Module 7

Question 1

Outline the S&P approach to credit rating

Answer 1

S&P’s ratings of creditworthiness are a subjective combination of factors arising from its rating framework, which consists of three elements:

1. sovereign risks, eg taxation, currency control
2. business risks, eg industry prospects, management quality
3. financial risks, eg profit level, cashflow, capital structure and flexibility.

Within the above framework ERM capability is categorised into weak, adequate, strong or excellent. The significance of ERM capability within the overall credit rating for insurance companies depends on two features:

1. how complex the risks are that the insurer accepts
2. how easily the insurer can access capital.

Question 2

List the five main areas that are measured by S&P in order to assess ERM capability

Answer 2

There are five main areas that are measured in order to assess the ERM capability:

1. risk management culture
2. risk control
3. extreme event management
4. risk models and economic capital models
5. strategic risk management.

Question 3

Outline how S&P assess an insurer’s risk management culture

Answer 3

S&P define risk management culture to be the degree to which risk and risk management are important considerations in all aspects of corporate decision making.

The dimensions that S&P considers are:

1. its philosophy towards risk and its risk appetite
2. the governance and organisational structure of the risk management function
3. the external and internal risk and risk management disclosures and communications
4. the degree to which there is understanding and participation in risk management across the company.

For each of these, S&P has developed a suite of favourable and non-favourable indicators.

Question 4

Outline how S&P assess an insurer’s risk control

Answer 4

The control mechanisms for key risks will be assessed, considering:

1. how well the company’s risk identification procedures are carried out
2. how well risks are monitored on an ongoing basis
3. the limits set for retained risks, how these limits will be adhered to and the consequences or actions taken when limits were not met
4. the execution of the risk management processes.

For each of these, S&P has developed a suite of favourable and non-favourable indicators.

For each insurance company, S&P develops an opinion as to the most important risks of the insurer, in particular those that are of high concern across the insurance industry, such as equity risk from embedded guarantees, concentration and event risk, and IT data security risk.

Question 5

Outline how S&P assess an insurer’s extreme event management

Answer 5

Extreme events are low frequency, high-impact events that can seriously affect an insurer’s financial health.

S&P look for evidence that the insurer:

1. considers various possible events
2. adopts an appropriate course (eg scenario or sensitivity testing) to measure the potential impact (on the company’s reputation, liquidity and overall financial strength)
3. prepares for such events (eg contingency plans)
4. carries out ‘post-mortem’ analyses and feeds back into contingency plans
5. performs extreme event management regularly but not in a routine checklist manner

Question 6

Outline what is meant by indicative, predictive and sensitivity risk measures

Answer 6

Indicative measures – give a broad indication of the trend in a risk, eg sums assured, premiums earned, values of assets, staff turnover. They might be obtained directly from accounting, administrative or underwriting systems.

Predictive measures – measure risk directly or indirectly in relation to a loss at a particular percentile of a distribution, eg Value at Risk, expected shortfall. They can be estimated using complicated and powerful simulation models (deterministic or stochastic).

Sensitivity measures – return the sensitivity of a value to a change in an underlying factor, eg duration, convexity, the Greeks. They can be obtained via closed-form calculations or stochastic simulation models.

Question 7

Outline how S&P assess an insurer’s risk and capital models (8)

Answer 7

S&P might perform assessments of:
1. the range, quality, and use of indicative, predictive and sensitivity risk measures (taking into account the complexity of the insurer)

2. the appropriateness of the choice of projection approach
3. the degree to which the models reflect all important risks
4. operational issues (eg assumptions, procedures, validation)
5. whether a single model separate models are used
6. the consistency between models / ability to aggregate risk
7. modification of any standard formulae used
8. the degree to which economic capital is used actively in day-to-day management, business planning and strategic decision making

Question 8

Outline features of strategic risk management that S&P would view positively (6)

Answer 8

1. clear decision making re: retained risks (eg avoid, diversify)
2. clear asset investment strategy (eg by class, sector, country)
3. pricing reflects clear standards for risk/return payoff 4. appropriate capital allocation
4. justifiable dividend policy linked to RAROC
5. director / employee remuneration linked to RAROC

Question 9

List the strengths of the S&P approach (8)

Answer 9

1. emphasis on Enterprise Risk Management, ie not in silos
2. focus on the use of risk capital measures
3. relating performance to risk choices and tolerances
4. useful breakdown of ERM analysis into components
5. encouragement of greater transparency of ERM practices
6. introduction of a classification system to facilitate communication
7. common criteria applied to all insurance companies, but also tailored to each one (although limited details on how this is done)
8. argued that a high rating may help organisations attract and retain customers who are increasingly sophisticated

Question 10

List the weaknesses of the S&P approach (6)

Answer 10

1. limited to insurance and reinsurance companies
2. hard to assess the approach objectively as:
   − limited description given of actual procedures and measures
   − the strengths (above) are derived from the company’s marketing literature, and the tone could be argued to be overly optimistic
3. no explicit mention of agency risk
4. ‘complicated and powerful simulation models’ used will be highly subjective and are problematic (eg model risk)
5. unclear impact – ie did the adoption of this formalised approach to RM assessment have any significant impact on S&P’s views?
6. there are other viewpoints – eg the company may well have a better understanding of its risks than a rating agency

Question 11

Discuss why an insurer might achieve a ‘strong’ rating from S&P (4)

Answer 11

1. insurer has strong capabilities to consistently identify, measure, and manage risk exposures and losses within the enterprise’s predetermined tolerance guidelines.
2. however, the insurer is somewhat more likely to experience unexpected losses that are outside of its tolerance level than an excellent ERM insurer
3. some evidence of the enterprise’s practice of optimising risk-adjusted returns, though it is not as well developed as those of leading industry practitioners
4. risk and risk management are usually important considerations in the insurer’s corporate decision making