Chapter 10: Risk and uncertainty

Question 1

Uncertainty

Answer 1

Inability to predict the future with confidence

Question 2

Risk

Answer 2

The possibility of outcomes being worse than expected

Question 3

Main headings that the uncertainties face by a general insurer can be considered

Answer 3

• uncertainty as to the outcome of the business already written
• uncertainty as to the premiums the insurer needs to charge in future to achieve a desired financial result

Question 4

Classification of elements that contribute to the uncertainties of a general insurer

Answer 4

• those that affect the claims experience
• those that affect the expenses, including commission
• those relating to investments
• business risks, including new business or lapse risks

Question 5

Reserving risk

Answer 5

Risk that the claims arising from expired business turn out to be greater than the reserves

Question 6

How do claim delays contribute to uncertainty?

Answer 6

Reporting delay leads to uncertainty as to claims incurred but not reported.

Settlement delay leaves uncertainty as to the reported claims’ untimate cost.

Question 7

When setting the premium rates required in future, apart from uncertainties that affect the financial outcome of the existing business, what further uncertainties are there?

Answer 7

• extent to which past experience will be relevant to the future
• the extent of any adjustments that need to be made to the experience of the recent past to allow for exceptional claims that have occured or have failed to occur
• possible changes to assumptions required as projections have to extend even further into the future
• the appropriate choice of rating factors and premium relativities

Question 8

Uncertainties relating to the claims experience stem from:

Answer 8

• variability in size of claim at any one time, from one period to another
• delays between incidents giving rise to claims and the reporting and ultimate settlement of the claims
• types of policy and cover provided
• characteristics of policyholders, including possible anti-selection
• attitudes of policyholders to claiming
• crime rates
• economic conditions
• judicial decisions
• legislation/regulation
• accumulations of risk
• catastrophes
• latent claims
• currency risk
• reinsurance risk
• interpretation of wording
• infaltion and consequential rates of escalation of claims

Question 9

How do types of policy and cover contribute to uncertainty?

Answer 9

If a radically new type of policy is introduced, there may be considerable uncertainty regarding the information on which the premiums are to be based.

Question 10

How do the characteristics of policyholders contribute to uncertainty?

Answer 10

If policyholders with different characteristics from those of the existing clientele are attracted, the resulting claims experience may differ from the past in ways that are difficult to determine. There may also be scope for anti-selection.

Question 11

Main types of legislative changes

Answer 11

• fiscal changes, such as increases in tax on insured items or their repair or indeed tax on insurers generally
• changes in the law which increase the amount of cover being provided, such as the removal of the legal limit on compensation levels
• changes in the law that restrict or forbid the use of certain factors in underwriting

Question 12

Reinsurance risks

Answer 12

• not purchasing the right type of reinsurance or enough of it
• doubts as to the availability and cost of the desired reinsurance
• difficulty assessing reinsurance value for money
• whether catastrophe reinsurance will prove satisfactory with regard to such features as the size of the retention, the reinstatement provisions and the upper limit of the cover
• the ability to make reinsurance recoveries. There is potential for reinsurers to default, especially following catastrophes or poor claims experience for the industry as a whole.
• failure to comprehend the true coverage/limits of a reinsurance arrangement and therefore being exposed to risk in areas that were thought to be reinsured

Question 13

Uncertainty regarding commission

Answer 13

Different brokers are paid different levels of commission - risk that the mix of business by broker changes .

If different sales methods are used, so that a higher proportion of business is sold on higher commission terms, the average commission rate will increase.

Persistency risk if differential rate of commission is paid on business aquisition to that paid on renewal = spreading these commission rates across future level premiums.

Question 14

Sources of uncertainty regarding other expenses

Answer 14

Changes in:

• progression of staff costs in relation to the amount of business
• legal and professional charges
• rates of inflation of the kind that affects expenses (salary-related inflation)

Dounts as to the appropriateness of the allocation of expenses among the different types of business

Question 15

Uncertainty regarding investments

Answer 15

• market conditions may worsen
• a larger than expected portion of the assets may not be available for investment. There is usually some delay between the broker receiving the premium and passing it on to the insurer. Similarly, the insurer usually pays a claim in full and then has to wait for recoveries from reinsurance or salvage. Debtors may, in total, form quite a large portion of the insurer’s total assets. If the average delay increases, a lower proportion of the insurer’s assets will be earning investment return, so the average rate of investment income will fall.
• claims may have to be paid sooner than expected
• assets may need to be realised in unfavourable conditions
• poor investment management

Question 16

Further investment risk may arise in situations where:

Answer 16

• there’s insufficient liquidity in the portfolio and there’s a need to pay a large claim. The insurer may need to realise illiquid assets at unfavourable prices
• if insurer deviates from a matched position in pursuit of higher returns, there is liquidity risk if duration of assets > duration of liabilities. Currency mismatching risk if currency in which claims and expenses are paid in appreciates
• invested in less ecure instruments = higher default risk
• quantity of free assets is small in relation to those directly backing liabilities = increases chance that assets will be insufficient when needed to pay liabilities

Question 17

When can movements in asset values impair solvency?

Answer 17

If there is:

• a fall in certain sectors of the market in which investments are held
• a failure/adverse performance of individual assets or investments
• an adverse movement in currency rates

Question 18

Business risks

Answer 18

• failure of a third party, e.g. policyholders, brokers, reinsurers, staff, suppliers
• timing risk, with premiums or recoveries received later than expected or claims paid sooner
• the insurance cycle
• new business and lapses
• operational risks

Question 19

Risks regarding competition

Answer 19

• the products they offer may not appeal to their potential customers
• prices they need to charge for their products to achieve a satisfactory financial result may be too high to be competitive
• as a consequence of losing business to competitors, their unit costs rise so that they find it even harder to price their products competitively
• if they deliberately under-price in response to competition, the prices they actually charge may be insufficient to produce a satisfactory financial result
• their admin structures and channels for obtaining business may become obsolete, for example because of tech developments exploited by their competitors, resulting in additional costs to update

Question 20

Writing loss leaders

Answer 20

The process of winning new business by charging less than economic premiums to increase business volumes, with the hopes of recovering costs later when premiums are increased to sound levels (sufficient to cover costs).

Question 21

Operational risk

Answer 21

Risk associated with the management (mismanagement) of the company. Refers to the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events

Question 22

Examples of operational risk

Answer 22

• Admin risk
• Compliance risk
• Event risk
• Fraud risk
• Governance risk
• Strategic risk
• Technological risk
• Pension scheme risk

Question 23

Administration risk

Answer 23

Risk of error of failure associated with the administration aspects of the firm’s operations

Question 24

What does administration risk depend on?

Answer 24

• extent to which the firm’s admin is outsourced
• extent of centralised and decentralised functions
• level of staff expertise

Question 25

Compliance risk

Answer 25

The risk of non-adherence to legislative and internal firm requirements, Cost of implementing future regulatory reforms

Question 26

Event risk

Answer 26

Risk associated with the potential impact of significant events on the operation of the firm, such as the financial system crisis, a major change in fiscal system or a natural disaster. Not intended to include firm's underwriting losses from such events as this would be covered within insurance risk

Question 27

Fraud risk

Answer 27

Risk associated with inentional misappropriation of funds, undertaking with the objective of personal benefit at the expense of the firm.

Question 28

Governance risk

Answer 28

The risk associated with the board and/or senior management of the firm not effectively performing their respective roles.

Question 29

Strategic risk

Answer 29

The risk arising from the inability to implement appropriate business plans and strategies, make decisons, allocated resources or adapt to changes in the business environment.

Question 30

Technological risk

Answer 30

Risk of error or failure associated with the technological aspects of its operations. In particular, the hardware systems and software utilised to run those systems.

Question 31

Pension scheme risk

Answer 31

The risk that the firm is required to make good any shortfall in pension scheme assets realtive to its liabilities.

Question 32

Group risk

Answer 32

The risk that a firm experiences from being part of a group (i.e. being a subsidiary of the parent of the group as opposed to being a stand alone entity).

Question 33

Types of group risk

Answer 33

- Capital risk - Reputational risk - Group reinsurance risk - Risks in centralised functions - Political risk

Question 34

Capital risk | Group risk

Answer 34

Capital is often provided by the parent company. If the group experiences losses, this could lead to the parent company being unable to assist its subsidiaries. The subsidiaries can thus not rely on the parent's capital in the event of a loss.

Question 35

Reputational risk | Group risk

Answer 35

If the parent shares part or all of the firm's name, there may be a large degree of association. This might give rise to reputational risk.

Question 36

Group reinsurance risk | Group risk

Answer 36

Formal reinsurance arrangements may be on favourable Ts&Cs (since the group buys reinsurance "in bulk" for the entire group). If the reinsurer withdraws these terms as a result of an issue with the parent company (or other part of the group), then a particular subsidiary will have to obtain reinsurance at (less favourable) market rates. May also be a concentrated credit risk if an event affects a number of subsidiaries who are all reinsured by the same reinsurer.

Question 37

Risks in centralised functions | Group risk

Answer 37

Where firms rely on a group company to provide centralised functions, such as marketing/accounting & actuarial support, risks may result from these arrangements. E.g. accounting errors occurring centrally can be perpetuated throughout the group, which could lead to significant (even catastrophic) losses when the error is eventually identified.

Question 38

Political risk | Group risk

Answer 38

The risk of any potential change in the political environment that alters the expected outcome and value of a given economic action by changing the probability of achieving business objectives. Particularly important for firms operating in emerging markets as the potential for rapid political changes makes estimating loss reserves a moving target.

Question 39

The implications of a low solvency margin

Answer 39

- subject to intervention from the supervisory authority (to an increasing degree the further the margin falls) - possible before minimum is reached - loss of confidence in the market leading to a loss of business. This loss of confidence may extend to the stock market, with falls in the share price - A need to restrict business to prevent intervention by the supervisory authority. This may result in the loss of profitable business - Probably the need to purchase more reinsurance to increase protection against fluctuations. - May result in more constrained investment policy