Chapter 45: Risk Management Tools II Flashcards
6 Risk Management tools
- Reinsurance
- Alternative risk transfer
- Diversification
- Underwriting at the proposal stage
- Claims control procedures
- Management control systems
How might you diversify business?
Across:
- different classes
- different geographical areas
- different reinsurers
- different asset classes and stocks
What is underwriting?
Underwriting is the assessment of potential risks to charge a fair premium.
Why do providers underwrite business?
S - identifying and offering special terms to SUBSTANDARD risks
A - avoiding ANTI-SELECTION
F - reducing the risk of over insurance by FINANCIAL UNDERWRITING
E - ensuring that EXPERIENCE follows that expected in the pricing basis
R - using RISK-CLASSIFICATION to ensure that all risks are treated fairly
Main ways in which special terms can be applied
- additions to premiums
- reductions to benefits
- exclusion clauses
Alternatively:
- risk may be declined
- insurance may be deferred.
3 Different types of underwriting used by life insurance companies
- medical
- lifestyle
- financial
Claims control systems can also be used to help manage risk.
What do claims control systems do?
They mitigate the consequences of a financial risk that has occurred, guarding against fraudulent or excessive claims.
An example of a claims control system would be the management of ongoing income protection or permanent health insurance claims.
What are the 4 types of management control systems used to reduce risk?
- data checks
- accounting and auditing
- monitoring liabilities
- taking special care over options and guarantees
General Risk Evaluation Methods
- More data = more accurate parameterisation = easier to set up models (particularly stochastic).
- Inconsistent data – some parameters may be easier to analyse than others – consider common
- Het data = different trends may complicate model = scenario analysis may be more appropriate
Scenario analysis Method
- For each group of risks a representative plausible scenario is developed.
- For each scenario the consequences of the event occurring are calculated.
- A number of different scenarios may be considered.
Scenario analysis Advantages
- Scenario analysis is useful when a full mathematical model is inappropriate.
- For the risks being modelled it will be possible to pull together plausible scenarios (including particularly adverse scenarios).
- Removes risk of using many subjective parameters
- Easier to communicate than other approaches.
- Useful for capital assessment review, eg failure of new product
Scenario analysis Disadvantages
- The consequences of scenarios occurring may be more difficult than constructing the scenario.
- Likelihood of different outcomes is not apparent.
- Choice of scenarios requires external input, this in turn is critical.
Stress testing Method
- Modelling of extreme changes and scenarios.
- Will be looking at correlations and volatilities which are observed to simultaneously increase during extreme events.
- Aim to identify weak areas by looking at effect of different combinations of correlations and volatilities.
- Key area is constructing appropriate stress test scenarios.
- Must be able to consider interaction with other parameters (e.g. financial) to check for weaknesses in portfolio.
Stress testing Advantages
- Identifying the key risks to be tested will enable stress testing to show weak areas in the portfolio.
- Appropriate for extreme, wide-ranging scenarios
Stress testing Disadvantages
- Difficulty in identifying appropriate correlations for other parameters
- Need to consider sensitivity of portfolio to extreme movements in parameters, which may be difficult to model.
Stochastic modelling Method
- Variables are modelled using probability distributions.
- Dynamic interaction between variables.
- The result will be a distribution of outcomes.
Stochastic modelling Advantages
- Shows a distribution of possible outcomes, which provides a more complete picture than other approaches.
- By only allowing some parameters to vary stochastically it may be possible to focus on the particular risks which are of interest.
- Allows user to understand likelihood that a guarantee will bite and the financial impact of the guarantee
Stochastic modelling Disadvantages
- Require a probability distribution to be applied to parameters which may be difficult to derive, and will require expert judgement (may be subjective/ arbitrary)
- Also requires correlation and interaction between parameters to be set up which may present further difficulties.
- Computationally intensive approach which increases costs.
Diversification
- Swap contracts to swap uncorrelated risk packages
* Exposure to counterparties other than reinsurers (cap markets, banks, etc.)
Smoothing of results
- Integrated risk covers provide multi-line, multi-year reinsurance, which stabilises the cedant’s results
- Increased diversification = reduced volatility
Solvency
Stabilise experience over time = possible easing of sol reqs that insurer needs to meet
Source of capital
- Post loss funding
* Securitisation – liability does not have to be accounted for in stat returns
Cheaper cover
- Securitisation – insurance risk uncorrelated with market risk, cap markets may require lower return on capital than reinsurers
- Integrated risk covers – insurer not over-insured
- Integrated risk covers - reinsurer obtaining multi-line (diversified) portfolio, therefore may be happy to offer more favourable terms than if the individual risks were priced separately
Greater security of payment
- Capacity of cap markets greater than that of reinsurers = lower risk of default
- Securitisation = capital provided to insurer up-front
More efficient risk management
- ART products can be tailored to requirements of insurer = over-insurance avoided
- Insurance derivatives to hedge against risks
Tax advantages
• Products may be structured to exploit tax loopholes
