Chapter 11: Risk and Uncertainty

Question 1

Uncertainty

Answer 1

The inability to predict the future with confidence.

Question 2

6 Categories of risks and uncertainties MR DAMPP

Answer 2

Model Error
Random Error
Data errors from systems and procedures
Adjustment factors
Market conditions
Portfolio movements- business mix uncertainty
Parameter error

Question 3

4 Main headings of elements of risk and uncertainty

Answer 3

• those affecting CLAIMS EXPERIENCE
• those affecting EXPENSES
• those relating to the INVESTMENTS
• BUSINESS RISKS, including new business or lapse risks

Question 4

3 Main types of legislative changes

Answer 4

FISCAL CHANGES,
such as increases in tax on:
- insurers,
- insured items or their repair

CHANGES IN THE LAW:

• which increase the amount of cover being provided, eg removal of a legal limit on compensation levels
• restrict using certain factors in underwriting

Question 5

Reinsurance risks (6)

Risks with reinsurance decisions

Problems with reinsurance decisions

Answer 5

• not purchasing the right type of reinsurance, or enough of it
• doubts as to the AVAILABILITY AND COST of the desired reinsurance
• difficulty assessing reinsurance value for money
• whether catastrophe reinsurance will prove satisfactory with regard to such features as the size of the retention, the reinstatement provisions and the upper limit of cover
• the ABILITY to make reinsurance RECOVERIES. There is the potential for reinsurers to default, especially following catastrophes or poor claims experience for the industry as a whole
• failure to comprehend the true coverage/limits of a reinsurance arrangement and therefore being exposed to risk in areas that were thought to be reinsured.

Question 6

How do radically new types of policy and cover contribute to uncertainty?

Answer 6

If a radically new type of policy is to be introduced, there may be considerable uncertainty regarding the INFORMATION on which the premiums are to be based.

Question 7

How do
Characteristics of policyholders
contribute to uncertainty?

Answer 7

Policyholders with different characteristics means the resulting claims experience may differ from the past, in ways that are hard to determine.

Question 8

4 Sources of uncertainty regarding other expenses include:

Answer 8

Refer another card
examples - broker mergers, aggregator power, offshoring costs, increase in legal expenses, economic factors such as inflation, wage inflation, etc. accounting changes and costs associated thereof, changes in taxes, levies.

Question 9

Uncertainty regarding investments (4)

Answer 9

• market conditions may worsen
• claims may have to be paid sooner than expected.
• assets may need to be realised in unfavourable conditions.
• poor investment management.
• a larger than expected portion of the assets may not be available for investment. There is usually some delay between the broker receiving the premium and passing it on to the insurer. Similarly, the insurer usually pays a claim in full and then has to wait for recoveries from reinsurance or salvage.
  Debtors may, in total, form quite a large portion of the insurer’s total assets. If the average delay increases, a lower proportion of the insurer’s assets will be earning investment return, so the average rate of investment income will fall.

Question 10

Risks regarding competition (business) (5)

Answer 10

Our (insurer’s) products MAY NOT APPEAL to their potential customers

the prices they need to charge for their products in order to achieve a satisfactory financial result may be TOO HIGH TO BE COMPETITIVE

as a consequence of losing business to competitors, their UNIT COSTS RISE so that they find it even harder to price their products competitively

if they deliberately under-price in response to competition, the prices they actually charge may be insufficient to produce a satisfactory financial result.

ADMINISTRATIVE STRUCTURES and channels for obtaining business may BECOME OBSOLETE, for example because of technological developments exploited by their competitors, resulting in additional costs to update.

Question 11

Writing “loss leaders”

Answer 11

the process of
… winning new business
… by charging less than economic premiums
… to increase business volumes,
… with the hopes of recovering costs later when premiums are increased to sound levels
(sufficient to cover costs).

Question 12

4 implications of a low solvency margin

Answer 12

An insurer with a low solvency margin may be subject to intervention from the supervisory authority

• A loss of confidence in the market leading to a loss of business (may also extend to the stock market, with falls in the share price).
• A need to restrict business to prevent intervention by the supervisory authority. This will result in possible loss of profitable business.
• need to purchase more reinsurance to increase protection against fluctuations.

Question 13

Process uncertainty  effect on claims

Answer 13

Process error refers to the inherent randomness underlying a book of business.
An insurer’s specific process uncertainties stem from:
1. general claims uncertainty relating to the specific business written
2. internal influences, eg changes in reserving philosophy or mix of business.

Question 14

Process uncertainty - External sources of claims uncertainty (10)

Answer 14

1. claim frequency
2. claim amounts
3. claim payment patterns.
4. Development pattern changes
5. Legislation or laws
6. Economic factors
7. Demand surge
8. Climate change
9. Bodily injury claims - stuctured settlement and not lumpsum
10. Third party behaviour eg. law firms

Question 15

Process Uncertainty - External - Claim Frequency

Answer 15

1. Random fluctuation
2. Change in pH propensity to claim
3. Increasing litigousnous
4. Intrepretation of wordings - adverse to insurer

Question 16

Process Uncertainty - External - Claim Amounts

Answer 16

1. Accumulations of risk - may occur due to the insurer’s business acquisition strategy (eg it might target policyholders of a particular type) or they may arise inadvertently (eg there may be a large concentration of policies taken out by individuals living close to the insurer’s head office). Accumulations may also arise as a result of a catastrophe event.
2. Random variation - Due to the variability in the size of claims, there may be uncertainty as to whether changes in claim costs from year to year are due to changes in underlying risks or are simply the result of random variation.
   The level of random variation will be higher, the smaller the portfolio of business. This problem is therefore greater for small companies (or small classes of business) where we would expect a larger variation from year to year

Question 17

Process Uncertainty - External - Claim payment patterns

Answer 17

Delays - reporting and settlement
Uncertainty about the date of claim
Size of the claims - Large claims are likely to suffer the longest settlement delays, especially in liability classes where the claims may need to be settled by the courts.

Question 18

Process Uncertainty - External - Claim development patterns changes

Answer 18

Claims development patterns may change over time. This may be due to a number of factors.
1. Speed of settlement - known causes that can be adjusted for
For example, there may be political pressure on insurers to speed up the payment of claims following a natural disaster, or payment / recording of claims may slow down due to staff shortages.
Where development patterns change due to a known cause, such as those mentioned above, then allowances can be made in the reserving process, although these are often judgemental.
2. unknown causes - However, there will be occasions where the development pattern changes without explanation, and the impact of this may not have been included within the premium or claims reserving process.
Actions taken by the insurer, eg a change to the standard reserve posted while awaiting further claim information, can cause a permanent shift in the development pattern.

Question 19

Process Uncertainty - External - Demand surge

Answer 19

Following a major catastrophe, there will be increased demand for goods and services in the affected areas.
For example, the demand for builders may increase following a flood. This increase in demand could force up the price for such goods and services to an unpredictable extent.

Question 20

Process Uncertainty - External - Climate change

Answer 20

Over the last decade, global weather patterns have changed significantly from an insurance point of view.
For example, global temperatures are slightly higher and severe weather events are becoming more frequent and more severe in some regions, eg Asian typhoons. In other areas, eg the Gulf of Mexico, the impact of climate change is much less clear. Various agencies have produced climate models that predict further volatility in global weather patterns.
Historical occurrence patterns for weather-related claims may no longer be appropriate. For example, windstorm claims may now be more frequent and/or severe and could therefore take a longer time to settle. Additionally, claims from areas traditionally not covered by the major catastrophe models may also become more frequent or severe, eg Thai Floods.

Question 21

Process Uncertainty - External - Bodily injury claims

Answer 21

Some governments have introduced legislation concerning the payment of bodily injury claims. The idea is that to indemnify the policyholder, the claim payment should be in the form of income replacement, instead of a lump sum. This effectively increases administration, resulting in higher claims servicing and reporting costs for a longer period and hence higher claims handling reserves.

Question 22

Process Uncertainty - External - Differences in third party behaviour (eg lawyers actively seeking out asbestos claimants)

Answer 22

The behaviour of third parties may also impact claim characteristics for certain classes.
For example, lawyers may actively seek out people affected by asbestos-related illnesses, or PPI business. This would increase the claim frequency and may also have an effect on severity.

Question 23

Process Uncertainty - External - Government legislation

Answer 23

fiscal changes, such as increases in tax on insured items – many claims are settled on a replacement basis (ie the insurer replaces the damaged item), so if the sales tax on that item increases, the cost of replacing that item will increase and the claim cost will increase
 
changes in the law that increase the amount of cover being provided, such as removal of a legal limit on compensation levels
changes in the law that restrict or forbid the use of certain factors in underwriting.

Question 24

Process Uncertainty - External - Economic conditions

Answer 24

The effect of economic conditions on claims
Mortgage indemnity is one class that is heavily affected by economic conditions. A number of economic variables could have a direct impact on claims. For example:
1. inflation – this will directly affect claim amounts
2. unemployment – this could lead to certain sections of society being unable to afford insurance, and so produce a different mix of business
3. economic growth – this could lead to more sections of society being able to afford insurance (and higher levels of cover in some cases), and so produce a different mix of business
4. change in the value of the exchange rate – for business transacted in a currency other than that of the country in which the insurer is based, there is a risk that the insurer’s results will be adversely affected by changes in the exchange rate between the two currencies; there will also be uncertainties stemming from currency mismatching between assets and liabilities, and because it may be impossible to predict the currency in which a claim will have to be settled.

Question 25

Internal sources of process uncertainty with respect to claims (6)

Answer 25

changes in business mix
booked reserves different to best estimate
new markets
new distribution channels
new claims handling procedures
use of profit share arrangements

Question 26

(i)
Suggest possible strategies that might lead to a change in business mix. (ii) Suggest other reasons why the business mix might change.

Answer 26

(i)
Strategies leading to a change in business mix
strategic change in target market
change in distribution channels used
change in marketing method
change in pricing structure
introduction of new rating structures
change in underwriting processes
change in claims handling procedures

(ii) Other reasons why the business mix might change increase in anti-selection by policyholders
change in the attitude to claiming
change in fiscal regime, eg tax relief on certain groups of policyholders buying insurance
change in regulatory regime, eg certain types of insurance becoming compulsory
change in company reputation, eg a company becoming seen as a budget provider

Question 27

Process uncertainty  effect on other areas of the business (other than claims)

Expenses uncertainty
Mnemonic - A TAD NOBLE
Investment Uncertainty
Mnemonic - AGE ROT

Answer 27

1. Broker mergers lead to more pricing power on brokers’ side
2. Aggregators
3. Accounting changes
4. Off-shoring
5. Changes in tax rate
6. Levies
7. Economic conditions
8. New types of investment
9. Globalisation of investment markets
10. Competition
11. The insurance cycle
12. Expenses uncertainty

A TAD NOBLE:
Aggregators
Tax
Accounting changes
Distribution channels
New markets
Off-shoring
Broker Power
Levies
Economic conditions

AGE ROT:
Actions by central bank
Globalisation
Economic cycle
REturn
Overseas influences
Type of investment

Question 28

Parameter uncertainty

Answer 28

Parameter uncertainty refers to the uncertainty arising from the estimation of parameters used in a model. Given that any model is an artificial representation of a real-life situation there will always be a certain degree of parameter uncertainty in the models that we use.
This arises from:
1. Data, format of data inadequate data from TPA
2. Change in case estimate reserving philosophy
3. Large and exceptional claims
4. claims inflation not as expected
5. New distribution channels
6. Planned or unplanned changes in mix

Question 29

Parameter uncertainty arising from data

Answer 29

Data may be:
of a poor quality
internally inconsistent
incomplete
non-existent.
Format of data
Inadequate data supplied by third party claims handlers

Question 30

Parameter uncertainty arising from Change in case estimate reserving philosophy

Answer 30

Reserving philosophy within a company will change from time to time. For example, if claims handlers have under-reserved a case in the recent past, they may be inclined to overestimate future claims to compensate.
There may also be changes in reserving philosophy following a change in senior personnel.
This could involve a change in reserving methods, or a change in the basis used for the reserve estimates (within an acceptable range). If changes in reserving philosophy are known, it may be possible to make adjustments.
The

Question 31

Parameter uncertainty arising from Large and exceptional claims

Answer 31

1. Large claims can be expected to have different frequency and severity distributions to attritional and catastrophe claims. They are also likely to have different development patterns. There may also be differences in development pattern based upon the type of large claim.
   For example, a large windstorm claim may develop at a different rate to a large flood claim, although both types of claim may be experienced in a property book.
   It is normal practice to remove large claims from the development and project these separately to attritional losses.
   Uncertainty may also arise in how a large claim is defined. They could be defined as claims over a particular threshold (possibly with a different threshold for different perils, often set to achieve sufficient data and with an eye on the reinsurance programme), or large claims may be a subjective management decision.
   If the threshold method is chosen, there is the additional uncertainty as to whether this increases over time, and at what rate. Effectively the threshold would decrease going backwards through cohorts due to the inflation assumption.
   On some occasions, there may be an absence of large reported claims, and the reserving actuary may wish to add a loading to reflect this fact. This will give rise to additional uncertainty.
2. Catastrophes
3. Latent Claims

Question 32

Parameter uncertainty arising from Claims inflation not as expected

Answer 32

Inflation assumptions will often be required; for example, for calculating an initial loss ratio for the Bornhuetter-Ferguson method.
The actual inflationary experience will be a determinant in whether the chosen reserves are too high or too low.

Question 33

Model (specification) uncertainty

Answer 33

Model uncertainty arises from the choice of or specification of the model.

Question 34

Suggest reasons why model error is less easy to detect than parameter error.

Answer 34

Parameter error may be identified using sensitivity tests on individual parameters. Insight can be gained into the effect of varying different parameters, enabling the user to pinpoint the parameters that have the biggest effect. Model error may be misinterpreted as a combination of parameter errors, and hence is harder to detect.

Question 35

Sources of model error

Answer 35

1. Programming error
2. Simulation error/very less simulation numbers
3. Model design
   - Incorrect dependencies
   - Incorrect distributional assumptions in modelling reserve uncertainty

Question 36

Describe how judicial decisions can exacerbate the uncertainty surrounding latent claims.
State

Answer 36

The development of latent claims is often uncertain: one court judgement can act retrospectively over many policies, which can result in large losses for the insurer.
The effect of judicial decisions is very similar to that of inflation. In fact, the effect of judicial decisions is often simply referred to as ‘court inflation’.
Court inflation results from court awards. The differences between court inflation and price inflation are as follows:
   court inflation, historically, has been higher than price inflation
court inflation tends to remain level for a period, then increase in sharp jumps when new precedents are created
court inflation is less predictable than price inflation.
From time to time, judicial decisions will set new precedents for the admission of certain claims, and the amounts at which they will be settled.
Decisions relating to imprecise policy wordings can lead to the admission of new types of claim that had not been allowed for in the original costings. Liability claims are particularly exposed to this type of risk.
Courts also periodically set new levels of award or compensation for existing categories of claim.
The effect of such awards will be to increase immediately the average amount at which all future claims of a similar nature are likely to be settled … … including those that have already been reported.
Such awards are very hard to predict, so it is even harder to allow for this form of inflation than normal claim inflation.
Claim payments that are intended to represent the future lost earnings of an individual, following an accident, are likely to be based upon the present value of that future income.
The courts may from time to time change the rate of interest at which insurers are allowed to discount future earnings. This change could have a dramatic effect upon the overall claim payments. Court awards can be impacted by decisions made in other countries too.

Question 37

Outline the main risk and uncertainty features of property damage and liability classes of business.

Answer 37

Property damage 
   Short tail, so shorter time period, hence less time for events to go against the insurer.
Geographic accumulations possible. Potentially lots of claims from weather-related incidents.
Reasonably homogeneous risks. Amounts limited by sum insured or value of building.
Liability 
     
Claims frequency lower on average but more variable. Amounts much more uncertain too, possibly unlimited cover.
Long tail so more exposure to unexpected inflation, asset inadequacies and reinsurer failure.
Varied heterogeneous risks.
Possible accumulations due to concentrations of products or employees. Exposure to court awards and judicial inflation. Potential exposure to latent claims.

Question 38

List the areas of greatest uncertainty for a general insurer when producing estimates of its claims.

Answer 38

1. claims emerging from the latest period of exposure, ie IBNR claims
2. the possibility of new types of latent claims emerging from liability classes
3. inflation of the longest-tail liabilities
4. catastrophe claims, eg the uncertainty surrounding huge floods due to climate change
5. claims arising from unexpired risks.

Question 39

Reserving uncertainty/claims uncertainty (both external and internal)
MNEMONIC:
BALANCED FLACCID DAFT CRUMB

Answer 39

Behaviour of third parties
Amounts of claims
Latent claims
Assumption on distribution
New classes
Catastrophes
Economic conditions
Development Patterns
Frequency of claims
Legislation
Area (Globalization)
Climate Change
Claim handling procedures
Inflation
Demand Surge
Distribution Channels
Arrangements for profit shares
Format of data
Third party handlers
Competitive Pressure
Reserving philosophy
Unusal/large risks
Mix of business
Bodily injury claims

Question 40

ROC uncertainty
CGI MICE - mnemonic

Answer 40

Competition
Globalization
Insurance cycle
margins on premiums
investment returns
Claims Expenses