describe the 4th step of ERM process (Monitor)

A

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

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17
Q

Provide 4 firm functions facilitated by enterprise risk models.

A
  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.
18
Q

Provide 3 characteristics of a good Enterprise Risk model.

A
  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)
19
Q

What happens if enterprise risk model is weak?

A

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.

20
Q

Identify the 4 essential elements of a mathematical enterprise model.

A
  1. Underwriting risk
  2. Reserving risk
  3. Asset risk
  4. Dependencies/correlations
21
Q

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

A

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

22
Q

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

A

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

23
Q

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

A

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.

24
Q

Briefly describe pricing risk.

A

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.

25
Q

Identify the 5 types of Parameter Risk.

A
  1. Estimation risk
  2. Projections risk
  3. Event risk
  4. Systematic risk
  5. Model risk
26
Q

Describe estimation risk

A

Misestimation of model parameters due to imperfect data.

27
Q

Describe projection risk.

A

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.

28
Q

Describe event risk

A

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.

29
Q

Provide 2 examples of event risk

A
  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)
30
Q

Briefly describe systematic risk

A

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.

31
Q

Provide 3 sources of cat modelling uncertainty

A
  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.

32
Q

Describe Reserving Risk

A

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.

33
Q

Identify 4 important classes of assets to model

A
  1. Bonds
  2. Equities
  3. Real estate
  4. Exchange rates
34
Q

Identify a key aspect of asset modelling.

A

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.

35
Q

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

A

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.

36
Q

Provide 3 sources of dependancies

A
  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.
37
Q

Briefly explain why insurers tend to focus on tail dependency.

A

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.

38
Q

Provide 4 reasons for holding sufficient capital.

A
  1. Sustain current underwriting
  2. Provide for adverse reserve changes
  3. Support growth
  4. Satisfy regulators, rating agencies and shareholders.
39
Q

Briefly describe 4 common approaches for setting capital requirements.

A
  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.
40
Q

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

A

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.

41
Q

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

A

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

42
Q

Identify a positive consequence of risk modelling.

A

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.

CAS Exam 9 (24 decks)

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