Objective 2 - Health Insurance Risks Flashcards Preview

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Flashcards in Objective 2 - Health Insurance Risks Deck (64):
1

Regulatory actions levels for Health RBC ratios

Actions are based on the Health RBC ratio (defined in a separate list)
1. Company Action Level (ratio of 150%-200%) - requires that a company submit a corrective action plan
2. Regulatory Action Level (ratio of 100%-150%) - allows the commissioner to examine the company and issue and order specifying corrective actions
3. Authorized Control Level (ratio of 70%-100%) - allows the commissioner to place the company under regulatory control if deemed to be in the best interests of policyholders and creditors
4. Mandatory Control Level (ratio less than 70%) - requires the commissioner to take regulatory control of the company

2

Formula for Health RBC after Covariance

1. RBCAC = H0 + {H1^2 + H2^2 + H3^2 + H4^2} ^ (1/2), where
a. H0 is the Asset Risk for Affiliates - the risk that a stock investment in an affiliate may lose value
b. H1 is the Asset Risk for Other Assets - the risk that investments may default or decrease in value
c. H2 is the Underwriting Risk - the risk of having inadequate premiums in the future (most impactful risk for health insurers)
d. H3 is the Credit Risk - the risk of not recovering the amounts owed to the insurer
e. H4 is the Business Risk - includes several misc. types of risk, such as admin expense risk and excessive growth risk
2. Authorized control level capital = RBCAC / 2
3. Health RBC ratio = total adjusted capital / authorized control level capital

3

Formulas for the H2 (U/W Risk) component of Health RBC

1. U/W Risk = Claim Experience Fluctuation Risk + Other U/W Risk
2. Claim Experience Fluctuation Risk is the sum of risk charges for 5 product groupings (comprehensive, Med Supp, dental and vision, Medicare Pt D, and other)
a. For each grouping, the risk charge = premium * ratio of incurred claims to premium * risk factor * managed care risk adjustment factor
b. The last 2 components of this formula are pulled from tables of factors that vary by coverage type
3. Other U/W Risk includes:
a. Coverages not included in claim experience fluctuation risk, such as DI, LTC, stop loss, and AD&D. Various tables of factors are used for calculating risk charges for these coverages.
b. Adjustments for rate guarantees and premium stabilization reserves

4

Features of ERM that distinguish it from traditional risk management

1. Instead of focusing on risk mitigation or avoidance, ERM creates organizational resilience in achieving corporate goals
2. ERM views the organization holistically, rather than in silos
3. ERM is embedded within the management framework, rather than being the responsibility of a single risk manager
4. ERM provides a common language to discuss risks and opportunities
5. ERM provides a framework for identification and evaluation of potentially harmful conditions and events
6. ERM ensures the organization assumes no more risk than necessary in order to achieve its goals

5

The process of the typical risk management approach

1. Identifying risk - identifying circumstances and events that may cause harm to the organization. This is where most risk management programs fall short because they are focused only on known risks.
2. Evaluating risk - determining the likelihood and severity of those events
3. Mitigating risk - applying methods that reduce the possibility these events will occur or reduce the financial impact when they occur

6

Reasons why organizations fail to detect emerging risks

1. An uncertain future - it is likely to be different than what is expected
2. Poor info about the current conditions in the organization and the environment lead to flawed expectations for the future
3. Poor understanding of organizational complexity makes it difficult to understand the meaning of the info available
4. Poor judgment in deciding how to respond to organizational challenges
5. Financial incentives given to management do not align with other stakeholders

7

The ERM process for managing enterprise-wide risk

The traditional process (see separate list) is still used, but is approached differently
1. ERM expands the risk profile by searching for unknown risk. This consists of:
a. Developing a detailed description of the business system (consider questions related to reasons it is difficult to detect emerging risks), and
b. Constructing the risk hypothesis, which is a structured understanding of the organization's risk profile and its ability to achieve corporate goals under both normal and stressed conditions
2. Then traditional risk management is used to evaluate and mitigate known risks, with ERM ensuring that an integrated approach is used
a. Risk evaluation includes developing ranges of the likelihood and severity of potential harmful events
b. Risk mitigation involves deciding what to do about the various potentially harmful conditions
3. Then an appropriate risk capital is determined - regulators have mandated minimum capital requirements, but insurers should also hold additional surplus to reduce the likelihood of regulatory intervention
4. ERM follows up with monitoring and oversight by the board of directors and senior management

8

Possible indicators of emerging risk

1. High employee turnover
2. Frequent reassignment or replacement of project managers for major initiatives
3. Frequent downtime of computer systems
4. Frequent manual overrides or intervention required
5. Numerous manual processes
6. Frequent complaints from internal or external customers
7. Significant variance of key indicators from normal or best practice
8. Reactive, rather than proactive, approach to problem solving
9. The frequency of surprises

9

Typical information contained in the risk register

This register is created to record scenarios and events that have been considered in the risk evaluation
1. Description of the risk scenario
2. Details of how and when the scenario was identified
3. Which corporate goals the scenario affects
4. Description of the method used to quantify risk exposure and the time horizon for modeling
5. The range of outcomes considered
6. The outcome of a reverse stress test, which identifies the conditions that would cause risk capital to be exceeded
7. Assessment of likelihood and impact prior to mitigation under both normal and stressed environments
8. Description of mitigation strategies and assessment of their effectiveness and cost
9. Assessment of the likelihood and impact after mitigation
10. Assignment of responsibility for monitoring the risk scenario
11. Details regarding action plans
(Also see risk register list in Sweeting Ch. 8)

10

Types of risk mitigation strategies

1. Risk avoidance - for example, choosing not to expand into new areas. This method will not work on most business risks because they are simply too unavoidable
2. Risk transfer - the most common method is through insurance. For example, ceding large claim risk to a reinsurer
3. Risk control - done through performance improvement. For example, actuarial and U/W risk is controlled through internal policies and using best practice methodologies

11

Characteristics to enter into the risk dashboard for each identified risk

The dashboard provides a high-level overview of the organization's exposure to risk
1. Brief description of the risk
2. Line of business affected
3. Gross likelihood - expected frequency of occurrence prior to mitigation
4. Gross impact or severity - potential loss prior to mitigation
5. Gross risk rating - the combination of likelihood and severity
6. Control effectiveness - ability of mitigation strategies to reduce likelihood or severity
7. Net likelihood after mitigation
8. Net impact or severity after mitigation
9. Net risk rating - combining likelihood and severity after mitigation, and including the effect on capital
10. Tolerance - willingness to accept the risk remaining after mitigation
11. Net risk rating vs. tolerance
12. Action plan status - implementation status of mitigation strategies

12

Senior management responsibilities for implementing ERM

1. Communicating support of the ERM process to the rest of the company
2. Maintaining a culture of performance improvement and learning from successes and failures
3. Allowing for open discussion of risk
4. Providing direction to the risk management committee and chief risk officer
5. Determining risk appetites and limits
6. Establishing limits of authority for risk assumption

13

Responsibilities of the chief risk officer (CRO)

1. Being the chief champion of the ERM process
2. Leading the risk management committee
3. Directing the ERM process by guiding business units as they prioritize, evaluate, and mitigate risk
4. Guiding info collection and performance monitoring
5. Testing the perceived risk profile
6. Modifying the risk profile and risk models using emerging experience and knowledge
7. Ensuring the organization continues to learn from emerging experience and that the risk profile is continuously update

14

Benefits of ERM

1. Credit agencies may be willing to offer lower borrowing costs
2. Regulators and the board of directors may allow management more flexibility in managing the company
3. Management will better understand the business system
4. The organization will know how much corporate risk capital should be held
5. There will be fewer unknown risks

15

Common features of ERM frameworks

1. An assessment of the context in which the framework is operating. This includes understanding the internal and external environments and the interests of stakeholders
2. A consistent risk classification must be established
3. The risks to which the organization is exposed must be identified
4. The risks must be assessed and compared to target levels of risk
5. A decision must be taken on how to deal with risks that exceed targets
6. Measures to manage risk are implemented
7. The process needs to be monitored, documented, and communicated

16

Models of risk management

1. "Three lines of defense" - consists of the following tiers of risk management:
a. Day-to-day management by first-line business units
b. Ongoing monitoring by the central risk function (CRF)
c. Occasional audits of first-line business units and the CRF
2. "Offense and defense" - says the first-line business units should take as much risk as they can to maximize returns while the CRF should reduce risk as much as possible to minimize losses. Should be avoided because it sets up the first two lines of defense to be in opposition.
3. Policy and policing - says the CRF should set risk management policies and then monitor compliance with those policies. But often results in the CRF being too "hands-off".
4. Partnership - says the first-line business level units and the CRF should work together closely to maximize returns subject to an acceptable level of risk. This may leave the CRF too involved to give and independent assessment of first-line units.

17

Categories of risk faced by organizations

1. Market risk - the risk inherent from exposure to capital markets (eg, fluctuations in value of assets held)
2. Economic risk - eg, price and salary fluctuation
3. Interest rate risk - the risk arising from unanticipated changes in the overall level of interest rates or in the shape of the yield curve
4. Foreign exchange risk - the risk when cash flows received are in a currency different from the cash flows due
5. Credit risk - default risk (eg, a default on loans or a reinsurer failure)
6. Liquidity risk - the risk that a firm cannot easily trade its assets or that it cannot raise additional financing when required
7. Systemic risk - the risk of failure of a financial system (see separate list)
8. Demographic risk
a. Mortality risk - the risk that a portfolio will suffer from mortality being greater than expected (negatively affects life insurance)
b. Longevity risk - the risk that a portfolio will suffer from mortality being less than expected (negatively affects pension and annuity business)
9. Non-life insurance risk - the risk related to the incidence of claims and their intensity
10. Operational risks - risks that impact the way in which a firm carries on business (see separate list)
11. Residual risks - risks that remain once action has been taken to treat a risk. For example, if an interest rate swap is used to reduce exposure to changes in interest rates, the residual risk is that the bank will not be able to make its payments on the swap.

18

Types of systemic risk

1. Financial infrastructure - eg, a bank unable to pay back loans from other banks
2. Liquidity risk - can become systemic if a run on banks occurs
3. Common market positions - feedback risk is the risk that a change in an investment's price will result in further changes in the same direction. This could then impact all investors who have common investment positions.
4. Exposure to common counter-party - the risk that a relatively small failure will cascade through several layers of investors

19

Types of demographic (mortality or longevity) and non-life insurance risk

1. Level risk (for life insurance) or U/W risk (for non-life insurance) - the risk that the average level of claims for a particular population will differ from what was assumed
2. Volatility risk - the risk of claims differing from assumed due to volatility in a small population
3. Catastrophe risk - the risk of large losses due to some significant event (such as a natural disaster)
4. Trend risk - the risk claim rates will change unexpectedly from current levels

20

Types of operational risks

1. Business continuity risk - the risk that an external event will affect the physical ability of a firm to carry on business at its normal place of work
2. Regulatory risk - the risk that an organization will be negatively impacted by a change in legislation or regulation, or that it will fail to comply with current legislation or regulation
3. Technology risk - the risk of a technology failure, including loss or disclosure of confidential info, data corruption, and computer system failure
4. Crime risk - this results from the dishonest behavior of individuals (eg, theft of money or intellectual property by an employee)
5. People risk (see separate list)
6. Bias - a type of systemic risk
a. Deliberate bias can arise if key risks are intentionally omitted or downplayed
b. Unintentional bias may occur due to overconfidence in one's ability to complete a difficult task
7. Legal risk - the risk arising from poorly-drafted legal documents
8. Process risk - the risk inherent in the processes used by firms (eg, underwriting and claim handling)
9. Model risk - the risk that financial models used to assess risk or otherwise help make financial decisions are flawed
10. Data risk - the risk of using poor data
11. Reputational risk - failures related to other risks can lead to a loss of confidence in the organization and a subsequent loss of business
12. Project risk - refers to all of the various operational risks in the context of a particular project
13. Strategic risk - the risk the organization will not make a conscious decision of what its strategy is and how it intends to implement it

21

Types of people risk

1. Employment-related risks - the risk that the wrong people are employed, retained, or promoted
2. Adverse selection - the risk that the demand for insurance will be positively correlated with the risk of loss
3. Moral hazard - the risk that people who are insured will be less likely to avoid risk
4. Agency risk - the risk that a party that is appointed to act on behalf of another will instead act on its own behalf

22

Broad areas in the risk identification process

1. Risk identification tools (see separate list)
2. Risk identification techniques (see separate list)
3. Assessment of the nature of risks
a. Quantifiable risks can be modeled
b. Unquantifiable risks can often be analyzed by the groups that identify them
4. Recording risks in a risk register - the register details all of the risks faced by the organization. It should be constantly updated to reflect the changing nature of risks and the evolving environment

23

Risk identification tools

1. SWOT analysis - identifies the organization's:
a. Strengths (eg, market dominance, economies of scale, and effective leadership)
b. Weaknesses (eg, high costs, a lack of direction, and financial weakness)
c. Opportunities (eg, innovation, additional demand, and cheap funding)
d. Threats (eg, new competitors, price pressure, falling liquidity, and increased regulation)
2. Risk checklists - lists that are used as a reference for identifying risks in a particular organization or situation
3. Risk prompt lists - similar to checklists, but rather than seeking to pre-identify every risk, they simply identify categories of risk that should be considered
4. Risk taxonomy - more detailed than a prompt list, containing a description and categorization of all risks that might be faced
5. Risk trigger questions - lists of situations or areas in an organization that can lead to risk
6. Case studies - can suggest specific risks to consider, particularly if there are similarities to the organization in the case study
7. Risk-focused process analysis - involves constructing flow charts for every process used by the organization and analyzing the points at which risks can occur

24

Risk identification techniques

1. Brainstorming - this is an unrestrained or unstructured group discussion
2. Independent group analysis - without collaboration, all participants write down ideas on risks that might arise. These ideas are aggregated and there is a discussion. Risks are anonymously ranked.
3. Surveys - participants are given a list of questions about different aspects of the organization to try to draw out the risks faced
4. Gap analysis - consists of a survey that asks two types of questions: the desired level of risk exposure and the actual level of exposure
5. Delphi technique - begins with an initial survey of experts who comment on risks anonymously and independently. Is followed by subsequent surveys that are based on earlier responses. Continues until there is a consensus or stalemate.
6. Interviews - individuals are interviewed independently to identify the organization's risks
7. Working groups - comprised of a small number of individuals who have familiarity with the risks identified. They investigate more fully the risks which have been identified already.

25

Information to include for each entry in the risk register

1. A unique identifier
2. The category within which the risk falls
3. The date of assessment for the risk
4. A clear description of the risk
5. Whether the risk is quantifiable
6. Info on the likelihood of the risk
7. Info on the severity of the risk
8. The period of exposure to the risk
9. The current status of the risk
10. Details of scenarios where the risk is likely to occur
11. Details of other risks to which this risk is linked
12. The risk responses implemented
13. The cost of the responses
14. Details of the residual risks
15. The timetable and process for review of the risk
16. The risk owner
17. The entry author
(See also risk register list in Bluhm ch 47)

26

Economic capital and risk optimization measures

Definition of economic capital - the additional value of funds needed to cover potential outgoings, falls in asset values, and rises in liabilities at some given risk tolerance over a specified time horizon
1. Risk-adjusted return on capital (rA) = risk-adjusted return / economic capital. Is well suited for comparing different lines of business within a firm.
2. Economic income created (EIC) = (rA = rH) * EC, where rH is the hurdle rate of return and EC is the economic capital. Is the rate of return that each unit of a product sold must earn to cover the additional amount of risk it generates.
3. Shareholder value (SV) = EC * (rA - rG) / (rH - rG), where rG is the rate of growth of the cash flows. Represents the discounted present value of all future cash flows. Unlike the first 2 measures, which were single-period, SV reflects longer term based on present value.
4. Shareholder value added (SVA) = EC * [(rA - rG) / (rH - rG) - 1] = SV - EC

27

Purposes of an internal economic capital model

1. To determine how much capital a firm should hold to protect it against adverse events
2. To price new products and decide how to allocate capital across business lines
3. To assess the amount of economic capital that should be held over time.
4. To assess the impact of changes in investment strategy and capital structure
5. To look at how an organization copes in the face of extreme events
6. To help measure performance
7. To carry out due diligence for corporate transactions
8. To provide info on the financial state of the organization to a regulator

28

Considerations for designing an economic capital model

1. Must agree on what the model will be used for
2. Must agree on what risks will be modeled
3. Must decide which approach to use
a. Factor table - requires a certain amount of capital to be held for each unit of a particular activity
b. Deterministic approach - stress test that considers the amount a firm would lose under different scenarios
c. Stochastic approach - use a stochastic, parametric, or empirical model to produce a large number of simulated results
4. Decide whether the model will be run on an enterprise-wide basis, or whether individual models will be run for each business line with the results being combined later
5. Consider what output is required from the model

29

Categories of risk for health insurance companies

(There are separate lists of the types of risks for each of these categories)
Market Risk:
1. Environmental risk
Credit & Underwriting Risk:
2. Financial risk
3. Pricing risk
Operational Risk:
4. Operational risk
5. Reputational risk
6. Strategic risk

30

Environmental risks for health insurers

1. Buyer environment - buyers strengthen or lessen their market position
2. Competition
3. Economy
4. Fraud (external) - fraud by providers or customers
5. Legal
6. Regulatory and legislative
7. Supplier environment - suppliers strengthen or lessen their market position

31

Financial risks for health insurers

1. Asset default
2. Data - insufficient data to assess a given risk
3. Financial viability
4. Interest rate
5. Liquidity
6. Model - a model does not reflect the process being analyzed
7. Reinvestment risk
8. Reserve adequacy - the level of reserves held is inadequate or excessive

32

Operational risks for health insurers

1. Billing and collections
2. Claims processing
3. Contract wording
4. Data technology and management - IT system failure
5. Fraud (internal)
6. Human resources - the firm does not hire the right people to perform needed tasks
7. Network management - network providers give poor service
8. Reinsurance
9. Sales force being ineffective
10. Training - the firm's employees being inadequately trained
11. Vendor relations - not selecting the right vendor or TPA

33

Pricing risks for health insurers

1. Anti-selection
2. Authority - premium rates deviate from pricing policies
3. Competition
4. Data - data is inadequate, incomplete, or inappropriate
5. Financial viability of capitated providers
6. Model - the pricing model does not properly reflect all pricing risks
7. Mortality
8. Regulatory and legislative
9. Reinsurance
10. Trend: inflation - the actual trend differs from the pricing assumption
11. Trend: intensity and severity
12. Trend: technology
13. Trend: utilization
14. Underwriting

34

Reputational risks for health insurers

External:
1. Disgruntled policyholder
2. Rating agencies - risk of a rating downgrade
3. Stock analysts - analysts misinterpret info or are impatient for profits
Internal:
4. Claims adjudication - slow claim payments
5. Corporate governance
6. Distribution - poor sales tactics destroy reputation
7. Fraud - control measures do not properly prevent fraud

35

Strategic risks for health insurers

1. Capital management - the company cannot get capital to support its strategy
2. Growth - growth is mismanaged
3. Incentives - incentives are misaligned with the corporate strategy
4. Management failure
5. Mergers and acquisitions - acceptable merger and acquisition candidates are unavailable
6. Network management - the company is unable to contract with providers
7. Reinsurance - coverage is not available at an acceptable cost

36

Financial uses of reinsurance

1. Increase financial capacity - enables the insurer to write larger amounts than otherwise
2. Catastrophe protection - prevents financial destabilization from a single catastrophic claim
3. Stabilize earnings - strategies to stabilize earnings include:
a. Control exposure to loss on each individual (specific stop loss)
b. Control of aggregate losses (aggregate stop loss)
c. Managing the mix of business (can emphasize profitable lines by assuming business)
d. Increasing the spread of risk (through trade reinsurance - "reciprocity")
4. New business growth - can help to grow a new product line quickly
5. Improve balance sheet position - can move some liabilities to the reinsurer's balance sheet
6. Reinsurance as guarantor - the reinsurer is ultimately responsible for its share of the business
7. Retrocessional reinsurance (reinsurance for the reinsurer) - reinsurance companies also use reinsurance for the same reasons just listed

37

Non-financial uses of reinsurance

1. Increase intellectual capacity - useful for a new line of business or a small existing one
2. Joint ventures - situations where reinsurance is used to achieve marketing cooperation:
a. Fronting - because the reinsurer is not licensed as a direct insurer, a ceding company sells the product and then cedes nearly 100% to the reinsurer. Not allowed in NY.
b. Lack of ceding company commitment - a direct writer may be selling the product only as an accommodation product, so it would cede nearly 100% of the risk to a company with more expertise with that product
c. Mutual interests - if both companies want to sell the product and can be involved, could use coinsurance
3. Acquisition - the buyer assumes the obligation of the seller through an assumption reinsurance agreement

38

Limitations of reinsurance

1. It cannot make an uninsurable risk insurable
2. It cannot make an inadequate premium adequate
3. It can be misused - for example, by reinsuring too much of the risk, the ceding company is essentially giving away profits
4. It can be used for improper and illegal purposes

39

Types of reinsurers

1. Reinsurance companies - offer products and services to other insurance carriers
2. Insurance carriers - some have reinsurance divisions specializing in various products
3. Reinsurance facilities or pools - a group of companies that band together to accept risk

40

Methods of reinsurance risk transfer

1. Facultative reinsurance - each risk is submitted to the reinsurer for acceptance or rejection
2. Automatic or treaty reinsurance - all business meeting certain U/W rules is accepted by the reinsurer

41

Types of reinsurance programs

1. Proportional reinsurance - a fixed % of the ceding company's risk is reinsured. Coinsurance or quota share is the most common form. The reinsurer receives a fixed % of the premium less a ceding allowance, or decides the premium to charge to cover its portion of the risk.
2. Non-proportional reinsurance - the ceding company is reimbursed if a loss exceeds a certain amount. Includes excess of loss and aggregate excess (aka specific and aggregate stop loss).

42

Ceding company considerations in designing a reinsurance program

Reinsurer qualities
1. Financial condition and continuity
2. Flexibility ( in the terms and arrangement)
3. Experience and ability - the reinsurer's own portfolio should be profitable
4. Services provided
5. U/W - could be outsourced
Other
6. Rates and terms
7. Admin costs - will be affected by retention amount and minimum ceding amount
8. Degree of management involvement - should be reduced if the reinsurer is knowledgeable and helpful
9. Profits lost to the reinsurer - don't want retention to be too low
10. Business relationships - must have good faith on both sides

43

Reinsurer considerations in underwriting proposed business

1. Ceding company business objectives - how will the business objectives (such as growth and profit) affect the performance of the reinsured business?
2. Ceding company management - is it strong and experienced? What is the appetite for risk? What are their attitudes toward reinsurance?
3. Reinsurance program objectives (eg, stable earnings, access to services, minimize risk of new product) - these will determine what type of reinsurance is appropriate
4. Financial condition of the ceding company (should be well capitalized with good ratings)
5. Administration - will premium and claims be promptly reported? Are procedures strong and followed?
6. Underwriting - does the ceding company have the competence to U/W the business?
7. Claim adjudication - what is the claim payment philosophy? Does claim processing reflect policy provisions?
8. Marketing and sales - is the marketing strategy focused? Does the reinsurer know the market?
9. Expected reinsurer profit - will the reinsurer have an adequate spread of risk and adequate premiums?

44

Keys to reinsurer success

1. Rating (determining the reinsurance premiums) - re-rate and renew business periodically
2. Expertise - must have U/W, claims, and pricing expertise to provide services and evaluate the direct company
3. Client mix - a large # of average-sized ceding companies will produce a better spread of risk than just a few large clients
4. Credible size - to develop a credible block of business, quote only those coverages that fit the reinsurer's marketing niche
5. Consistency - must exercise sound risk management techniques, throughout market ups and downs

45

Uses of reinsurance for group medical benefits

1. Reinsurance for a ceding company - may be done through either quota share reinsurance (with the ceding % usually btwn 20% and 100%) or excess reinsurance
2. Reinsurance for the employer's risk under a self-funded medical plan - done through stop loss plans. Most reinsurers require both specific and aggregate stop loss.

46

Types of reinsurance for disability income insurance

1. Automatic excess - the direct writer retains the first $X of benefit per individual. Preferred by large insurers.
a. Variation 1: Extended elimination period (aka duration excess) - the ceding company retains all the risk for the first n months, so retention is based on a period of time (not a dollar amount)
b. Variation 2: Specified dollar amount - reinsure cumulative individual losses in excess of a specified dollar amount. This is not used much today.
2. Facultative (quota share) - favored by small and medium-sized companies who need the reinsurer's services and expertise. The reinsurer provides net rates to which the ceding company adds its expense loads

47

Long term care characteristics making it desirable to use reinsurance

1. It is a low frequency, high severity product
2. Insured claim cost data is scarce
3. It is a new product - the benefit structure is still evolving and liberalizing
4. The claim cost curve is steep - this will delay the emergence of actual experience for decades
5. The future direction of claim costs is debatable
a. Some expect costs to increase as medications keep sick people alive longer
b. Others expect costs to decrease due to cures for diseases such as Alzheimer's
6. The product is capital intensive - the steep claim cost curve leads to substantial active life reserves
7. Reinsurers have an advantage - they have access to numerous direct carriers and thus have the opportunity to help all clients avoid past mistakes

48

MCCSR minimum capital requirements

The minimum capital requirement is the sum of five risk components:
1. Asset default (C-1) risk
2. Mortality, morbidity, and lapse risks
3. Changes in interest rate environment (C-3) risk
4. Segregated funds risk
5. Foreign exchange risk
The MCCSR ratios compare capital available to capital required
1. The minimum total ratio for life insurers is 120%, with a supervisory target of 150%. The capital available in the formula is adjusted net tier 1 capital + net tier 2 capital.
2. The majority of the capital held should be in tier 1. The minimum adjusted net tier 1 ratio is 60%, with a supervisory target of 105%. The capital available in the formula is adjusted net tier 1 capital.

49

Components of gross tier 1 capital

Tier 1 (core capital) consists of the highest quality capital elements
1. Common shareholders' equity
2. Participating accounts
3. Qualifying non-cumulative perpetual preferred shares
4. Qualifying non-controlling interests in subsidiaries arising on consolidation from tier 1 capital instruments
5. Qualifying innovative tier 1 instruments
6. Non-participating accounts (for mutual companies)
7. Accumulated foreign currency translation adjustments reported in Other Comprehensive Income (OCI)
8. Accumulated net unrealized loss on available-for-sale equity securities reported in OCI
9. Accumulated changes in liabilities reported in OI under shadow accounting
10. Accumulated defined benefit pension plan remeasurements reported in OCI

50

Formulas for net tier 1 capital

Net tier 1 capital = gross tier 1 capital minus:
1. Goodwill
2. Intangible assets in excess of 5% of gross tier 1 capital
3. Adjusted negative reserves calculated policy by policy and negative reserves ceded to unregistered insurers
4. Cash surrender value deficiencies calculated on a grouped aggregate basis
5. Back-to-back placements of new tier 1 capital between financial institutions
6. Each net defined benefit pension plan recognized as an asset on the insurer's balance sheet net of any associated deferred tax liability
Adjusted net tier 1 capital = net tier 1 capital minus:
1. 50% of deductions/adjustments
2. Deductions from tier 2 capital in excess of total tier 2 capital available

51

Types of tier 2 capital

Tier 2 (supplementary capital) falls short of tier 1 by not being permanent or not being free of mandatory fixed charges against earnings. But tier 2 still contributes to the financial strength of a company.
1. Tier 2A: hybrid capital instruments (having certain characteristics of both equity and debt)
2. Tier 2B: limited life instruments
3. Tier 2C: other capital items
4. Net tier 2 capital is total tier 2 capital minus:
a. 50% of deductions/adjustments
b. Back-to-back placements of new tier 2 capital between financial institutions

52

Characteristics of the ideal insolvency process

1. Good relationships between the task force and the receiver
2. Good policy records
3. Few uncovered obligations
4. Facts and solution are clear and agreed on by the receiver and the task force
5. Joint solicitation of proposals and negotiation of an assumption reinsurance agreement with a strong reinsurer
6. No resistance to a court order of liquidation with a funding of insolvency
7. Prompt regulatory approvals of agreements among the receiver and the affected guaranty association
8. Quick closing to move policyholders to a solid insurer
9. Guaranty associations' obligations fully satisfied at closing
10. Task force involvement in asset recovery

53

Major steps in the ERM process

1. Risk identification and classification - classify risks into categories, such as market risk, credit risk, and operational risk
2. Risk measurement and prioritization - includes identifying unfavorable outcomes and the likelihood they will occur
3. Risk management and aggregation - involves establishing risk tolerance levels and developing action plans relative to the risks that have been identified

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Definition of ERM

The discipline by which an organization in any industry assesses, controls, exploits, finances, and monitors risks from all sources for the purpose of increasing the organization's short- and long-term value to its stakeholders

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Processes included in the ERM control cycle

1. Risks are identified
2. Risks are evaluated
3. Risk appetites are chosen
4. Risk limits are set
5. Risks are accepted or avoided
6. Risk mitigation activities are performed
7. Actions are taken when risk limits are breached

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Considerations when performing services related to risk evaluation

1. Info about the financial strength, risk profile, and risk environment of the organization. For example, the nature and complexity of the risks faced by the organization, and the degree to which the organization's different risks interact with one another.
2. Info about the organization's risk management system, including:
a. The risk tolerance of the organization
b. The risk appetite of the organization
c. The components of the organization's ERM control cycle
d. The knowledge and experience of management and the board of directors regarding risk assessment and risk management
3. The relationship between the organization's financial strength, risk profile, and risk environment and the organization's risk management system
4. The intended purpose and uses of the actuarial work product

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Required disclosures for communications subject to ASOP #46 on risk evaluation in ERM

1. The results of the economic capital model, their intended use, and any known limitations of the model
2. The results of the stress and scenario tests, their intended use, and any known limitations of these tests
3. The methodologies and sources of info for identifying and evaluating emerging risks
4. Any material changes in the system, process, methodology, or assumptions from those previously used
5. Significant assumptions used in the risk evaluation and interdependencies among risks and statistical distributions
6. The risks included in the risk evaluation and their relative significance, as well as known material risks not included and the rationale for not including them
7. Whether and how the modeled future economic conditions have been reviewed and tested for reasonableness

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Decisions that must be made in running an economic capital model

1. The risk metric to be used
2. The time horizon for the calculation
3. Risk tolerance - the level of risk that is acceptable
4. Management actions that will be taken in response to particular scenarios, such as changes to investment strategy, decision to withdraw products, or payment of dividends or bonuses
5. Whether to include new business in the future

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Allocating an organization's capital based on benefits of diversification

1. Allocate full stand-alone capital requirement to each line and retain diversification benefit centrally. May make lines uncompetitive.
2. Give full benefit of diversification to new line triggering the benefit. This is arbitrary.
3. Allocate the benefit in proportion to the stand-alone capital requirements by line of business. This is unfair to smaller segments creating larger diversification benefits.
4. Euler capital allocation principal - considers marginal contribution of each additional unit of business to overall capital requirements. This method is complex.

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Reinsurance provisions of group medical vs. stop-loss contracts for self-funded plans

1. Incurred vs. paid claims - excess medical is on an incurred basis with a 12-18 month run out period; specific and aggregate are on a paid basis
2. Reinsurance coverage period - group medical covers losses occurring in the coverage period; stop loss coverage is provided for the length of the contract if it was written while the reinsurance was in effect
3. Covered charges - excess medical follows insurance policy claim definition; stop loss follows claim definition in plan document
4. Covered risks - medical excess insured risks are cert holders; stop loss insured risk is the self-funded plan
5. Claim liability - medical excess incurs the liability when services are provided; stop loss liability is incurred when the plan pays the claim, subject to coverage terms (ie, 12/15)

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How guaranty associations work

Guaranty associations are created by state legislators to protect policyholders of insolvent insurance companies, up to specified limits (usually $100K). All licensed insurers must participate and help cover losses when member company in the same line becomes insolvent.
1. Insurance commissioner determines when a company should be declared insolvent and then seizes control of the company and operates it.
2. The commissioner may appoint a receiver to supervise the company's activities
3. The guaranty association cooperates with the receiver in determining whether to rehabilitate or liquidate the company
4. When a liquidation order is issued, the guaranty associations pay claims and continue coverage
5. Insolvent companies licensed in multiple states will be handled by a task force of guaranty associations

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Important elements of the task force and receiver joint work plan for insolvencies

1. Proactive policyholder communications
2. Regular and prompt claim payments
3. Short-term administrative arrangements (should be as stable/consistent with current practices as possible)
4. Long-term administrative arrangements
5. Improve administrative arrangements

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Order of decisions for a guaranty association task force in handling an insolvency

1. Make a quick assessment of the situation, including claim backlog, assets, and TPAs
2. Develop a plan with the receiver to process claims in the short-term
3. Joint communications with receiver to policyholders, claimants and providers
4. Negotiate agreements to allow funding of claim payments
5. Evaluate relationships with drug card providers, discount service providers and TPAs
6. Evaluate receiver's ability for long-term claim payment vs. a TPA
7. Evaluate methods to reduce claims backlog

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Considerations when developing, reviewing, or maintaining risk evaluations models

1. Whether the models are a fit for the purpose, including model adaptability, sophistication, reliability, data quality, appropriateness of methodology and statistical approaches.
2. Whether the assumptions are appropriate, including that they are supportable and documented appropriately, are regularly reevaluated for appropriateness, and whether anticipated management actions are reflected