Chapter 2 Flashcards
what are the financial risks that have the greatest priority for life insurers?
1) losing some or all of the company’s original investment
2) failing to earn some of all of an expected return.
what are financial risks that are priority risks for insurers ?
1) credit risk
2) Market risk
3) underwriting risk
Define credit risk
risk that either a party will default on its obligations to an insurer will sustain a loss based on an adverse change in a party’s creditworthiness.
define default risk
AKA: invested asset credit risk
refer to the risk that and insuere will not recieve the cash flow to which it is entitled because a party with which the insurer has a financial arrangement is late with payments or entirely fails to pay its obligations.
default
a failure to meet a financial obligation is known as a default.
define counterparty risk
risk that a counterparty will fail to perform an obligation to an insurer.
Define market risk
the risk arising from movements in the direction of an entire financial market.
what kind of forms does market risk take?
equity risk, interest-rate risk, reinvestment-rate risk, liquidity risk and currency risk.
what is equity risk?
When market risk applies to the stock market
What is interest-rate risk?
the uncertainty arising from fluctuations in market interest rates.
what is reinvestment-rate risk?
the risk that the returns on funds to be reinvested will fall below anticipated levels.
define liquidity risk
What is currency risk?
the risk arising from changes in currency exchange rate.
What is underwriting risk
refers to the specific risks that insurers assume through the insurance and annuity contracts they underwriter.
policy holder behaviour risk.
is the risk that a company faces as a result of the choices made policyholders.
insures rely on what 4 basic strategies for managing financial risks?
1) Avoiding risk
2) controlling risk
3) accepting risk
4) transferring risk
What is avoiding risk?
avoiding risk involves taking actions to eliminate a person’s or company’s exposure to risk.
What is controlling risk
involves reducing or mitigating the actual losses resulting from a given risk exposure.
- underwriting guidelines.
What is accepting risk
a third strategy to manage risk is to accept or retain risk.
to retain a risk is to recognize the existence of the risk and accept the financial responsibility for that risk.
what is transferring risk
involves shifting the financial responsibility for a risk to another party, generally exchange for fee.
Insurers also transfer their risk under insurance and annuity contracts by purchasing reinsurance. what is that.
Reinsurance is a type of insurance that one insurance company (direct writer) purchases from another insurance company (reinsurere)
** transfer of risk.
What is asset-liability management? (ALM)
- consit of a portfolio approach to managing the risks associated with a company’s assets and liabilities.
- is the practice of coordinating the administration of an insurer’s assets portfolio wiht the administreation of its liability portfolio - so as to achieve the best possible financial effects.
- the process is designed to help insureres manage risks at an acceptable level and take advantage of opportunities to earn a return.
What is a portfolio
collection of assets with differing degrees and kinds of risk, usually assembled for meeting a defined set of goals
what is an asset portfolio
holds the insuere’s securities and other invested assets.
What is a liability portfolio
which represents the insurers obligations to customers.
what is a diversifiable risk
risk that is specific to an individual assets or insurer.
- credit risk is an example
- most financial risks
non-diversifiable risk
a risk that affects all assets in our economic system and is therefore not specific to an individual asset or insurer.
what assets are assembled into a portfolio, their combine risks can have desrirable or undesirable interactions. What is the risk augmentation effect?
present if the combination of specific risks is greater than the sum of those risks.
what assets are assembled into a portfolio, their combine risks can have desirable or undesirable interactions. What is the risk offset effect (hedge)
present if the combination of specific risk is less than the sum of those risks.
ALM involves four primary portfolio management approaches, name them
1) diversification
2) cash-flow matching
3) duration matching
4) hedging
What is diversification?
a technique for spreading risk by investing in different assets having different risk profiles.
- effective in controlling diversifiable risk,
what is asset concentration risk?
the risk of the excessive concentration of assets in a any single category
what is cash-flow matching
a technique that involves identifying the patterns of cash outflows for products and matching those cash outflows with a selection of assets that will produce a similar pattern of cash inflow.
What duration matching
a stragetegy that involves matching the duration statistics for fixed-income assets such as bonds with the duration statistics for the product
What is the definition of duration?
a statistic that measures the price sensitivity of an asset to change in interest rates.
What is Hedging risk?
a strategy that involves holding an asset with characteristics that counterbalance one or more of the risks in the investors risk array.
How can an insurer counterbalance the option risk in a variable annuity secondary guarantees?
by purchasing derivative securities that have offsetting characterisitcs.
Success of portfolio management and application strategies depends on the insurer’s ability to balance assets and liabilities - what happens in that?
1) total assets exceed total liabilities
2) total cash inflow over any time period execed or are reasonably close to total cash outflow over the same period
3) intereactions between the asset and liability portofolities are likely to reduce or eliminate some risk, risk through risk offset
4) interactions between the assets and liability portfolios produce residual risks that insurers can actively manage
For effective ALM, a company must coordinate its financials expertise in the areas of what?
1) investment policy and operations.
2) product design and pricing
3) insurance risk management, including underwrtiting, diversitifcation, claims, managment, and reisnurance programs,
4) operating expenses, including information system costs, legal costs and employee compensations.
Insurers commmonly use what tw formal ALS reports for external reporting?
1) an actuarial opinion and memorandum (AOM), with supporting documentation.
2) crediting-rate resolution
The actuarial opinion and memorandum (AOM) consists of which two separate documents.
1) actuarial opinion. brief and simply states that the company’s reserves are adequate given the assets supporting them. 3
2) actuarial memorandum- lengthy formal report containing documentation supporting the conclusion expressed int eh actuarial opinion.
True or False. All insures license in the US must submit an actuarial opinion to regulatory authorities with the annual statement.
true
and a qualified and duly assigned actuary must sign the opinion.
What is a crediting-rate resolution
formal declaration by the board of directors of the rate of interest the insurer will credit on customer’s money help in interest bearing products.
An annual crediting-rate resolution typically presents details about the company’s interest-crediting strategies. What is that?
they are the formulas and criteria a company uses to set the interest rats it will credit for interest-sensitive products.
What are some of the most common internal ALM reports?
1) investment activity report
2) the investment portfolio performance review.
3) the duration gap report.
What is an investment activity report?
specifies the details of all investment portfolio transactions, including all asset acquisitions and all dispositions of assets from the investment portfolio through sales, prepayments, or repayment at maturity.
** MOST FREQUENTLY PRODUCED OF ANY REPORT in formal ALM reporting system.
what is an investment portfolio performance review.
a wuarterly investment and ALM report that summarizes the company’s investment performance for the board of directors and the ALM committee.
** BORADEST SCOPE IN ALM REPORT, not most detailed.
The investment portfolio performance review presents information about which aspects of investment performances?
1) overall growth in the portfolio’s monetary value, specified in terms of price appreciation, and income growth; analysis of capital gains and loses, market value changes
2) Acquisitions and dispositions by asset type.
3) Narrative discussion of the portfolio composition, known as the asset mix, and the suitability of the asset mix.
4) Narrative explanations of key events in the external environment and the company’s strategic responses to those events.
5) sumarry rpeorts on special topics such a problem assets, real estate investments and international investments.
What is a duration gap report?
provides a snapshot of the insuere’s asset-liability match at the time of the report.
- describes results of a duration analysis of the company’s investment and product portfolios and discusses the ineres’ current exposure to portfolio cash flow mismatches caused by changes in the market interest rates.
What is Enterprise risk management (ERM)?
a system that identifies and quantifies risks from both potential threats and potential opportunities and manages these risks in a coordinated approach that supports the organization strategic objectives.
- Encompasses all of an organizations efforts to manage risks.
- includes potential for failing to take advance of an opportunity in the risk assessment.
What is a risk control process?
gathers information and then evaluates, monitors, and limits risk exposure.
- identify risk exposures through the organization
- evaluate the organization’s risk exposures and prioritize each one.
- create managerial accountability for monitoring and actively managing each risk.
- assign risk limits and implement an action plan for each top-priorty risk.
what is extreme event management?
type of risk taking that emphasizes catastrophic risks that materialized only rarely.
ie: terrorism, natural disasters, economic downturn.
- challenges: low frequency, high-severity events are often unpredictable.
What are some high-priority risks typically addressed by ERM?
1) credit risk: default risk, counterparty risks.
2) market risk: equity risk, interest-rate risk, reinvestment-rate risk, liquidity risks, currency risk reinvestment-rate risk
3) underwritint risk: pricing risk, policyholder behavior risks.
4) operational risks: distribution risk, HR risk, technolgoist risk, business partner risk, event risk.
A large insurer might employ a (chief risk officer) CRO, or (risk management director) RMD to manage risk activities. Other company might have a risk committee?
a senior management , group whose primary role is to provide overall guidance and control of an insurer’s ERM efforts.
- Almost all insurers, however, deploy a cross-functional risk committee.
what is risk appetite?
refers to a company’s long-term capacity for risk taking.
* qualitative concept describing the comapny’s attitude toward risk.
What is risk tolerance?
is a company’s stated limits on risk taking in specified categories.
** risk tolerance becomes the quantitative expression of the company’s risk appetite
What are some characteristics of strategic risk management?
1) incoporating risk into all decision making
2) taking a long-term view of the company’s risk profile
3) adopting a risk-adjusted financial measurement system, particularly in the are of incentive compensation.
4) Exploiting risk that have the potential to create competitive advantages.