Brehm CH4 Flashcards
Describe Operational risk
The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
7 types of operational risk loss events
- Internal fraud
- External fraud
- Employment practices and workplace safety
- Clients, products and business practices
- Damage to physical assets
- Business disruption and system failures
- Execution delivery and process management
Describe internal fraud risk
Acts by an internal party that defraud, misappropriate property (unfairly take) or circumvent the regulations
Examples: misreporting of positions, employee theft and insider trading, claim falsification
Describe external fraud risk
Acts by a third party the defraud, misappropriate property or circumvent the law
Examples: robbery, forgery, and computer hacking, claim fraud, falsifying application information
Describe employment practices and workplace safety risk
Acts that are inconsistent with employment, health or safety laws
Examples: WC claims, violation of employee health and safety rules, discrimination claims and organized labor activities, repetitive stress
Describe clients, products and business practices risk
Unintentional or negligent failure to meet a professional obligation to specific clients. The nature/design of a product also poses an operational risk.
Examples: Fiduciary breaches, misuse of confidential customer information, money laundering, sale of unauthorized products, client privacy, bad faith and red-lining
Describe Damage to physical assets risk
Loss or damage to physical assets from natural disaster
Examples: terrorism, vandalism, earthquakes and floods, physical damage to its own office building and its own automobile fleets
Describe business disruption and system failures risk
Examples: hardware and software failures, telecommunication problems and utility outages, processing center downtime and system interruptions
Describe execution, delivery and process management risk
Failed transaction processing or process management, and relationships with vendors
Examples: data entry errors, incomplete legal documentations, unapproved access given to client accounts and vendor disputes, policy processing and claim payment errors.
Examples of primary causes of P&C company impairment
- Deficient loss reserves
- Underpricing
- rapid growth
- Alleged fraud
- Overstated assets
- Catastrophes
- Reinsurance failure
- Reckless management
What’s the root reason for insurer failure?
The accumulation of too much exposure for the supporting asset base.
What’s fulcrum of operational risk
The plan loss ratio determination process
Describe Bridging model and operational problem with it
Bridging model: where more mature prior-year ultimate loss ratios are bridged forward using estimates of year-over-year loss cost and price level changes.
Operational problem: it produces a high degree of interdependence between prior-year ultimate loss ratio. Thus, optimistic older prior-year loss ratios can roll forwrad and lead to optimistic plan loss ratios.
Describe reserve conflagration
When older prior years begin to deteriorate, the BF ELRs for the newer prior years will increase (via the bridging). This represents pure operational risk.
Describe 3 operational risk associated with Lemur’s plan loss ratio and reserving processes
- Unpredictability of the insurance process: The plan loss ratio could not accurately forecast the loss ratio.
- People failure: The plan loss ratio model could have accurately forecasted the loss ratio, but wasn’t properly used.
- Process and governance failure, The plan loss ratio model did accurately forecast the loss ratio, but the indications were ignored.
Describe cycle management
It’s the management of underwriting capacity as market prices chagne with the underwriting cycle
4 categories that system performance assessments focus on
- Stability
- Availability
- Reliability
- Affordability
Describe performance assessment under naive cycle management
- Maintain market share
- As the insurer decreases prices and expands coverage, price adequacy drops. Although this allows the insurer to maintain premium volume, exposure increases.
- As the underwriting cycle hits bottom, the insurer start to have increased losses from its increases exposure.
- The insurer runs the risk of being downgraded, which may drive customers away (this is stability and availability problem)
- The insurer also runs the risk of being insolvent, which means customers may not receive full claim payments (this is reliability and affordability problem)
Describe performance assessment under effective cycle management
- a firm must re-engineer its underwriting decision processes.
- The insurer can achieve process improvements by focusing on intellectual property, underwriter incentives, market overreaction and owner education
Describe how intellectual property can achieve process improvement
- An insurer’s franchise value is driven by intangible assets (intellectual property)
- Example: expertise of an insurer’s staff, the proprietary database of policyholder information, pricing and reserving, market relationships and reputations
- Managers must focus on retaining top talent during periods of capacity retraction and continue to develop their skills
- Managers must maintain a presence in their core market channels
- Managers must continue to invest in systems, models, and databases
Describe how underwriter incentives can achieve process improvement
- Cycle management requires adaptability and responsiveness
- 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, underwriter incentives should be based on how well underwriters supported the portfolio goals throughout the year.
Describe how market overreaction can achieve process improvement
- The insurance industry tends to overreact to the underwriting cycle.
- Example: market prices and coverage tend to soften below reasonable levels. Eventually, market prices and restrictions overcorrect to the over extreme
- Insurers can take advantage of this market overreaction by better managing underwriting capacity
- Firms with the most available capacity during the price-improvement phase(hard market) will reap huge profits that can offset several years of underwriting losses
Describe how owner education can achieve process improvement
- Owners must understand what their financial figures mean and what to do with that information
- It’s important that owners not make calls for increased market share during the worst possible point in the cycle
- Owners should understand what the overhead expense ratio is telling them. For example, a higher overhead expense ratio indicates operational inefficiency for most firms. For an effective cycle management, the overhead expense ratio is expected to rise as premium volume decreases.
2 goals of agency theory
- Aligning management and owner interest
- Understanding the impacts of potential divergence
2 examples on why it’s difficult to align the interests of owners and management
- A company can agree to pay management a percentage of the increase in its market cap after five years. This might lead management to make riskier investments. Gambling with owner’s money
- A company can agree to pay management in stock grants or stock options. Since management’s compensation is completely tied to the performance, management might be less willing to take on risk.
Describe pension funding risk
- Combines financial and HR components
- Models that incorporate financial risk with firm demographics are needed to quantify this risk
Describe IT failure risk
- Includes traditional hardware and software failure, as well as viruses and internet attacks
- Monitoring and contingency planning are key in managing this risk
Describe other HR risks
- include loss of important staff, employee fraud, inadequate training, errors, rule breaking, incompetence
-Monitoring and controlling these risk is more important than quantifying/funding them
Describe reputation risk
- Results from product tampering, bad press coverage, off-hours behavior of key employees
-Monitoring and controlling these risk is more important than quantifying/funding them
Describe lawsuits risk
- results from a variety of things such as making too much money, making too little money, improper business practices.
- Although monitoring behavior is key for this risk, funding may provide value as well.
Describe CSA (control self-assessment)
it’s a process through which internal control effectiveness is examined and assessed.
The objective is to provide reasonable assurance that all business objectives will be met.
Main objectives of internal control
To ensure:
1. the reliability and integrity of information
2. compliance with policies, plans, procedures, laws, regulation and contracts
3. safeguarding of assets
4. economical and efficient use of resources
5. the accomplishment of established objectives and goals for operations or programs
Describe risk indicators
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.
Key risk indicators (KRI) are forward-looking indicators of risk, whereas historical losses are backward-looking
Examples of insurer KRIs (key risk indicators)
- production (hit ratios, retentions)
- internal controls (audit results, audit frequency)
- staffing (employee turnover, training budget)
- claims (frequency, severity)
What does six sigma mean?
Customer-specified tolerances for product defects are plus/minus three standard deviations from the mean.
It’s a management framework, focusing on existing process improvement and predictive design.
How six sigma can be used in financial services industry
It can help firms identify and eliminate inefficiencies, errors, overlaps and gaps in communication and coordination.
Steps needed for operational risk portfolio management
- Identify exposure bases for each key operational risk source
- Measure the exposure level for each BU for each operational risk source
- Estimate the loss potential (frequency and severity) per unit of exposure for each operational risk, reflecting the existing levels of internal controls and process effectiveness
- Combine steps 2 and 3 to produce modeled BU loss frequency and severity distributions
- Estimate the impact of mitigation, process improvements or risk transfer on the BU loss frequency and severity distributions
Definition of Strategy
a 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
Describe strategic risk management (SRM)
- to devise and deploy a systematic approach for managing strategic risk, such as industry, technology, brand, competitor, customer, product, stagnation
- using strategic risk analysis as an input for the strategy development process, aiding strategy formulation, evaluation, choice and implementation
Examples of strategic risks for an insurer
- Industry (capital intensiveness, overcapacity) - high risk
- Technology (experience technological advancement in the internet distribution and data management) - low risk
- Brand (insurance products are fairly homogeneous. A reputation for fair claims handling and low prices can certainly improve franchise value) - moderate risk
- Competitor (pricing below the market to grab more market shares, entering a new market with inadequate underwriting expertise) - moderate risk
- Customer (this risk is worse for large commercial insurance companies )- moderate risk
- Project (mergers and acquisitions can destroy the value of a company. Insurers often under-invest in R&D and IT) - high risk
- Stagnation (Insurers have a hard time redeploying assets. Suffer from extensive reporting lags and mismatched revenue/expenses. Tend to respond poorly to market price cycles ) - high risk
Characteristics of scenario planning
- The range of future outcomes is limited to a fixed number of states called scenarios. They describe how various elements might interact under certain conditions
- Scenarios are tested for internal consistency and plausibility
- Scenarios are used to explore the joint impact of various uncertainties
- Scenarios change several variables at one time, trying to capture the impacts of major shocks in key variables
- Scenarios are more than just simulation output. They include subjective interpretations of factors that cannot be modeled.
Key steps in the scenario planning process
- Define the scope - time frame and level of analysis
- Identify the major stakeholders
- Identify basic trends
- Identify key uncertainties
- Construct initial scenario themes
- Check for consistency and plausibility
- Develop learning scenarios
- Identify research needs
- Develop quantitative models
- Evolve toward decision scenarios
Advantage of scenario planning
- The company thinks through responses beforehand. It can prescreen and agree on the best response. It can also save time during cries by having strategic action plans laid out and ready for use
- Organizational inertia is reduced (the plan is more flexible). The unrealistic urge to make the numbers at all costs is reduced
