Chapter 31: Other Risk Controls

Question 1

List 4 risk management tools available to a financial product provider, other that reinsurance and Risk Transfer

Answer 1

1. Diversification
2. Underwriting at the proposal stage
3. Claims control processes / procedures
4. Management control systems (reduces exposure to risk)

Question 2

Give 5 examples of how an insurer can diversify its business

Answer 2

1. Different lines of business
2. Different geographical areas
3. Different reinsurers
4. Different asset classes
5. Different assets held within a class

Question 3

Why might an insurance company use reciprocal QS reinsurance to diversify its risks in preference to selling a wider range of insurance contracts itself?

Answer 3

Marketing and selling a wide range of contracts is expensive. It also gives the insurance company the reputation of being a ‘generalist’ rather than a specialist player, which might not be the company’s desired strategy.

Reciprocal quota share reinsurance, where one company reinsures a part of another company’s business and vice versa, enables the insurance company to concentrate its marketing, sales and administrative effort on its chosen segment of the market (whilst still achieving a diversified portfolio). This should be more efficient.

Question 4

What is underwriting?

Answer 4

Underwriting is the assessment of potential risks so that each can be charged an appropriate premium

Question 5

Why do insurers underwrite business?

Answer 5

SAFARI

• (Identify) substandard risks, for which special terms will need to be quoted - while aiming to accept as many risks as possible on standard premium rates.
• Avoid anti-selection - Not fraudulent or illegal - involves not disclosing useful information that can help with pricing because the insurer did not ask for it
• Financial underwriting to reduce the risk of over-insurance on large policies
• (Ensures) Actual claims experience is in line with that expected in the pricing basis
• Risk classification to ensure that all risks are rated fairly (premium commensurate with the risk)
• Identify for substandard risks, the most suitable approach and level of special terms to be offered

Question 6

Characteristics of a class of insurance for which underwriting is important

Answer 6

1. Size of the policy is large
2. Gains to be made from anti-selection is large (eg term vs endowment insurance)
3. Cover is optional rather than compulsory

Question 7

What are the 3 main types of underwriting?

Answer 7

1. Medial
2. Financial
3. Lifestyle

Question 8

Who might interpret medical underwriting information?

Answer 8

Medical evidence is interpreted by specialist underwriters employed by the company.

Question 9

List 3 factors that lifestyle underwriters may investigate.

Answer 9

1. Applicant’s occupation
2. Applicant’s leisure pursuits
3. Applicant’s normal country of residence

Question 10

What is the purpose of performing financial underwriting for a life insurance contract, and what information on the applicant may be obtained in order to carry it out?

Answer 10

The purpose of financial underwriting is to assess whether the proposed SA is reasonable relative to the financial loss that the applicant would suffer if the insured event occurs. The aim is to reduce the risk of over-insurance.

Information obtained may include:

• The applicant’s occupation and salary
• The proposed SA selected by the applicant
• Details of other insurance policies held by the same applicant
• Whether the applicant has an insurable interest in the insured life

Question 11

List 6 possible decisions that can be made following underwriting

Answer 11

1. Accept on standard terms
2. Reject / decline
3. Deferral of cover

Accepted on special terms including:

4. Addition to premium, commensurate with the degree of extra risk.
5. Reduction in benefit, commensurate with the degree of extra risk
6. Exclusion clause(s)

Question 12

What are claims control systems?

Answer 12

Claims control systems mitigate the consequences of a financial risk that has occurred.

They guard against fraudulent or excessive claims.

Question 13

Give 4 examples of claims control systems

Answer 13

1. Requiring claimants to submit a claim form
2. Requiring evidence of eligibility to claim, e.g. death certificate
3. Requiring continued evidence of eligibility to claim, e.g. for LTCI
4. Requiring estimates of the extent of a loss, e.g. by the policyholder, or a company approved by the insurer, or by a loss adjuster

Question 14

Explain why insurers may encourage income protection insurance benefit claimants to make a partial return to work, with a continued benefit.

Answer 14

This will benefit the insurer in terms of paying a lower claim amount, plus the longer-term health of the policyholders may be improved by entering active employment again.

This can reduce the time to recovery from the current claim and reduce the likelihood of future claims.

Question 15

Describe the 4 types of management control systems used to reduce risk.

Answer 15

1. Data recording - the company should hold good quality data on all risks insured and on the risk factors identified during underwriting, to ensure that adequate provisions are established and to reduce operational risks.
2. Accounting and auditing - effective procedures enable adequate provisions to be established, regular premiums to be collected and finance providers to be reassured.
3. Monitoring liabilities - this protects against aggregation of risks to an unacceptable level. Also, by monitoring new business volumes, it helps ensure the provider is not exceeding the resources available; new business mix to monitor the risk to profitability due to cross-subsidies.
4. Taking special care over options and guarantees - in particular, monitoring will determine whether the options and guarantees are likely to bite.

Question 16

Outline how the investment risks associated with options and guarantees can be managed

Answer 16

Liability hedging can be used, i.e. choosing assets which match the liabilities so that they move consistently with each other.

For example:

• where the benefit is linked to an external index, the liabilities can be hedged using derivatives linked to the same index.
• put options can be used to hedge guaranteed minimum benefits under UL or WP products.

The hedging can be dynamic, i.e. rebalancing the underlying hedging portfolio as market conditions change.

Question 17

How should low likelihood, high impact risks be dealt with?

Answer 17

It is important to manage these risks in a measured way. Whilst they are very important and credit rating agencies and regulatory authorities are very interested in them, it is important not to concentrate unduly on these risks at the expense of other types of risk.

Low likelihood, high impact risks can be:

• diversified away to a limited extent
• passed to an insurer or reinsurer
• mitigated using management control procedures such as disaster recovery planning.

Some such risks have to be accepted, and the organisation then has to assess an appropriate amount of capital to hold against the risk event (e.g. by stress testing) - if the event lies within the company’s risk tolerance.

Question 18

How does a provider decide how much capital to hold against a retained risk?

Answer 18

The amount of capital to hold is the amount necessary in order that the provider can withstand an event that might occur with a given probability over a given time period.

The shorter the time period chosen, the lower the ruin probability must be.

Question 19

List 5 components of the total cost of risk

Answer 19

1. Expected loss costs
2. Disruption of business
3. Insurance premiums (and other risk mitigation costs)
4. Risk managers’ salaries
5. Cost of capital held against the risks