Objective 2 Flashcards
Regulatory action levels for Health RBC ratios
- Company Action Level (Ratio 150-200%) - company must submit a corrective action plan
- Regulatory Action Level (ratio 100-150%) - allows commissioner to examine the company and issue order specifying corrective actions
- Authorized Control Level (ratio 70-100%) - allows commissioner to place the company under regulatory control if deemed in the best interest of policyholders and creditors
- Mandatory Control Level (ratio lt 70%) - commissioner must take regulatory control
Formula for Health RBC after Covariance
- RBCAC = H0 + (H1^2 + H2^2 + H3^3 + H4^2) ^1/2
a) H0 = asset risk (affiliates)
b) H1 = asset risk (other)
c) H2 = underwriting risk
d) H3 = credit risk
e) H4 = business risk - Authorized control level capital = RBCAC/2
- Health RBC ratio = total adjusted capital / authorized control level capital
Formulas for H2 (underwriting risk) component of Health RBC
- Underwriting Risk = Claim Experience Fluctuation Risk + Underwriting Risk
- Claim Experience Fluctuation Risk is sum of risk charges for five product groupings (comprehensive, Med Supp, dental / vision, Med PD, and other)
a) for each grouping, risk charge = premium * ratio of incurred claims to premium * risk factor * managed care risk adjustment factor
b) The last two components come from tables of factors that vary by coverage type - Other Underwriting Risk includes
a) Coverages not included in 2, such as DI, LTC, stop loss, and AD&D. Tables of factors are used to calculate risk charges.
b) Adjustments for rate guarantees and PSRs
Features of ERM that distinguish it from traditional risk management
- Instead of focusing on risk mitigation or avoidance, ERM creates organizational resilience in achieving corporate goals
- Holistic (vs. siloed) view of org
- Embedded in management framework
- Provides common language to discuss risks and opportunities
- Provides a framework for identification and evaluation of potentially harmful conditions/events
- Ensures the org assumes no more risk than necessary to achieve corp goals
The process of the typical risk management approach
- Identify
- Evaluate
- Mitigate
Reasons why organizations fail to detect emerging risks
- Uncertain future
- Poor info about current conditions in org / environment lead to flawed future expectations
- Poor understanding of org complexity makes difficult to understand meaning of avail info
- Poor judgement in deciding how to respond
- Misaligned incentives between management / other stakeholders
ERM Process for managing enterprise-wide risk
Traditional process still used, but approached differently
- ERM expands risk profile by searching for unknown risk. Consists of:
a) Detailed description of business system
b) Construct risk hypothesis (structured understanding of risk profile / ability to achieve goals) - Traditional risk management is used to evaluate and mitigate known risks
- Appropriate risk capital is determined
- Monitoring and oversight by board / senior mgmt
Possible indicators of emerging risk
- High Ee Turnover
- Frequent reassignment of Proj Mgrs for major initiatives
- Frequent downtime of computer systems
- Frequent manual overrides or intervention required
- Numerous manual processes
- Frequent complaints from internal/external customers
- Significant variance of key indicators from normal / best practice
- Reactive (vs proactive) problem solving
- Frequent surprises
Typical information contained in the risk register
Created to record scenarios and events that have been considered in the risk evaluation
- Description of the risk scenario
- Details of how / when the scenario was identified
- Which corporate goals the scenario affects
- Description of the method used to quantify risk exposure and the time horizon for modeling
- The range of outcomes considered
- The outcome of a reverse stress test (IDs conditions that would cause risk capital to be exceeded)
- Gross likelihood and impact (normal / stressed envs)
- Description of mitigation strategies, assessment of effectiveness and cost
- Net likelihood and impact
- Assignment of responsibility for monitoring
- Details regarding action plans
Types of risk mitigation strategies
- Avoid
- Transfer
- Control
Characteristics to enter into the risk dashboard for each identified risk
High-level overview of the organization’s exposure to risk
- Brief description of the risk
- Line of business affected
- Gross likelihood
- Gross impact
- Gross risk rating
- Control effectiveness
- Net likelihood
- Net severity
- Net risk rating
- Tolerance
- Net risk rating vs. tolerance
- Action plan status
Senior management responsibilities for implementing ERM
- Communicate support of ERM process
- Maintain culture of performance improvement and learning from successes and failures
- Allow for open discussion of risk
- Provide direction to RM committee and CRO
- Determine risk appetites and limits
- Establish limits of authority for risk assumption
Responsibilities of the chief risk officer (CRO)
- Chief champion of ERM process
- Lead risk management committee
- Direct ERM process by guiding bus. units as they prioritize, evaluate, and mitigate risk
- Guiding info collection and perf monitoring
- Testing the perceived risk profile
- Modifying the risk profile and risk models using emerging experience and knowledge
- Ensuring the organization continues to learn from emerging experience and that the risk profile is continuously updated
Benefits of ERM
- Credit agencies may be willing to offer lower borrowing costs
- Regulators and the board of directors may allow management more flexibility in managing the company
- Management will better understand the business system
- The organization will know how much corporate risk capital to hold
- There will be fewer unknown risks
Common features of ERM frameworks
- Assessment of the context in which the framework is operating (int/ext env, interests of stakeholders)
- Consistent risk classification established
- Risks identified
- Risks assessed and compared to targets
- Decision made on risks that exceed targets
- Measures to manage implemented
- Monitor, document, communicate
Models of risk management
- Three lines of defense
a) Day-to-day management by first-line business units
b) Ongoing monitoring by central risk function (CRF)
c) Occasional audits of first-line business units and CRF - Offense and defense - first-line units take as much risk as they can, CRF reduces as much as possible. Avoid - puts first 2 lines in opposition.
- Policy and policing - CRF sets RM policies and then monitors compliance. Often results in “hands-off” CRF
- Partnership - first-line business units and CRF work together closely to maximize returns subj. to acceptable risk level. May leave CRF too involved to give ind assessment of first-line units.
Categories of risk faced by organizations
- Market
- Economic
- Interest rate
- Foreign exchange
- Credit
- Liquidity
- Systemic
- Demographic (mortality / longevity)
- Non-life insurance
- Operational
- Residual
Types of systemic risk
- Financial infrastructure
- Liquidity (in a run on banks)
- Common market positions
- Exposure to a common counter-party
Types of demographic and non-life insurance risk
- Level
- Volatility
- Catastrophe
- Trend
Types of operational risks
- Business continuity
- Regulatory
- Technology
- Crime
- People
- Bias (deliberate / unintentional)
- Legal
- Process
- Model
- Data
- Reputational
- Project
- Strategic
Types of people risk
- Employment-related
- Adverse selection
- Moral hazard
- Agency
Broad areas in the risk identification process
- Risk identification tools
- Risk identification techniques
- Assessment of nature (quantifiable / unquantifiable)
- Recording in a risk register
Risk identification tools
- SWOT analysis (Strengths, Weaknesses, Opportunities, Threats)
- Checklists
- Prompt lists
- Taxonomy
- Trigger questions
- Case studies
- Risk-focused process analysis
Risk identification techniques
- Brainstorming
- Independent group analysis
- Surveys
- Gap analysis
- Delphi technique
- Interviews
- Working groups
Purposes of an internal economic capital model
- Determine how much capital a firm should hold
- Price new products and decide how to allocate capital across business lines
- Assess amount of economic capital that should be held over time
- Assess impact of changes in investment strategy and capital structure
- Look at how an organization copes in the face of extreme events
- Help measure performance
- Carry out due diligence for corporate transactions
- Provide information on the financial state of the organization to a regulator
Considerations for designing an economic capital model
- What the model will be used for
- What risks will be modeled
- Approach (factor table, deterministic, stochastic)
- Enterprise-wide or by business line and combined later
- Output required
Definition of economic capital
Definition of economic capital: additional value of funds needed to cover potential outgoings, falls in asset values, and rises in liabilities at a given risk tolerance over a specified time horizon
Risk optimization measures
- Risk-adjusted return on capital
r_A = risk-adjusted return / economic capital
good for comparing different lines of business within a firm - Economic income created
EIC = (r_A - r_H) * EC
Rate of return that each unit of a product sold must earn to cover additional amount of risk it generates - Shareholder value
SV = EC * (r_A - r_G) / (r_H - r_G)
Discounted present value of all future cash flows - Shareholder value added
SVA = SV - EC
Disc. PV of future cash flows, above required economic capital
Categories of risk for health insurance companies
- Environmental
- Financial
- Operational
- Pricing
- Reputational
- Strategic
Environmental risks for health insurers
- Buyer environment
- Competition
- Economy
- Fraud (external)
- Legal
- Regulatory / legislative
- Supplier environment
Financial risks for health insurers
- Asset default
- Data
- Financial viability
- Interest rate
- Liquidity
- Model
- Reinvestment
- Reserve adequacy
Operational risks for health insurers
- Billing and collections
- Claims processing
- Contract wording
- Data technology and management
- Fraud (internal)
- Human resources
- Network management
- Reinsurance
- Ineffective sales force
- Inadequate training
- Vendor relations
Pricing risks for health insurers
- Anti-selection
- Authority
- Competition
- Data
- Financial viability of capitated providers
- Model
- Mortality
- Regulatory and legislative
- Reinsurance
- Trend: inflation
- Trend: intensity
- Trend: technology
- Trend: utilization
- Underwriting
Reputational risks for health insurers
- Disgruntled policyholder
- Rating agency downgrade
- Stock analysts (misinterpret or impatient)
- Claims adjudication (slow)
- Corporate governance
- Distribution (poor sales tactics)
- Fraud (control measures)
Strategic risks for health insurers
- Capital management
- Growth
- Incentives
- Management failure
- Mergers and acquisitions
- Network management
- Reinsurance
Financial uses of reinsurance
- Increase financial capacity
- Catastrophe protection
- Stabilize earnings (specific, aggregate, mix, or increase spread)
- New business growth
- Improve balance sheet position
- Reinsurance as guarantor
- Retrocessional reinsurance
Non-financial uses of reinsurance
- Increase intellectual capacity
- Joint ventures
a) Fronting
b) Lack of ceding company commitment
c) Mutual interests - Acquisition
Limitations of reinsurance
- Cannot make an uninsurable risk insurable
- Cannot make an inadequate premium adequate
- Can be misused
- Can be used for improper or illegal purposes
Types of reinsurers
- Reinsurance companies
- Insurance carriers
- Reinsurance facilities or pools
Methods of reinsurance risk transfer
- Facultative
2. Automatic or treaty
Types of reinsurance programs
- Proportional (coinsurance or quota share)
2. Non-proportional (excess of loss, aggregate excess)
Ceding company considerations in designing a reinsurance program
Reinsurer qualities 1. Financial condition / continuity 2. Flexibility in terms and arrangement 3. Experience and ability 4. Services provided 5. Underwriting Other 6. Rates and terms 7. Administration costs 8. Degree of management involvement 9. Profits lost to reinsurer 10. Business relationships
Reinsurer considerations in underwriting proposed business
- Ceding company business objectives
- Ceding company management
- Reinsurance program objectives
- Financial condition of ceding company
- Administration (prompt reporting / strong procedures?)
- Underwriting
- Claim adjudication (philosophy / reflects policy provisions)
- Marketing and sales (focused / reinsurer niche)
- Expected reinsurer profit
Keys to reinsurer success
- Rating
- Expertise (UW / pricing / claims)
- Client mix
- Credible size
- Consistency
Uses of reinsurance for group medical benefits
- For ceding company - through quota share (usually cede between 20-100%) or excess
- For self-funded employer plan - through stop loss. usually require both specific and aggregate
Long term care characteristics making it desirable to use reinsurance
- Low frequency, high severity
- Scarce insured claim cost data
- New product - benefits still evolving
- Claim cost slope is steep (delays emergence of experience for decades)
- Future direction of claim costs debatable (prolong vs cure)
- Capital intensive (active life reserves)
- Reinsurers have an advantage (access to numerous direct carriers, see what doesn’t work)
MCCSR minimum capital requirements
Sum of five risk components
1. Asset default (C-1)
2. Mortality, morbidity and lapse
3. Changes in interest rate environment (C-3)
4. Segregated funds
5. Foreign exchange
MCCSR ratios compare capital available to capital required
1. Minimum total for life insurers 120%, supervisory target 150% for adj net tier 1 + net tier 2
2. Majority should be adj net tier 1. Minimum 60%, supervisory target 105%.
Components of gross tier 1 capital
Consists of the highest quality capital elements
- Common shareholders’ equity
- Participating accounts
- Qualifying non-cumulative perpetual preferred shares
- Qualifying non-controlling interests in subsidiaries arising on consolidation from tier 1 capital instruments
- Qualifying innovative tier 1 instruments
- Non-participating accounts
- Accumulated foreign currency translation adjustments reported in Other Comprehensive Income (OCI)
- Accumulated net unrealized loss on available-for-sale equity securities reported in OCI
- Accumulated changes in liabilities reported in OCI under shadow accounting
- Accumulated defined benefit pension plan remeasurements reported in OCI
Formulas for net tier 1 capital
Net tier 1 capital equals gross tier 1 minus:
- Goodwill
- Intangible assets over 5% of gross T1
- Adjusted negative reserves calculated policy by policy and negative reserves ceded to unregistered reinsurers
- Cash surrender value deficiencies calculated on a grouped aggregate basis
- Back-to-back placements of new tier 1 capital between financial institutions
- Each net defined benefit pension plan recognized as an asset on the insurer’s balance sheet net of any associated deferred tax liability
Types of tier 2 capital
T2 (supplementary capital) is not permanent, or has mandatory fixed charges against earnings.
- Tier 2A: hybrid capital instruments (equity/debt)
- Tier 2B: limited life instruments
- Tier 2C: other capital items
- Net T2 is gross minus:
a) 50% of deductions / adjustments
b) back-to-back placements of new T2 capital between financial institutions
Characteristics of the ideal insolvency process
- Good relationships between task force and the receiver
- Good policy records
- Few uncovered obligations
- Facts and solution are clear and agreed on by the receiver and the task force
- Joint solicitation of proposals and negotiation of an assumption reinsurance agreement with a strong reinsurer
- No resistance to court order of liquidation with a finding of insolvency
- Prompt regulatory approvals of agreements among receiver and affected guaranty associations
- Quick closing to move policyholders to a solid insurer
- Guaranty associations’ obligations fully satisfied at closing
- Task force involvement in asset recovery
Major steps in the enterprise risk management process
- Risk identification and classification
- Risk measurement and prioritization
- Risk management and aggregation
Definition of enterprise risk management
The discipline by which an organization in any industry assesses, controls, exploits, finances, and monitors risk from all sources for the purpose of increasing the organization’s short- and long-term value to its stakeholders
Processes included in the ERM control cycle
- Identify
- Evaluate
- Appetites
- Limits
- Accept or avoid
- Mitigation
- Actions when limits are breached
Considerations when performing services related to risk evaluation
- Information about financial strength, risk profile, and risk environment of the organization
- Information about the organizations risk management system, including
a) risk tolerance
b) risk appetite
c) components of ERM control cycle
d) knowledge/experience of management re ERM
e) actual execution of control cycle - Relationship between (1) and (2)
- Intended purpose and uses of actuarial work product
Required disclosures for communications subject to ASOP #46 on risk evaluations in ERM
- Results of economic capital model, intended use, known limitations
- Results of stress and scenario tests, intended use, known limitations
- Methodologies and sources of info for ID / eval emerging risks
- Any material changes in system, process, methodology, or assumptions from previous
- Significant assumptions used in the risk evaluation and interdependencies among risks / statistical distributions
- Risks included in risk evaluation and relative significance, and known material risks not included and rationale
- Whether and how modeled future economic conditions have been reviewed and tested for reasonableness
