Chapter 18- Risk Management and Control

Question 1

Outline the requirements of Insurance Act to demonstrate sound risk management? (5)

Answer 1

o Good corporate governance

o Sound risk management procedures

o Adequate control functions

o Independent audit and monitoring functions

o Adequate disclosure and reporting to stakeholders

Question 2

Outline the provision in the Insurance Act regarding adopting, implementing and documenting of a governance framework? (5)

Answer 2

• Protects the interest of the policyholders

• Proportionate to the nature, scale and complexity of the insurance business and risks

• Include an effective system of corporate governance, internal control and risk management

• The insurer also requires monitoring system to ensure compliance

• The prudential authority may require independent review at the insurers costs if not satisfied

Question 3

outline the functions of a risk committee established? (8)

Answer 3

• Assist the board of directors in developing risk management strategy

• Assist the board of directors in evaluating the adequacy and effectiveness of a risk management system

• Identify the build-up of a concentration of risk

• Assist in identifying and monitoring any material risk

• Facilitate communication between the board of directors and senior management

• Ensure segregation between risk management and operation duties

• Introduce measure to enhance risk management

• Oversee the monitoring of risk management at an individual business unit and enterprise level

Question 4

the requirements for a risk management system is as follows? (5)

Answer 4

• Effective risk management is critical to honouring its promise to policyholders

• Insurer must have a board approved, enterprise wide risk management system consisting of a strategies, policies, procedures and tools for assessing, monitoring, reporting and mitigating material risks

• The risk appetite of the system must be aligned with business objectives and strategies

• An insurer must establish, maintain and operate within a system of effective internal control

• To provide appropriate governance the following control functions would be required:
o Risk management
o Compliance
o Internal audit
o Actuarial function

Question 5

outline the roles and responsibilities regarding risk management? (4)

Answer 5

• The board of directors hold the ultimate responsibility to ensure compliance with the prudential standards

• The head of the control functions are responsible to provide an opinion on the effectiveness of risk management and internal controls

• The internal auditors will conduct a review to provide assurance to the board of directors of effective risk management

• The insurer’s external auditors will provide assurance to the PA as well as the board regarding the compliance with prudential standards

Question 6

outline the duties of a risk managment function? (5)

Answer 6

• Assists the board of directors and senior management to develop and maintain a risk management system

• The risk management function provides reasonable assurance that there are adequate mechanisms to
o Identify individual and aggregated risks
o Assess, monitoring and manage risk identified
o Gain and maintain an aggregate view of the insurers risk profile
o Forward looking assessment of the insurers profile

• Provides written reports to the board, senior management, other control functions regarding risk profile, risk exposures and appropriate mitigation actions

• Document and report material changes to the risk management system

• Have access to the board of directors

Question 7

Outlined what would be documented in a risk management strategy as a minimum? (6)

Answer 7

• Identify objectives of the strategy

• Describe each current material risks and emerging risks

• List the policies and procedures for dealing with risk management

• Summaries the roles and responsibilities of risk management functions, board, senior management and board committees

• Included documented process for board approval for changes or deviations

• Outline process for creating awareness of risk management system

Question 8

An insurers risk appetite statement clearly include? (4)

Answer 8

• Overall risk that they are willing to accept in strategic objectives and business plan

• For each type of material risk that maximum levels to which they are willing to operate within

• Monitor and report compliance with limits

• Regular review appropriateness of limits

Question 9

List the board approved policies in the risk management system? (14)

Answer 9

• Asset-liability management
• Capital management
• Concentration
• Credit
• Fitness and proprietary
• Information technology
• Insurance fraud
• Investment
• Liquid management
• Operational
• Outsourcing
• Reinsurance and risk transfer
• Remuneration
• Underwriting

Question 10

outline the requirements in the ALM policy? (4)

Answer 10

• Clearly specify the nature, role and extent of ALM as well as integration with product design, pricing and investment management

• Co-ordinate the management of asset and liability risk

• Recognise the interdependence between assets and liabilities (correlation between asset classes and business line)

• Take into account off-balance sheet risk and the contingency that they may revert to the insurer

Question 11

outline the requirements in the capital management policy? (6)

Answer 11

• Internal capital planning process

• Strategy for ensuring that adequate capital is maintained

• Provide identification and measurement of risk that may result in capital shortfalls

• Establish procedures to monitor compliance with internal and regulatory capital targets

• Set out actions that will occur in the event of a capital shortfall

• Provide for appropriate management and regular review

Question 12

outline the requirements in the concentration risk policy? (2)

Answer 12

• Identify sources of concentration risk and strategies to ensure risks remains in established limits

• Analyses possible correlation between risk of concentrated exposure

Question 13

outline the requirements in the credit risk policy? (6)

Answer 13

• Set out approach in assessment, monitoring, managing and reporting on credit risk

• Proportional to complexity, scale of insurers operations

• Identify the full range of credit exposures including direct (credit facilities and debt instruments)and indirect (financial instruments)

• Identify range of exposure that they would want to retain

• Provide a quantification for credit risk

• Identification of risk mitigation such that credit exposure is kept within the desired limits

Question 14

outline the requirements in the insurance fraud policy? (4)

Answer 14

• Outline appropriate strategies and procedures to deter, prevent, detect, report and remedy insurance fraud

• Outline appropriate strategies for managing fraud risk

• Consider the effectiveness of fraud risk management may be enhanced by contributing to industry wide initiatives

• Provide a prompt for reporting to regulatory bodies

Question 15

outline the requirements in the investment policy? (9)

Answer 15

• Ensuring compliance with asset requirements prescribed under the financial soundness standards

• Set out strategy for investing including asset allocation and how they are related to ALM

• Explicit risk management to more complex and less transparent classes

• Take into account factors the will influence long-term sustainability example environment, government and social

• Investments would need to be made such that it ensures security, quality, liquidity and profitability of insurance portfolio

• Investments that do not trade on regulated financial markets are kept within prudent levels

• Ensures appropriate diversification

• Ensures that conflicts of interest are avoided or managed such that benefits are made in the best interests of the policyholders

• Ensure appropriate matching with respect to unit-linked, index-linked and guaranteed liabilities

Question 16

outline the requirements in the liquidity managment policy? (5)

Answer 16

• Sets out identification, assessment, monitoring, management and reporting of liquidity risk such that obligations can be met as they fall due

• The approach should be proportional and should include triggers to detect breaches and action plans to respond to liquidity stresses

• Include modelling of the insurers liquidity from a range of scenarios e.g. catastrophes, downgrades and defaults

• Take into account the liquidity consequences of financial difficulties or reinsurance default

• Impact of adverse scenarios of the liquidity given investments

Question 17

outline the requirements in the operating risk policy? (2)

Answer 17

• Sets out identification, assessment, monitoring, management and reporting of operational risk

• To the extent that quantitative data is available it should be used quantify operational risks

Question 18

outline the requirements in the underwriting policy? (7)

Answer 18

• Identify that nature of insurance risk including the class of insurance as well as the risk to be underwritten

• Describe the formal risk assessment process for underwriting
o Criteria used for assessment
o Methods for monitoring the emerging experience
o Methods by which the emerging experience is taken into consideration in the underwriting process

• Establish decision making process and controls where non-mandated intermediaries and underwriting managers perform binder functions

• Set out actions of insurer to assess and manage the risk of loss from inadequate pricing

• Establish the insurers process with respect to assumption setting with reference to risk appetite

• Set out the relevant data to be considered in the underwriting process

• Review the adequacy of the claims management process

Question 19

outline the requirements in the reinsurance policy? (7)

Answer 19

• Outline the strategies and procedures for selecting appropriate reinsurance programmes

• Ensure that transparent reinsurance and risk transfer arrangements allow PA to understand economic implications

• Provide process and procedures to ensure compliance with selection strategy

• Identify the level of risk transfer that is appropriate given the insurers risk appetite

• Establish principles of assessing the appropriateness, creditworthiness and diversification from instruments

• Establish procedures for assessing the effectiveness of risk transfer

• Provide for liquidity management due to mismatch between claims payments and recoverables

Question 20

In monitoring the credit risk to which the insurer is exposed the internal controls will take into account the following? (6)

Answer 20

• Counterparty exposure is the amount the firm would lose if a counterparty were to fail to meets its obligations

• Assets exposure is the amount a firm will lose if an assets or assets class where to yield less than expected

• Adequacy of diversification in spreading credit risk

• Likelihood of defaults

• Expected loss in the event of defaults

• Exposure period

Question 21

Market risk controls will include the following? (3)

Answer 21

o Defining governance arrangements and authorisation levels around investment management decisions

o Understanding the sensitivity of liability calculations to movements in the market

o Outline likely management actions in the event of certain movements in key market indicator levels

Question 22

Define liquidity risk? (1)

Answer 22

• Liquidity risk is the risk arising from short-term cashflows where a mismatch occurs and assets will have to be realised at a loss to meet the outgo

Question 23

Provide examples of operational risk? (5)

Answer 23

o Internal and external fraud

o Failure to comply with employment law

o Damage to physical assets

o Business disruption and system failures

o Transactional processing failures

Question 24

outline insurance risk management? (2)

Answer 24

• Insurance risk refers to the fluctuations in timing, frequency and severity of insured event relative to the that expected at the time of underwriting

• Information that may be monitored include
o A statement of profit and loss for each class of business it writes
o Amount and detail of new business written and the amount of business that has been cancelled
o Emerging trends in persistency and expenses levels

Question 25

outline group risk? (2)

Answer 25

• Group risk arise where one firm in a company can impact on the reputation and financial soundness of different firms within the group

• Group risk can also arise from internal loans and internal reinsurance agreements

Question 26

Define Reinsurance? (5)

Answer 26

• Reinsurance is an agreement where one party (the reinsurer)
• In consideration for a premium
• Partially or fully indemnifies another party (the cedant)
• From the liabilities associated with one or more polices
• In one or more reinsurance contracts

Question 27

Outline the reasons for reinsurance? (4)

Answer 27

• Reduce claim fluctuations

• Reduce new business strain

• Technical expertise

• Improve solvency position through increased capital

Question 28

Outline the Types of reinsurance? (4)

Answer 28

• Original terms

• Risk premium

• Catastrophe loss

• Financial reinsurance

Question 29

Outline the factors that will influence the choice of reinsurance? (7)

Answer 29

• The purpose and requirement for reinsurance
• The cost of reinsurance
• Risk appetite of the insurer as well as technical expertise
• Variety of reinsurance offered
• Type of business
• Maturity of business
• Legal and tax implications

Question 30

Outline the elegibility criteria that needs to be met such that the reinsurance can be taken into account in financial soundness calculations? (5)

Answer 30

• The assessment of the risk transfer must be carried out in context of commercial environment, judge with reference to a range of outcomes (reasonably to occur in practice)

• A reassessment must be done if there is a material change to the risk transfer instrument

• Reasonable probability of significant loss without the instrument

• Where risk mitigation (transfer of significant risk) is not self-evident this should then be verified

• Furthermore documentation regarding the economic intent and risk analysis (cash flow projection for various scenarios) must be held by both parties

Question 31

State the limit on premiums that a direct insurer can reinsure? (1)

Answer 31

There is a limit of 75% of premiums that a direct insurer can reinsure (this is increased to 85% is the reinsurer is part of the same insurance group)

Question 32

outline factors that should be considered when setting the retention limit? (9)

Answer 32

• Free capital
• Cost of reinsurance
• Impact of capital requirements
• Average benefit amounts and distribution of benefits amounts
• Increase in benefit amounts in the future
• The retention limits on other products
• Risk appetite
• Experience underwriting (technical expertise)
• Profit sharing agreements

Question 33

Outline the various factors that should be considered when determining the level of underwriting? (9)

Answer 33

• Expenses associated with underwriting
• Reduction in anti-selection
• Level of underwriting of competitors
• The impact on reinsurance terms
• The impact on marketing as well as sales volumes
• The effectiveness of underwriting
• The uncertainty created by claims management underwriting
• The degree of homogenous group desired
• Regulation regarding the constitution and employment equity

Question 34

Outline the modelling and considerations regarding logevity risk and mortality projections? (5)

Answer 34

• A large part of longevity risk is the impact of future mortality improvements

• Process based projections aim to model trends in mortality from a biomedical perspective (which is only effective if the process causing death can be mathematically modelled)

• Extrapolative trends are based on projecting historical trends in the future however there is a degree of subjectivity regarding the selection of historic period

• Actuaries now have the option of stochastic projection of future mortality

• Assumptions at old ages are significantly uncertain due to the lack of data (a common approach is to use a limiting age)

Question 35

outline longevity hedging using a longevity swap? (7)

Answer 35

• Longevity swaps are a tool by such companies to hedge risk although the use in South Africa to date has been limited

• The purpose of the swap is to remove the uncertainty around the cost of providing immediate annuities by fixing this cost

• The swap has two counterparties:
o Counterparty A (the insurance company)
o Counterparty B (a reinsurer or bank)

• Counterparty A pays a fixed series of payments agreed at the outset of the swap (“fixed leg”)

• Counterparty B pays a floating series of payments linked to the actual annuity amounts paid

• The insurer has fixed its outgo but has also increased its counterparty risk therefore collateral is an important mechanism

• In order to value the swap they need to agree on a discount rate as well as mechanism to determine assumed life expectancy to determine the value of the floating leg

Question 36

outline the underwriting and risk managment regarding HIV/AIDS? (3)

Answer 36

• There are some products that are specifically defined for HIV positive lives which takes into account reduced life expectancy which is reflected in the cost of the product

• On the other hand underwriting for HIV is essential until underwriting makes it illegal

• A binding ASISA code of practice lays down the procedures that must be followed:
o Confidentiality
o Action against the alarming rate of substitution of blood samples
o Provision of appropriate counselling for those that test positive
o The long-term insurance industry agreed to remove exclusions for HIV/AIDS since 2005

Question 37

Outline the sources of unit pricing risk? (7)

Answer 37

Inequitable Treatment among generations of policyholders
o Errors in the calculation of the prices at which units are allocated and redeemed
o Errors in the calculation of prices at which units are created or cancelled
o The way that compensation for errors or inequity is determined

Operational Risk
• More generally systems are being changed for whatever reason may carry out of date or inaccurate information

Basis Risk
• The basis to calculate unit prices will depend on whether the company is a net allocator or redeemer of units in the internal unit fund (therefore there is a risk that the basis is not changed)

Income and dividends tax
• A risk arises if during the period of deduction from the unit fund and calculation of tax the tax rates where to change

Capital Gains Tax
• The actual capital gains will unlikely be precisely the same as the allowance as there is usually a long period between the change in market value (where the deduction is made from the unit fund) and when the assets is realised and capital gains is crystallised

Anti-selection risk
• There may be some form of anti-selection if surrenders/ portfolio switches are permitted at a price the does not reflect the underlying assets of the fund

Liquidity and related risks
• Additional risks can arise if the underlying assets are relatively illiquid for example large property investments
• If there are significant withdrawals then it will take some time to dispose of these assets