Brehm Ch 4

Question 1

Define operational risk

Answer 1

Risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

It includes legal risk, but excludes strategic and reputational risk.

Question 2

List the 7 types of operational risk

Answer 2

1. Internal fraud
2. External fraud
3. Employment practices and workplace safety
4. Clients, products and business practices
5. Damage to physical assets
6. Business disruption and system failures
7. Execution, delivery and process management

Question 3

Describe the internal fraud type of operational risk and provide an example

Answer 3

Acts by internal party that unfairly take property or circumvent regulations.

Insurer-specific example:
claim falsification
insider trading
employee theft

Question 4

Describe the external fraud type of operational risk and provide an example

Answer 4

Acts by a third-party that unfairly take property or circumvent regulations.

Insurer-specific example:
falsifying application information
computer hacking

Question 5

Describe the employment practices and workplace safety type of operational risk and provide an example

Answer 5

Acts that are inconsistent with employment, health or safety laws.

Insurer-specific example:
repetitive stress
discrimination claims
general liability (customer slip and fall at office)

Question 6

Describe the clients, products and business practice type of operational risk and provide an example

Answer 6

Unintentional or negligent failure to meet a professional obligation to specific clients.

Ex:
client privacy
bad faith
red-lining
misuse of confidential customer information
money laundering

Question 7

Describe the damage to physical assets type of operational risk and provide an example

Answer 7

Loss or damage to physical assets from natural disasters

Ex:
damage to own office
damage to own automobile fleets
terrorism
vandalism
earthquakes and floods

Question 8

Provide an example of business disruption and system failures type of operational risk

Answer 8

Processing center downtime
System interruptions
Telecommunication problems

Question 9

Describe the execution, delivery and process management type of operational risk and provide an example

Answer 9

Failed transaction processing or process management, and relationships with vendors.

Ex:
policy processing errors
claim payment errors
data entry errors
unapproved access given to client accounts
incomplete legal documentation

Question 10

Identify 3 causes of P&C company impairments

Answer 10

1. Deficient loss reserves
2. Underpricing
3. Rapid growth
4. Alleged fraud
5. Overstated assets
6. Catastrophes
7. Reinsurance failure
8. Reckless management

Question 11

State the root reason for insurer failure.

Answer 11

Although reserves are normally cited as primary cause of insolvency, root reason for insurer failure is the accumulation of too much exposure for supporting asset based.

Deficient carried reserves are indicators of deficient initial reserving which is driven by optimistic plan loss ratios or premature reserve releases.

The plan LR determination process is considered the fulcrum of operational risk.

Question 12

Fully describe a bridging model leading to financial downfall

Answer 12

Ultimate LR from mature years are trended forward to set the new plan LR.

Ultimate LR for immature prior years are calculated with BF method using ELRs set to initial plan LR for each prior year.

An operational problem with bridging process is that it produces a high degree of interdependence between prior year ultimate loss ratios. Thus, optimistic older prior-year loss ratios can roll forward and lead to optimistic plan loss ratios.

Eventually, older years deteriorate, cause many AYs to deteriorate.

Question 13

Explain 3 possible explanations if an insurer failed due to reserve deterioration from bridging model. Explain how each relates to operational risk.

Answer 13

1. The model could not have accurately forecasted the loss ratio (or reserves)
   Operational risk: process and system failure (or inherent uncertainty and no operational risk if all competitors were wrong)
2. Model could have accurately forecasted the loss ratio (or reserves) but was improperly used.
   Operational risk: people failure
3. Model did accurately forecast the loss ratio, but the indications were unpopular and ignored.
   Operational risk: process and governance failure

Question 14

Identify 2 potential negative consequences of an optimistic plan LR to the company’s financial results.

Answer 14

1. Using an optimistic plan LR as ELR can lead to reserve deficiencies
2. Using an optimistic plan LR as ELR can lead to inadequate rates

Question 15

Explain why it is difficult to separate operational risk from underwriting risk when explaining the impact of an optimistic plan LR on the company’s financial results in retrospect.

Answer 15

It’s difficult to determine if forecasting model could not accurately predict the LR (underwriting risk) or if the model was simply not used/implemented appropriately (operational risk).

Question 16

Briefly describe cycle management

Answer 16

Cycle management is the management of UW capacity as market prices change with UW cycle (hard or soft).

Question 17

System performance assessments for cycle management rely on which 4 characteristics.

Answer 17

1. Stability
2. Availability
3. Reliability
4. Affordability

Question 18

Provide an example of naive cycle management and its possible results.

Answer 18

Writing business at inadequate prices during a soft market in order to maintain market share.

Possible results:

1. Insurer may be downgraded, causing policyholders to switch insurers (failure of stability and availability requirements)
2. Insurer may go insolvent with partial recoveries on claims for policyholders (failure of reliability and affordability requirements)

Question 19

Provide an example of effective cycle management. Why is this challenging?

Answer 19

Disciplined underwriting:
Soft market = decrease WP volume (do not write inadequately priced business)
Hard market = increase WP volume

This is challenging because it affects many critical areas simultaneously: planning, underwriting, objective setting and incentive bonuses.

Question 20

Describe 2 areas to focus for effective cycle management.

Answer 20

1. Intellectual Property
   An insurer’s franchise value is driven by intellectual property.
   Ex:
   Retain and continue to develop top talent through soft markets
   Maintain a presence in core marketing channels
   Maintain consistent investment in systems, models and databases
2. Underwriter Incentives
   Incentive plans should be flexible so underwriting decisions are aligned with corporate objectives, which change with market conditions.
   Ex:
   If prices drop too low, underwriters may need to stop writing new business, but their bonuses and employment should not be at risk.
3. Market overreaction
   When prices fall too low in a soft market, the insurer should maintain underwriting discipline and write less.
   When market hardens and prices overcorrect, the insurer will have capacity to write significantly more business profitably.
4. Owner Education
   Some financial figures may diverge from those of peer companies, such as:
   a. Premium volume: will drop during soft markets
   b. Overhead expense ratio: maintaining intellectual property during a premium decline will cause the expense ratio to rise

Question 21

Briefly explain how agency theory relates to operational risk

Answer 21

Agency theory considers management agents of a firm’s owners, whose interests are not always aligned.

These divergent interests are an operational risk.

Question 22

State 2 goals of agency theory

Answer 22

1. Aligning management and owner interests
2. Understanding the impacts of potential divergence

Question 23

Describe how interests of management and owner diverge when company agrees to pay management a % of increase in its market capital after n years.

Answer 23

Incentive: percentage of increase in market capital after n years.

Result: management may take too much risk to increase firm value because:
a. High upside benefit (big payoff if there is a major increase in firm value)
2. Low downside risk (gambling with someone else’s money)

Question 24

Describe how interests of management and owner diverge when company agrees to pay management in stock grants or stock options.

Answer 24

Incentive: stock grants or stock options

Result: management may become too risk-averse because:
a. Shareholders may have diversified portfolios
b. Management has a large portion of their wealth tied to the company

Question 25

Describe and explain how to handle pension funding risk

Answer 25

Combines financial and HR components.

Quantify this risk with models that include financial risk and firm demographics.

Question 26

Describe and explain how to handle IT failure risk

Answer 26

Includes traditional hardware and software failure as well as viruses and internet attacks.

Monitor and control with contingency planning.

The remaining risk could be quantified and funded.

Question 27

Describe and explain how to handle other HR risks.

Answer 27

Includes loss of important staff, employee fraud, inadequate training errors, rule breaking and incompetence.

Identification and control of these risks is most important.

Question 28

Describe and explain how to handle reputational risk.

Answer 28

Results from product tampering, bad press coverage, off-hours behaviour of key employees, etc.

Monitoring and controlling these risks is most important.

Question 29

Describe and explain how to handle lawsuits.

Answer 29

Results from a variety of things (making too much/little money, improper business practices)

Monitoring is key, but funding may provide value as well. Corporate culture can also reduce the risk of lawsuits.

Question 30

Describe Control Self-Assessment (CSA)

Answer 30

CSA is a process through which internal control effectiveness is examined and assessed.

Objective is to provide reasonable assurance that all business objectives will be met.

Question 31

Identify the 5 primary objectives of internal controls.

Answer 31

1. Reliability and integrity of information
2. Compliance with policies, plans, procedures, laws, regulations and contracts
3. Safeguarding of assets
4. Economical and efficient use of resources
5. Accomplishment of established objectives and goals for operations or programs

Question 32

Explain what are Key Risk Indicators (KRIs)

Answer 32

Risk indicators are measures used to monitor the activities and status of control environment of a particular business area for a given operational risk category.

They must have a frame of reference (escalation criteria/trigger level). When KRIs reach these, management is required to take action.

Question 33

Explain the key difference in review frequency of KRIs.

Answer 33

While typical control assessment processes occur only periodically, risk measures can be measured daily.

Question 34

Explain the key difference with historical losses of KRIs.

Answer 34

KRIs are forward-looking indicators of risk, whereas historical losses are backward-looking.

Question 35

Provide 4 insurer KRI examples

Answer 35

1. Production:
   Hit ratios
   Retention ratios
   Pricing levels
   Rate per unit of exposure
2. Internal controls
   Audit results
   Audit frequency
3. Staffing
   Employee turnover
   Training budget
   Premium per employee
   Policies per employee
4. Claims
   Frequency
   Severity
   New classes of loss

Question 36

Describe the 6 sigma framework and list 4 areas of focus.

Answer 36

Six sigma is a management framework.

Name means that customer-specified tolerances for product defects are plus/minus 3 standard deviations from mean.

Six sigma focuses on:
1. Process redesign
2. Project management
3. Customer feedback
4. Internal communications
5. Design tradeoffs
6. Documentation
7. Control plans

Question 37

Provide 3 examples of insurer processes that might benefit from process improvements of six sigma.

Answer 37

1. Underwriting
   Exposure data verification
   Exposure data capture
   Price component monitoring
   Classification
   Hazard selection
2. Claims
   Coverage verification
   ALAE
   Use of outside counsel
   Case reserve setting
3. Reinsurance
   Treaty claims
   Reporting
   Coverage verification
   Reinsurance recoverables
   Disputes
   Letters of credit
   Collaterization

Question 38

Provide 2 benefits of six sigma

Answer 38

Identify and eliminate:
1. Inefficiencies
2. Errors
3. Overlaps
4. Gaps in communication
5. Gaps in coordination

Question 39

Describe the steps needed for operational risk portfolio management.

Answer 39

1. Identify exposure base (payroll, head count, policy count, premium volume)
2. Measure the exposure level
3. Estimate the loss potential (frequency and severity) per unit of exposure
4. Create loss frequency and severity distributions by combining steps 2 and 3
5. Estimate the impact of risk mitigation, process improvement or risk transfer on freq/sev distributions

Question 40

Define strategic risk

Answer 40

Strategic risk is the risk to the company from making the right or wrong strategic decisions, not making a decision or not recognizing that a strategic decision needs to be made.

It’s the risk of choosing the wrong plan given market conditions.

Question 41

Define strategy

Answer 41

Long-term series of actions designed to take a company from its current state to its desired future state and aims to provide a competitive advantage over other companies in the same market.

Question 42

Describe 2 things that strategy is not

Answer 42

1. Pure business planning
   Strategy goes beyond this by ensuring companies understand the markets in which they are competing, where they sit relative to their competitors and how they will compete and outperform their rivals.
2. Tactics
   Tactics are short-term and detailed. Strategy is long-term and broad in scope.

Question 43

Define strategic risk management (SRM)

Answer 43

Means to devise and deploy a systematic approach for managing strategic risk.

Question 44

List 2 important elements of strategic risk.

Answer 44

1. Voluntariness of exposure
2. Controllability of consequences
3. Discounting in time
4. Knowledge of risky situation
5. Magnitude of impact
6. Group/individual factors

Question 45

List 2 concerns factored into strategic decision making under simplistic approach.

Answer 45

1. Obtaining more accurate forecasts
2. Adjusting factors empirically
3. Raising thresholds for required returns
4. Estimating best, probable and worst case outcomes (rudimentary scenario analysis)
5. Considering selected probabilities on key factors

Question 46

Describe 4 components of strategic risk analysis, their level of risk to insurer and provide an example.

Answer 46

1. Industry
   Capital intensiveness, overcapacity, commoditization, deregulation, cycle volatility.
   Insurer risk: very high
   Ex:
   UW Cycle
   Insurance as a commodity
2. Technology: shift, patents, obsolescence
   Insurer risk: low
   Ex:
   Data management
   Innovations in distribution over internet
3. Brand
   Erosion or collapse
   Insurer risk: moderate
   Ex:
   Reputation loss through bad press or class action lawsuits.
4. Competitor
   Global rivals, gainers, unique competitors.
   Insurer risk: moderate
   Ex:
   Predatory pricing from competitors
   Entrance into new market with inadequate expertise/system
5. Customer
   Priority shift, power, concentration
   Insurer risk: moderate
   Ex:
   This is an issue with large commercial insurance business
6. Project
   Failure of R&D, IT, business development or M&A
   Insurer risk: high
   Ex:
   Value-destroying M&A, underinvesting in R&D and IT
7. Stagnation
   Flat or declining volume, price decline, weak pipeline.
   Insurer risk: high
   Ex:
   Response to changes in UW cycle

Question 47

Describe scenarios used in scenario testing.

Answer 47

Range of future outcomes is limited to a fixed number of states called scenarios.

Scenarios…
1. Describe how various elements might interact under certain conditions.
2. Are tested for internal consistency and plausibility.
3. Are used to explore the joint impact of various uncertainties.
4. Change several variables at one time, trying to capture the impacts of major shocks in key variables.
5. Are more than just simulation output. They include subjective interpretations of factors that cannot be modelled.

Question 48

Describe the key steps in scenario planning process

Answer 48

1. Define the scope of the analysis (time frame, segments, etc)
2. Identify the major stakeholders (customers, competitors, employees, shareholders)
3. Identify basic trends and their influence on organization
4. Identify key uncertainties
5. Construct initial scenario themes by combining key elements
6. Check for consistency and plausibility (scenarios should be realistic and internally consistent)
7. Develop learning scenarios (identify themes that are strategically relevant)
8. Identify research needs (understand trend and uncertainties identified)
9. Develop quantitative models
10. Evolve toward decision scenarios (iterative process to converge to scenarios used to test strategies and generate new ideas)

Question 49

Describe a traditional planning approach

Answer 49

Begins by defining key plan components by LOB:
1. Base loss ratio
2. Cost trend
3. Price change
4. Target premium volume
5. Plan loss ratio

Question 50

Describe 2 issues of the traditional planning approach

Answer 50

1. Based upon plan estimates
   Theoretically, these estimates are unbiased and realistic.
   In reality, they are often overly optimistic due to the need to meet overall corporate profit or premium volume targets.
2. When actuals deviate from overly optimistic plan, managers are reluctant to deviate from plan numbers.
   This results in booked numbers that are unrealistic for far too long.
   Underwriters do whatever is necessary to meet their plan numbers at the detriment of the company’s health.

Question 51

Describe the scenario planning approach (alternative to traditional planning)

Answer 51

In contrast to traditional planning approach, scenario planning expands the single point estimate for price change from different scenarios (pessimistic, realistic, optimistic).

The likelihood and response plans for each scenario must be decided in advance.

For the 3 options, firm would need to develop detailed plans that would be activated depending on how market conditions play out (need to be monitored).

Question 52

Calculate scenario LR

Answer 52

Scenario LR = Base LR *(1+Cost Trend)/(1+Price Change)

Question 53

Describe a potential insurer response in the optimistic scenario

Answer 53

Ride the wave:
Insurer might books premium written.

Question 54

Describe a potential insurer response in the pessimistic scenario

Answer 54

Bail out:
The insurer might tighten premium written to avoid chasing market share in unprofitable environment.

Question 55

Describe 2 advantages of scenario planning

Answer 55

1. Company thinks through responses beforehand
   Can select best strategic response to different market conditions
2. Reduces organizational inertia
   Provides more flexibility compared to trying to “make plan” even if market conditions change

Question 56

Describe advanced scenario planning

Answer 56

Using ERM models, large sets of scenarios can be generated.

Depending on the scenario, the best strategy can be found by maximizing some performance metric and reducing downside risk.

Question 57

Describe how advanced scenario planning can be used in asset risk management.

Answer 57

For each scenario, various asset strategies are tested by simulating returns.

Each strategy is represented as a set of asset selection rules. Rules are repeatedly applied to rebalance portfolio in response to environment changes.

Rebalancing measures include selling bonds, changing investment allocations and buying tax-exempt investments in response to portfolio tax position.

Selected portfolio is the one that maximizes a performance metric (ex: NI, economic value) and reduces downside risk (ex: TVaR).

Question 58

Provide 2 examples of insurance-related action rules in response to environment changes,

Answer 58

1. Hold price in response to market price decreases. This reduces premium volume and market share.
2. Allocate underwriter capacity in various ways based on anticipated price adequacy levels.

Question 59

Describe how interactions between multiple firms might be handled in scenario planning.

Answer 59

In reality, multiple companies are engaged in strategy testing simultaneously.

These strategies compete with each other, creating negative impacts.

Capturing the dynamics of simultaneous action requires agent-based modelling (ABM).

Question 60

Describe agent-based modelling (ABM)

Answer 60

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.

When one agent’s changes interact with another agent’s changes, new qualities are creates in the environment (emergent properties).

Question 61

Provide an example of how one firm’s strategy might conflict with another firm’s strategy.

Answer 61

One firm might independently plan to target a profitable market segment.

The firm might 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 competitors attempts to grow in the same segment, prices drop and profitability decreases.

ABM allows a firm to model these types of interactions.