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Define ERM

- Process of systematically and comprehensively identifying critical risks, quantifying their impacts and implementing integrated strategies


Four aspects of ERM

- should be a regular process, not just a one time event
- should be considered on an enterprise basis
- focuses of risks that have significant impact to the value of a firm
- 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


Four risks an insurer faces

- Insurance hazard risk: risk assumed by insurer in exchange for a premium (consists of U/W 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. (execution of IT systems, policy service systems, etc.)
- Strategic: risk associated with making the wrong or right strategic choices. ie. risk of choosing the wrong plan, given the current and expected market conditions


Four steps in the ERM process

- Diagnose: conduct a risk assessment to determine material risks that exceed company-defined threshold
- Analyze: risks that exceed a company threshold are modeled 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


Characteristics of a good ERM

- shows the balance between risk and reward from different strategies (changing the asset mix or reinsurance program)
- model reflects importance of various risks to business decisions
- model includes mathematical techniques to reflect the relationships among risks (dependencies)
- recognizes and reflects on its own imperfections. Imperfections include parameter uncertainty, simplistic assumptions and in some cases poor data quality
- modelers have a deep knowledge of the fundamentals of those risks
- modelers have a trusted relationship with senior management of the company
- model reflects the uncertainty of the output of other models being incorporated (such as cat models or macroeconomic models)


What happens if a firm employs a weak enterprise risk model

often exaggerate certain aspects of risk while underestimating others. This can lead to overly aggressive or overly cautious corporate decision making


Four type of parameter risk

- Estimation risk: misestimation of model parameters due to imperfect data
- projection risk: changes over time and the uncertainty in the projection of these changes
- event risk: situations where there is a causal link between a large unpredicted event (Outside of the company's control) and losses to the insurer
- systematic risk: risks that operate simultaneously on a large number of individual policies. They are non-diversifying and do not improve with added volume


Example of Event risk

Latent exposures such as asbestos


Example of systematic risk



Three sources of uncertainty in catastrophe models

- probabilities of various events
- amount of insured damage caused by each event
- data quality


Describe a key aspect of asset modeling

- modeling scenarios consistent with historical patterns. When generating scenarios against which to test an insurer's strategy, the more probable scenarios should be given more weight


Four reasons for holding sufficient capital

- sustain current u/w
- provide for adverse reserve changes
- provide for declines in assets
- support growth
- satisfy regulators, rating agencies and shareholders


Four common approaches for setting capital requirements

holding enough capital:
- so that the probability of default is remote (very conservative and mainly protects the policyholder)
- to maximize the insurer's franchise value. Franchise value includes an insurer's b/s, customer base, agency relationships, reputation, etc. (maximizing franchise value protects both the policyholder and the shareholder)
- to continue to service renewals (since renewals tend to be more profitable)
- so that insurer not only survives a major cat but thrives in its aftermath


Discuss why default is not the most appropriate reference point for setting capital requirements. Suggest a more meaningful reference point

- strictly protects current policyholders. To protect shareholder value, you should focus on avoiding significant partial losses of capital that could erode franchise value.
- more appropriate reference point would be the minimum capital to maintain a target credit rating. If an insurer's rating is downgraded significantly, it can suffer loss to franchise value. Setting this as a reference point, the capital is set with the goal of maximizing the insurer's value.