Insurance MFI Flashcards
How is underwriting risk for an insurance company quantified?
Using the Solvency Index:
Solvency Index = (Applied Risk Loading + Available Own Funds) / (Riskiness of Portfolio)
, where the riskiness of portfolio refers to the standard deviation of the probability distribution of claims
Underwriting risk is a larger source of risk in:
A) Non-life
B) Life
C) Reinsurance
D) Depends
Underwriting risk is a larger source of risk in non-life insurance.
In life insurance, firms are able to utilize a wider and more reliable statistical basis of mortality tables, while, in most cases, the benefits are determined in advance (valued contract). This makes life insurance less exposed to underwritings gaps.
Who is most exposed to Longevity Risk? A) Non-Life B) Life C) Policyholder D) Reinsurer Why?
Life insurance companies are more exposed to longevity risk: life contracts are long-term contracts, and premiums are determined in advance for the whole period. This could expose the insurer to the effect of long-term (decreasing) mortality trends. This is known as “longevity risk”.
Which techniques/features can help a non-life insurer mitigate underwriting risks?
A) Legal limitations: randomness, indemnity principle
B) Portfolio selection: the creation of portfolios that optimize the insurability criteria (large number, independence, homogeneity
C) Contractual limitations
D) Premium determination based on “experience” rating
E) Reinsurance
F) All of the above except legal limitations
G) All of the above
G) All of the above
The following statement is NOT true for a reinsurance contract:
A) Reinsurance allows the insurer to replace uncertainty of claims volatility with a known cost (reinsurance premium)
B) By using reinsurance, the insurer can decrease the riskiness of its portfolio and optimize its solvency index
C) In a reinsurance transaction, the insurer seeking reinsurance is known as the REINSURER, while the company assuming a part of the risk is known as the CEDING COMPANY
D) The reinsurance creates NO relationship between the policyholder and the reinsurer.
NOT TRUE -> C) In a reinsurance transaction, the insurer seeking reinsurance is known as the CEDING COMPANY, while the company assuming a part of the risk is known as the REINSURER
What is NOT a main purpose of reinsurance for the ceding company?
A) Increasing of insurance capacity
B) Improving quantitative harmonization of portfolio
C) Elimination of moral hazard and adverse selection
D) Improving segmentation and diversification of risks
WRONG: C) Elimination of moral hazard and adverse selection
Which of the following is NOT a source of market risk?
A) Interest rate risk: risk of losses due to changes in the term structure of interest rates
B) Equity risk: risk of losses due to changes in the market prices of equities
C) Spread risk: deterioration of the credit standing of issuers of financial instruments
D) Real estate risk: risk of losses due to changes in the market prices of real estate
E) Exchange risk: risk of losses due to changes of currency exchange rate
C) Spread risk: deterioration of the credit standing of issuers of financial instruments is not a source of market risk, but a source of COUNTERPARTY RISK
Which of the following is not a source of “asset risk” for an insurance company?
A) Market risk
B) Longevity risk
C) Counterparty risk
D) Liquidity risk
B) Longevity risk is a source of UNDERWRITING RISK, not asset risk
Why is decreasing (persistently low) interest rates an issue for insurance companies?
Due to the (normally) longer duration of insurance liabilities cash flows compared to those of assets (negative duration gap), insurers are particularly exposed to a decrease in interest rates and particularly affected by persistently low-interest-rate scenarios (current scenario).
Which of the following types of reinsurance offers the largest protection to the ceding company? A) Quota share (proportional) B) Excess loss (non-proportional) C) Surplus (proportional) D) Stop loss (non-proportional)
D) Stop loss (non-proportional) offers the largest degree of protection to ceding company
The reinsurer is bound to pay when a loss on the entire portfolio exceeds a certain amount. It is actually insurance against the poor performance of the insurance process related to that portfolio
What is reinvestment risk?
Due to the nature of the insurance business model, liabilities typically have a longer duration than assets, which results in a negative duration gap (DA-DL*D/E+D).
When invested assets do not have at least the same term as the expected liabilities’ cash-out flows, insurers are obliged to REINVEST. Currently, due to low/negative interest rates, insurers are investing at interest rates that are too low (reinvestment risk).
What is a peril? A) the policyholder B) the insured in a reinsurance contract C) the event of damage (fire) D) the damage (burned-down house)
C)
Peril: aleatory event impacting the risk unit and create some kind of damage (but not the damage itself)
Example: if we have a risk that a policyholder’s house will burn down, the peril is the fire.
What is NOT true about “pure risk”?
A) Uncertain events that in the event of occurrence produces negative effects
B) Event that could generate either loss or a profit (upside and downside risk)
C) Underlying category (line of business) incl. property risk, liability risk and personal risk
WRONG: B) Events that could generate either a loss or a profit are defined as “speculative risks” - not pure risk, which concerns only the downside risks
In the context of pure risk, an underlying category is LIABILITY risk. What characterizes this specific line of business?
A) Deals with things that are owned by an individual. E.g., the house, car, jewelry, etc.
B) Deals with protection against claims resulting from injuries and damage to OTHER people or property
C) Deals with a person. E.g., death, injury, other need for medical attention, etc.
B) Liability risk deals with protection against claims resulting from injuries and damage to OTHER people or property.
Property risk: deals with things that are owned by an individual. E.g., the house
Personal risk: deals with a person. E.g., death, injury, other need for medical attention, etc. to the policyholder
The insurance process has two fundamental features: select two:
A) Transferring risk
B) Sharing losses
C) Retaining the risk
D) Reduction of the possibility/ intensity of pure risk
The process has two fundamental features:
- Transferring risk: from one individual to a group of individuals
- Sharing losses: all members of the group (portfolio) pay a premium, which is how the losses of those hit by the unfortunate event are covered.
WRONG: retain risk means doing nothing, while reducing the intensity/possibility of risk occurrence refers to the policyholder’s carefulness (Not a part of the insurance process)
What is NOT a characteristic of the a posteriori probability?
A) the probability of an uncertain future event computed based on an empirical study of past experience
B) it is an actuarial concept
C) It helps the insurance company determine premium price
D) It is the MOST accurate way to estimate the probability of an adverse event
WRONG: D) It is useful in determining the probability of occurrence, since it provides with basis for forecast.
BUT, it is less accurate than a priori probability computation
A priori probability: the probability based on the underlying conditions that cause the event
(e.g. the probability of heads turning up when tossing a coin is ½), which can be assumed as
the BEST estimate of the probability that the event will occur in the future
How is the Law of Large numbers linked to A Priori probability and A Posterior probability?
The observed frequency of an event (A Posteriori probability) more nearly approaches A Priori probability as the number of trials approaches infinity.
After observing the proportion of the time that the various outcomes have occurred within a large sample of risk units over a long period of time, under essentially the same risk exposure conditions, it is possible to construct a probability distribution. The A Priori probability assigned to the event can be approximated by the mean of the probability distribution.
This is the probability at which the outcome is expected to occur in the future.
Why may the Law of Large Numbers improve the estimation of future probability of occurrence of events?
Only in this the presence of both large PAST SAMPLE SIZE and large SIZE OF THE GROUP of risk units in a portfolio, the law of large numbers could allow for quite accurate estimations of the future; smaller dispersion of the individual value from the mean of the probability distribution, and more stable risk conditions.
With the law of large numbers applied, things will in a large degree continue to happen in the future as they have happened in the past.
What does “stability of conditions” mean?
Stability of Conditions refers the when things continue to happen in the future as they have happened in the past - which allows for more accurate predictions of the probability of certain events’ occurrence.
The stability of conditions can be achieved when the estimate of past events’ occurrence is accurate thanks to the law of large numbers.
What is the problem with self-insurance? Choose 2
A) does not require a risk evaluation process
B) losses are never fully covered
C) losses are difficult to predict, and the self-insurer may save up a wrong amount of funding
D) poses opportunity costs for the self-insurer
Correct: C and D
The problem with this strategy is that the self-insuring individual doesn’t know how much to set aside as risk provision to fund possible losses, which eventually leads to opportunity costs of the capital parked, and the risk that the saved-up amount is not enough to cover the expenses connected to the damage.
Therefore, self-insurance is NOT EFFICIENT/ EFFECTIVE
Which of the following characteristic of an “unfunded mutual insurance plan” is WRONG??
A) Firms with similar risks of loss and are relatively uncorrelated pool together their risk
B) All units split evenly any accident costs that the participants might incur
C) Entails greater counterparty risk than funded mutual insurance plans
D) Entails smaller counterparty risk than a funded mutual insurance plan
WRONG: D)
An unfunded mutual insurance plan entails higher counterparty risk than funded mutual insurance plans, because in the former case, the participants have not made advance payments for the expected future losses - thus, some may choose not to pay if the event occurs.
What is NOT a characteristic of a FUNDED mutual insurance plan?
A) All participating parties agree to make an advance payment for predicted future losses for the group
B) The type of risk management pooling seen in the insurance business
C) Has no drawbacks
D) Each participant exchanges an uncertain loss for a certain cost (the advance payment)
WRONG: C)
The drawback of a funded mutual insurance plan is that the payment of any participant is independent of whether any given individual will actually incur a loss (the cost is certain). Meanwhile, it can be very difficult to predict future losses in advance, which may lead to wrong estimation of the advance payment amount necessary
What does a “Pooling agreement” mean?
Multiple parties (2+) agree to execute risk pooling - that is, each party agrees to pool their resources and split evenly the accident costs that may arise within the pool of participants.
What is NOT a benefit of risk pooling?
A) reduction of expected loss per party
B) reduction of standard deviation for the probability distribution of the group as a whole
C) higher predictability of future loss events as the number of participants increases
WRONG: A) reduction of expected loss per party is NOT the case. Typically the expected loss per party is independent of the number of participants in the pool and independent of whether the risk is pooled at all.
With pooling, and due to the law of large numbers, the standard deviation of the probability distribution will decrease for the group as a whole, and this decrease is further intensified as number of participants in the pool increases.
What are NOT a condition for efficient pooling? Choose 1-3
A) Independence: the occurrence of loss for one party must not affect the probability of occurrence for others in the pool
B) Equal distribution: all risk units are exposed to similar risks (type and intensity)
C) Experience rating: the premium paid by each individual affects the price of future premiums to be paid by that individual
D) Normal distribution
WRONG: C) Experience rating is a method to avoid/ decrease adverse selection issues - but NOT a precondition for efficient pooling.
D) Normal distribution is a potential effect that arises as the pooling agreement becomes larger (more participants) - thus, it is a product, NOT a condition for efficient pooling.
As a pooling arrangement becomes larger (more participants), which are the two effects that will occur?
- Law of large numbers: Standard deviation of each participant’s cost gets closer to zero. I.e., the risk of gaps between expectations and actual occurrence becomes lower for each participant.
- Approaching normal distribution: The probability distribution becomes more and more bell shaped until it eventually equals a normal distribution
Is pooling not beneficial if the two conditions (independence and similarity in terms of risk) are not met?
Pooling will still be beneficial if the two criteria for efficient pooling are not met.
Pooling will still decrease the standard deviation of average loss when the number of participants increases.
The participants do NOT need to be INDEPENDENT, but they MUST NOT be PERFECTLY CORRELATED - i.e., they must be SUFFICIENTLY INDEPENDENT and SUFFICIENTLY SIMILAR in terms of probability distributions.
The two conditions are NOT NECESSARY for pooling to be beneficial, but the more they are true, the more is the efficiency of the pooling.
Explain the effect that CORRELATION between risk units in a portfolio has on risk reduction.
Risk is not reduced when losses are perfectly positively correlated; risk is reduced only when there is less than perfect positive correlation, but not as much as when losses are fully uncorrelated and completely independent.
As the number of participants in the pooling arrangement increases, what is NOT the case?
A) The probability of extreme outcomes (very high or low average loss) decreases
B) The probability that the average losses (amount paid by each participant) will be close to the expected loss increases
C) The probability distribution of each risk unit’s cost becomes more bell-shaped
D) Decreases the expected loss
E) Non of the above
WRONG: D) expected loss is NOT decreased - only the probability that the losses materializing will be closer to the expected average loss - that is, the predictability of correct contribution (premium) increases.
How is a pool’s expected loss calculated?
Expected loss = probability of occurrenceloss if occurrednumber of participants
A pooling risk management strategy transforms a pure risk for individuals into a speculative risk for the insurance company. Why?
Insurance companies require a premium that is higher than the amount of expected losses in the pool. I.e., they have higher coverage, while the insurer’s probability for positive payout (profit) becomes larger.
I.e., the negative side of the speculative risk for the pool decreases.
What does it mean that insurance companies have an “inverted production cycle”?
Inverted production cycle: revenues precede costs in the production cycle of insurance companies. This means that liquidity is less important since revenues are generated before costs are incurred.
However, risks are connected to whether your revenue is large enough to cover losses that occur in the future, making the loss estimation essential.
What is NOT a characteristic for a pure risk to be insurable?
A) a large number of homogeneous and independent units
B) The loss produced by the risk must be measurable
C) The loss must be fortuitous or accidental
D) Must be a result of a catastrophic event
WRONG: D) In principle, the process does not work well if a loss is produced by a catastrophic event (loss incurred by a larger percentage of units at the same time). Such a loss makes many exposure units dependent on each other, and NOT INSURABLE
The following must be true in order for a pure risk to be fully insurable:
- There must be a sufficient LARGE NUMBER of HOMOGENEOUS (similar probability distribution) and, independently exposed units.
- The loss produced by the risk must be definite or MEASURABLE.
- The loss must be fortuitous or ACCIDENTAL
Why may insurers deviate from the theoretically optimal risk pooling and premium?
Often, insurers accept a lower insurance performance of the portfolio in exchange for the faster and wider acquisition of financial resources (premiums) to invest.
Meanwhile, competition pressure can prevent an accurate selection and pricing of the risk units or even push to underwrite risks which are not fully insurable.
What is a cross-subsidization strategy? And why can it be useful?
A cross-subsidization strategy could be implemented between different lines of business to create diversification.
i.e., performing well in one line of business can be used to compensate for less optimal performance in another line of business.
This strategy may be implemented to reduce the adverse effects of suboptimal pooling (choosing risk units that deviate from theoretical optimal)
Which are the two key risks for insurance companies?
A) Insurance risk
B) Default risk
C) Moral Hazard
D) Investment risk
A and D:
Insurance risk: the possibility that the actual risk experience of the portfolio is more costly than the estimation made when the advance payment was determined – i.e., the pool of premiums is not sufficient to cover the pool of losses.
Investment risk: the possibility that the return on the investment activity is negatively or not sufficient to achieve the expected targets (e.g., to compensate expected insurance losses), or lower than any estimation made in the calculation of the advance payment.
What are the consequences of the inverted production cycle?
A) Importance of correct pricing
B) Premiums should be invested temporarily
C) The insurance activity must be controlled by public authorities
D) All of the above
D) All of the above
Why is correct pricing important in insurance given the inverted production cycle?
Correct pricing is crucial since it determines the success of the insurance company business. Wrong determination of premium exposes the insurance to the risk of being unable to cover the expenses actually materializing.
What is meant by “premiums should be invested temporarily” in the context of an inverted production cycle?
Premiums should be invested temporarily: insurance companies have a large time span from the receival of advanced payment to their payment obligation arise – which leaves these companies with immense capital resources that must be allocated in investments to generate an additional source of profit or to be more competitive in premium pricing (efficient asset allocation allows room for lower premium price)
Why must the insurance activity be controlled by public authorities as a consequence of the inverted production cycle?
Since insurance companies collect premiums and invest this capital, they are essentially investing and managing financial resources that are not owned by the insurer, but by the policyholders. I.e., the asset allocation should fit the need of the policyholder in terms of potential future claims.
The inverted production cycle is a source of “the typical risk”/ “underwriting risk” for an insurer - what is this risk?
The underwriting risk for the insurer is NOT related to the uncertainty of whether an adverse event will occur, but to the possibility of differences (GAPS) between the actual damage in the portfolio of risk units and the estimated damage that is at the basis of premium calculation. I.e., they risk that the premiums received are not high enough to cover the amount of claims.
What does it mean when a gap (in the context of underwriting risk) is “normal”? How is this normal gap managed?
Normal gaps: normally, you can easily have to a certain extent of a gap between the estimation of the actual loss. Due to this, insurance companies always add a certain amount (risk loading) on top of the best estimate of potential losses, when determining the premium
What does it mean when a gap (in the context of underwriting risk) is “systematic”? How is this systematic gap managed?
Systematic gap: is when the gap is always in the same direction – either positive or negative. In this case, the insurer can draw the conclusion that the premium best estimate is wrong, and there is a need to reprice the premium price.
What does it mean when a gap (in the context of underwriting risk) is “exceptional”? How is this exceptional gap managed?
Exceptional gap: e.g., when the gap is consistently positive (or 0), but suddenly, it becomes negative in a given year.
Here, the countermeasure is to set aside a certain amount of cash as a cushion in the good years for such events when they occur in a bad year.
What is NOT a factor affecting the frequency and intensity of gaps?
A) Homogeneity (similarity) between risk units
B) Number of risk units
C) Independence among risk units
D) Stability of conditions
E) All of the above
All answers are correct - they are the factors affecting the frequency and intensity of gaps.
Why are insurance companies sometimes forced to perform imperfect portfolio selection?
Normally, a number of difficulties and constraints do not allow selecting the ideal risk units to be included in the portfolio (portfolio selection)
Examples include competitive or financial pressures, leading to necessary imperfect selection of risk units in the portfolio.
Which of the following is NOT an action that an insurance company can implement to reduce its underwriting risk?
A) Contractual conditions and limitations
B) Specific pricing methods
C) Reinsurance
D) All of the above
D) All of the above
After having selected the units, insurers can (e.g., under imperfect portfolio selection) implement actions to reduce the riskiness of the portfolio (the underwriting risk). In particular:
• Contractual conditions and limitations
• Specific pricing method
• Reinsurance
What is “insurable interest” in the context of an insurance contract?
Having an insurable interest means that the purchaser of insurance coverage must be at risk to sustain economic losses (pure risk) as a precondition for receiving a benefit (a compensation) under insurance of that risk.
Insurable interest is required for a contract to be considered an insurance contract.
What does “reimbursement of expenses” mean in the context of insurance contract benefits?
Reimbursement of expenses: the contract provides that in case of the occurrence of a given adverse event, the insurer will compensate the policyholder for up to a certain amount/percentage of the loss incurred by the policyholder
E.g., a policyholder can get medical expenses reimbursed by the insurer up to a certain amount/%.
What does “indemnity” mean in the context of insurance contract benefits?
Is a contract where the amount of compensation in event of damage is determined by an estimation of the loss. Different from reimbursement expenses, these losses can be difficult to quantify.
E.g., if a policyholder has had a car crash, the amount of damage is firstly estimated by the insurance company, before determining what the policyholder should receive as compensation
What does “forfeiture amount” mean in the context of insurance contract benefits?
Forfeiture amount: a contract where, in case of a damage event, the compensation paid to the policyholder is pre-determined. There is no need to make an estimation of the loss since the compensation amount has already been determined in the contract.
In life insurance, what type of benefit is typically received by the policyholder?
Forfeiture amount: a contract where, in case of a damage event, the compensation paid to the policyholder is pre-determined. There is no need to make an estimation of the loss since the compensation amount has already been determined in the contract.
This is the typical type of benefit that a policyholder will receive in life insurance, since it would be very difficult to determine the value of a life in the event of a death.
Which type of benefit is typically common in non-life insurance?
A) Reimbursement of expenses
B) Forfeiture amount
C) Indemnity
D) A + B
E) A + C
E) A + C
Reimbursement of expenses and indemnity are often the structure of benefits in non-life insurance, while forfeiture is more often the structure in life insurance.
What are two features that make insurance contracts aleatory (random)?
The two essential features that make the insurer’s obligation random are the
- AMOUNT: the monetary size of what the insured party gets if the insurance contract pays off.
-TRIGGER: determines if and when this amount should be paid.
In order for a contract to be “random”/ aleatory, and therefore to be recognized as insurance, the trigger and/or the benefit amount of the insurance contract must be based on an uncertain event, where the uncertainty has not been fully resolved at the policy’s inception.
What is the “principle of indemnity”?
The principle of indemnity states that the insurer agrees to pay no more than the actual amount of the loss borne by the policyholder.
The purpose of the principle of indemnity is to reduce moral hazard - prevent the policyholder from deliberately profiting from a loss.
What are the two overall types of insurance contracts based on the structure of benefit payment?
A) Valued contract
B) Forfeiture contract
C) Indemnity contract
D) Peril contract
Insurance contracts can be classified into two classes:
- Valued Contract: the amount that the insurer pays is pre-established at the time the inception of the contract, without any regard to the actual amount of loss caused by the event.
- Indemnity Contract: the amount that the insurer pays is determined after the occurrence of a loss, and the amount paid equals or is proportionate to the value of the loss.
What is “adverse selection” in the context of portfolio selection?
Adverse selection: When an insurer cannot distinguish between a “good” and a “bad” unit (in terms of riskiness), the premium charged will be based on some average estimation across both types of customers.
What does moral hazard mean in the context of insurance?
Moral hazard: arises from hidden action. Insurance contracts may lessen the policyholder’s attention to risk prevention, knowing that compensation will be paid in case of the event happening.
Which of the following actions can be taken by the insurance company to decrease the risk of adverse selection? Select 1-5
A) contractual clauses B) individual ratings C) experience rating D) deductibles E) class rating
B) individual ratings
C) experience rating
E) class rating
Are tools that allow for more precise risk rating
What is “individual rating” in terms of risk rating methodologies?
In principle, the best methodology would be to asses each risk unit individually, where pricing of premium is based on the actual loss experience of the specific risk unit.
This is, however, very time-demanding and perhaps infeasible in reality.
What is “class rating” in terms of risk rating methodologies?
Class ratings: for practical reasons, faster methodologies than individual ratings are necessary. With class ratings, the insurance company first defines classes for a given risk based on a risk proxy of risk intensity, then classifies the risk units (policyholders) into the most fitting class ratings.
What is “experience rating” in terms of risk rating methodologies?
Experience rating is a way to limit any inaccuracy of “class rating”. Under this method, risks are priced based on class rating, but in the following periods, the price is somehow adjusted based on the actual loss experience of the specific risk unit.
Which of the following actions can be taken by the insurance company to decrease the risk of moral hazard? Select 1-6
A) Deductibles B) Franchises C) Experience rating D) Exclusions E) Class rating F) Policy limits
Correct measures for limitation of moral hazard: A) Deductibles B) Franchises D) Exclusions F) Policy limits
