QA Bank Part 5

Question 1

State the characteristics of an insurer’s liabilities that should be taken into account so that the appropriate assets can be selected.

Answer 1

• term
• amount
• currency
• nature (fixed, increasing with inflation, or super-inflation)
  of the liabilities

Question 2

7 Reasons why in practice the assets held by a general insurer may not be a perfect match for the liabilities.

Answer 2

• The company may choose not to match liabilities (if it has plenty free reserves)
• If the company is making underwriting losses, an unmatched position may be taken to try to make investment profits to offset these losses.
• The company may be forced to invest in much shorter, liquid assets with a more stable market value, in order to protect its statutory solvency position.
• The timing of the liabilities will be uncertain and therefore difficult to match.
• It may not be possible to match, eg if claims inflation is different from the inflation protection available from real assets.
• There may be regulatory limits on the amount of assets that can be invested in certain asset classes.
• Matching assets may not be available.

Question 3

Comment on the suitability of government bonds as investments for:
- meeting claims from household contents insurance

Answer 3

Short-term bonds are suitable for household contents.

Longer-term bonds are unsuitable as the liabilities are short-tailed.

Question 4

Comment on the suitability of government bonds as investments for:
Employer’s liability insurance

Answer 4

Bonds would not be appropriate for employers’ liability, as real assets would be a better match.

Question 5

Comment on the suitability of government bonds as investments for:
Free reserves

Answer 5

Bonds are normally NOT appropriate for free reserves. We prefer assets with a higher expected return and offer better protection against inflation.

Question 6

Comment on the suitability of direct property investments for:
- meeting claims from household contents insurance

Answer 6

Direct property would be unsuitable for household business because of lack of marketability and large unit size.
The investments would also be too long term.

Question 7

Comment on the suitability of direct property investments for:
- employers’ liability insurance

Answer 7

Property would be UNSUITABLE. Although the nature and term may be about right, the lack of marketability could be a problem.

The large unit size would also make it difficult to hold a sufficiently diversified portfolio.

Question 8

Comment on the suitability of direct property investments for:
Free reserves

Answer 8

Direct property could be ACCEPTABLE for a portion of the free reserves. The insurer’s own office may form part of the assets.

Question 9

Define a “risk clash”

Answer 9

Risk clash is correlation that occurs between risks in the same class.

Question 10

Define a “class correlation”

Answer 10

Class correlation refers to the correlation that occurs between risks in different classes.

Question 11

8 Factors a firm should consider when modelling market risk

Answer 11

• changed market values of investments
• variation in interest rates and the effect on the market value of investments
• the level of investment income
• counterparty / issuer defaults, unless addressed under credit risk.
• severe economic or market downturn or upturn leading to adverse interest rate movements and/or equity market falls.
• inadequate valuation of assets.
• currency movements
• the extent of any mismatch of assets and liabilities, including reinvestment risk.

Question 12

3 Ways in which assets can be modelled

Answer 12

1. Model EACH ASSET INDIVIDUALLY
   This can be time consuming.

2. Model ASSET GROUPS
The groups will be chosen based on the class of asset, term of the asset and the currency in which the assets are denominated.

3. Model a NOTIONAL PORTFOLIO
   A notional portfolio may be based on the long-term investment strategy of the firm, rather than the actual asset mix currently held by the insurer.

This can involve less computation than the other methods, and ensures that investment and capital management decisions are not influenced by any short-term deviation from the benchmark holding.

Consideration should be given to:

• Specific attributes to the firm’s portfolio, eg concentrations of asset holdings
• The freedom of the investment managers to move away from their benchmarks - this would increase the riskiness of the investment strategy and the consequent capital charge required.

this method may be appropriate where the actual assets are widely spread, or the investment strategy is based on indices.

Question 13

Define liquidity risk

Answer 13

The risk that a firm is unable to meet its obligations as they fall due as a consequence of having a timing mismatch or a mismatch between assets and liabilities.

The risk is associated with the process of managing timing relationships between assets and liabilities.

Question 14

9 Factors to consider when assessing liquidity risk

Answer 14

• the extent of mismatch between the assets and liabilities
• the amount of assets held in highly liquid forms
• the uncertainty of the liability cashflows
• the variation in the level of free assets over each stage of the underwriting cycle
• correlations with both insurance and market risk
• failures to forecast cashflow requirements accurately
• process weaknesses, such as poor credit control and poor management of disputes
• ability to manage unplanned changes in funding sources
• severity of the scenarios used in any scenario testing, and correlations between variables in each scenario.

Question 15

3 Components that should be incorporated within a risk measure

Answer 15

A risk measure should incorporate:

• an actual measure, eg Value at risk, balance sheet surplus
• a level of confidence that this is achieved, eg 99.5%
• a time horizon over which it must be achieved.

Question 16

A risk profile is defined by (2)

Answer 16

• the risks that have been modelled (and how they have been modelled) …
  … which will include risks from business already written plus a finite period of new business activity.
• the key outcome used to measure success or failure…
  … eg the profit over a selected time horizon, or the balance sheet position at the end of a selected time horizon.

Question 17

Risk tolerance

Answer 17

A parameter (or set of parameters) that links the risk measure, as applied to the risk profile, to a single capital amount.

Question 18

13 Factors affecting the level of detail / accuracy with which risks may be modelled

Answer 18

• size of the reserves
• risk management measures in place to deal with the risk.
• materiality of the risk
• extremity of the risk (frequency)
• relevance of available data
• credibility of available data
• regulatory constraints
• practical constraints
• sensitivity of any proposed parameters
• level of detail required by the business, ie the purpose of the investigation.
• acceptability of approximations for less material risks
• acceptable size of the model and time needed for it to run.
• time needed to review and test the model.

Question 19

Factors to consider when assessing

investment credit risk

Answer 19

• PROBABILITY OF DEFAULT:
• – financial strength rating
• – state-dependent migration matrices (moving between ratings)
• SIZE OF THE LOSS given that default occurs.
• SPREAD risk
• CORRELATIONS between counterparties and asset classes
• likelihood of SYSTEMIC FINANCIAL RISK
• potential correlations with the financial and economic modelling factors used in the assessment of market risk.

Question 20

Factors to consider when assessing

Counterparty credit risk

Answer 20

• underwriting and reserving elements separately
• the probability of default under normal conditions
• the probability of default in different extreme scenarios
• the size of the loss given that the default occurs
• non-recoveries due to reinsurance / broker disputes, and the extent to which this is considered within operational risk.
• the duration of the long-tailed liabilities
• any collateral held by the insurer

Consideration should also be given:

• if there is significant exposure to a single counterparty
• to correlations between counterparties.

Question 21

Situations where supervisory authorities may impose restrictions on the investment holdings

Answer 21

The insurer may deem it appropriate to impose restrictions:

• on the market in general, or
• on insurers selling particular product lines, or
• at certain stages of development

The situation where an insurer is in difficulty, having breached or being in danger of breaching regulations.

Question 22

5 Examples of the controls the supervisory authority may impose

Answer 22

• RESTRICTION on the amount of certain types of assets that can be taken into account when assessing solvency
• CUSTODIANSHIP of assets
• PREVENTION from holding certain assets
• PRESCRIPTION to hold certain assets
• requirement to hold MISMATCHING RESERVES

Question 23

5 Possible sources of non-investible funds

Answer 23

Non-investible funds are monies held:

• by REINSURERS (ie who are due to pay a reinsurance claim)
• by AGENTS AND BROKERS who owe premiums to the company
• by POLICYHOLDERS who are paying premiums by instalments
• by policyholders who pay end of year adjustments to premiums because of exposure adjustments or experience rating
• by policyholders who are slow to pay premiums.

Question 24

The effect of non-investible funds on financial management

Answer 24

Non-investible funds will NOT EARN INVESTMENT INCOME. Therefore, they may reduce profits.

The company may try to counter this effect by investing a higher proportion of the remaining funds in assets with a higher expected return.

As non-investible funds are short-term assets, then a smaller proportion of the remaining proportion needs to be invested short.

However, if the company is concerned about the default risk of the non-investible funds, then it may look for greater security from the investible assets.

Alternatively it may set aside provisions for bad debts.

There may be a regulatory limit that restricts the level of non-investible funds that can be included when demonstrating solvency.
The company should ensure that solvency is not jeopardised.

Question 25

Define stress testing

Answer 25

Stress testing quantifies the effect of varying a single parameter. It is a preliminary step in performing a scenario test. Stress tests may be deterministic but they are often developed with probability distributions in mind.

Question 26

Define scenario testing

Answer 26

Scenario testing quantifies the effect of a change in multiple parameters. It is a natural extension to a stress test.

Question 27

Define sensitivity testing

Answer 27

The process of testing the extent to which the results of a capital model change as a result of making a small change to an assumption in the model.

Question 28

What are stress tests used for?

Answer 28

Stress tests are a necessary tool in assisting an insurer in managing its risks and maintaining adequate financial resources to deal with the risks to which it is exposed. They can be used to IDENTIFY AND QUANTIFY the impact of different STRESSES on an insurer's expected financial position. Stress tests are often used: - for modelling future catastrophe claims - for analysing the impact of unlikely adverse stresses of one parameter - to perform additional tests on uncertain assumptions - as a matter of good corporate governance, even if more sophisticated models are also used, - to improve an insurer's understanding of the potential impact of individual risks in isolation - to identify and investigate the risks incurred by extreme movements in parameters.

Question 29

What are scenario tests used for?

Answer 29

Scenario tests are often used: - to consider the combined effect of a number of risks and the cumulative effect of several different mitigating actions occurring at the same time - to allow for interactions between variables that would not be considered under stress tests - within stochastic models to explore combinations of randomly-generated values for the key parameters by exploring scenarios that you might otherwise not have imagined to be important - to help understand the relationships between different types of risks - as a communication tool, to make the range of results more comprehensible - to help with scenario planning and "what-if" analysis _________________________________ Stress and scenario tests can also be used: - as a broad approach when using a capital model: - -- stress and scenario tests are used explicitly within deterministic models - -- stress and scenario tests are used implicitly with stochastic models - to validate the output from stochastic models for reasonableness - to help calibrate assumptions in stochastic models - to provide a transparent link between the capital model and the insurer's risk register. - to provide a useful mechanism for entering into a dialogue with senior management and give them comfort as to the reasonableness of the overall capital value - for those risks that cannot easily be modelled quantitatively and where more subjective judgement is required.

Question 30

What are sensitivity tests used for

Answer 30

- to identify the more sensitive assumptions in the capital model, ie assumptions that, if changed, would have the greater impact on the results of the capital model. Attention and justification should then be focused on these values. - as part of the stochastic modelling process (to run the model using different distributions and parameters to check sensitivity) - to help select assumptions - where there are several possible selections for an assumptions, that each appear equally reasonable, a sensitivity test may be carried out to find out the change to capital model result from making different selections for the assumption under consideration - as a minimum standard and part of the validation and sign-off process - to help understand the variability and uncertainty in parameter values so that these can be communicated to the board and senior management.

Question 31

How could insurance risk lead to liquidity risk

Answer 31

Lower than expected levels of new business or an unexpected mix of business, eg smaller policies than expected, will result in lower premium income than expected. Premium income is often used to pay current liabilities so that a more long-term investment strategy can be followed. A reduction in premium income can therefore lead to a lack of liquid assets with which to meet current liabilities. This is a type of underwriting risk. Higher than expected claims can lead to liquidity issues if there are not enough liquid assets available to pay the claims. This is a type of reserving risk. Higher claims may be due to: - a higher than expected level of attritional claims - more large claims than expected - the existence of catastrophe claims - the emergence of latent claims.

Question 32

How could MARKET risk lead to liquidity risk

Answer 32

If assets and liabilities are mismatched by term, then the insurer may face liquidity issues, since it may not be able to liquidate sufficient assets in a timely manner (if insufficiently liquid assets are held). In this case it may need to realise assets at a time when market conditions are unfavourable. Similarly, if asset income does match liability outgo by term, but the income on the assets is defaulted, this may lead to liquidity issues.