Briefly define enterprise risk management
ERM is defined as the process of systematically and comprehensively identifying critical risks, quantifying their impacts and implementing integrated strategies to maximize enterprise value
Briefly describe four aspects of the ERM definition
1) an effective ERM program should be a regular process, not just a one-time event
2) Risks should be considered on an enterprise basis
3) ERM focuses on risks that have a significant impact to the value of a firm
4) Risks must be quantified as best as possible. The impact of each risk should be calculated on an overall, portfolio basis and correlations with other risks should be considered.
Briefly describe four risks that an insurer faces
- Insurance hazard - risk assumed by insurer in exchange for premium. Consists of underwriting risk, accumulation/cat risk, and reserve risk.
- Asset - risk in the insurer's asset portfolio related to volatility in interest rates, foreign exchange rates, equity prices, credit quality and liquidity
- Operational - risk associated with the execution of the company's business. For example, risks include the execution of IT systems, policy service systems, etc.
- Strategic - risk associated with making the wrong or right strategic choices. In other words, it is the risk of choosing the wrong plan, given the current and expected market conditions.
Briefly describe the four steps in the ERM process
- Diagnose - company conducts a risk assessment to determine material risks that exceed a company-defined threshold
- Analyze - risks that exceed a company threshold are modelled as best as possible
- Implement - implement various activities to manage the risks
- Monitor - monitor the actual outcomes of the plans implemented in the previous steps against expectations.
Provide three characteristics of a good enterprise risk model
- The model shows the balance between risk and reward from different strategies (such as changing the asset mix or reinsurance program)
- The model reflects the relative importance of various risks to business decisions
- The model includes mathematical techniques to reflect the relationships among risks (dependencies)
Briefly explain what may happen if a firm employs a weak enterprise risk model
Models without the good characteristics of an ERM model often exaggerate certain aspects of risk while underestimating others. This can lead to overly aggressive or overly cautious corporate decision making
Briefly describe four types of parameter risk
- Estimation risk - misestimation of model parameters due to imperfect data
- Projection risk - refers to changes over time and the uncertainty in the projection of these changes
- Event risk - refers to situations in which there is a causal link between a large unpredicted event (outside of the company's control) and losses to the insurer.
- Systematic risk - refers to risks that operate simultaneously on a large number of individual policies. Thus, they are non diversifying and do not improve with added volume.
a) Provide an example of event risk
b) Provide an example of systematic risk
a) latent exposures such as asbestos
Provide three sources of uncertainty in catastrophe models
- Uncertainty relating to the probabilities of various events
- Uncertainty relating to the amount of insured damage caused by each event
- Uncertainty related to data quality
Briefly describe a key aspect of asset modeling
A key aspect of modelling is modelling scenarios consistent with historical patterns.
When generating scenarios against which to test a insurer's strategy, the more probably scenarios should be given more weight.
Provide four reasons for holding sufficient capital
Capital must be sufficient to:
- sustain current underwriting
- provide for adverse reserve changes
- provide for declines in assets
- support growth -satisfy regulators, rating agencies, and shareholders
Briefly describe four common approaches for setting capital requirements
1. holding enough capital so that the probability of default is remote
2. holding enough capital to maximize the insurer's franchise value. Franchise value includes an insurer's balance sheet, customer base, agency relationships, reputation, etc.
3. holding enough capital to continue to service renewals
4. holding enough capital so that the insurer not only survives a major cat but thrives in its aftermath.
Provide four advantages of using economic capital for an ERM analysis
- Provides a unifying measure for all risks across an organization
- More meaningful to management than risk-based capital or capital adequacy ratios
- Forces the firm to quantify the risks it faces and combine them into a probability distribution
- Provides a framework for setting acceptable risk levels for the organization as a whole AND for individual business units
An insurer is currently holding capital at the 1-in-4256 VaR level. Given this information, explain why the insurer might select the 1-in-4000 VaR as its target capital level.
The insurer might choose the 1-in-4000 VaR because it is a round number AND because it is slightly less than the current capital level.
a) Provide two disadvantages of using standard deviation to measure risk.
b) For each disadvantage above, briefly describe an alternative risk measure that addresses the disadvantage.
- Favorable deviations are treated the same as unfavorable ones
- As a quadratic measure (i.e. based on the second moment), it may not adequately capture market attitudes to risk
- Semistandard deviation – only uses unfavorable deviations
- Skewness – since this uses a higher moment, it might better capture market attitudes
Briefly describe five types of tail-based risk measures.
- VaR – percentile of the probability distribution
- TVaR (tail value at risk) – expected loss at a specified probability level and beyond
- XTVaR (excess tail value at risk) – calculated as TVaR minus the overall mean
- EPD (expected policyholder default) – calculated by multiplying (TVaR – VaR) by the complement of the specified probability level
- Value of default put option – when capital and/or reinsurance is exhausted, the firm has the right to default on its obligations and put the claims to the policyholders. The market value of this risk is the value of the default put option. It is usually estimated using options pricing methods
Briefly describe probability transforms.
Probability transforms measure risk by shifting the probability towards the unfavorable outcomes and then computing a risk measure with the transformed probabilities
TVaR is often criticized because it is linear in the tail. Briefly describe a probability transform that can be used to overcome this criticism.
Under transformed probabilities, TVaR becomes WTVaR (weighted TVaR). This is NOT linear in the tail and considers a loss that is twice as large to be more than twice as bad
Briefly describe generalized moments.
Generalized moments are expectations of a random variable that are NOT simply powers of that variable
Describe how the following things affect the amount of capital held by an insurance company:
- Customer reaction
- Capital requirements of rating agencies
- Comparative profitability of new and renewal business
- Customer reaction – some customers care deeply about the amount of capital being held by insurers and/or the financial rating of an insurer. Oftentimes, declines in financial ratings can lead to declines in business
- Capital requirements of rating agencies – different rating agencies require different amounts of capital to be held by an insurer
- Comparative profitability of new and renewal business – renewal business tends to be more profitable due to more informed pricing and underwriting. Thus, it is important to retain renewal business. If renewals comprise 80% of the book, then the insurer should be able to maintain 80% of its capital in a bad year. In this case, the insurer should hold enough capital so that 20% of its capital could cover a fairly adverse event
Briefly describe what it means for a risk decomposition method to be “marginal.”
Marginal means that the change in overall company risk due to a small change in a business unit’s volume should be attributed to that business unit
Provide two reasons why the marginal property is desirable.
- it links to the financial theory of “pricing proportionality to marginal costs”
- It ensures that when a business unit with an above-average ratio of profit to risk increases its volume, then the overall company ratio of profit to risk increases as well
Describe two required conditions for a marginal decomposition.
- Works when business units can change volume in a homogeneous fashion
- Works when the risk measure is scalable. This means that multiplying the random variable by a factor multiplies the risk measure by the same factor (p(aY ) = ap(Y )). This is also known as homogenous of degree 1
a) In most cases, firms allocate capital directly. Briefly describe how a firm can allocate the cost of capital.
b) Explain how a business unit’s right to access capital can be viewed as a stop-loss agreement.
c) Provide one approach for calculating the value of the stop-loss agreement.
Part a: Set the minimum profit target of a business unit equal to the value of its right to call upon the capital of the firm. Then, the excess of the unit’s profits over this cost of capital is added value for the firm. Essentially, we are allocating the overall firm value (rather than the cost of capital) to each business unit
Part b: Since the business unit has the right to access the insurer’s entire capital, it essentially has two outcomes – make money or break-even. This is how a stop-loss agreement works as well
Part c: Calculate the expected value of a stop-loss for the business unit at the break-even point
Provide two disadvantages of leverage ratios.
They do not distinguish among business classes
They do not incorporate risks other than underwriting risks
Briefly describe how IRIS ratios are used to measure firm health.
For each ratio, a range of reasonable values is determined. Any company that has four or more ratios that do not fall within their corresponding reasonable ranges are considered to be at risk and warrant regulatory scrutiny
a) Briefly describe how risk-based capital (RBC) models differ from leverage ratios.
b) Provide the four main sources of risk contemplated in RBC models.
c) Briefly describe how RBC models quantify these sources of risk.
Part a: Unlike leverage ratios, risk-based capital (RBC) models combine measures of different aspects of risk into a single number
- Invested asset risk
- Credit risk
- Premium risk
- Reserve risk
Part c: Each of these risks is measured by multiplying factors by accounting values. The magnitude of the factor varies by the quality and type of asset or the line of business
a) In terms of risk charges, fully describe one reason why a regulatory RBC model might differ significantly from a rating agency RBC model.
b) In terms of risk charges, fully describe one reason why two rating agency models might differ significantly.
Part a: Use of the models – the A.M. Best and S&P models are used to determine whether the company will be viable in the long term, while regulatory models are used to evaluate the one-year likelihood of insolvency. Thus, the rating agency models should have higher factors
Part b: Presence of a covariance adjustment – many models have covariance adjustments intended to reflect the independence of the various risk components. With this adjustment, the total required capital is less than the sum of the individual risk charges. The reduction in capital depends on the relative magnitudes of the risk charges (greater reductions occur when risk charges are similar in size)
An actuary is tasked with projecting his firm’s balance sheet over the next 3 years. Rather than using best estimates, the actuary must project the balance sheet under 5 separate scenarios.
a) Briefly describe the difference between static scenarios and stochastic scenarios.
b) Briefly describe 2 critical features the actuary’s projection model must include.
Part a: Static scenarios are pre-defined scenarios (defined by the firm). Stochastic scenarios are generated through a stochastic process
- The projection model should include correlations among the various moving parts (for example, how do stock returns move with a shock event)
- The projection model should include reflections of management responses to adverse financial results
Briefly describe three ways in which parameter risk manifests itself.
- Estimation risk – arises from using only a sample of the universe of the possible claims to estimate the parameters of distributions
- Projection risk – arises from projecting past trends into the future
- Model risk – arises from having the wrong models to begin with