Chapter 24 Nature of risks (1)

Question 1

Overview of the broad categories of insurer risks

Give an overview of the broad catergories of risk faced by insurers (8)

(CA1/ARM recap; not in ST1/F101 notes)

Answer 1

• Financial risks
  
  1. Business risk
  2. Liquidity risk
  3. Market risk
  4. Credit risk
• Non-financial risks
  
  1. Operational risk
  2. External risk

Question 2

Various possible sources of health insurer risk:

List the various possible sources of risk to a health insurer

(When approaching this question, try and use the broad categories of risks which you’ve learned about so far; the list ‘sub-risks’ within each category. Most risks are business risks)

Easily 30+ points, including sub-risks and broader categories

Answer 2

Financial risks

• Business risk
  
  1. Risks in investigations (model, parameter, random flactuation)
  2. Policy data and other data
  3. Morbidity: claim incidence rates, claim inception rates, sickness duration, claim amount
  4. Mortality
  5. Early screening diagnosis
  6. Expenses (including inflation)
  7. Persistency/withdrawals
  8. New business mix
  9. New business volumes
  10. Anti-selection and non-disclosure
  11. Guarantee and options
  12. Competition
  13. Aggregation and concentration of risk
  14. Management of company
  15. Legal, regulatory and tax developments (makes more sense in this catergory than any other other category)
• Market risk
  
  1. Investment performance
     
     • Market fluctuations
     • How assets change vs liabilities
• Credit risk
  
  1. Counterparties
     
     • distribution
     • provision of medical services
     • reinsurance
  2. Others: credit downgrading

Non-financial risks

• Operational risk
  
  1. Fraud
  2. Actions of board members
  3. Actions of distributors
  4. Failure of management systems and control
• External risk
  
  1. Catastrophes

Question 3

Risks in investigations:

Define 3 risks which normally arise in investigations

e.g. when setting mortality assumptions for pricing (6)

Answer 3

• Model risk:
  
  • Inappropriate/erroneous probability distribution chosen for underyling model e.g. future mortality.
• Parameter risk:
  
  • Underlying model correct, but parameters inadequate (don’t reflect future experience of lives insured/to be insured)
• Random fluctuation risk:
  
  • Actual future experience may not correspond with model/parameters adopted (even though these adequately reflect lives insured/ to be insured)

Additional comments

• First 2 risks always exist (impossible to predict future with complete certainty).
• Extent of 3rd depends on numbers exposed to risk: smaller number = greater risk.
• These risks are also associated with other major assumptions e.g. investment, expenses

Question 4

Risk due to data: types of data

What type of data might an insurer work with? (2)

What kind of ‘other data’ might insurer use (5)

Answer 4

1. Policy data
   
   1. eg age at entry, policy term, duration in force, sum assured
   2. maintained by insurer
   • 2. Other data
        1. ​Internal data from other products
        2. External data
     3. Insurance industry data
     4. National stats
     5. Overseas markets

Question 5

Risk due to data: types of data

We’ve covered the various data an insurer might use and what its potential sources of data might be; what would an insurer use this data for? (9)

(Remember a useful acronym from CA1/ARM)

Answer 5

Main actuarial reason for policy data:

• Regular valuation of liabilities

Uses of data: MAFIA PEPRS acronym from CA1/ARM :)

1. Marketing
2. Administration
3. Financial planning and management
4. Investments
5. Accounting
6. Provisioning/reserving
7. Experience statistics and analysis/investigations
   
   1. done to give appropriate advice
   2. inaccurate data => inaccurate advice
   3. model points:
      
      1. not always practical/cost effective to do investigation on whole book.
      2. can use model points, then scale up results
      3. the fewer the model points, less accurate
8. Premium rating or product costing
9. Risk management
10. Statutory returns

Question 6

Risk due to data

Discuss main issues for health and care products compared to life insurance products (3)

Answer 6

For health and care contracts specifically, the following issues are experienced (more so than for life insurance:

• Limited credibility
  
  • smaller policy volumes e.g CI and LTCI
  • lower incidence rates e.g. IP and CI
• Limited applicability of past data
  
  • Changes to products/market over time
  • Limited relevance of past data due to sensitvity to
    
    • socio economic conditions (IP)
    • medical advances (CI)
    • longevity/health at older ages (LTCI)
• Limited applicability of industry data
  
  • ​Due to heterogeneity of products and markets

Question 7

Risk due to data: risks due to policy data

Explain how policy and other data can be a source of risk to a health insurer specifically with reference to policyholder data (10)

Answer 7

Policyholder data: main risk is poor maintenance

• company may not maintain adequate, accurate and complete records required by actuary and so
  
  • results of supervisory valuation may be innacurate
  • other investigations may be inaccurate and so advice innapropriate
• risk when used in investigations
  
  • eg investigations modelling part/whole of business
  • risk that model doesn’t adequately reflect business
  • properly referred to as a model or modelling risk - risk that results from model office being an over-simplification of the real company in terms of the portfolio of policies currently in force and as a consequence behaving unrealistically

Question 8

Risk due to data: risks due to other data/non-policy data

Explain how other data (ie non-policyholder data) can be a source of risk to a health insurer (5)

Comment on these risks in the context of other data which is ‘internal’ to the insurer (4)

Comment on these risks in the context of external data (3)

Answer 8

Other data (internal, and or external data)

• other data may be used for actuarial assumptions eg used to determine claim incidence, surival periods, mortality
• data may
  
  • be adequate, but not suitable for the task at hand (see comment regarding external data below)
  • be purely purely inadequate or undreliable indicators of future experience
  • be of insufficient volume
  • suffer from population differences causing data to no longer be applicable to population being considered

Internal data

• even if other data is internal, it may be inadequate for many reasons:
  
  • missing data
  • inaccurate data,
  • insufficient volume,
  • inappropriate for task at hand

External data

• inadequacy of data is worsened where overseas/external data is used..
• because policy conditions may differ significantly from what’s used in company
• any external data used may be inadequate or unreliable and even when reliable it may prove to be inappropriate

Question 9

Claim incidence rates, claim inception rates, estimates of sickness duration, mortality rates

Describe what type of risks arise in terms of claim incidence rates, claim inception rates, estimates of sickness duration, and mortality rates? (5)

Regarding these claim incidence rates, claim inception rates, estimates of sickness duration, mortality rates, list some key health and care factors (5) that lead to

• difficulty in estimating these assumptions
• risk in the investigations which use these assumptions

Answer 9

Risks which arise re

• claim incidence rates, claim inception rates, estimates of sickness duration, and mortality rates will usually be
  
  • determined by investigations done by the insurer/actuary
  • used in investigations done by the insurer/actuary
• in these investigations, 3 key risks arise
  
  • model risk: inappropriate probability distribution or model
  • parameter risk: parameters don’t reflect future experience
  • random fluctuations risk: actual future experience differs from model and parameters

What health and care factors make these assumptions difficult to estimate/risky to use in investigations:

• New diseases and epidemics / preventative measures over time
• Lifestyle changes affecting prevalence of certain illnesses
• Utilisation levels may differ over time
• Claim definitions will differ over time
• Claim durations / recoveries will change over time

Question 10

Claim incidence rates, claim inception rates, estimates of sickness duration, mortality rates

Describe additional factors related to model/parameter/random flacuation risk that arise when conducting investigations that estimate (or make use of) claim incidence rates, claim inception rates, estimates of sickness duration, mortality rates (6)

Answer 10

Additional factors regarding model/parameter/random flactuarion risks

• model and parameter risk always exist, but their extent depends on reliability and applicability of the data used in investigations
• parameter risk especially is worsened by poor data, essentially expanding the funnel of doubt in future
• random fluctuations risk arises due to
  
  • heterogeneity of lives insured and/or low numbers exposed to risk (reducing impact of “law of large numbers”)
  • it may still apply to large samples, but more so with small samples
• in addition, there’s always a risk is that experience is simply more adverse than expected, as no-one can predict the future

Question 11

Claim amounts

Describe risks to the insurer related to claim amounts which are either estimated, or used in investigations (8)

Answer 11

Claim amounts are a significant source of uncertainty, especially for indemnity products, such as PMI cover; the following factors contribute to uncertainty in the cost of PMI claims

• new diseases or epidemics
• changes in cost of medical treatment due to medical innovations, advances in technology, currency fluctuations etc.
• changes in lifestyle and prevalence of medical conditions
• policyholder or medical professional behaviour affecting utilisation of medical services
• poor claims control and fraud may result in the insurer paying claims that should have been excluded due to benefit limitations
• introduction of claims management processes, such as preferred providers
• an aging population, which implies that there will be greater demand for healthcare treatment
• currency fluctuations which may result in volatility in cost of medical treatment that relies on imported equipment or pharmaceuticals

Question 12

Earlier screenings

Describe risks to the insurer related to the impact of earlier screenings (4)

Answer 12

Advances in medical science mean that claims for health insurance might increase. As time progresses (earlier) screening is often encouraged, which may lead to the following

• increased claims frequency
• insurers finding themselves facing claims significantly earlier than was expected on the basis of the data on which premiums were calculated
• earlier diagnosis may prompt some claims that would not otherwise have been payable (because policyholder wouldve died prior to diagnosis, or lapsed or term policy may have expired)

Question 13

Investment performance: risks due to investment performance

For what purposes might investment assumptions be needed, and what risks does this introduce? (4)

What key factors influence the significance/importance of the investment return assumption (2)

Answer 13

Investment return assumptions

• may be needed for investigations which rely on existing assets or future investment
  
  • return will need to allow for both income and capital appreciation on amounts to be invested in the future
  • both model risks and parameter risks apply
• some investigations require assumptions as to future income and capital on existing assets.
• likely to require comparison between value of assets and value of liabilities, also capital values risk on assets being valued.

The importance of the assumption depends

• importantly on the size of the reserves
• in part on the delay between premium receipt and claim payment

Question 14

Investment performance: risks due to investment performance

In what way may investment return assumptions be modelled? (4)

What kind of investment risks may be introduced due to 3rd parties? (3)

Answer 14

Investment return might be modelled deterministically or stochastically

• in either case there are model, parameter
• in deterministic modelling, can also use sensitivit/scenario testing to better understand risk, hence reduce it
• in a stochastic model the random fluctuations are modelled explicitly (modelling volatility of returns)

Asset management

• the passing of responsibility for the process or management of investments to 3rd parties introduces further investment risks

Question 15

Investment performance: significance thereof for various health insurance products

Describe the extent of risk that investment performance gives rise to under various scenarios (3)

Answer 15

PMI

• Investment performance be of lesser significance considering PMI due to its short-tail from premium receipt to claim settlement.

Long term contracts

• For some long-term insurance, particularly pre-funded long-term care, the investment performance, and hence risks, may be major considerations.

Currency risks

• Insurers paying claims in foreign currencies the insurer will be exposed to exchange rate movements and may need to invest in assets in the relevant foreign currencies.

Question 16

Expenses and inflation

In what way does expense/inflation risk arise in the investigations done by actuaries? (5)

Given that expense/inflation risks arise in investigations done, describe factors which drive/cause these risks to the insurer (8)

Answer 16

For investigations carried out by actuaries, assumptions will need to be made as to the future expenses/expense inflation to be incurred

• these will be allowed for implicitly or explicitly…
• …either on deterministic or stochastic basis, for inflation.
  
  • therefore introducing parameter risk

There is a risk of

• higher than expected expenses
  
  • the risk may be greater if 3rd parties are involved
• higher than expected expense inflation leading to expense risk
  
  • this can have model, parameter and random components
  • stochastic modelling may be used to reduce this risk
• contributions to expenses from premiums and charges may
  
  • simply not be enough to cover expenses over time
  • be significantly mismatched with actual expenses incurred over time

Question 17

Persistency/withdrawals

Describe the risks which insurer face in terms of persistency/withdrawals (12)

For what product(s) in particular might peristency/withdrawal rates be very closely monitored, and why? (4)

Answer 17

The unpredictability of persistency makes it a risk (there is parameter risk and model risk). This gives rise to the following risks impacts

• Early withdrawals, asset shares
  
  • usually represent a particular risk of loss, because of failure to recoup initial expenses and,
  • asset shares can be very low or negative compared to surrender value at time of withdrawal eg unit-linked pre funded LTCI
• Impact of selective withdrawals
  
  • persistency experience different from expected may invalidate assumptions about effects of selective withdrawals on mortality, critical illness or sickness experience
• Impact on expense assumptions
  
  • ​expense assumptions may also be invalidated due to the effect of withdrawals on the volume of business in force
  • withdrawals may lead to mismatch btwn charges & expenses
  • reducing business volumes means risk of increasing per-policy expenses
• Lapse and re-entry
  
  • this risk is especially important in market where increasing data and aggressive competition is driving the price down.
  • has happened in CI environments

Persistency rates will be closely monitored under PMI…

• …because, often, initial costs (and maybe commissions) are amortised over an assumed average number of renewals
• persistency is extremely important in the short term to recoup initial expenses

Question 18

Risks due to mix of business: by nature and size of contract

Describe risks arising to the insurer due to nature/size of contract (5)

Answer 18

The unpredictability of mix of business by nature and size of contract is a risk for the insurer.

Change in M.O.B by

• nature
  
  • type of contract (eg LTCI vs CI)
  • contract design (eg with profits vs unit linked)
  • premium frequency (single vs regular)
• size of contract

…could cause:

• significant change in risk profile/capital needs of company
  
  • which may lead to an overstretching of the company’s capital and other resources available to cover the risk.
• mismatch between charges and expenses in terms of
  
  • timing
  • amount: in particular, if contracts are on average smaller than assumed, expense loadings may fail to cover company’s overheads

Question 19

Risks due to mix of business: by source

Describe the risks arising to the insurer due to mix of business by source (9)

In what case is this risk of particular concern/importance (2)

Answer 19

Different distribution channels

• …involve different sales methods and reach different populations
• as a result, the demographic and expense experience of the various channels is likely to differ eg by
  
  • claim inception,
  • morbidity,
  • average claim size,
  • expenses
• variation form the insurer’s assumed mix by source could therefore invalidate the insurer’s demographic and expense assumptions

Risks due to mix of business by source is particulalry important if

• insurer is charging a weighted average price across distribution channels.
• less so if charging a different price per distribution channel

Question 20

Volume of new business

What risks arise due to the volume of new business the insurer writes/experiences?

Consider risks due to

• volume of business too high (2)
• volume of business too low (7)

How does monitoring of risk due to volumes of business differ for short term busines? (3)

Answer 20

Too much volume of business may lead to risk of unsufficient

• capital to cover financing requirements
• admin resources to process new policies

Too little volume of business may lead to risks regarding

• expense risk:
  
  • ​overheads spread over too few policies (expense loadings in premiums/charges insufficient)
  • mismatching of charges and expenses
• new products’ (fixed) development costs:
  
  • risk of not recovering fixed development costs already incurred
• fall in new business
  
  • damages profitability, competitiveness, long term viability

Monitoring of risk due to business volumes for short term business

• for short-term insurance business, risk management and monitoring may be more focused on
  
  • the overall volume and mix of…
  • …in-force business rather than specifically on new business