Capital Modelling Methodolgies

Question 1

Future Premium Income

Answer 1

Projected separately for each CoB. May also be split by source of business/ some other differential.

Assumptions usually set following consultation with sales managers/ underwriters/ business planners

Question 2

Future Claims

Answer 2

Split into attritional, large, cat and or:

Claims from business that is written in the future.
Claims from the period of unexpired risk on existing business
Development of notified claims (IBNER)
IBNR

Question 3

Future Expenses

Answer 3

Assumptions about some expenses simply a function of others in the business plan (eg commission)

Other expenses such as staff costs or rent will be more difficult to predict as they will depend on the projected business growth and staffing plan

Question 4

Ceded Reinsurance

Answer 4

Take into account:

Existing arrangements

Potential changes to those arrangements

Possible new arrangements, particularly where there are forecast changes in underlying direct exposures

Any expected softening/hardening in future reinsurance costs

Question 5

Investment Return

Answer 5

Current investment portfolio held

Investment prospects and expectations about future economic environment

Current and projected future investment policy of the general insurer

Question 6

Economic Environment

Answer 6

Need to make consistent assumptions about future inflation and future interest rates

Allowance for other features such as increased moral hazard associated with increased claim frequencies during times of recession

Question 7

Insurance cycle

Answer 7

Allow for the fact that different CoBs may be at different stages in the cycle

Question 8

Operating Environment

Answer 8

Take account of what’s happening internally within the company and its potential influence on future cashflows

Eg impact that high staff turnover may have on ability to meet regulatory deadlines; or loss of an underwriting team on the ability to meet a business plan

Consider potential changes in legislation and their impact, eg potential impact of change in Ogden rates on future claims payments

Question 9

Stress Testing

Answer 9

Quantifies the effect of varying a single parameter; useful for understanding the potential impact of individual risks in isolation.

Stress tests should be calibrated to the appropriate risk measure and should be undertaken as a matter of good corporate governance

Question 10

Scenario Testing

Answer 10

Quantifies the effect of a change in a combination of parameters; useful for considering the combined effect of a number of risks and the cumulative effect of several different mitigating actions occurring at the same time.

Should look at the impact of unlikely, but not impossible, adverse scenarios.

Consider which risks the firm is exposed to and the correlations between these risks.

Question 11

Sensitivity Testing

Answer 11

Process of testing the extent to which the results of a capital model change as a result of making a small change to an assumption in the model.

Question 12

Purpose of sens testing

Answer 12

Identify the more sensitive assumptions in the model.

Can then pay greater attention to justifying and documenting rationale for selecting values of these assumptions.

Care should be taken where changes in assumptions have a smaller impact than expected due to the design of the model- may suggest that a re-evaluation of the model design is needed.

Question 13

Sens testing practical issues

Answer 13

May not be practical to sens test all assumptions so can:

Change loss ratio std dev of all classes by a fixed multiple or only test the two or three largest classes

Question 14

Back testing

Answer 14

Tests how well the model predicts the range of outcomes that actually occur.

Question 15

Purpose of back testing

Answer 15

Essential to ensure that the model is a sufficiently accurate reflection of the real world

May indicate shortcomings in the model that are not detected by other tests

Assesses the validity of the assumption that past performance is a good indicator of future performance

Question 16

Analysing results of back testing

Answer 16

An assessment will need to be made as to whether the deviation is simply a consequence of the expected random variation, or a more systemic effect such as a permanent change in the environment or an erroneous assumption or parameter.

Question 17

Documentation

Answer 17

There should be a clear audit trail from the impact of any financial calculations to the relevant risk capital allocation in the capital model, whatever modelling approach is adopted.