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ERM Exam > Objective 4 > Flashcards

Objective 4 Flashcards

1
Q

Four Categories of Responses to Risk

(FERM 16)

A
  1. Reduce
  2. Remove
  3. Transfer
  4. Accept
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2
Q

Five features of a good Risk Response

(FERM 16)

A
  1. Economical;
  2. Matches closely to the risks intended to control;
  3. As simple as possible;
  4. Active, not just informative;
  5. Retained unless they are significant
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3
Q

Description of “Risk Acceptance”

(FERM 16)

A

The risks are retained.

This happens if the cost of removal or transfer is greater than the cost of retaining the risk exposure.

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4
Q

Description of “Risk Transfer”

(FERM 16)

A

Changing the risk exposure to a firm by transferring the consequences of a risk event to another party

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5
Q

Two important categories of risk transfer

(FERM 16)

A
  1. Non-capital market transfer
  2. Capital market risk transfer
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6
Q

Common forms of “Capital Market Risk Transfer”

(FERM 16)

A
  1. Bond (e.g., a catastrophe bond);
  2. Put option
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7
Q

Definition of “Capital Market Risk Transfer”

(FERM 16)

A

Turning risk exposure into an investment that can be bought and sold, where investors take on the risk exposure in exchange for a risk premium.

Also known as securitization.

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8
Q

Benefits of “Capital Market Risk Transfer”

(FERM 16)

A
  1. Provides a market-based price for the risk if the security is being traded;
  2. Provide a quicker way of raising capital.
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9
Q

Forms of insurance as a “Non-Capital Market Risk Transfer”

(FERM 16)

A

1. Traditional form

  • A firm transfers a risk by paying a premium to the insurer.

2. Self-insure

  • A firm (a) sets assets aside to absorb the loss, OR (b) transfers the risks to a wholly-owned captive insurance company.
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10
Q

Common type of “Non-Capital Market Risk Transfer”

(FERM 16)

A

The most common form is insurance, which is the payment of a premium to buy protection from a risk.

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11
Q

Description of “Proportional or quota share (re)insurance”

(FERM 16)

A

Transfers a proportion of each policy sold to a third party, allowing the firm to take on more business and therefore to build a more diversified portfolio

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12
Q

Description of “Average-loss (re)insurance”

(FERM 16)

A

Can average over

(1) number of years to smooth profits and lower premiums, or
(2) can require a range of events to occur before payout is made.

Can help protect against concentrations of risk.

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13
Q

Types of insurance policies as a “Non-Capital Market Risk Transfer:

(FERM 16)

A

1) Proportional or QS (re)insurance
2) Excess-of-loss (re)insurance
3) Average-loss (re)insurance

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14
Q

Description of “Excess-of-loss (re)insurance”

(FERM 16)

A

Pays out losses after a certain level.

If the level is very high, this becomes catastrophe insurance.

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15
Q

Description of “Risk Reduction”

(FERM 16)

A

Includes:

1) Taking active steps to limit the impact of a risk ocurring;
2) Creating more robust systems and processes to reduce the change of risk emerging or to impact the impact. Includes diversification.

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16
Q

Description of “Risk Removal”

(FERM 16)

A

Ensuring that the institution is not exposed to that risk at all

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17
Q

What are 4 ways to manage market risk?

(FERM16)

A
  1. Policies, procedures and limits (acceptable risk level, decision-makers, risk limits)
  2. Diversification (asset classes, geographical regions, economic sectors)
  3. Investment strategy
  4. Hedging (futures, forwards, options)
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18
Q

What are the differences between futures and forwards?

(FERM16)

A
  • Futures are traded on exchanges; Forwards are OTC
  • Futures are standardized contracts; Forwards are custom-tailored
  • Futures have lower counter-party risk than Forwards
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19
Q

Why is there basis risk in Futures?

(FERM16)

A

Because of the standardization, which means that futures cannot be used to hedge exactly the risk faced.

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20
Q

How is basis risk calculated at time t?

When is there no basis risk?

(FERM16)

A

Bt = Xt - Ft

There is no basis risk if:

1) hedge is required until exact date of expiry
2) underlying asset is exactly the same
3) there are no uncertain cash flows (e.g., sell/purchase, dividends, other costs)

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21
Q

What derivatives (other than futures) are used to hedge against loss?

(FERM16)

A
  1. Put option
  2. Credit default swap (CDS), which provides payment on the default of a bond or index
  3. Out-performance option, which provides a payment if the returns on one asset exceed those on another by more than a certain amount
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22
Q

What are two categories of interest rate risk, in terms of hedging?

(FERM16)

A
  1. Direct exposure (to interest rates)
  2. Indirect exposure (to interest-sensitive liabilities)
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23
Q

What are 5 hedging tools for direct exposure?

(FERM16)

A
  1. Forward rate agreements (FRAs), OTC contracts with payments based on an interest rate applied to a notional amount
  2. Interest rate caps, a series of individual caplets (pmt = max{imarket - ipre-det rate, 0} * notional amount)
  3. Interest rate floors, a series of individual floorests (pmt = max{ipre-det rate - imarket, 0} * notional amount)
  4. Interest rate swaps, where one side pays a fixed rate in exchange for a floaring rate of interest
  5. Interest rate swapation, same as swap but with an option and requires a premium
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24
Q

What are 3 hedging tools for indirect exposure?

(FERM16)

A
  1. CF Matching, where payments match as closely as possible
  2. Duration Matching (a.k.a., Redington’s Immunization)
  3. Heding using Model Points, where amount at each term or model point is chosen such that the overall interest rate sensitivity between A and L is as close as possible
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25
Q

What are 5 ways to mitigate foreign exchange risk?

(FERM16)

A

Hedge the net level (difference between two amounts) of currency exposure using:

  1. Forwards
  2. Futures
  3. Options
  4. Swaps
  5. Other Derivatives
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26
Q

What are 6 ways to manage credit risk?

(FERM16)

A
  1. Change the capital structure (strategic, not level of capital)
  2. Reduce the volume and mix of business
  3. Increase UW standards (on OTC derivatives)
  4. Conduct due diligence (on counterparty involved)
  5. Buy credit insurance or CDS
  6. Securitize assets (for risk transfer)
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27
Q

How is a CDS structured?

(FERM16)

A
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28
Q

How is a CDO structured?

(FERM16)

A
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29
Q

What are ways to manage liquidity risks?

(FERM16)

A
  1. Allow for transfer of liquidity within and across legal entities
  2. Incentivize employees to allow for liquidity risk
  3. Use investment strategy to manage market liquidity risk
  4. Allow for liquidity risk in the product design
  5. Ensure funding diversification, both in the term and source
  6. Gauge the firm’s ability to raise capital from each source
  7. Have a contingency funding plan to provide liquidity in times of stress
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30
Q

What are ways to control operational risks?

(FERM16)

A
  1. Use appropriate systems and processes
  2. Outsource some of the processes to external organizations
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31
Q

What are ways to limit business continuity risk?

(FERM16)

A
  1. Have contingency plans for an alternative business location
  2. Ensure regular data backup, preferrably in a remote location
  3. Ensure that key personnel and staff can work from home
  4. Test the contingency plans regularly
  5. Consider consequiential loss insurance on top of other business insurance
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32
Q

What are ways to limit regulatory risk?

(FERM16)

A
  1. In-house departments dedicated to learn about imminent changes and disseminate them around the firm
  2. Suscribe to alert services
  3. Hire consultants
  4. Take action of any proposed changes are likely to have an adverse effect
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33
Q

What are ways to limit technology risk?

(FERM16)

A
  1. Have a dedicated central IT resource
  2. Backup data and run secondary servers
  3. Ensure software and security patches are up-to-date
  4. Consider new software and how it interacts with other systems
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34
Q

What are ways to limit employment-related risk?

(FERM16)

A
  1. Have the right recruitment procedures
  2. Retain the right employees
  3. Support employees
  4. Identify poorly performing employees
  5. Train employees for their roles
  6. Maintain good relationships with any collective bodies
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35
Q

What are ways to limit moral hazard?

(FERM16)

A
  1. Make the consequences unattractive
  2. Assess claims above a certain amount
  3. Lower the limit for which claims are assessed in times of economic stress
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36
Q

What are ways to limit bias?

(FERM16)

A
  1. Ensure that reports and assessments are checked by a competent and independent party
  2. Use objective criteria in the checking
  3. Compare peers’ quotations
  4. Ensure that the board has the skills to ask the right questions
  5. Make people aware the unintentional biases
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37
Q

What are ways to limit legal risk?

(FERM16)

A
  1. Keep managers and employees informed
  2. Seek legal advice if there is any doubt over the legal status of a particular course of action
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38
Q

What are ways to limit process risk?

(FERM16)

A
  1. Regularly review the proesses and systems used
  2. Stress test the process and the ways it fits into the broader structure if a new process is introduced
  3. Use risk-focused process analysis to manage the structure as a whole
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39
Q

What are ways to limit model risk?

(FERM16)

A
  1. Have a rigorous, documented process for model coding, together witha clear audit trail
  2. Ensure that all models are actually designed for their original use, or that there is a sound reason for putting such model to another use
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40
Q

What are ways to limit data risk?

(FERM16)

A
  1. Limit the data that can be input
  2. Check that the dates are reasonable and valid
  3. Require the data that can be accepted only if all fields are completed using valid entries
  4. Re-check the data if it is transferred
  5. Combine duplicated entried (de-duplication) if personal data are used for analysis
41
Q

What are ways to limit reputational risk?

(FERM16)

A
  1. Scan possible action for potential reputational damage
  2. Insitute a sound ERM framework
  3. Rebuild the organization’s reputation as quickly as possible if it is damaged
42
Q

What are ways to limit project risk?

(FERM16)

A

Create a comprehensive ERM framework that allows for the interaction between the different processes and the resulting risk concentrations

43
Q

What are ways to limit strategic risk?

(FERM16)

A

Ensure that a firm correctly positioned in its market (choose a strategy and constantly review it with the changes in industry and competitors)

44
Q

What is a portfolio approach to managing market risk?

(ERM110)

A
  • Determine properly the net position of the portfolio
  • Identify the fundamental risks
  • Decompose the overall portfolio into underlying risk factors
  • Aggregate and manage the risks on a net basis
45
Q

What are policies and proceures used to manage credit risk?

(ERM110)

A
  1. Internal controls
  2. Documentation provisions
  3. Credit enhancement structures
  4. Counterparty credit evaluation
  5. Use of risk limits for counterparties
46
Q

What are compontents of internal controls for operational risk?

(ERM110)

A
  1. Oversight of informed and involved senior management
  2. Documentation of policies and procedures
  3. Independent risk management function
  4. Independent internal audits
  5. A back office with sufficient technology and systems
  6. Independent check and balance system
47
Q

What are the uses of key rate durations?

(ERM111)

A
  1. To measure the interest rate risk exposure of an interest rate-contingent claim
  2. To replicate option-embedded bonds by using a portfolio of option-free bonds
  3. Used in structure portfolio management techniques
  4. To quantify the interest rate bets for the manager
  5. To provide a procedure to control interest rate risk exposure
48
Q

What were several challenges faced by insurers in the financial crisis?

(ERM112)

A
  • Significant realized losses
  • Unrealized losses via AOCI
  • A severe drop in market capitalization vs. the broader market
  • Falling RBC ratios
49
Q

What were ways to raise capital during the financial crisis?

(ERM112)

A
  • Issue common and preferred equity
  • ISsue senior unsecured debt, surplus notes and subordinated debt
  • De-risk where possible
  • Attempt to divest business
50
Q

What are six core processes to create the most efficient ERM approach?

(ERM112)

A
  1. Risk governance
  2. Risk and capital measurement
  3. Risk budgeting
  4. Liquidity risk management
  5. ALM and SAA
  6. Risk reporting
51
Q

What are the steps in the ALM and SAA process?

(ERM112)

A
  1. Investment objectives and constraints
  2. Asset universe and assumptions
  3. Liability cash flow and replicating portfolio
  4. Risk measures
  5. Risk-return trade-offs
  6. ALM and SAA
52
Q

What are common uses of SPVs?

(ERM115)

A
  1. Securitization
  2. Asset transfer
  3. Financing
  4. Risk sharing
  5. Financial engineering
  6. Raising capital
53
Q

What are benefits of using SPVs?

(ERM115)

A
  • Asset ownership
  • Minimal red tape
  • Clarity of documentation
  • Freedom of jurisdiction
  • Tax benefits
  • Legal protection
  • Isolation of financial risk
  • Meeting regulatory requirements
54
Q

What are the risks (from a sponsoring firm’s perspective) of using SPVs?

(ERM115)

A
  • Lack of transparency (monitor results and track who has the risk)
  • Reputational risk (credit rating subject to SPV’s performance)
  • Signaling effect (high degree of attention to SPV)
  • Franchise risk (affiliated SPV affects sponsor’s other relationships)
  • Liquidity and funding risk
  • Equity risk (equity tranche collapsing)
  • Mark-to-market risk (force sale of assets in SPV negatively impacts firm BS)
  • Regulation (different regulation applies to SPV)
55
Q

What are ways to manage the risks in SPVs?

(ERM115)

A
  • Governance
  • Reporting capability (firm should have the reporting capability to assess aggregate SPV exposure in comparison to other firm-wide risks)
  • Oversight (firm should monitor SPV activity)
  • Motivation (reconsider purpose of SPV)
  • Regulation (tighten reporting requirements)
  • Simplification
  • Consolidation
  • External ratings
  • Reintermediation
56
Q

What is reintermediation?

(ERM115)

A
  • Stop using SPVs through reintermediation of OBS assets back into the BS of sponsoring firm
  • Why is it used?
    • Restricting the flow of information
    • Moral hazard (investors) - they know banks are backing up the SPV, so they don’t carefully scrutinize
    • Moral hazard (banks) - if fully bankruptcy remote
57
Q

What is risk financing?

(ERM1122)

A

Process of providing funds or capital for payment of losses

The short-term goal is to transfer the responsibility for paying losses from the entity that incurred the loss to another entity

58
Q

What are two key elements of definint ART?

(ERM122)

A
  1. Innovative use of risk financing techniques to structure an ART program
  2. Use an alternative mechanism to finance risk
59
Q

What is an alternative risk financing mechanism (ARFM)?

(ERM122)

A

RFM

  • An RFM is a legal entity that is the means by which fund are made available to pay for losses. The legal entity has independent existence, which means it has decision-making and executive authority.

ARFM

  • Describes the activities of the captives that finance risk outside the TRT insurance regulatory system
  • Note all ARFMs are captives, and not all use insurance techniques
  • Includes:
    • RPGs
    • Self-insurance pools
    • Captives
60
Q

Describe RPGs

(ERM122)

A
  • Allows smaller insureds (those without the financial strength to retain risk) to buy liability insurance “in bulk” / in an effcient manner
  • Avoids laws in some states which prevent groups forming solely for the purpose of buying insurance
  • Eases handling multistate filings for rates and policy forms, encouraging risk capital to enter the market
  • Reduces insurance costs since it does not separately underwrites each insured entity
  • It does not assume risk
61
Q

Describe self-insurance pools

(ERM122)

A
  • Mechanism for joint access to coverage and claims services, and stabilize insurance costs
  • Operate as a mutual benefit association (unfunded pool), where the pool can assess members to pay losses as they occur
    • Pool members have joint liability
    • Pool members have longer-term liability and are required to post collateral
  • It does not take risks
  • Example: WC pools
62
Q

Describe a captive

(ERM122)

A
  • “Insurance company that is wholly owned and controlled by its insureds”
    • Must be a licensed insurance company
    • Must have risk capital since it takes risk
  • Its primary purpose is to insure the risks of its owners
  • The primary benefeciaries of its UW profits are its insureds
63
Q

What are the elements of captive insurance?

(ERM122)

A
  1. Choose to put capital at risk
  2. Work outisde the commercial regulated marketplace
  3. Achieve the insured’s risk financing objectives
64
Q

What is a risk taker?

(ERM122)

A
  • The entity that takes the “risk” in return for premium
  • In captives, there are two types of risk takers:
    • The source of risk - the operating entity that undertakes activities to generate risk
    • The owner of risk - who bears the ultimate financial impact and is the source of capital required
65
Q

What are pure captives?

(ERM122)

A
  • Captives insuring only the risks of their owners
  • The purpose of writing the risk is to allow the insured owner of the captive to more effectively manage its own risks
    • If there is a commercial purpose (e.g., to sell insurance to make a profit), then the captive would not be pure
66
Q

What are two forms of group-owned captives?

(ERM122)

A
  1. Industrial insured group captive
    • Insure only insureds in the same industry group or with homogeneous risk
    • Members o the group are all sophisticated insureds
  2. Reinsurance pool
    • Allows a group of insured from entirely different industry groups to own a captive jointly
    • Its purpose is to pool risk, and it does not provide direct insurance
67
Q

What is a risk retention group (RRG)?

(ERM122)

A
  • A licensed insurer with required homogeneous risk and all insureds must be owners
  • Purposes:
    • Avoid multi-state regulation
    • Create new UW capacity
68
Q

What are sponsored captives?

(ERM122)

A
  • The difference between pure and sponsored, is that sponsored captives:
    • Are not formed by its insureds
      • Participants are those whose risks are underwritten
      • Sponsor contributes the captive’s core capital
    • Do not pool the risks of its insureds
      • May keep separate underwriting account for each insured participant
69
Q

What are association captives?

(ERM122)

A
  • Those formed by an association for hte benefit of its members
  • Association members will have representation in the captive’s board and actively participate in decisions relating to the captive’s use
70
Q

Why do insurers in the U.S. rely heavily on reinsurers?

(ERM128)

A
  1. To support the issuance of new policies
  2. To minimize fluctuations in loss experience
  3. To limit and diversify individual and portfolio risks (particularly in the case of catastrophes and natural disasters)
71
Q

What are the functions of reinsurance?

(ERM128)

A
  1. To limit an insurer’s loss experience resulting from insured risk exposures
  2. To increase an insurer’s underwriting capacity
  3. To promote more efficient allocation of an insurer’s capital
  4. To facilitate an insurer’s entry to or exit from a particular line of business or market segment
  5. Protection for cedents against the accumulation of losses from a natural disaster or other catastrophe
72
Q

What is reinsurance?

(ERM128)

A
  • A commercial agreement whereby one company (the reinsurer) indemnifies another (the cedent) for insurance losses under policies of insurance issued by the cedent
  • Under a reinsurance contract, the cedent is protected from its own exposure to loss by transfer of the specified insurance risk to a reinsurer
73
Q

What are the elements of reinsurance relationship?

(ERM128)

A
  1. A contract between at least 2 insurance companies
  2. One or more underlying insurance contracts
  3. A transfer of some insurance risk from the cedent to the reinsurer(s) pursuant to the contract of reinsurance
74
Q

What is reinsurance for reinsurers?

(ERM128)

A
  • Also known as “retrocessions”
  • The ceding reinsurer (retrocedent) redistributes some of the reinsurance risk it has assumed from its cedents through contracts with one or more reinsurers (retrocessionaires)
  • May also pool risks from several affiliates and purchase retro that covers such risks places by the reinsurance group on a more efficient basis
75
Q

What are two forms of reinsurance contracts?

(ERM128)

A
  1. Treaty agreement (automatic reinsurance)
  2. Facultative agreement
76
Q

What is treaty (automatic) reinsurance?

A
  • Premium and losses associated with the covered risks are automatically covered by the agreement to be transferred
  • The reinsurer does not analyze the reinsured business on a policy-by-policy basis before accepting the risk cession
  • Reinsurers must rely on the cedent to make sound underwriting and claims-management decisions
  • Typically classified as “pro-rata” or “excess-of-loss” contracts
77
Q

What is pro-rata reinsurance?

(ERM128)

A
  • The insurer and reinsurer share premiums and exposures to losses in an agreed proportion
  • Pro-rata reinsurance treaties may be further classified as either “quota share” or “surplus share”
78
Q

What is “excess-of-loss” reinsurance?

(ERM128)

A
  • Protection against insured losses sutained above a predetermined threshold, known as the cedent’s “retention”
  • Does not create a proportional sharing of risk
  • Helps stabilize the net losses (i.e., after reinsurance recoveries) in an insurer’s portfolio
79
Q

What are the advantages and disadvantages of pro-rata reinsurance?

(ERM128)

A
  • Advantages:
    • Simple in design and to administer
    • Provides the cedent with “surplus relief” and the capacity to write more business or at larger limits
  • Disadvantages:
    • May come at a relatively high cost due to the cedent in terms of underwriting incoe and total return (as comapred to XL)
80
Q

What are the forms of XL treaties?

(ERM128)

A
  1. Per ocurrence XL
    • Protects cedent from the accumulation of multiple policy losses arising from a single event
  2. Aggregate XL
    • aka Stop-loss reinsurance
    • Protect against the accumulation of losses over the effective period
  3. Per risk XL
    • Protection above an insurer’s retention on individual risks or policies
81
Q

Describe facultative reinsurance

(ERM128)

A
  • Permits an insurer to decide which insured risks will be submitted to a reinsurer for consideration
  • The reinsurer has the opportuinity to underwrite the individual risk and may elect to accept or decline such risk
  • May be structured as XL or pro-rata
  • Reasons for using facultative:
    • For large or unusual risks
    • May be wholly or partially outside the scope of a cedent’s treaty arrangements
  • Creates greater administrative burdens on both cedents and reinsurers because potential risk cessions must be analyzed on an individual basis rather than in advance as a book of business
82
Q

What are uses of reinsurance?

(ERM128)

A
  1. Stabilizing UW results
  2. Increasing UW capacity
  3. Supporting entry into and exit from insurance markets
  4. Promoting capital allocation among affiliates. Reasons include:
    • Pooling arrangements
    • Efficient capital allocation
    • Reinsurance captive in the US life insurance industry
  5. Achieving risk concentration or diversification
83
Q

Detail the reasons behind reinsurance between and among affiliates

(ERM128)

A
  1. Pooling arrangements
    • Insurers in a group may want to participate in joint underwriting pool, where disparate UW experiences are pooled together
    • Risks are allocated back to one/some participats sharing in that UW experience, each assuming its assigned portion of the pool through reinsurance
  2. Efficient capital allocation
    • Tailor the risk or financial profile of separate legal entities within the group to address regulatory, rating agency, or managerial concerns
  3. Reinsurance captive in the US life insurance industry
    • To manage statutory reserve levels
84
Q

Why are the capital markets attracted to the reinsurance business?

(ERM128)

A
  • Because of the low correlation between investment risk and underwriting risk
  • Alternative reinsurance solutions may be employed to protect cedents against a variety of risks, but these instruments have primarily been geared towards property catastrophy risks (short time horizon to maturity) allowing investors to particiapte in contracts of a few years or less and evaluate returns soon after contract expiration
85
Q

What are some types of alternative reinsurance?

(ERM128)

A
  • Cat bond
    • Structured debt indstrument that transfers risk from a sponsor (insurer) to investors (capital markets) under terms and conditions similar to an insurance contract
  • Sidecar
    • Temporary reinsurance vehicle that shares premiums and losses exclusively with an insurer
    • Primarily on a pro-rata basis, generally for business associated with catastrophe risk
  • Industry loss warranty (ILW)
    • Provides coverage for an insurer if the industry-wide insurance loss from an event satisfies a pre-determined condition
    • The insurer’s own loss will usually also be required to trigger payment under an ILW contract
  • Collateralized reinsurance
    • Fully collateralized insurance-linked security that can be tailored to supplement the terms and conditions of a traditional reinsurance contract
    • The collateral, posted by investors, is equal to the coverage limits of the reinsurance net of the premium
    • The collateral is held in a separate account to satisfy losses due to the ceding insurer, the reinsurance premiums constitute the investor’s return
86
Q

What are forms of cat bond triggers?

(ERM128)

A
  1. Indemnity trigger
    • Actual incurred loss of the sponsor
  2. Parametric trigger
    • Description of the physical characteristics of the catastrophe
  3. Industry loss trigger
    • Amount of insured loss incurred by the industry
87
Q

Describe the formation of a cat bond

(ERM128)

A
  1. An insurer establishes a SPV that issues notes to investors
  2. Funds raised by investors are managed by the SPV in a segregated collateral account which is available to pay the sponsoring company in the event of a loss
  3. If the event does not occur, the following is returned to the investors:
    • premium paid to the SPV by the sponsor,
    • the principal on the note, and
    • the investment income earned thereon
88
Q

Describe the formation of a sidecar

(ERM128)

A
  1. Sponsor (insurer or reinsurer) establishes a company (the sidecar) for a limited purpose and duration
  2. The sidecar may be financed by debt and equity through third party investors (capital markets)
  3. The proceeds from the debt, equity and premiums ceded by the sponsor are placed in a trust account as collateral for losses that may arise under ceded insurance policies
89
Q

What are the benefits of alternative reinsurance?

(ERM128)

A
  1. Provide an element of diversification to an insurer’s reinsurance portfolio
  2. The collateralization of a cat bond helps reduce credit risk and enhances predictability of reinsurance costs since the bond terms typically last several years
  3. Sidecar may be used to provide an additional source of reinsurance to an insurer when the reinsurance market has limited capital (e.g., following a natural disaster) and therefore allows an insurer to write more business during a time where rates are high
  4. An ILW offers low transaction costs because the payout is linked to an industry loss figure, not the specific portfolio of the insurer; and thus, an ILW may offer a more affordable solution to catastrophe protection
  5. Collateralized reinsurance allows non-traditional reinsurers to efficienty offer additional capacity for catastrophe loss, often on a retrocession basis
90
Q

What are assumption serting sources?

(OR - AS)

A
  1. Experience studies
  2. Industry information (SOA studies, Moody’s default study)
  3. Reinsurer experience studies
  4. Consultant (experience studies, knowledge of industry assumptions)
  5. Judgement (actuarial, asset managers, investment department)
91
Q

Describe the spectrum of assumption setting sources

(OR - RA)

A
92
Q

Describe the spectrum of assumption ownership

(OR - RA)

A
93
Q

What is the typical mortality assumption setting process?

(OR - RA)

A
  • Base mortality assumption
    • Primary source: experience studies, when available
    • Supplemented with: similar products, reinsurance experience, industry information if necessary
  • Mortality imrovement and older age mortality
    • Significant judgement
    • Some industry thinking
    • Some experience
  • Ownership
    • Ideally set at BU for all applications, but varies
    • Margins vary by application but should be coordinated, ideally
94
Q

What is the typical lapse assumption process?

(OR - RA)

A
  • Base lapse assumption:
    • Primary source: experience when available, especially in the early durations
    • Supplemented with similar products and reinsurance experience for mid-durations
    • Judgment used for ultimate durations
  • Post-level term experience
    • Limited company and industry experience for 10-year term in durations just after level term period
    • Judgment
  • Dynamic lapse behavior
    • Some experience
    • Judgment
  • Ownership
    • Ideally set at BU for all applications
    • Margins may vary by application but should be coordinated, ideally
95
Q

What is the typical expense assumption process?

(OR - AS)

A
  • Level of expenses
    • Should be based on total company expenses
    • Split by acquisition and maintenance
    • Removal of certain items that are truly one time in nature
    • Allocation of corporate and BU overhead by acquisition and maintenance
    • Allocation to each product, particularly for overhead
  • Selection of drivers
    • Some companies use a fair amount of rigor in determining appropriate factors although other do not
  • Ownership
    • Level is set basedon information available for each function
    • Driver is determined by each function
    • Margins and sensitivities will likely vary by application
96
Q

What is the other liability assumptions process?

(OR - AS)

A
  • Assumptions:
    • Flexible premium payment
    • Partial withdrawal
    • Guarantee utilization
    • Loan utilization
  • Sources:
    • Some experience
    • Judgment
  • Ownership:
    • Need to set at product level, but may be set by each function
    • Margins and sensitivities will likely vary by application
97
Q

What is the typical economic assumption setting process?

(OR - AS)

A
  • Types of economics assumptions:
    • Interest rates
    • Equity returns
    • Inflation
    • Spreads and defaults
    • Currency
  • Sources:
    • Current economic environment
    • Investment expert expectations
    • Projected based on available models
  • Certain items vary by purpose:
    • Real world vs market consistent
    • Investment strategy
  • Ownership:
    • Generally set at a company level for all products
98
Q

Describe the steps in ideal assumption setting and governance process

(OR - AS)

A
  1. Determine assumptions in scope
    • Model purpose
    • Assumption categories (type and granularity)
    • Level
  2. Inventory current assumptions
    • Document current assumptions and current assumption sources
    • Categorize assumptions
  3. Set assumption using current and experience
    • Experience
    • Credibility blend
    • Reflect relevant information / techniques
  4. Develop governance process
    • Document process & assumption source
    • Approval from independent committee
    • Set up experience review process
    • Implement formal procedure for assumption review
    • Communicate & store assumption

ERM Exam (6 decks)

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