Chapter 5 - Risk classification and Measurement

Question 1

Name two regulations for this topic risk classification and measurement

Answer 1

Solvency II: EU Insurance
Basel II: World banks

Question 2

For identifying risks that could threaten an organisations business what do you need a good knowledge of going into the risk identification process?

Answer 2

Circumstances of the organisation
Features of the business environment
General business and regulatory environment

Question 3

What are the steps for risk identification - high level

Answer 3

Have to come up with a risk register and then there is a list of responsibilities who is going to quantify that risk, mitigate that risk, pass that risk onto someone else etc

Question 4

Describe the brainstorm/ delphi approach to identifying a list of possible risks faced by a business

Answer 4

List possible risks by asking staff for example
Discuss the risks and their interdependence
Evaluate risks by frequency and severity
Generate and discuss mitigation options

Beware with this method: influence of management over lower level staff. Must be
anonymous. People most likely to understand the risks
are not management but those at lower levels.

Question 5

Give example of low frequency, high severity events and vice versa

Answer 5

Low frequency high severity : earthquake
High frequency low severity : expense fraud

Question 6

What options to firms have for risk classification models and methods

Answer 6

Regulatory formula or internal model - Internal model is more popular but requires approval and generally cannot be used by smaller firms.

Question 7

Describe the Solvency II standard formula for risk classification - what it includes and why insurers if they can choose to use an internal model.

Answer 7

Regulatory formulas are one-size-fits all so may omit some risks; for Solvency II this includes:
* Real interest rates
* Equity implied volatility
* Unit linked annuities (only a thing in IE and UK)
* Some risks are significant for business but may not
be incorporated in regulatory capital formulas:
* Strategic risks
* Adverse regulatory developments.

Regulatory model is very prudent in its assumptions - encourages use of internal model insetad
Reason for allowing internal model is because a lot of risks can be specific to a particular
insurer, their underwriting, claim management etc

Question 8

Why do insurers use an internal model for risk classification when they can?

Answer 8

Regulator would have concern that insurers would underplay the risk- why would they do this? Insurers would do this so they don’t have to hold alot of
capital, don’t want to have to hold extra capital. Even though the standard model does not catch some adverse risks, it is very prudent and would cause insurer to have to hold mroe capital than internal model.

Question 9

What should a risk register entail/detail?

Answer 9

List of risks, each accorded a frequency (probability) and
severity (impact) and maybe also regulatory capital required.
Must detail how risks are dealt with: retained/ mitigated/ diverisfied.
For retained risk include:Details of control measures, Risk owner, Board member with oversight, Risk concentration identification

Question 10

What is a key underwriting and insurance risk for insurers?

Answer 10

Claim numbers and amounts

Question 11

Detail what claim size depends on and what risks insurers face based on claim numbers and amounts

Answer 11

Determination of claim size depends on the nature of cover.
Life insurance- fixed sum assured, regardless of the
cause of death. - risk of people dying sooner
Property damage is usually on an indemnity basis (reimbursing
only losses sustained). - risk of overpaying. There is maximum sum assured for each policy,
but many losses will be smaller than this maximum.
Some classes of business have no limit on claims:
compulsory third party liability.

Claims can be hard to verify at times

Question 12

What are unwanted extra risks an insurance company or underwriting company face?

Answer 12

Risks of claims underestimation.
Insurance premium cycle.
Risk concentrations - lots of things at once
Expense overruns
Operational risks - general business risks
Political risks - politicians intervening in insurance pricing?

Question 13

Explain the idea of the insurance premium cycle

Answer 13

Falling competition occurs as some people leave the market and then all the other insurers raise their profits cause they can which encourages new entrants and prices soften: Means that insurers who have acquired customers may be stuck in a premium cycle outside of their control - may be writing business even when losing money. Cant just discard customers in bad times as very expensive to set up new customer.

Question 14

Why is premium variation much less than policy premium variability in general for motor insurance?

Answer 14

Because of the amount of competition - compulsory service

Question 15

Give some customer behavior risks an insurer faces

Answer 15

Adverse selection: you end up insuring the worst risks.
Moral hazard: Policyholders take less care, because they can claim on
insurance.
Lapses and take-up of options and guarantees.
Propensity to claim (including fraud but also those wealthy enough and not bothering on small claims - good thing :))

Question 16

What are ways to mitigate underwriting risks?

Answer 16

Diversify
Write less business
Tighten underwriting criteria
Repricing - happens annually in personal lines
Customer segmentation and risk selection
No-claims bonus systems
Insurable interest
Increase deductibles/risk retention
Claims management processes.
Outwards reinsurance.
Ride the insurance cycle

Question 17

How does no claims bonus system mitigate underwriting risks?

Answer 17

No-claims bonus systems and other incentives to
reduce claim propensity.- Not many small claims.

Question 18

Explain what is meant by deductibles and risk retention to mitigate underwriting risks

Answer 18

A deductible is the amount of money that you are responsible for paying toward an insured loss. - Increasing deductibles would reduce the amount insurer is liable for.
Risk retention is the planned acceptance of losses by deductibles -mrisk is consciously retained rather than transferred.
You cant increase deductibles or risk retntions for compulsory insurances such as motor.

Question 19

How do businesses manipulate accounts to make business look less risky and hence appear to “mitigate risks”

Answer 19

Profit comes through in accounts is the change in reserves as well as the claims you pay - often times
companies can want curve to look less risky or smooth so may alter presentation.

Question 20

What does CLT say about a large number of independent, identically
distributed sources of profit or loss, each with finite
variance.

Answer 20

CLT says the sum of these profits is approximately asymptotically
normally distributed:
With mean equal to the sum of the individual means
And variance equal to the sum of individual variances
Convergence is fast when individual risks are (roughly)
symmetric and thin-tailed.

Question 21

Explain risk driver with examples

Answer 21

A risk driver is an external factor that might apply to many
policies at once. Ex: social trends, healthcare, bad weather on property damage, Policing effectiveness impact on theft claims,Claims inflation (for example: shortage of parts) , Legal precedents and court awards.

Question 22

Does CLT work for risk drivers?

Answer 22

Central Limit Theorem might still work conditional on risk drivers: For large portfolios, risk driver uncertainty dominates diversifiable
risks.

However - most time in reality it wont work as independence fails.

Question 23

Why might Model parameters may be misestimated?

Answer 23

Bad possible events not in data because history was unusually
benign - ENIDS not factored in
Future trends not anticipated (eg climate change).

Model may not incorporate:
Failure to allow for adverse selection or moral hazard.
Latent claims not captured(eg asbestos)
Coverage uncertainty (eg cyber)

Question 24

Explain latent claim:

Answer 24

A latent claim is a claim that arises from a risk not anticipated by the underwriter and not priced for in the original policy

Question 25

How does cash accounting differ from balance sheet accounting

Answer 25

Cash accounting doesn’t account for stuff you owe, invested or will have to pay
These decisions reflect balance sheet thinking:
EX: I ‘invested’ €10 000 to insulate my house. - Cash accounting this is a loss.
But BS thinking: Money is not lost if we spend it to acquire an asset of
value.
The profit is what we spent relative to the value of the
asset acquired.

Question 26

Whats the accounting method deemed as the model method?

Answer 26

Model accounting is almost always at fair value for everything as much as
possible.

Question 27

Give definition for book value measurement of assets, liability and amortised cost

Answer 27

Asset book value = price originally paid
Liability book value = premium received (insurance)
or deposit made (banking)
Amortised cost = historic cost * remaining lifetime /
lifetime at acquisition.

Idea is to spread profits and losses evenly over
the lifetime of a contract.

Question 28

Define fair value

Answer 28

The fair value of a liability is the value at which the liability could
be settled or transferred between willing (but not anxious) parties
* With no connection between the parties (an ‘arms length’
arrangement)
* Each party has all relevant and material information
* Each party is alike in all ways

Can also be thought of as: The amount that the enterprise would have tCo pay a third party to take
over the liability:`exit’ value

Question 29

Contrast historic cost/book value and fair value

Answer 29

Historic
Transaction price is an objective fact.
Different instances of the same asset
or liability held at different values.
Distinction between ‘realised’ and ‘unrealised’ gains/ loss
* Can be manipulated by sale and
repurchase (B&B)
* Good or bad news can be ‘buried’.
* Difficult to tax unrealised gains.

Fair Value
Forward-looking valuation.
* Consistent for instances of
same asset or liability.
All gains counted realised or not.
* Market prices may be (too) volatile
and reflect fickle
sentiment rather than `true’ value.
* For non-traded contracts, relies on
models of hypothetical trades, -errors or manipulation.

Question 30

Define BEL

Answer 30

Present value of probability-weighted expected cash flows.
Use market-consistent assumptions and low-risk discount rates.
Matching calculation and replication arguments.

Question 31

Define risk margin

Answer 31

Cost of bearing risks: could relate to costs of raising,
holding or distributing capital.

Question 32

Define contractual service margin for future profits

Answer 32

Cannot be negative; prevents inception profit (like UPR)
Used for IFRS but not Solvency II - Profit realized over the term of the assurance/contract.

Question 33

What components make up insurance technical provisions?

Answer 33

Contractual service margin for future profits
Risk margin
BEL

Question 34

How are technical provisions presented differently across regulatory balance sheet and accounting balance sheet?

Answer 34

For regulatory balance sheet you will only see risk margin and BEL
Whereas accounting balance sheet will also have contractual service
margin liability

Question 35

Also when dealing with solvency technical provisions what is different to insurance technical provisions?

Answer 35

For solvency you
don’t have the
contractual service
margin, you can be
seen to have realised
profit all up front and not have it as a
liability

Question 36

Explain the idea between audited vs economic balance sheet

Answer 36

An audited balance sheet that is distorted by arbitrary
accounting conventions.
An economic balance sheet that reflects economic reality.

Controversial - be aware of shallow narratives and loaded terms.

Question 37

Explain how often accounted using netting

Answer 37

Financial statements are very often netted off figures. Ex: Reinsurance assets may be netted against insurance liabilities.

Question 38

What is a balance sheet stress test?

Answer 38

A stress test is an instant revaluation of the balance sheet under an alternative, usually adverse but plausible set of assumptions. In stress testing, you don’t usually assume dividends will be paid or capital
will be raised, As a stress test is designed to determine how much capital should be
obtained. Just consider one risk at a time.

Question 39

What is a reverse stress test?

Answer 39

A reverse stress test is when you don’t specify the size of stress in advance,
you specify the impact. Asking how large a shock has to be to cause a firm to fail.

Question 40

What is scenario analysis

Answer 40

Scenario analysis looks at the emergence of
adverse experience over a number of years rather than instantly.

Question 41

What is Monte carlo Analysis

Answer 41

Monte Carlo analysis tests multiple randomly
generated scenarios, at a single point in time or over multiple time periods.

Question 42

Can you describe how risks can have different impacts on balance sheets depending on timings

Answer 42

Some risks have an immediate impact ex: weather event
Others emerge over time, potentially long periods of
time.- Trends in court awards, longevity improvements or worsening due to pollution, cumulative effect of interest rates.
Some claims and risks can be hard to classify: Can the trends be captured in a balance sheet
snapshot? Hard to know ex: how much has quality of life been impaired.

Question 43

Describe the actuary in a box problem

Answer 43

Long-term changes are reflected in a balance sheet stress test by the impact of an assumption change.
Thus, all risks are collapsed into a short time horizon, using an exit value approach.
The balance sheet stress does not reflect all future experience changes, just the ones that would change the actuary’s estimates.
‘Actuary in a box’ problem – simulating changes in long term assumptions over a short horizon.

Question 44

What is the regulatory answer to when does a financial firm have sufficient assets to cover its
liabilities with some scope for absorbing future adverse events?

Answer 44

Old answer: Assets>Liabilities valued on a cautious basis
Modern regulatory language separates:
* A base valuation on a realistic set of assumptions.
* A stress test corresponding to a cautious set of assumptions.

Question 45

What is meant by required capital and available capital

Answer 45

The required capital is the loss (decrease in available capital) passing from the base valuation to the stressed valuation.- Based on balance sheet
A firm’s available capital (assets-liabilities) should exceed its required capital. This of course is equivalent to having assets exceed liabilities in the cautious valuation.
Capital adequacy - regulatory will only approve business if available > regulatory
Insolvent - liabilities > assets

Question 46

What does capital adequacy mean?

Answer 46

Means available capital in excess
of regulatory required capital
Capital adequacy - regulatory will only approve business if available > regulatory
Insolvent - liabilities > assets

Question 47

What does insolvency mean?

Answer 47

Available capital is zero

Question 48

What is the benefits to customers of capital rules?

Answer 48

Solvency regulation is there to protect consumers from loss in the
event that a financial firm fails.
Capital requirements provide a safety margin so that customer contracts can still be honoured even following adverse
experience.- protection agaisnt credit risk.
Regulators are required to enforce this because consumers lack the information, skill or resources for this monitoring.

Question 49

What are the 3 pillars of the European solvency II Directive

Answer 49

Quantification of risk exposures and capital requirements.
Supervisory regime
Disclosure requirements

Question 50

What are the capital requirements numbers as per Solvency II

Answer 50

The capital requirements are (supposed to be) risk- based, using a 1-year time horizon, fair value accounting and a 99.5%-ile loss. This compares to bank capital requirements which are (supposedly) 99.9%-ile.

Question 51

What three main elements does Solvency regulation distinguishes of non-life risk:

Answer 51

Reserve risk - Deterioration in technical provisions in respect of outstanding claims.
Premium risk -Increase in technical provisions in respect of future accidents for premiums as yet unearned.
Catastrophe risk

Question 52

How can one express premium risk stress mathematically

Answer 52

The premium risk stress is expressed as a % of max{last year’s earned premium,
next year’s forecast earned premium}

Question 52

How can one express reserve risk stress mathematically

Answer 52

Reserve risk stress is expressed as % of outstanding claim reserves (including
incurred but not reported claims)

Question 53

What are mortality stresses that can be a carried out and what will they effect

Answer 53

Mortality up: Stressed mortality rate = 1.15 * base mortality rate. Applies to T.Assurance etc
Mortality down (Longevity): Stressed mortality rate = 0.8 * base mortality rate. Applies to pensions/annuities
Mortality catastrophe: Stressed mortality = base mortality + 0.0015. For next year only, then back to base case.

Question 54

Give an example of sickness or disability stresses and expense stresses

Answer 54

Sickness or Disability (multiplicative stresses)- can have stressed inception rates or stressed recovery rates (slower recovery)
Expenses Could have Instant increase by factor of 1.1 compared to base. Or expenses grow 1% per annum faster than base assumption. Technical Provisions for administrative expenses, need new calculations done for new regulation or new hires

Question 55

Give an examples of lapse stresses that can be applied

Answer 55

• All future lapse rates *1.5
• All future lapse rates *0.5
• Instant lapse of 40% of policies, stabilises thereafter.
• Only count policies where each scenario hurts.

Question 56

Give examples of market risk stresses you could apply and test

Answer 56

• Variable interest securities - equities fall for example, currency strengthens etc
  The base calculation of technical provisions uses a term structure of spot interest rates st that vary by term t. - Could do inetrest rate stresses. Downward, upward where the stressed spot rate is applied to liabilities and
  fixed income assets. The net effect is what matters.
  Need to allow for impact on assets AND liabilities.

Question 57

How does the time horizon of spot rates affect their volatility

Answer 57

Short spot rates are more volatile than long spot rates. Similarly Discount rates vary by term and reflect the fact that short term int rate are typically more volatile than long term

Question 58

What is spread risk

Answer 58

Spread risk is ability of spreads to get larger on bonds

Question 59

Name 4 rating agents

Answer 59

Credit agencies: standard and poor, moodys, AM best, fitch,

Question 60

What does Solvency II say about government bonds

Answer 60

Solvency ii says gov bonds cant default :However this is because of a political reason , standard formula assumes theres no default because of the EU solidarity. Regulation doesnt want to disrespect other governments and say they they cant pay debts

Question 61

What is the multiplicative downward stress to the value of a corporate bond

Answer 61

The multiplicative downward stress to the value of a corporate bond is proportional to t/(15+t), where t is the (discounted cash flow weighted) mean term of the bond in years.

Question 62

Where can counterparty default risk arise - insurers/underwriters

Answer 62

Loans made to customers, other firms or governments.
Outward reinsurance contracts.
Derivative contracts with banks.
Trade creditors and debtors

Question 63

Does your own default risk reduce liabilties?

Answer 63

Fair value would imply `yes’ but this has the unpalatable consequence that companies appear to profit from exacerbating their own credit risk.

Solvency II says no

Question 64

What is a common way to mitigate credit risk

Answer 64

It is common to mitigate credit risk using collateral assets which can be seized in a default event.

Question 65

What three concepts are counterparty default models often based on?

Answer 65

EAD: Exposure at default (maximum amount of loss on default if no residual value recovered).
LGD: Loss given default ( = 1 – proportion recovered). - exposure you suffer
PD: Probability of default.

Question 66

What are some uncertain balance sheet items

Answer 66

Mark-to-model liabilities * Policyholder behaviour
* Management actions
* Contract boundaries
* Liability discount rates and illiquidity premiums
* Risk margins
llliquid assets
* Property
* Commercial real estate loans
* Equity release mortgages
* Deferred tax credit (relies on future profits)

Question 67

What is meant by single name exposure

Answer 67

Measure the `single name exposure’ by aggregating default exposures by counterparty. This can be complicated if one group is simultaneously a reinsurer, a derivative counterparty and a tenant.

Question 68

What are formulae needed to find the default loss distribution for a single name in a model

Answer 68

The loss is EAD * LGD * D
Where D = 0 or 1 with probability 1-PD or PD respectively.
Mean = EAD * LGD * PD
Variance = EAD2 * LGD2 * PD * (1-PD)
Stress test is a loss of 5 * EAD * LGD * sqrt[PD * (1-PD)]
Max PD of [5-sqrt(21)]/10 = 4.17% when loss = EAD * LGD