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Flashcards in Brehm Chapter 4 Deck (27):
1

Describe seven types of operational risk loss events

- internal fraud: acts by an internal party that defraud, misappropriate property or circumvent the law or company policy (eg. claim falsification)
- external fraud: acts by a third party that defraud, misappropriate property or circumvent the law (ex. claim fraud)
- employment practices and workplace safety: acts that are inconsistent with employment, health or safety laws (eg. repetitive stress)
- Clients, product and business practices: unintentional or negligent failure to meet a professional obligation to specific clients (eg. bad faith)
- damage to physical assets: loss or damage to physical assets from natural disasters (eg. physical damage to insurer's office building)
- Business disruption and system failures: disruptions of business operations due to hardware and software failures, telecommunication problems, etc. (eg. processing center downtime)
- execution, delivery and process management: failed transaction processing or process management, and relationships with vendors (eg. policy processing errors)

2

Identify three causes of P&C company impairments

- deficient loss reserves
- underpricing
- rapid growth

3

An actuary believes the root reason for insurer failures is reserve deficiency. State if this is correct

no, the reason is accumulation of too much exposure for the supporting asset base

4

Explain how the a company's plan loss ratio determination process is considered the "fulcrum" of operational risk. Fully describe a bridging model that could lead to the financial downfall. Include three explanations for the company's downfall and explain how they are related to operational risk

- bridging model determines the plan loss ratios by bridging forward more mature prior-year ultimate loss ratios using year-over-year loss cost and price level changes. If the BF method is used for immature prior years with an ELR equal to the initial plan LR for the year, the PY ultimate LR will remain close to its plan LR. Once older prior years being to deteriorate, the BF ELRs for the more recent PY will increase via the bridging. This could lead to a booked reserve deficiency, possible rating downgrade and large exodus of policyholders
- explanation 1: plan LR and reserve models could not accurately forcast the loss ratios and reserves. If competitors were not facing similar problems in forecasting, this explanation implies operational risk exists
- explanation 2: plan loss ratio and reserve models could have accurately forecasted the LR and reserves, but the models were not properly used. Presents an operational risk due to people failure
- Explanation 3: plan loss ratio and reserve models did accurately forecast the loss ratios and reserves but indications were ignored. this is an operational risk due to process governance and failure.

5

Describe cycle management. provide and example of naive cycle management.

- cycle management is the management of UW capacity as market prices change with the UW cycle
- Naive cycle management: if company decreased prices and expanded coverage to "maintain market share" during a soft market resulting in a drop in price adequacy. As UW cycle hits bottom, company would begin to recognize increased losses from its increased exposure. This could eventually lead to a rating downgrade, which may drive customers away and lead to stability and availability problems. Company may also become insolvent, which would lead to reliability and affordability problems

6

describe four areas that a company should focus on to ensure effective cycle management

- Intellectual property: insurer's franchise value is driven by intangible assets (ie. IP) Managers must focus on retaining top talent during periods of capacity retraction and continue to develop their skills. Managers must also maintain a presence in their core market channels
- Underwriter incentives: cycle management requires adaptability and responsiveness. Oftentimes, UW incentives are written once a year and are tied to "making the plan". Problem is plan is based on one assumed market situation. Plans should be fluid and change based on the market condition. If prices drop to an acceptable level, underwriters should be able to stop writing new business without fearing that their bonuses will be in jeopardy
- Market overreaction: insurance industry tends to overreact to UW cycle. eg. market prices and coverage tend to soften below reasonable levels, eventually market prices and restrictions overcorrect to the other extreme. Firms can take advantage of this overreaction by better managing their UW capacity. Firms with the most available capacity during the hard market will reap huge profits that can offset several years of UW losses
- Owner education: owners must understand what their financial figures mean and what to do with that info. Under effective cycle management, financial figures may look out of line when compared with other companies. EG. premium volumes will drop under cycle management. For most firms, this is a bad sign. for an insurer practicing effective cycle management, this is fine. Important that owners not make calls for increased market share during the worst possible point in the cycle

7

Describe control self-assessment

- process through which internal control effectiveness is examined and assessed. The goal is to provide reasonable assurance that all business objectives will be met

8

Identify primary objectives of internal controls

- reliability and integrity of information
- compliance with policies, plans, procedures, laws and regulations and contracts
- safeguarding of assets
- economical and efficient use of resources
- accomplishment of established objectives and goals for operations or programs

9

Briefly describe key risk indicators. explain the difference in review frequency between self-assessments and key risk indicator measurements

- measures used to monitor the activities and status of the control environment of a particular business area for a given operational risk category
- typical control self-assessment processes occur only periodically, key risk indicators can be measured daily

10

Explain the difference in key risk indicators and historical losses

- key risk indicators are forward looking indicators of risk, whereas historical losses are backward looking

11

Provide four insurer specific examples of key risk indicators

- Production: hit ratios
- Employee retention: turnover ratio
- internal controls: audit results
- claims: frequency

12

Describe the six sigma management framework

- management framework that focuses of process redesign, project management, customer feedback, internal communication, design tradeoffs, documentation and control plans. For the financial services industry, six sigma can help firms identify and eliminate inefficiencies, error, overlaps and caps in communication and coordination

13

Three insurer processes that might benefit from the six sigma management framework

- UW: exposure data verification, exposure data capture, price component monitoring, classification and hazard slection
- Claims: coverage verification, ALAE, use of outside counsel and case reserve setting
Reinsurance: treaty claim reporting, coverage verification, reinsurance recoverables, disputes, letters of credit and collaterization

14

Explain difference between strategic risk taking or strategic risk

- Strategic risk-taking refers to intentional risk-taking as an essential part of a company's strategic execution. Strategic risks are unintentional risks that occur as a result of strategy planning or execution

15

categories of strategic risk. For each category, provide the magnitude of risk and an insurance-related example

- Industry: capital intensiveness, overcapacity, commoditization, deregulation, cycle volatility. Magnitude of risk: very high eg. insurers suffer from capital intensiveness and overcapacity
- technology: shift, patents, obsolescence. Magnitude: Low eg. insurers may experience technological advancement in internet distribution (issuing policies over internet or adjusting claims over the internet) and data management
- Brand: erosion or collapse, Magnitude: moderate, eg. insurance products are fairly homogenous, primary feature of insurance product is the ability to pay the claim, insurers can differentiate themselves on price and service. Reputation for fair claims handling and low prices can improve franchise value
- competitor: global rivals, gainers, unique competitors, Magnitude: moderate eg. pricing below the market to grab market share is a significant risk to rival insurers, entering a new market with inadequate UW expertise, pricing systems, policy servicing capabilities is another risk, multiple competitors targeting the same market segment is a risk
- customer: priority shift, power concentration Magnitude: moderate eg. risk is worse for large commercial insurance (assuming personal insurers will have exposures spread over country)
- project: failure of R&D, IT, business development or M&A Magnitude: high, eg. mergers and acquisitions can destroy the value of a company (didn't consider integration costs, timelines, reserve deficiencies), insurers often under-invest in R&D and IT
- stagnation: flat or declining volume, price decline and weak pipeline Magnitude: high eg. insurers have a hard time redeploying assets, most insurer assets are intellectual assets which have a large degree of task specificity. Insurers have extensive reporting lags and mismatched revenue/expenses. some mismatch caused by fact that insurers continue to write business at inadequate prices in order to fund current year expenses. Insurers respond poorly to market price cycles. (insurers try to maintain premium volume and market share during price declines) Improper performance incentives for underwriters contribute to this

16

Describe two situations where interest of the firm's owners and mangaement may not be aligned

- company can agree to pay management a percentage of the increase in its market cap after five years. This ties manager compensation to the firm's

17

Describe two situations where interest of the firm's owners and management may not be aligned. Quantifying this operational risk can be extremely difficult. Provide an alternative solution for managing this risk.

- company can agree to pay management a percentage of the increase in its market cap after five years. This ties manager compensation to the firm's performance, management may be more willing to take on risky investments since from their perspective, they could either end up very rich or right were they are now. this allows them to gamble with the owner's money
- company pays management in stock grants or stock options. since management's compensation is completely tied to the performance of the firm, they are probably less diversified than the firm's owners and may be less willing to take on risk
- rather than trying to quantify this risk, we should study the incentive plan and make adjustments if necessary

18

Describe the traditional planning approach based on "plan estimates"

- "plan estimates" are single point estimates and tend to be overly optimistic due to the need to meet overall corporate profit or premium volume targets. When actuals deviate from the overly optimistic plan, managers are reluctant to deviate from the plan numbers which results in booked numbers that are unrealistic for far too long

19

Describe two issues caused by using the tradition planning approach based on "plan estimates"

- firm may have an unforeseen reserve deficit
- overall portfolio mix (combination of written premium and corresponding written loss ratios) may not be what is intended. eg. if leadership had known that the loss ratios would be xx.x% during the planning phase, the target premium volume may have differed

20

Describe the scenario planning approach

expands the single point estimates to include various scenarios. The likelihood and response plans for each scenario must be decided in advance. For each option the firm would need to develop detail plans that would be activated depending on how market conditions play out

21

Two advantages of the scenario planning approach

- firm thinks through responses beforehand. It can prescreen and agree on the best response. It can also save time during crises by having strategic action plans laid out and ready for use
- organizational inertia is reduced (ie. plan is more flexible). the unrealistic urge to make the numbers at all costs is reduced

22

briefly describe advanced scenario planning

- in basic scenario planning, scenarios and strategies are manually generated. In advanced scenario planning the best strategy for each scenario is found by maximizing some performance metric and reducing downside risk

23

Describe how advance scenario planning is used in asset management

- for each scenario, various asset strategies are tested by simulated the returns of portfolios selected by different strategies
- each strategy is represented as a set of asset selection rules, where the rules are repeatedly applied to rebalance the portfolio in response to the environment changes as the scenario progresses
- rebalancing measures include selling bonds, changing investment allocations and buying tax-exempt investments in response to the portfolio tax position
- the selected portfolio is the one that maximizes a performance metric (ex. net income, economic value) and reduces downside risk (TVaR)

24

provide two examples of insurer-related action rules that could be applied in response to environment changes in advanced scenario planning

- hold price in response to market price decreases. This reduces premium volume and market share
- allocate underwriter capacity in various ways based on anticipated price adequacy levels

25

Briefly describe how the interaction between multiple firms might be handled in scenario planning. provide and example of how one firm's strategy might conflict with another firm's strategy

- in order to capture the interactions between firms during scenario planning, firms must employ agent-based modeling (ABM). ABM is a method for studying systems of interacting "agents". These "agents" are independent entities capable of assessing the environment, selecting courses of action and using those selections to effect change on the environment.
- one firm might plan (in isolation) to target a market segment identified as profitable, the firm would create detailed plans outlining the target premium volume and loss ratio. but fail to recognize the fact that other competitors have also noticed the profitable segment. When all competitors attempt to grow in the same segment, prices drop and the profitability of the line decreases

26

Explain Agency theory

- considers management agents of a firm's owners, whose intersets are not always aligned. These divergent interests are an operational risk
- two goals of agency theory studies: aligning management and owner interest and understanding the impacts of potential divergence

27

contrast operational risk and strategic risk

- operational risk is the risk of loss from failed or inadequate internal systems, processes, people or from external events (includes legal risk but excludes strategic or reputational risk)
- strategic risk is risk of loss from making right or wrong strategic decision