Chapter 31 - Other risk controls

Question 1

What are the main internal risk management tools?

Answer 1

Diversification

Underwriting at proposal stage

Claims control/Claims underwriting

Management control systems

Question 2

Discuss diversification as a risk management tool.

Answer 2

Diversification can be utilised within the following areas:

Lines of business

• Diversify types of products sold
• Preferably uncorrelated/negatively correlated risk exposures

Geographical diversification
- Helps to diversify effects of weather, natural disasters, epidemics, population specific issues with morbidity or mortality and other possible reasons

Reinsurers
- Diversify effect of default risk

Investment - asset classes

• Diversify types of assets
• Also currency and location(e.g. foreign investment) of assets

Investments - assets within classes
- That is investing in shares of companies in uncorrelated industries or properties in different geographical locations or with different functions, for example.

Some problems with diversification may include:

• Complex administration
• Expertise required
• Additional locations of operations required
• Regulatory constraints
• Capital required

A possible solution to these would be reciprocal quota share (or other?) reinsurance with other direct writers
- One company reinsures part of its business to another in exchange for accepting part of this reinsurer’s business

Question 3

Discuss underwriting at the proposal stage as a risk management tool.

Answer 3

Underwriting generally refers to the assessment of potential risks so each can be charged an appropriate premium.

The two main risks underwriting helps to manage are:

Risk of mispricing premiums

• Ensure claims experience does not depart too far from what was assumed in the pricing of contracts.
• could lead to excessive losses if too low
• or loss of market share if prices are too high

Risk of anti-selection

• if premium is structured incorrectly
• does not account for appropriate risk/rating factors
• Ensure policyholders pay a fair price
• Decline significant risks/offer them special terms

As a risk management tool, underwriting is used for the following reasons:

Classify risks into homogeneous groups for which standard terms can be offered
- Requires adequate risk classification

Identify risks for which special terms need to be quoted

Identify most suitable approach for the special terms to be offered. Options include, but not limited to:

• Increased premium
• Reduced benefit
• Exclusions
• Defer cover
• Decline cover

Use financial underwriting to reduce risk of over-insurance for larger proposals

• Financial underwriting involves comparing the amount insured with the relative losses to be incurred due to claim event, or the financial strength of the potential policyholder
• Could identify attempts at fraud and reduce moral hazard

Question 4

Discuss the process of life insurance underwriting.

Answer 4

Can be split into 3 main parts, followed by some interpretation and selection of control method

Medical underwriting

• Asses applicant’s health to ensure it is of an appropriate standard to accept their risk
• Focus will depend on what risks product is exposed to
• Methods of underwriting include:
  1) Questions on proposal form
  2) Report from policyholder’s doctor
  3) Medical examination from insurer’s choice of doctor
  4) Specialist test
• Relative cost and gain from chosen method should be weighed up, as well as marketability considerations

Lifestyle underwriting
- Considers non-medical risk factors, such as occupation, hobbies/activities and geographical location

Financial underwriting

• Ensures level of cover approximately matches required level of needs
• Involves assessing financial health of the client
• E.g. could use ration of benefits to annual salary

Results need to be interpreted by reference to the defined ‘standard policyholder’

Specification of terms

• Decide whether to offer on standard terms, special terms or reject altogether
• Main form of alternative terms would include:
  1) Increased premium
  2) Reduced benefit
  3) Exclusion clauses

Question 5

What are the main practical consideration for underwriting as a life insurer?

Answer 5

Expenses
- Additional cost incurred roughly related to level of detail acquired

Opportunity costs

• Will also decline some policies and thereby lose income (while obviously reducing risk)
• May lose some benefits of pooling of risk
• Reduced marketability of product

Competitive considerations

• Underwriting process of competitors needs to be approximately followed or improved to increase marketability
• Differences in risk/rating factors used in underwriting will also lead to anti-selection risk

Question 6

Discuss claims control systems.

Answer 6

Claims control systems mitigate the consequences of a financial risk that has occurred. They guard against fraudulent or excessive claims.

Need to compare costs vs benefits

Reputational risk if claims are rejected

Question 7

Discuss management control systems

Answer 7

There are some risks that cannot be avoided and may require some form of management control system.

Data and recording system
- Ensures right premiums are collected and right benefits and commissions are paid

Accounting and auditing system

• Proper collection of premiums
• Proper understanding of liabilities
• Proper understanding of financial position

Monitoring of liabilities

• Identify risk aggregation and concentration
• Identifies impact of new business strain
• Identifies cross subsidies and business mix

Options and guarantees system
- Identifies whether options/guarantees are likely to trigger

Other examples of management control systems include

• A-L matching
• Business continuity planning and disaster recovery planning
• Cyber security
• Effective governance and oversight including policies for managing the business
• “control” functions in insurance
• contract management
• sales control

Question 8

Discuss how risk associated with options and guarantees can be managed.

Answer 8

Guarantees

• Can use investments to hedge against expected liabilities incurred by guarantees offered
• Investment will depend on form of the guarantee
• More complex guarantees may require purchase of OTC assets or dynamic hedging

Options
- Could similarly be hedged in investment markets, or restricted through eligibility criteria, e.g. can only exercise on certain dates

Possible difficulties
- May be impossible or expensive to directly hedge some liabilities

Question 9

Discuss how low probability, high impact risks can be managed.

Answer 9

Generally refers to catastrophic events

Can be diversified to some extent
- Only in a limited way

Can be passed on to other insurers or reinsurers

Can be mitigated by management control procedures, such as disaster recovery planning.

Hold capital to help deal with such risk events, as determined by stress testing, scenario analysis and stochastic modelling

Establish risk tolerance, i.e. up to what level of risk does the company still want to be operable in the worst case scenario. This then implies the company accepts it may go insolvent in a worse, even rarer scenario which was not deemed worthwhile to look at.