Ch 31: Other Risk Control Flashcards
Tools to aid management and control of risk for a financial product provider:
- Diversification
- Underwriting at the proposal stage - ensures fair price is paid for risk
- Claims control procedures - mitigate consequences of risk event that has occurred
- Management control systems - reduce exposure to risk
Diversification
Diversification
Risk can be diversified within the following:
* Lines of business
* Geographical areas of business
* Providers of reinsurance
* Investments - asset classes
* Investments - assets held within a class
Notes:
- Diversification of business lines achieved by
marketing wide range of contracts insuring a wide
range of risks - expensive in terms of administrative
systems, staff training etc. - Reciprocal reinsurance arrangements
Underwriting
Assessment of potential risks so that each can be charged an appropriate premium
Underwriting at proposal stage :Used to manage risks
- It can protect the provider from anti-selection
- It enables the provider to classify risks into homogeneous risks for which a standard premium can be
charged, and thus helps to ensure that all risks are rated fairly - It enables the provider to identify risks for which special terms need to be quoted
- For substandard risks - identifies most suitable approach and level for special terms
Examples of special terms: - Increasing premium for given level of benefit
- Decreasing benefit for given level of premium
- Exclusion clauses
- Deferring cover until more info known
- Declining cover
- It helps in ensuring that claim experience does not depart too far from that assumed in the pricing of
the contracts being sold - For larger proposals, it will help reduce the risk of over-insurance
LIFE INSURANCE UNDERWRITING
- Medical underwriting
- Lifestyle underwriting
- Financial underwriting
Medical underwriting:
- Assessing applicant’s health
- Asking questions on the proposal form
- Obtaining reports from a policyholder’s
doctor(s) - Carrying out a medical examination
- Performing specialist tests on the
applicant - Look at market practice in setting the
medical limits at which the various tests are
triggered / seek reinsurer’s advice
Lifestyle underwriting
- Assessing the impact of lifestyle on level of
risk - Applicant’s occupation
- Leisure pursuits of the applicant
- Applicant’s normal country of residence
- Examples: standard of living, diet & lifestyle,
climate, prevalent diseases, access to
medical care & quality of care, levels of
violent crime, terrorism/ war
Financial underwriting
- Assess financial health of applicant
to reduce risk of over-insurance
Interpretation of evidence
- Needs to be interpreted by specialist underwriters
- Initially reviewed by administrative staff - classify as
OK / not OK - If queries raised - passed on for further consideration
and dealt with by referring to reinsurer’s manual
Specification of terms
- Applicants whose state of health
reaches required standard - standard
terms - Special terms
- Addition to premium
- Reduction to benefit
- Exclusion clause
- Declining the applicant -
temporarily / permanently
Banking underwriting
Process by which banks decide whether potential
borrower is creditworthy
Includes:
* Assessment of willingness and capacity of
customer to repay loan
* Credit history and past performance of customer
* Customer identity and income verification
* Credit bureau data - other credit products taken
up by customer
* Internal scorecard assessments to determine
creditworthiness
* Collateral valuation and assessment in the case of
secured lending
Claims control systems
Claims control system:
* Mitigate the consequences of a financial risk that has occurred
* Guard against fraudulent / excessive claims
* Inspect, verify, different estimates, loss adjusters
* Ensures claim meets conditions and remains valid claim - claim management continues during claim
Management control systems
Examples of management control systems :
* Data recording
- Good quality data with emphasis on risk factors
- Reduces operational risks
* Accounting and auditing
- Enable adequate provisions to be established and
regular premiums to be collected
- Can reassure providers of finance of financial position
- Monitoring of liabilities taken on
- Protect against aggregation of risks of
a specific type to an unacceptable level - Monitor cross-subsidies
- Options & guarantees – monitor &
determine whether they are likely to
bite
Managing the risks associated with options and guarantees
Risk associated with options & guarantees
* Guarantees/ options could cost provider more than expected. Market risk: falls in market values could
cause such guarantees to bite more than expected
* Difficulties arising in relation to asset-liability matching & liquidity management due to uncertainty of
liability cashflows
Techniques for managing options and guarantees:
- Liability hedging and asset-liability matching
- Choosing assets which match the liabilities - move consistently with each other
- Use of derivatives
- Dynamic hedging - rebalancing underlying hedging portfolio as market conditions change
- Restricting option eligibility conditions
Low likelihood, high impact risks
Such risks are among the most difficult to manage, and:
* Can only be diversified in a limited way
* Can be transferred to an insurer / reinsurer
- Catastrophe insurance / stop loss cover
* Can be mitigated by manager control procedures, e.g., disaster recovery planning
Notes:
* Some such risks can only be accepted, with capital held against them
* Very rare events can fall beyond the company’s risk tolerance (e.g., with a less than 0.5% probability of
happening within a year) and so may be disregarded
Risk financing
- Price accepted for risk must be adequate
- Allowing risk taker to continue is business
- Contribution to profit
- Necessary to ensure that risks are actively managed
- Determine amount of capital to hold against risk accepted / retained
- To target a ruin probability over a specified period
- The shorter the period chosen, the lower the ruin probability must be
- Risk management process
- Ensure that there is sufficient capital - used efficiently and creates value for stakeholders
- Should reduce the total cost of risk
Risk management can optimise risk / return profile by:
- Supporting selective growth of the business
- Establish process for assessing new business opportunities - risk-adjusted return
- Allocate capital and other resources to units / activities with high risk-adjusted return - Supporting profitability through risk-adjusted pricing
- Prices should reflect cost of risk in addition to funding costs and operational expenses - Using limit setting to control size and probability of potential losses
- Basic exposure limits – provide absolute limits on exposure
- Stop loss limits - limits on actual losses, triggered when reached
- Sensitivity limits - keep potential losses from potential extreme events within acceptable bounds - Employing techniques to manage existing risks
- Active portfolio management
- Reduce risk, e.g., by duration matching
- Transfer risks to a third party
A general insurance company offers a worldwide travel insurance policy that provides coverage against the
following risks:
- medical cover required whilst in a foreign country
- loss of luggage whilst travelling
- flight delays of more than three hours.
Discuss tools that the insurance company can use to aid the management and control of the above risks. [10]
Diversification
* Lines of business e.g.
* Age group (under 14s, over 65s)
* Frequency of travel (single, multi-trip)
* Purpose of travel (business, winter sports etc.)
* Number of lives (single, family, groups)
* Sales channel
* Geographical areas of business
* Travel location (domestic, continent, worldwide)
* Reinsurance provider
* Use reciprocal quota share reinsurance
Underwriting at proposal stage
* Prevents anti-selection
* Enables the insurance company to classify risks into homogeneous groups for which a standard premium
can be charged
* A whole range of rating factors is used to determine granular data regarding the risk
* Ensures that all risks are rated fairly
* Identifies risks for which special terms need to be quoted e.g. special terms for certain activities e.g. ski
trip
* Insurer may simply decline risks e.g. historic medical conditions
* Helps ensure that actual claim experience not too far from that assumed in the pricing
* Reduces risk of over insurance e.g. very high level of medical expenses cover for someone who is terminally
ill
Claims control / claims underwriting
* Need to check the against the policy conditions on claim
* Mitigates consequences of a financial risk that has occurred
* e.g. maximum cap on lost luggage to avoid dispute on the quality of luggage bag and the contents inside
* use of exclusions/extra premiums for specific high value items e.g. cameras/laptops
* Guards against fraudulent or excessive claims e.g. have a prescribed list of overseas hospitals and/or
medical service providers
* Costs of implementing and maintaining a control system must be compared with the benefits gained from it
* use of excesses to reduce costs/admin of small claims
* Tight policy wordings to be able to impose exclusions/other conditions, but need to balance against
competitiveness of product
Management control systems
* Data recording
* Ensure adequate provisions are established for the risks
* Reduce the operational risks from having poor data
* Accounting and auditing
* Can’t change the risks accepted but enables proper provisions to be established
* Monitoring of liabilities taken on
* Protects against aggregation of risks of a specific type to an unacceptable level
* e.g. request flight dates and times from policyholders so the insurer can crossreference against events
and be aware of any risk sooner
* Check business mix is as expected
* e.g. regularly monitor claims especially by location travelled to, or
* Spread across airlines
* Feed back into future pricing and reserving
Other risks and tools
* Insurer also needs to be aware of high impact but low probability risks e.g. plane crash/disease outbreaks
* These can only be diversified in a limited way
* Can use CAT reinsurance/related ART to transfer away
* Other types of reinsurance/ART/derivatives
* e.g. currency derivatives for paying claims in foreign currency
* weather derivatives for flight delays
You work at a life insurance company and one of your responsibilities is looking after the reinsurance. You have
recently re-tendered your reinsurance on one product line. Two reinsurers quoted the same price. State (with a
brief explanation) the other factors you would consider in making the decision of who to award the tender to. [5]
- Profit share terms – maybe one offered terms and the other didn’t or the one offered better terms
- Guarantee period of reinsurance rates – one with the longer guarantee period would be better
- Relative financial security of two reinsurers – one with higher credit rating would be a better choice
- Current relationship with two reinsurers – you would be inclined to work with the one you have a better
relationship with; but you might also feel too exposed to one reinsurer already and might select the other for
that reason - Relative technical expertise of the two reinsurers – hard to measure; might also be based off what they
promise - Additional services offered by the reinsurers – underwriting or claims assistance; help with data analytics
etc - Other terms of the agreement – underwriting & claims referral levels (level of freedom granted to insurer)
- (Commission terms – there might be commission offered by one of the reinsurers and not the other)
