Risks (13-15)

Question 1

Lists all the

Risks

3 Accronyms

Answer 1

AEIO + BCC
1. Counterparty risk
2. Investment performance risk
3. Business risk (CCOMME VW)
a. Competition
b. Options and guarantees
c. Mix of new business by nature/size of contract and by source
d. Mortality and morbidity rates
e. Expenses (including effect of inflation)
f. Volume of new business
g. Withdrawals
h. Claim experience for health care products
4. Operational risk (FAFA P)
a. Fraud
b. Actions of board of directors or staff
c. Failure of appropriate management systems and controls
d. Actions of distributors
e. Policy and other data
5. External risk
a. Legal, regulatory, and fiscal developments
6. Aggregation and concentration of risk (including credit failure)
7. Credit rating

Question 2

Risks

New business mix

By nature and size of contract

Answer 2

1. A change in a business mix will result in a change in its risk profile and capital needs beyond its resources.
2. if contract are smaller than aniticipated income from charges and premium loadings and expenses will be mismatched.

Nature refers to:
* class of business
* contract type
* contract design (with-profit vs unit-linked)
* premium frequency

income and expense mismatch might also result from:
* cross-subsidation between different types of contracts (where certain types of contracts contibute more to overheads)

Question 3

Risks

New business mix

By source

Answer 3

Source = distribution channel.
* different distribution channels reach different populations
* mortality, withdrawal and expense assumptions are based on ditribution channels and population demographics
* change in the mix of new business by source will invalidate those parameters
* company would charge the same price irrespective of distribution channel
* price is based on average expected experience based on an assumed mix by source.
* withdrawal is based on financial sophistication and who initiated the sale

Risk can be dealt with by:
* charging different prices for different distribution channels

Question 4

Risks

Volume of new business

Answer 4

Departure from the model of future new business will invalidate the parameters for future expenses.

Higher than expected volumes:
* would require more capital
* will place strain on administration systems
* not enough resources available to cope

Lower than expected volumes:
* for new products, fixed development costs will not be recouped
* reduced number of overall inforcce policies to spread fixed costs

Question 5

Risks

Options and Guarantees

Answer 5

• When a life insurance company offers guarantees or options, they are providing terms before the event they relate to occurs.
• To determine the cost of offering these terms, the actuary must use parameters for future experience and relevant assumptions for the situation.
• They must also create a model to calculate the cost.
• However, there are risks associated with choosing the model and parameters.

Model choices:
1. deterministic model: projection of 1 possible outcome
a. could use a range of deterministic scenarios and assign probabilities to each outcome and take expectation based on this
b. method is very subjective
2. Stochastic modelling
a. model unit growth using suitable model and parameters
b. simulate many values at maturity
c. cost of guarantee is caluclated for each option
d. expected cost would be the average over all outcomes.
e. only valid if model and parameters are appropriate

Question 6

Risks

Competition

Answer 6

The pressure to compete in a free market may drive management to take risks beyond what can be supported by available resources.

Decisions include:
1. reduced premium rate or charges under new business
2. offer guarantees and options under new business
3. increase bonusses
4. increase salaries and commissions
5. not increasing reviewable charges on existing business

Impact of above decisions can be compounded if greater than expected new business result

Question 7

Risks

Actions of the Board of Directiors

Answer 7

Directors:
individuals who have the legal responsibility to:
* Make decisions affecting the running of the company
* impose proper systems of management and controls on the financial operations of the company.

The actuary will:
* make recommendations as to how it should operate
* so that risk profile stays within resources available to it.
* and to ensure fair treatment of p/h
* directors dont have to follow recommendations

why won’t they:
* competitive reasons
* strategic company goal: max new business or amount of funds
* max shareholder earnings

Question 8

Risks

Actions of Distributors

Answer 8

Distributors: salespeople
They may act in their own/client interest which will give rise to financial risk for the LI
* encouring lapse and re-entry - where there is no exit penalties or clawback of commission payments. The earlier it ocurs, the greater the loss
* taking advantage of product design loopholes
* taking advantage of opportunities that arise due to timing effect in unit pricing practices

Dealt with:
* design products and process to account for this
* engage with distributors to discourage bad practices

Question 9

RIsks

Failure of appropriate management systems and controls

Answer 9

• Risks arise despite implementing control systems, as there’s always a chance of contravening controls due to inadequate monitoring or human error.
• Control failures can lead to financial losses, regulatory intervention, and reputational damage.
• Control failures may sometimes result in financial gains for the insurer but still pose ongoing risk.
• Two levels of risk exist: one from inadequate pricing leading to financial loss, and another from failures in control systems leading to incorrect pricing.
• Control system failures increase the risk associated with the pricing process.
• Optimal decision-making strategies aim to minimize risks by implementing more elaborate management control systems.

Question 10

Risks

Counterparties

Answer 10

Risk that counterparties will not meet their obligations, fully or partially.

Examples:
* reinsurance agreements
full liability rests with the direct writer
* outsourcing arrangements (poor quality service)
can result in complaints
* corporate bonds held as investments (non-payment of coupons/capital)
credit risk
* distribution arrangements (non-recovery of broker balances)
where broker collects rpemium and pass them on to LI
Risk is delay in receipt or never receving premiums at all

Question 11

Risks

Legal, regulatory and fiscal developments

Answer 11

Risk that these environments change adversely.

LTCI:
* Politically sensitive: well-being of old people and the funding of the finance to provide care
* State might decide to charge for nursing ans well as personal long-term care
* insurer will face increased costs

Control:
* allow prudently for extra claims outgo, if regulator insist on enhanced benefits
* product design - flexibility of beneifts such that future changes in state attitude will not cause a loss that has not been costed

Question 12

Risks

Fraud

Answer 12

General type of control failure:
* caused by deliberate intent of one or more parties
* Directors/staff - special acces to financial systems, computer programs and data
* P/h - fraudelent claims, or lying during underwriting
* Other ouside parties - may obtain access to computer systems, esp where there are external components eg. website

Question 13

Risks

Climate change

Answer 13

Could arise from:
1. changes in physical environment
2. secondary impacts in the economy at a regional or global scale

3 Categories:
Physical risks
* first order effect of environmental changes
* greenhouse emissions, pollution and land-use
* increased mortality or morbidity due to global warming or polution
Transition risks
* economic, politcal and market changes as a result of efforts to mitigate climate risks
* policy changes to reduce fossil fuel cossumption - lost value in fossil fuel and carbon - intensive industry investments
Liability risks
* injured parties seeking compensation for impacts of climate change
* link between pollution and adverse health conidtions resulting in new class of latent claims

Question 14

Risks

Aggregation and concentration of risks

Answer 14

• important to understand in risk individually
• potential financial impact will depend on how risks emerge and how they relate to each other
• impact is best assessed through stocastic modes, incorporating prob distr of the key risks
• this will allow for correlations between parameters

Aims of LI:
* max profits (shareholder and/or policyholder)
* max return on available capital

Assessing the risk:
Overall risk can be measuremetn against above aims but also allowing for:
* capital and other resources available
* cost of failing to meet public interest need
* cost of failing to meet legislative requirements

Effect of risk management on desicion making:
* find a strategy that satifies the desired trade-off between risk and return

Question 15

risks

Credit failure

Answer 15

LI’s credit rating: external assessment of the aggregation of the risls
* down-grade in credit rating: advers publicity, decreased new business, increased lapses/wtihdrawals
* struggle to find new capital,

Question 16

Risks

Policy and other data

Answer 16

Policy data: database of policies’ information (e.g. age at entry, term, sum assured, etc)
Used for:
* Liability valuations
* Supervisory capital valuations
* Internal investigations
* Marketing and distributions
Other data: any data required to make assumptions e.g. claims data
Used for:
* Feasibility studies for new products
* Setting assumptions
* Computer analysis

RISK: If there is incorrect data, the impact depends on how wrong and how sensitive business is to errors

Problems/Risks:
* Company does not maintain **adequate, accurate, complete **records (trash in trash out), which would result in inaccurate valuation of liabilities
Solution: Actuary should carry out data checks

Where model points are used to represent all/part of the business:
Risk: Model points do not adequately represent underlying data
Risk: Model is an over-simplification of real company and behaves unrealistically
* Missing data
* Not enough data to be statistically credible
* Changes in definitions/formats make some data unusable
* Not appropriate for population you want to apply it to
* Other data: not adequate to provide reliable indictors of future experience, due to inaccuracy and/or insufficient volume.
* Risk that data is in appropriate – because is based on different population than for which it will be used

Solutions:
* Check movements in data
* Look for extreme values
* Compare data to previous results
* Insurer should encourage accurate data collection and understand the quality of data and indicate any potential data issues in documents

Data issues for health and care products:
* Smaller policy volumes and lower incidence rates
* Changes to products and market over time limits applicability of past data
* Heterogeneity of products and markets limits applicability of industry data
* Past data relevance is limited by sensitity to socio-economic conditions (IP), medical advances(CI) and longevity and health at older ages (LTCI)

Question 17

Risks

Mortality

Answer 17

Model Risks
* risk that model/probability ditribution is inappropriate
Parameter risks
* parameters used within the model do not rflect future experience of the class of lives insured or to be insured, eventhough model may be appropriate
Random fluctuations
* actual future experience may not correspond with model or parameters eventhough these adequalty reflect he lives insured or to be insured
* most likely to arise if the numbers exposed to risk are not large enough for the law of large numbers to apply

Extent of the first two risks differ according to reliability and applicability of exisitng data.

Parameter risk compounds whereas random fluctuation risk reduces over time
The likelihood of assumptions for the future being right depends on the quality and relevance of the data. There will however always be an expanding funnel of doubt, where the risks increase as the period of projection increases. This could be because of new diseases or advancements in medical treatments

Question 18

Risks

Claims experience for health and care products

Answer 18

Healthcare insurance cover events that are more complex and benefits that can vary according to the severity of the episode.

IP and LTCI: main riks is that claim inception rates and claim durations are higher than expected. (risk related to misestimation of transfer probabilities in mulitiple state model)

CI: main risk is rate of diagnosis of the critical illnesses

Model, paramenter and random fluctuation risk more sever due to complexity of products and the lack of reliable and applicable data and smaller policy volumes

Question 19

Risks

Investment performance

Answer 19

**Investment risk: ** risk that the expected investment return differs from actual investment return. This could be due to model risk, parameter risk or random fluctuations risk. Investment risk also includes capital value risk, which is the risk that a company becomes insolvent due to changes in asset values.

Solution to Capital value risk:
* Immunisation
* Derivatives
* Try to invest similarly to competitors
* Diversify investments
* Choose a product design that minimise impact (TA have lower investment risk because lower reserves)
* Transfer investment risk to p/h with UL
* WP: just declare lower bonus

Points to consider for investments and investment risk
* Return on free capital vs solvency capital
* Capital growth or income from investment
* Pricing vs statutory valuation
* Permissible versus non permissible assets
* Time frame of investments
* Liquidity requirements

Risk from investments:
* Suitable assets to match liabilities are not available
* * Mismatch increases investment risk, increases the cost of investments and reduces returns
* Risk of volatile or poor investment returns
* * Increases the risk of supervisory insolvency.
* * Result in higher capital required to be held
* * Leads to higher capital costs
* * Leads to increase in premium or reduce policyholder returns
* * Leads to a marketing risk.

Question 20

Risks

Expenses & inflation

Answer 20

Assumptions regarding expenses allow implicitly/explicitly, either on deterministic/stochastic basis, for inflation. Therefore: parameter risk, model risk (if stochastic assumptions are used)
Def:
The risk that actual expenses are higher than expected or allowed for, including (but not restricted) due to the effects of inflation

Risks:
* charges received insufficient to meet actual expenses
* risk that expense allocation would make product uncompetitive
* risk that inflation is higher than expected
* Risk that charges received are lower than expected:
1. Investment performance risk
Charges are linked to fund value
2. Persistency risk
higher than expectd withdrawal, thus not recouping initial expenses
3. new business mix or volume risk
Mix is more weighted to lower charge policies
Volume is lower than expected and charges to meet fixed expenses are insufficient

Solution
* match amount and timing of expenses and charges
* transfer risk back to p/h - reviewable charges/premiums
* continually improve estimates
* appropriately invest to match inflations

Question 21

Risks

Withdrawal

Answer 21

Risk of estimating withdrawals wrong -> Model and parameter risk
A model that stochastically models investment performance and link withdrawal to this performance may be used, but may also be wrong and an example of model risk
Risks:
* Lower withdrawals than expected at the point where surrender value < asset share
* Higher withdrawals than expected at point where the surrender value > asset share
* Risk to mortality experience due to selective effect of withdrawals
Thus, by wrongfully assuming the withdrawal assumption, may invalidate the mortality assumption. This illustrates the dependence of the assumptions on each other.
* Increasing per policy fixed expenses due to loss of volumes
* The same dependence on the expense assumption is seen, as with mortality above

Factors that contribute to withdrawals:
* State of the economy -> economic cycle
* Surrender values
* Competition
* Distribution channel
* Who initiated the sale
* Premium level
* Duration in force and original term