Chapter 4: Operational, Financial, and Strategic Risk - Review (Part 4 - Finance & Strategic Risk)

Question 1

How is economic capital used as a standard for capital requirements of insurers?

Answer 1

• Economic capital is an estimate of the amount of capital a firm needs to remain solvent at a given risk tolerance level
• Developed by modeling potential variability in market value of a firm’s assets and liabilities

Question 2

Fair value accounting to determine economic capital

Answer 2

• Fair value is a market-based measurement that uses the price that either the asset owner would receive by selling the asset, or a liability holder would pay to transfer the liability
• Incorporates several factors - most important is future cash flows and the risk attached to those cash flows

Question 3

Why is the fair value of an insurer difficult to calculate?

Answer 3

• No readily available market for insurers’ largest liabilities: loss reserves and unearned premium reserves
• Reserve estimates are uncertain, particularly for future loss payments
• Assuming entity would require additional payment in case reserves are inadequate

Question 4

Five risks faced by insurers which RBC calculation tries to quantify

Answer 4

• Market risk (ex. change sin bond or stock prices)
• Credit risk (ex. defaults by those owing money)
• Liquidity risk (ex. losses caused by improper matching of asset and liability cash flows
• Insurance risk (ex. potential for adverse loss experience)
• Operation risk (ex. failed internal processes)

Question 5

Three advantages of economic capital analysis

Answer 5

• Focuses attention on the risks attached to an organization’s various activities and can define an organization’s risk tolerance
• Puts a value on an organization’s overall level of risk
• Helps organizations establish the amount of capital they need or the risks they can take with a given amount of capital

Question 6

Three disadvantages of economic capital analysis

Answer 6

• Analysis is complex and sophisticated
• It relies on underlying assumptions and probability estimates of various outcomes
• It uses fair value to assess all assets and liabilities at market value, which may produce changes in MVS unrelated to the company’s ability to operate on an ongoing basis

Question 7

What is Solvency II?

Answer 7

Solvency II is a fundamental review of capitalization of insurers in the European Union, sets capital requirements and risk management standards

Question 8

Three pillars of Solvency II

Answer 8

• Quantitative requirements of capital based on each insurer’s specific circumstances
• Requirements for insurers’ internal risk management process and the supervision of insurers
• Reporting, disclusre, and transparency of the risk assessment to the public and regulators

Question 9

What is strategic risk?

Answer 9

• Strategic risk can threaten an organization or proivde an opportunity
• external to the organization - systemic risks outside the control of any individual organization
• Three major risks: economic environment, demographics, political environment

Question 10

Economic environment

(Strategic risks)

Answer 10

Four major economic risk factors:

• Gross Domestic Product (GDP)
• Inflation
• Financial crises, including sovereign debt crises
• International trade flows and restrictions

Question 11

GDP

(Economic environement and strategic risk)

Answer 11

• Significant GDP growth during periods of economic expansion, or negative growth during recessions
• Organizations may trim costs and profit margins to compete successfully

Question 12

Inflation

(Economic environement and strategic risk)

Answer 12

• Mild inflation is typically beneficial - can pass increase costs along to consumers
• Mild inflation also accompanied by reasonable wage increases
• Large increases in inflation are difficult for both organizations and consumers to manage

Question 13

Financial crises

(Economic environement and strategic risk)

Answer 13

• Place various strains on organizations, including restricted access to credit
• Organizations with large cash reserves may be able to compete effectively

Question 14

International trade flows and restrictions

(Economic environement and strategic risk)

Answer 14

• Relatively free flow of trade across globe characterizes an expanding economy
• Benefits are not always equally distributed (ex. Chinese manufacturing output is higher than US output)
• Governments may impose tariffs or trade restrictions during economic downturns, leading to a slowdown in global economic activity

Question 15

Demographics

(Strategic risks)

Answer 15

• Population aging resulting from increasing life expectancy and reduced birth rates
• Organizations that manufacture producs or provide services targeting older population may be more successful

Question 16

Political environment

(Strategic risks)

Answer 16

• Result of governmental actions, ranging from minor requirements to seizure of all of an organization’s assets within a country
• Multinational organizations should identify as many political risks as possible that could affect the organization, particularly in countries in which they operate