Ch 14: Risk (2)

Question 1

Change in business mix risks: (4)

Answer 1

• By nature and size of contract:
  * Could lead to significant change in risk profile or capital needs of company that were not within the resources available to it
  * A significant unintended change in mix may cause a mismatch between the charges received and the expenes incurred. (if more policies with little contribution to overheads are sold than expected and less of other contracts with more contribution to overheads sold than expected - isnurance company might not receive sufficient overall contributons to cover overheads)
  * Also per-policy expenses may be less on smaller contracts and ths subsidised by larger contracts. If the actual mix is not in lne iwth what is expected, income from charges and premium loadings may be reduced and not matched by a reduction in expenses entirely
• By source of distribution channel
  * Mortality, withdrawal and expense assumptions will be based on expected mix of new business by source, a change in this mix may invalidate those parameters (only exposed to this risk if the company wishes to charge the same price for product through all distribution channels) (say if company prices differently for all channels and can achieve the same level of profitability in all channels then not exposed to this risk)

Question 2

Risk relating to volume of new business

Answer 2

• Too much business - Capital resources and administrative capacity may be exceeded
• Too little - fails to cover overhead expenses

Question 3

Risk associated with guarantees and options

Answer 3

• Company is offereing terms in advance of the happening of the event to which those terms relate
• Need to determine the cost of doing so using parameters for future experience combined with a model of how to calculate that cost. Risks associated with both of these
• Guarantee introduces risk that some shortfall will have to be covered by the company (this expected cost must be determined)
• Stochastic model will likely be used, assumptions on parameters and model used will introduce risk.
• Could protect itself if a suitable derivative is used

Question 4

Risks related to competition

Answer 4

• The need to compete may lead to decisions which increase its risk profile beyond that which can be supported by available resources, such as:
  * reduce premium rates or charges for new business
  * offer additional guarantees/options for new business
  * Increase bonuses for existing contracts
  * Increase salaries or commissions in respectie distribution channels
  * On existing business with reviewable charges - either do not increase the charges or reduce their rate of growth relative to ehat may have been intended originally.
  * Impact of above is compounded if greater volumes of new business result

Question 5

Risks associated with the actions of the management of the company

Answer 5

• Directors may make conscious deciosions to ignore sound risk-management advice in pursuit of other competitive aims such as maximising new business or shareholder earnings
• The risk management controls and systems in place are inadequate or not properly followed
• This may lead to:
  * Financial losses
  * Regulatory intervention (fines)
  * Reputational damage

Question 6

Actions of distributors which may increase risk and what the company can do to mitigate: (3) and (2)

Answer 6

• May take actions that are in line with their own/client interests but may give rise to financial risk to company:
• encourage lapse and re-entry where this is favourable to them but unfaourable to the company (if less profit is made than what would have been made had the initial policy not been discontinued)
• Take advantages of loopholes in contract design (anti-selection)
• Take advantage of timing loopholes in unit pricing practices
• Company needs to design its products and processes to minimise these risks as well as engaging with distributrs to discourage bad practice

Question 7

Def and risk arising from counterparties:

Answer 7

• Relies on entity to meet its obligations, risk that they fail to do this (default or do them at unacceptable standard)
• Reinsurance default
• Outsourcing arrangements (poor quality service)
• Corporate bonds default
• Distribution arrangements (non-recovery of broker balances)

Question 8

Climate change risks: (def and three classes)

Answer 8

• Risks arising from adverse changes in the physical environment and secondary impacts in the economy.
• Physical - first order impacts of environmental changes such as polution. (could increase mortality and claims)
• Transition - Refers to economic, political and market changes as a result of efforts to mitigate climate change (some investments may loose profitability (large carbon-footprint companies)
• Liability - arises from parties seeking compensation for the impacts of climate change (legal risks: new type of claim or not investing in sustainable invsetments)