Ch 31: Other Risk Control

Question 1

Tools to aid management and control of risk for a financial product provider:

Answer 1

• 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

Question 2

Diversification

Answer 2

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

Question 3

Notes:

Answer 3

• 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

Question 4

Underwriting

Answer 4

Assessment of potential risks so that each can be charged an appropriate premium

Question 5

Underwriting at proposal stage :Used to manage risks

Answer 5

• 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

Question 6

LIFE INSURANCE UNDERWRITING

Answer 6

1. Medical underwriting
2. Lifestyle underwriting
3. Financial underwriting

Question 7

Medical underwriting:

Answer 7

• 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

Question 8

Lifestyle underwriting

Answer 8

• 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

Question 9

Financial underwriting

Answer 9

• Assess financial health of applicant
  to reduce risk of over-insurance

Question 10

Interpretation of evidence

Answer 10

• 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

Question 11

Specification of terms

Answer 11

• 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

Question 12

Banking underwriting

Answer 12

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

Question 13

Claims control systems

Answer 13

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

Question 14

Management control systems

Answer 14

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

Question 15

Managing the risks associated with options and guarantees

Answer 15

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

Question 16

Techniques for managing options and guarantees:

Answer 16

• 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

Question 17

Low likelihood, high impact risks

Answer 17

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

Question 18

Risk financing

Answer 18

• 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

Question 19

Risk management can optimise risk / return profile by:

Answer 19

1. 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
2. Supporting profitability through risk-adjusted pricing
   - Prices should reflect cost of risk in addition to funding costs and operational expenses
3. 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
4. Employing techniques to manage existing risks
   - Active portfolio management
   - Reduce risk, e.g., by duration matching
   - Transfer risks to a third party

Question 20

A general insurance company offers a worldwide travel insurance policy that provides coverage against the
following risks:

Answer 20

• medical cover required whilst in a foreign country
• loss of luggage whilst travelling
• flight delays of more than three hours.

Question 21

Discuss tools that the insurance company can use to aid the management and control of the above risks. [10]

Answer 21

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

Question 22

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]

Answer 22

• 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)