Chapter 24 Nature of risks (1)

Question 1

Risks may often be classified as follows.

Answer 1

• model risk - risk that the underlying model is not adequate
• parameter risk - the risk that the parameters assumed for the underlying model are incorrect.
• random flactuations risk - the risk of unpredictable fluctuations arising from sample error. This is greater the smaller the sample.

Question 2

Risks faced by a health and care insurer

Answer 2

• Policy data
• other data
• Claims rates
• claim amounts
• investment performance expenses and inflation
• persistency
• mix of new business
• volume of new business

Question 3

Policy data

Answer 3

• inadequate, inaccurate or incomplete policy data could lead to incorrect results and recommendations in actuarial investigations, including those performed for the supervisory authorities.
• Where a model office is used, this may not represent the in-force business accurately enough.
• the second risk is properly referred to as a model or modelling risk. It risk that the results from the model office being an over-simplification of the real company in terms of the portfolio of policies currently in force and as a consequence behaving unrealistically.

Question 4

Other data

Answer 4

• Data used in the formulation of actuarial assumptions may be inadequate. eg to determine morbidity and mortality rates.
• Even where they are adequate in themselves, they may not be applicable to the purpose for which the actuary requires them.
• this is especially true where the actuary uses overseas data/external data for which policy conditions may differ significantly from those in the actuary’s company.
• any external data used may be inadequate or unreliable and even when reliable it may prove to be inappropriate.

Question 5

Internal data may be inadequate for various reasons

Answer 5

• missing data
• data is inaccurate
• not enough data for credibility

Question 6

Claim rates

Answer 6

• In most investigations carried out by an actuary, assumptions will need to be made regarding future mortality, incidence of critical illness and incidence and duration of sickness, as appropriate.
• 3 risks associated with these assumptions:
• model risk, parameter risk & random fluctuations.

Question 7

Claim amounts

Answer 7

• Claim amounts are a significant source of uncertainty for indemnity products, such as PMI cover.
• The following factors contribute to uncertainty in the cost of PMI claims:
• changes in cost of medical treatment due to medical innovations, advances in technology, currency fluctuations etc.
• changes in lifestyle and prevalence of medical conditions
• policyholder or medical professional behaviour affecting utilisation of medical services
• poor claims control and fraud may result in the insurer paying claims that should have been excluded due to benefit limitations.
• introduction of claims management processes, such as preferred providers.
• an aging population, which implies that there will be greater demand for healthcare treatment.
• new diseases or epidemics.
• currency fluctuations which may result in volatility in cost of medical treatment that relies on imported equipment or pharmaceuticals.

Question 8

Earlier screenings

Answer 8

• advances in medical science mean that claims for health insurance might increase.
• also, screening is often encouraged, which may increase claims frequency.
• if medical technology advances in diagnostic area, insurers may find themselves facing claims significantly earlier than was expected on the basis of the data on which premiums were calculated.
• earlier diagnosis may prompt some claims that would not otherwise have been payable( because policyholder wouldve died prior to diagnosis, or lapsed or term policy may have expired)

Question 9

Investment performance

Answer 9

• Investment return assumptions may be needed for the existing assets or future investment.
• Return will allow for both income and capital appreciation, on amounts to be invested in the future.
• The importance of the assumption depends in part on the delay between premium receipt and claim payment, and importantly on the size of the reserves.
• Investment return might be modelled deterministically or stochastically. In either case there are model, parameter and random fluctuations risks.
• In a stochastic model the random fluctuations are modelled explicitly.
• There is also a capital values risk in any investigation comparing existing assets with liabilities.

-asset management: the passing of responsibility for the process or management of investments to 3rd parties introduces further risks.

Question 10

Significance of investment performance

Answer 10

• Investment performance be of lesser significance considering PMI due to its short-tail from premium receipt to claim settlement.
• For some long-term insurance, particularly pre-funded long-term care, the investment performance and hence risks may be major considerations.
• insurers paying claims in foreign currencies the insurer will be exposed to exchange rate movements and may need to invest in assets in the relevant foreign currencies.

Question 11

Expenses and inflation

Answer 11

• Most investigations carried out by actuaries, assumptions will need to be made as to the future expenses to be incurred by the company.
• these will allow implicitly o explicitly either on deterministic or stochastic basis, for inflation.
• Therefore risk of parameter risk.
• There is a risk of higher than expected expenses.
• the risk may be greater if 3rd parties are involved.
• contributions to expenses from premiums and charges may be significantly mismatched with actual expenses incurred, over time.
• Higher than expected inflation of expenses leads to an expense risk. This can have model. parameter and random components.

Question 12

Persistency

Answer 12

• The unpredictability of persistency makes it a risk.
• there is parameter risk and model risk.
• Early withdrawals usually represent a particular risk of loss, because of failure to recoup initial expenses and asset shares can be very low or negative as a result.
• if persistency experience is different from expected it may invalidate assumptions about effects of selective withdrawals on mortality, critical illness or sickness experience.
• Expense assumptions may also be invalidated due to the effect of withdrawals on the volume of business in force.
• Persistency rates will be closely monitored under PMI where often initial costs and maybe commissions are amortised over an assumed average number of renewals.

Question 13

The mix of business by nature and size of contract

Answer 13

• The unpredictability of mix of business by nature and size of contract is a risk for the insurer.
• Unexpected variation in nature or size may change the risk profile of the company, which may lead to an overstretching of the company’s capital and other resources available to cover the risk.
• Coverage of per-policy expenses is particularly vulnerable to a reduction in the average size of policies issued.

Question 14

The mix of business by source

Answer 14

• Different distribution channel involve different sales methods and reach different populations.
• As a result, the demographic and expense experience of the various channels is likely to differ.
• Variation form the insurer’s assumed mix by source could therefore invalidate the insurer’s demographic and expense assumptions.

Question 15

The volume of business

Answer 15

• Insurers may experience difficulties as a result of:
• too much business, so that its capital resources or administrative capacity are exceeded.
• too little business, so that it fails to cover its fixed development/overhead expenses.
• parameters for future expenses will be based on a model of future new business. departure from this will invalidate the former.
• for short-term insurance business, risk management and monitoring may be more focused on the overall volume and mix of in-force business rather than specifically on new business.