Ch 14: Risk 2

Question 1

Summary Card

Answer 1

1. New business mix and volumes
2. Competition
3. Actions of the Board
4. Actions of distributors
5. Management systems and controls
6. Fraud
7. Counterparties

Question 2

Risk due to new business mix:

Explain how the mix of new business (M.O.B) may be a source of risk to a life insurer in terms of

Mix by nature/size of contract (3)

Mix by source (3)

Answer 2

• Mix by nature/size of contract
  
  • change in M.O.B by
    
    • nature
      
      • class of business (eg proportion of pensions sold)
      • type of contract (eg term ass vs endowment)
      • contract design (eg with profits vs unit linked)
      • premium frequency (single vs regular)
    • size of contract
    • mix
  • could cause significant change in risk profile/capital needs of company
  • in particular, if contracts are on average smaller than assumed, expense loadings may fail to cover company’s overheads
• Mix by source (distribution channels)
  
  • Pricing assumptions (e.g. mortality, withdrawals) based on expected M.O.B by source,
  • If same premium charged across channels, effectively causes some average weighting in assumptions.
  • Change in M.O.B by source may invalidate assumptions.

Question 3

Risk due to new business volumes:

Explain risks may arise for the insurer if new business is

• too much and ( 2 )
• too little ( 3 )

Answer 3

• Too much: risk of insufficient
  
  • capital to cover financing requirements
  • admin resources to process new policies
• Too little
  
  • expense risk:
    
    • ​overheads spread over too few policies (expense loadings in premiums/charges insufficient)
    • mismatching of charges and expenses
  • new products’ (fixed) development costs:
    
    • risk of not recovering fixed development costs already incurred
  • fall in new business
    
    • damages profitability, competitiveness, long term viability

Question 4

Risk due to competition:

• Why is competition risk a factor (2)
• Give 5 examples of decisions, which may be taken as a result of competition, that may increase a company’s risk profile (5)

Answer 4

• Why is competition a risk factor?
  
  • The need to compete, especially in a free market, may lead management to take decisions which increase risk profile beyond that supported by available resources
  • • 5 decisions due to competition which may increasing risk profile

1. Reduce premium rates or charges under new business contracts
2. Offer additional guarantees and options under new business contracts
3. Increase bonuses under existing contracts
4. Increase salaries or commission in respective distribution channels
5. Don’t increase charges/reduce charges’ growth rate relative to what may have been originally intended for existing business with reviewable charges

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

Question 5

Risk due to guarantees and options:

• Why might an insurer write products with options/guarantees arise? (2)
• Outline briefly how insurer would determine costs of options/guarantees (3)

Answer 5

1. Insurer may offer options/guarantees for competitive/regulatory reasons. Cost of these would need to be determined using parameters (risk for future experience) and model of how to calculate cost
2. Determining cost of risk
   
   1. deterministic modelling
      
      • would need to test range of possible scenarios, ranging from optimistic to pessimistic
      • assign probabilities to each outcome and take expecation based on this
      • v subjective (scenarios chosen; probabilities assigned)
3. stochastic modelling
   
   • best suited for options/guarantees
   • develop model with assumptions, producing thousands of simulated outcomes, hence cost of guarantee
   • expected cost could be average across simulations
4. considering risk reduction techniques eg. derivatives

Question 6

Risk due to actions of directors:

• What is the role of directors? (2)
• What role do actuaries perform (2)
• State 3 reasons why board of directors may not follow actuary’s recommendations to take actions that are within the company’s and available resources (3)

Answer 6

• Director’s role is to
  
  • make decisions which steer the running of the company
  • impose proper systems of management/control on financial operation of company
• Actuary’s role
  
  • Help judge financial risks with particular course of action
  • Ensure inappropriate risks are not taken, esp where security/fair treatment of polholders concerned
• Reasons why directors may not follow actuaries’ advice
  
  1. Competitive reasons
  2. Strategic company goals, such as maximising new busines volumes or amount of funds under management
  3. Maximise shareholder earnings

Question 7

Risk due to actions of distributors:

State 3 actions that a distributor could take that may create financial risk for a life insurer.

Answer 7

Distribution channel may take following actions, either in their interests, or interests of clients, but to detriment of life insurer.

Especially prevalent where distributor independant of insurer

1. Lapse and re-entry encouragement where no/low penalties exist, and no commission clawback
2. Take advantage of loopholes in product design
   
   • intermediary naturally try find best prems for client
   • some definitions may allow variation in intepretation e.g. smoker/non-smoker status
3. Take advantage of timing effects in unit pricing
   
   • ​e.g. if UP fixed daily at start, and MVs fall heavily during day, if units sold at end of day, and purchased at start of following day, significant profit can be made at insurer’s expense

Question 8

Risk due to failure of appropriate managament systems and controls:

State 3 problems that may result from the failure of management systems and controls

Answer 8

• Even if we assume enough control systems have been implemented (with proper documentation/training support for systems), there’s still a risk that one/more control is contravened (e.g. due to insufficient monitoring)
• May lead to

1. Financial loss
2. Regulatory intervention
3. Damage to reputation

Question 9

Risk due to fraud:

• Generally speaking, what causes fraud?
• Name 3 parties who might perpetuate fraud against an insurer.

Answer 9

• Fraud is generally the result of a type of control failure, caused by deliberate intent of one/more parties
• Can be perpetuated by:

1. Directors or staff (have special access to financial systems or insurer and to computer programs and data which support business)
2. Policyholders (main risk is fraudulent claims)
3. Other outside parties (who may obtain some access to computer systems of insurer e.g. website access)

Question 10

Counterparty risk:

• How does counterparty risk arise (2)
• Name 4 counterparties who might default on their obligations to an insurance company (4)

Answer 10

Counterparty risk arises

1. when insurer enters into agreements with another party/entity….
2. …and insurer relies on obligations under the agreement

Examples of counterparties

1. Reinsurer e.g .failure to pay their share of claims
2. Outsourcers
   
   • e.g. poor quality service for outsourced adminisration services (IT, investment managment, policy admin)
   • complaints from polholders + cost insurer to put things right
3. Corporate bond issuers e.g failure to pay coupons or capital
4. Distribution arragenements e.g distributors fail to pass premiums