Brehm Chapter 1

Question 1

Dynamic Financial Analysis (DFA)

Why wasn’t it incorporated

Answer 1

• Focused on volatilities in addition to expected values, which adds complexity
• Required working with different silos of the insurance company
• Required a “natural champion” - which most insurers lacked
• Lack of internal and external pressure

ERM was incorporated instead - had internal/external pressure

Question 2

ERM & Key Components

Answer 2

ERM - the process of identifying critical risks, quantifying their impacts and implementing strategies to maximize enterprise value
1. Identifying critical risks
2. Quantifying their impacts
3. Implementing strategies
4. Maximize enterprize value

Key Components
* Ongoing process, not 1 time exercise
* Consider risks across whole enterprise
* Focus on material risks only
* Risk includes both favorable and unfavorable deviations from expectation
* Risk must be quantifiable (if possible)
* Implement strategy to mitigate significant risks
* Compare risk and return

Question 3

ERM Risk Categories

Hint: Sofi Bank

Answer 3

Insurance Hazard Risk - risk taken from other parties in return for premium
* underwriting
* catastrophe
* reserve deterioration

Financial (Asset) Risk - risk to insurer’s asset portfolio due to changes in:
* interest rates, forex rates
* equity prices
* credit quality, liquidity

Operational Risk - execution risks of the insurer, things don’t go as planned
* difficult to (ERM) model - can be modeled in bulk using judgement or use other management methods

Strategic Risks - risks from insurer making wrong choices, or even realizing a choice needs to be made
* difficult to model

Sofi Bank

Question 4

ERM Process

Hint: MAD Management

Answer 4

Diagnosis - perform high level risk assessment
* set a threshold and focus on material risk (serious threats to the firm)

Analytical - need to model the material risks identified
* quantify risk with probabilities of potential outcomes
* aggregate risk, factor in correlation

Management
* avoid, reduce, mitigate the risk
* eliminate or transfer the risk
* keep risk if there is good risk return tradeoff (speculative risk)

Monitoring
* monitor and update plan if needed

Question 5

Good ERM Models/Modelers

Answer 5

Good ERM Models:
* show risk return tradeoff from different strategies
* reflect importance of the risks to business decisions
* factor in correlation/dependencies among the risks
* bad ones will overstate or understate certain risks

Good ERM Modelers:
* have deep understanding of the risks
* have trusted relationship with senior management

Question 6

ERM Model

ERM Model > Underwriting Risk

Hint: PCP - using PCPs to help price accurately!

Answer 6

Pricing Risk
* mis-estimating projected losses
* loss (freq/sev) may be understated

Parameter Risk
* incorrect paramaters –> incorrect outputs

Cat Model Uncertainty - need to incorporate
* varying cat models results, and updates
* assumptions and data quality

Question 7

ERM Model

ERM Model > Underwriting Risk > Parameter Risk

Hint: I need to SEE Parameters

Answer 7

• Estimation Risk - misestimation of model parameters
• Projection Risk - uncertainty in projections due to changes, i.e. freq/sev to future periods, gas prices, weather change, loss development
• Event Risk - significant unpredicted event (insurer didn’t price this in, not in historical data)
• Systematic Risk - risks (i.e. cats) that impact a large number of policies (non-diversifiable)

Question 8

ERM Model

ERM Model > Reserving Risk / Asset Risk

Answer 8

Reserving Risk:
* risk that reserves will development adversely
* reserve uncertainty impacts amount of capital that needs to be held

Asset Risk:
* variability in asset values (bonds, stocks, real estate, forex)
* modeling scenarios consistent with historical patterns

Question 9

ERM Model > Dependency/Correlation Risk

What is correlated?

Answer 9

Dependency/Correlation Risk
* UW cycle, insurance loss trend, reserve developments are correlated across LOBs
* Inflation rates, interest rates, equity values are correlated and should be account for in ERM model
* Cats are often correlated acrossed LOBs

Dependency is quantified with correlation coefficient
* insurers focused on modeling tail dependency
* tail dependency modeled using copulas

Question 10

Approach to Capital Requirements

Why it’s important + Approaches

Answer 10

Capital must be enough to:
* sustain current underwriting and support growth
* provide for adverse reserve changes or decline in assets
* satisfy regulators, rating agencies, shareholders

Holding enough capital so that the probability of default is very low/remote
* strong financial strength that’ll attract new business
* protects policyholders, but also not holding too much so that shareholder can earn sufficient returns

Holding enough capital to maximize insurer’s franchise value
* protects both policy/shareholder
* franchise value includes balance sheet, customer base, agency relationship, reputation

Holding enough capital to continue to service renewals
* these are typically more profitable

Holding enough capital so that the insurer not only survives a major cat, but also thrives in its aftermath

Question 11

Why is ERM bad at modeling tail events when determining capital need?

Answer 11

ERM models is least reliable in the extremes:
* difficult to model scenarios that would deplete all cpaital
* tail events are poorly understood
* there is little available data to help derive the tail