Brehm CH4 Flashcards
(43 cards)
Describe Operational risk
The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.
7 types of operational risk loss events
- Internal fraud
- External fraud
- Employment practices and workplace safety
- Clients, products and business practices
- Damage to physical assets
- Business disruption and system failures
- Execution delivery and process management
Describe internal fraud risk
Acts by an internal party that defraud, misappropriate property (unfairly take) or circumvent the regulations
Examples: misreporting of positions, employee theft and insider trading, claim falsification
Describe external fraud risk
Acts by a third party the defraud, misappropriate property or circumvent the law
Examples: robbery, forgery, and computer hacking, claim fraud, falsifying application information
Describe employment practices and workplace safety risk
Acts that are inconsistent with employment, health or safety laws
Examples: WC claims, violation of employee health and safety rules, discrimination claims and organized labor activities, repetitive stress
Describe clients, products and business practices risk
Unintentional or negligent failure to meet a professional obligation to specific clients. The nature/design of a product also poses an operational risk.
Examples: Fiduciary breaches, misuse of confidential customer information, money laundering, sale of unauthorized products, client privacy, bad faith and red-lining
Describe Damage to physical assets risk
Loss or damage to physical assets from natural disaster
Examples: terrorism, vandalism, earthquakes and floods, physical damage to its own office building and its own automobile fleets
Describe business disruption and system failures risk
Examples: hardware and software failures, telecommunication problems and utility outages, processing center downtime and system interruptions
Describe execution, delivery and process management risk
Failed transaction processing or process management, and relationships with vendors
Examples: data entry errors, incomplete legal documentations, unapproved access given to client accounts and vendor disputes, policy processing and claim payment errors.
Examples of primary causes of P&C company impairment
- Deficient loss reserves
- Underpricing
- rapid growth
- Alleged fraud
- Overstated assets
- Catastrophes
- Reinsurance failure
- Reckless management
What’s the root reason for insurer failure?
The accumulation of too much exposure for the supporting asset base.
What’s fulcrum of operational risk
The plan loss ratio determination process
Describe Bridging model and operational problem with it
Bridging model: where more mature prior-year ultimate loss ratios are bridged forward using estimates of year-over-year loss cost and price level changes.
Operational problem: it produces a high degree of interdependence between prior-year ultimate loss ratio. Thus, optimistic older prior-year loss ratios can roll forwrad and lead to optimistic plan loss ratios.
Describe reserve conflagration
When older prior years begin to deteriorate, the BF ELRs for the newer prior years will increase (via the bridging). This represents pure operational risk.
Describe 3 operational risk associated with Lemur’s plan loss ratio and reserving processes
- Unpredictability of the insurance process: The plan loss ratio could not accurately forecast the loss ratio.
- People failure: The plan loss ratio model could have accurately forecasted the loss ratio, but wasn’t properly used.
- Process and governance failure, The plan loss ratio model did accurately forecast the loss ratio, but the indications were ignored.
Describe cycle management
It’s the management of underwriting capacity as market prices chagne with the underwriting cycle
4 categories that system performance assessments focus on
- Stability
- Availability
- Reliability
- Affordability
Describe performance assessment under naive cycle management
- Maintain market share
- As the insurer decreases prices and expands coverage, price adequacy drops. Although this allows the insurer to maintain premium volume, exposure increases.
- As the underwriting cycle hits bottom, the insurer start to have increased losses from its increases exposure.
- The insurer runs the risk of being downgraded, which may drive customers away (this is stability and availability problem)
- The insurer also runs the risk of being insolvent, which means customers may not receive full claim payments (this is reliability and affordability problem)
Describe performance assessment under effective cycle management
- a firm must re-engineer its underwriting decision processes.
- The insurer can achieve process improvements by focusing on intellectual property, underwriter incentives, market overreaction and owner education
Describe how intellectual property can achieve process improvement
- An insurer’s franchise value is driven by intangible assets (intellectual property)
- Example: expertise of an insurer’s staff, the proprietary database of policyholder information, pricing and reserving, market relationships and reputations
- Managers must focus on retaining top talent during periods of capacity retraction and continue to develop their skills
- Managers must maintain a presence in their core market channels
- Managers must continue to invest in systems, models, and databases
Describe how underwriter incentives can achieve process improvement
- Cycle management requires adaptability and responsiveness
- Underwriter incentives are written once a year and are tied to “making the plan”. the problem is that the plan is based on one assumed market situation.
- Instead, underwriter incentives should be based on how well underwriters supported the portfolio goals throughout the year.
Describe how market overreaction can achieve process improvement
- The insurance industry tends to overreact to the underwriting cycle.
- Example: market prices and coverage tend to soften below reasonable levels. Eventually, market prices and restrictions overcorrect to the over extreme
- Insurers can take advantage of this market overreaction by better managing underwriting capacity
- Firms with the most available capacity during the price-improvement phase(hard market) will reap huge profits that can offset several years of underwriting losses
Describe how owner education can achieve process improvement
- Owners must understand what their financial figures mean and what to do with that information
- It’s important that owners not make calls for increased market share during the worst possible point in the cycle
- Owners should understand what the overhead expense ratio is telling them. For example, a higher overhead expense ratio indicates operational inefficiency for most firms. For an effective cycle management, the overhead expense ratio is expected to rise as premium volume decreases.
2 goals of agency theory
- Aligning management and owner interest
- Understanding the impacts of potential divergence
