Chapter 45: Risk Management Tools II

Question 1

6 Risk Management tools

Answer 1

• Reinsurance
• Alternative risk transfer
• Diversification
• Underwriting at the proposal stage
• Claims control procedures
• Management control systems

Question 2

How might you diversify business?

Answer 2

Across:

• different classes
• different geographical areas
• different reinsurers
• different asset classes and stocks

Question 3

What is underwriting?

Answer 3

Underwriting is the assessment of potential risks to charge a fair premium.

Question 4

Why do providers underwrite business?

Answer 4

S - identifying and offering special terms to SUBSTANDARD risks
A - avoiding ANTI-SELECTION
F - reducing the risk of over insurance by FINANCIAL UNDERWRITING
E - ensuring that EXPERIENCE follows that expected in the pricing basis
R - using RISK-CLASSIFICATION to ensure that all risks are treated fairly

Question 5

Main ways in which special terms can be applied

Answer 5

• additions to premiums
• reductions to benefits
• exclusion clauses

Alternatively:

• risk may be declined
• insurance may be deferred.

Question 6

3 Different types of underwriting used by life insurance companies

Answer 6

• medical
• lifestyle
• financial

Question 7

Claims control systems can also be used to help manage risk.

What do claims control systems do?

Answer 7

They mitigate the consequences of a financial risk that has occurred, guarding against fraudulent or excessive claims.

An example of a claims control system would be the management of ongoing income protection or permanent health insurance claims.

Question 8

What are the 4 types of management control systems used to reduce risk?

Answer 8

• data checks
• accounting and auditing
• monitoring liabilities
• taking special care over options and guarantees

Question 9

General Risk Evaluation Methods

Answer 9

• More data = more accurate parameterisation = easier to set up models (particularly stochastic).
• Inconsistent data – some parameters may be easier to analyse than others – consider common
• Het data = different trends may complicate model = scenario analysis may be more appropriate

Question 10

Scenario analysis Method

Answer 10

• For each group of risks a representative plausible scenario is developed.
• For each scenario the consequences of the event occurring are calculated.
• A number of different scenarios may be considered.

Question 11

Scenario analysis Advantages

Answer 11

• Scenario analysis is useful when a full mathematical model is inappropriate.
• For the risks being modelled it will be possible to pull together plausible scenarios (including particularly adverse scenarios).
• Removes risk of using many subjective parameters
• Easier to communicate than other approaches.
• Useful for capital assessment review, eg failure of new product

Question 12

Scenario analysis Disadvantages

Answer 12

• The consequences of scenarios occurring may be more difficult than constructing the scenario.
• Likelihood of different outcomes is not apparent.
• Choice of scenarios requires external input, this in turn is critical.

Question 13

Stress testing Method

Answer 13

• Modelling of extreme changes and scenarios.
• Will be looking at correlations and volatilities which are observed to simultaneously increase during extreme events.
• Aim to identify weak areas by looking at effect of different combinations of correlations and volatilities.
• Key area is constructing appropriate stress test scenarios.
• Must be able to consider interaction with other parameters (e.g. financial) to check for weaknesses in portfolio.

Question 14

Stress testing Advantages

Answer 14

• Identifying the key risks to be tested will enable stress testing to show weak areas in the portfolio.
• Appropriate for extreme, wide-ranging scenarios

Question 15

Stress testing Disadvantages

Answer 15

• Difficulty in identifying appropriate correlations for other parameters
• Need to consider sensitivity of portfolio to extreme movements in parameters, which may be difficult to model.

Question 16

Stochastic modelling Method

Answer 16

• Variables are modelled using probability distributions.
• Dynamic interaction between variables.
• The result will be a distribution of outcomes.

Question 17

Stochastic modelling Advantages

Answer 17

• Shows a distribution of possible outcomes, which provides a more complete picture than other approaches.
• By only allowing some parameters to vary stochastically it may be possible to focus on the particular risks which are of interest.
• Allows user to understand likelihood that a guarantee will bite and the financial impact of the guarantee

Question 18

Stochastic modelling Disadvantages

Answer 18

• Require a probability distribution to be applied to parameters which may be difficult to derive, and will require expert judgement (may be subjective/ arbitrary)
• Also requires correlation and interaction between parameters to be set up which may present further difficulties.
• Computationally intensive approach which increases costs.

Question 19

Diversification

Answer 19

• Swap contracts to swap uncorrelated risk packages

* Exposure to counterparties other than reinsurers (cap markets, banks, etc.)

Question 20

Smoothing of results

Answer 20

• Integrated risk covers provide multi-line, multi-year reinsurance, which stabilises the cedant’s results
• Increased diversification = reduced volatility

Question 21

Solvency

Answer 21

Stabilise experience over time = possible easing of sol reqs that insurer needs to meet

Question 22

Source of capital

Answer 22

• Post loss funding

* Securitisation – liability does not have to be accounted for in stat returns

Question 23

Cheaper cover

Answer 23

• Securitisation – insurance risk uncorrelated with market risk, cap markets may require lower return on capital than reinsurers
• Integrated risk covers – insurer not over-insured
• Integrated risk covers - reinsurer obtaining multi-line (diversified) portfolio, therefore may be happy to offer more favourable terms than if the individual risks were priced separately

Question 24

Greater security of payment

Answer 24

• Capacity of cap markets greater than that of reinsurers = lower risk of default
• Securitisation = capital provided to insurer up-front

Question 25

More efficient risk management

Answer 25

* ART products can be tailored to requirements of insurer = over-insurance avoided * Insurance derivatives to hedge against risks

Question 26

Tax advantages

Answer 26

• Products may be structured to exploit tax loopholes