Chapter 31 - Other Risk Controls

Question 1

Managing & Controlling Retained Risks

Answer 1

Retained Risks can be controlled through:
- diversification
- underwriting at the proposal stage – this ensures a fair price is paid for the risk
- claims control procedures – these mitigate the consequences of a risk event that has occurred
- management control systems – these reduce the exposure to risk

Question 2

Diversification

Answer 2

Risk can be diversified within the following:
- lines of business
- geographical areas of business
- providers of reinsurance
- investments – asset classes
- investments – assets held within a class

Question 3

Underwriting

Answer 3

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

Underwriting can be used to manage these risks in the following ways:
- Protect a provider from anti-selection.
- Enable a provider to Classify risks into homogenous groups for which a standard premium can be charged. Adequate risk classification within the underwriting process will help to ensure that all risks are rated fairly
- Enable a provider to identify risks for which special terms need to be quoted
- For substandard risks, the underwriting process will identify the most suitable approach and level for the special terms to be offered
- Help in ensuring that claim experience does not depart too far from that assumed in the pricing of the contracts being sold
- For larger proposals, the financial underwriting procedures will help to reduce the risk from over-insurance

Question 4

Claims & Management Control Systems

Answer 4

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

Management Control Systems include:

1. Data recording
   It is important that the company holds good quality data on all the risks it insures, with particular emphasis on the risk factors identified when the product was designed or when the risk was underwritten. While this cannot change the provider’s exposure to the business risks underwritten, it can assist in ensuring that adequate provisions are established for those risks, and reduce the operational risks from having poor data.
2. Accounting and auditing
   Again good accounting and audit procedures cannot change the risks accepted, but enable proper provisions to be established, regular premiums to be collected, and the providers of finance to the provider to be reassured as to its financial position.
3. Monitoring of liabilities taken on
   It is important to monitor the liabilities taken on by a company to protect against aggregation of risks of a specific type to an unacceptable level. Where the acceptance of risks involves the provider in new business strain, it is important to quantify the amount of new business to ensure that it is within the provider’s resources.

In addition, premium rating may involve cross-subsidies from one type or class of business to another. If the business mix expected in the premium rates is not achieved in practice, the profitability of the contract may be at risk.

4. Options and guarantees
   Care is required to monitor any options and guarantees and in particular to determine whether the options or guarantees are likely to bite

Question 5

Low likelihood, high impact Risks

Answer 5

• Among the most difficult to manage; they are likely to include both risks related to normal business activities and operational risks.
• Credit rating agencies and regulatory authorities pay significant attention to the ability of a company to withstand rare events, there is a temptation for management to concentrate unduly on such risks at the expense of the broad range of risks accepted.
• The nature of high impact, low probability risks will depend on the business

Low probability, high impact risks can be:

• Diversified in a limited way
• Passed to an insurer or reinsurer, usually by some form of catastrophe insurance or whole account aggregate excess of loss cover (commonly called ‘stop loss’ cover)
• Mitigated by management control procedures, such as disaster recovery planning

Some such risks can only be accepted as part of the consequences of the business undertaken, and the management issue then becomes how to determine the amount of capital that it is necessary to hold against the risk event. The techniques of scenario analysis, stress testing and stochastic modelling enable this to be done.

Finally, a company will have determined its own risk tolerance – for example, the ability to withstand an event that might occur with a 0.5% probability within 1 year. This means that the company accepts that it might be ruined by a rarer event, and has decided not to take such events into account in its risk management.

Question 5

Risk Financing

Answer 5

The risk management process will ensure that not only is sufficient capital available, but also that the capital is being used efficiently and that the organisation is creating value for shareholders and/or other stakeholders

Risk management can optimise the risk / return profile of the organisation by:

1. Supporting selective growth of the business:
   - Establish a process for assessing new business opportunities.
   - The process should include assessment of the risk adjusted return
   - Allocate capital and other resources to business units or activities with high risk-adjusted return
2. Supporting profitability through risk-adjusted pricing:
   - Prices should reflect the cost of risk (capital) in addition to funding costs and operational expenses
3. Using Limit setting to control of the size and probability of potential losses
   - Set basic exposure limits – to provide absolute limits on exposure
   - Set stop loss limits – limits on actual losses, which, if reached, trigger management action, e.g. hedging strategy
   - Set sensitivity limits – limits designed to keep potential losses from potential extreme events within acceptable bounds. They are used to avoid excessive concentrations of risk
4. Employing techniques to manage existing risks
   – Active portfolio management – in essence, a company comprises a portfolio of activities each with their own risk / return characteristics. The overall risks of this ‘portfolio’ can be assessed and managed in an analogous manner to those of a share portfolio of an active investment manager
   – Reduce risk (e.g. by duration matching – investing in assets of similar duration to the liabilities so that interest rate risk is reduced)
   – Transfer risks to a third party, e.g. using insurance or derivatives