individual life & annuities life risk management

Learn Today. Lead Tomorrow. ACTEX Learning

ACTEX Study Manual for

Individual Life & Annuities

Life Risk ManagementFall 2017 Edition

John Aprill, FSA, MAAA

ACTEX LearningNew Hartford, Connecticut

ACTEX Study Manual for

Individual Life & Annuities

Life Risk ManagementFall 2017 Edition

John Aprill, FSA, MAAA

Copyright © 2017, ACTEX Learning, a division of SRBooks Inc.

ISBN: 978-1-63588-136-3

Printed in the United States of America.

No portion of this ACTEX Study Manual may bereproduced or transmitted in any part or by any means

without the permission of the publisher.

Actuarial & Financial Risk Resource Materials

Since 1972

Learn Today. Lead Tomorrow. ACTEX Learning

ACTEX ILA Life Risk Management Study Manual, Fall 2017 Edition

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ACTEX Learning SOA Exam: ILA LRM

TABLE OF CONTENTS

Section A: Understanding Risk Management

LRM-100-14, The Theory of Risk Capital in Financial Firms A-1 to A-4 LRM-104-14, Rethinking Risk Management A-5 to A-10 LRM-123-15, Enterprise Risk Management, S&P, May 2013, pp. 3-28 A-11 to A-24 LRM-124-15, All on the Same Train, But Heading in Different Directions Underwood, Thomas and Ingram A-25 to A-30 LRM-125-15, Ch. 1 of Financial Risk Management, Sweeting A-31 to A-34 CIA: Dynamic Capital Adequacy Testing (DCAT) Educational Note, November 2013 (pp. 1-33) A-35 to A-46 ERM Specialty Guide, May 2006, Chapters 1-6 A-47 to A-58 Risk Appetite: Linkage with Strategic Planning A-59 to A-66 Describing Risk Culture, The Actuary, August 2012 A-67 to A-72

Section B: Understanding the Various Sources of Risks

Gregory, Chapter 7, Credit Exposure B-1 to B-8 Gregory, Chapter 10, Quantifying Credit Exposure B-9 to B-14 Gregory, Chapter 17, Wrong Way Risk B-15 to B-20 SN LRM-105-14, Mapping of Life Insurance Risks, AAA Report to NAIC B-21 to B-24 SN LRM-106-14, Moody’s Looks at RM & the New Life Insurance Risks – 2000 B-25 to B-28 SN LRM-126-15, Liquidity Risk, Saunders and Cornett, Ch. 17, pp. 493-514 B-29 to B-38 A New Approach for Managing Operational Risk, SOA Research 2008 B-39 to B-50

Section C: Measuring and Estimating Risk

LRM-108-14, Study Note on Parameter Risk C-1 to C-4 LRM-111-14, Value-at-Risk: Evolution, Deficiencies and Alternatives C-5 to C-8 LRM-112-14, Stress Testing, OSFI E-18 C-9 to C-12 LRM-121-14, Value at Risk – Uses and Abuses C-13 to C-16


LRM-127-15, Measures of Financial Risk, Dowd, Ch, 2, pp. 19-32 C-17 to C-20 LRM-128-15, A Short, Comprehensive, Practical Guide to Copulas, GARP, Oct. 2011 C-21 to C-26 LRM-129-15, Stress Testing, A Robust End to End Approach, GARP, Oct. 2011 C-27 to C-32 LRM-130-15, Diversification: Consideration of Modeling Approach & Related Fungibility and Transferability, CRO, Oct. 2013, pp. 4-14, 19-30 C-33 to C-44 How Fair Value Measurement Changes RM Behavior in the Insurance Industry, SOA-Rosner 2013 C-45 to C-54 Economic Scenario Work Group Report C-55 to C-58 Academy Interest Rate generator: Frequently Asked Questions (FAQ) June 2014 C-59 to C-62 Summary of “Variance of the CTE Estimator”, Risk Management Newsletter, August 2008, Issue No. 13 C-63 to C-64 Getting to Know CTE, Ingram, Risk Management Newsletter, July 2004, Issue No. 2 C-65 to C-66

Section D: Asset Liability Management

Asset Liability Management, Ch. 2, Defining Asset liability Management D-1 to D-10 Asset Liability Management, Ch. 3, Why Did ALM Become Important D-11 to D-16 LRM-114-14, ALM for Insurers D-17 to D-24 LRM-116-14, Life Insurance Forecasting and Liability Models, Exclude appendices D-25 to D-30 LRM-117-14, Key Rate Durations: Measures of Interest Rate Risk D-31 to D-36 LRM-118-14, Revisiting the Role of Insurance Company ALM w/in a RM Framework D-37 to D-40 LRM-119-14, Chapter 13 of Valuation of Life Insurance Liabilities, Cash Flow Testing, Lombardi D-41 to D-48 LRM-120-14, Chapter 14 of Life Insurance Products and Finance, Atkinson-Dallas Section 14.4 only on ALM Matching D-49 to D-52


Individual Life and Annuity Life Risk Management

SECTION A


Introductory Note

This section of the study manual contains material to supplement the course of reading on Understanding the Principles of Risk Management. Contained in this section are summary outlines of required readings. The student is cautioned that these outlines are not to be considered as replacements for the original work, but are to be used only as study aids in conjunction with the original work. ACTEX Publications would like to acknowledge the publishers of the original works upon which these outlines are based.

TABLE OF CONTENTS

Understanding Risk Management

LRM-100-14, The Theory of Risk Capital in Financial Firms A-1 to A-4 LRM-104-14, Rethinking Risk Management A-5 to A-10 LRM-123-15, Enterprise Risk Management, S&P, May 2013, pp. 3-28 A-11 to A-24 LRM-124-15, All on the Same Train, But Heading in Different Directions Underwood, Thomas and Ingram A-25 to A-30 LRM-125-15, Ch. 1 of Financial Risk Management, Sweeting A-31 to A-34 CIA: Dynamic Capital Adequacy Testing (DCAT) Educational Note, November 2013 (pp. 1-33) A-35 to A-46 ERM Specialty Guide, May 2006, Chapters 1-6 A-47 to A-58 Risk Appetite: Linkage with Strategic Planning A-59 to A-66 Describing Risk Culture, The Actuary, August 2012 A-67 to A-72

SN LRM-100-14


A-1

SN LRM-100-14 THE THEORY OF RISK CAPITAL IN FINANCIAL FIRMS

Note from the author: It is important to understand what is risk capital, how risk capital is measured, how risk capital is accounted for in the calculation of profits and finally to learn the economic cost of risk capital.

I. Introduction A. Features of principal financial firms 1. Credit-sensitivity of customers: Their customers can be major liability holders. 2. High costs of risk capital: Their opaqueness to customers and investors. 3. High sensitivity of profitability to cost of risk capital. B. What is Risk Capital? 1. Smallest amount that can be invested to insure value of firm’s net assets against a loss in

value relative to risk-free investment of those net assets. 2. Volatility of change in value of net assets is most important determinant of amount of

risk capital. 3. Differs from regulatory capital that attempts to measure risk capital according to a

particular accounting standard. 4. Differs from cash capital that represents up-front cash required to execute a transaction. 5. Cash capital is component of working capital. C. Summary 1. Amount of risk capital depends only on riskiness of net assets. 2. Economics costs of risk capital are spreads on price of asset insurance arising from information costs and agency costs. 3. Full allocation of risk capital is generally not feasible. II. Measuring Risk Capital A. First 3 examples 1. Risk capital and asset guarantees. 2. Risk capital and liability guarantees. 3. Liabilities with default risk. B. Conclusions from these 3 examples 1. Different accounting balance sheet. 2. Very similar risk-capital balance sheets. 3. Same amount of risk capital because underlying asset is the same. 4. Only difference is which party bears the risk of insuring an asset a. Example A: The insurance company. b. Example B: The parent. c. Example C: The note holder.

SN LRM-100-14


A-2

C. A More General Case 1. Basic functions of capital providers a. All provide cash capital and all are sellers of asset insurance b. Provide risk capital: Cash required for purchase of asset insurance; almost always performed by equity holders. 2. Cash capital is determined by assets of firm. 3. Risk capital is determined by riskiness of net assets of firm. 4. Debt and equity represent the netting of asset insurance against provision of riskless cash capital and risk capital. D. Contingent Customer Liabilities 1. Riskiness of net assets will in general differ from riskiness of gross assets. 2. It determines type of insurance required to permit default-free financing. 3. It determines amount of risk capital. III. Accounting for Risk Capital in The Calculation of Profits A. Risk capital is used to purchase insurance on net assets.

B. Insurance is a financial asset.

C. Gains/losses on this asset should be included in calculation of profitability.

D. Allocating costs of risk capital to individual businesses may be a problem.

E. Any allocation must be imputed because highly risky principal transactions often require little or no up-front expenditure of cash. IV. The Economic Cost of Risk Capital A. Firm pays spread paid over fair market value in purchase of insurance.

B. Reasons for spreads are adverse selection, moral hazard and agency costs.

C. Spreads will be higher because of opaqueness of principal financial firms.

D. Cost of risk capital will depend on form in which insurance is purchased.

E. Spreads on each form are determined differently.

F. Task for management is to weigh spread costs of different sources of asset insurance to Find the most efficient way of spending risk capital.

G. In calculating expected profitability risk-capital costs should be expensed along with cash-capital costs.

SN LRM-100-14


A-3

V. Hedging and Risk Management A. Hedging risk exposures reduces asset risk.

B. Hedging market exposure reduces required amount of risk capital.

C. If there are spread costs for risk capital and they depend on amount of risk capital, then reduction in risk capital from hedging will lead to lower costs of risk capital if hedges can be acquired at relatively small spreads. VI. Capital Allocation and Capital Budgeting A. Incremental cost of risk capital is proportional to incremental amount of risk capital.

B. Diversification can dramatically reduce firm’s overall risk capital.

C. In effect, businesses coinsure one another requiring less external asset insurance.

D. If marginal risk capital is used for allocation among businesses, some risk capital will not be allocated to any business.

E. Conclusions 1. Full allocation of risk capital overstates marginal amount of risk capital. 2. Risk capital evaluated on a stand-alone basis overstates marginal risk capital. F. Risk capital is a function of 1. Riskiness of net assets affected by correlations among business units. 2. Value of net assets affected by their correlation with broad market. VII. Summary and Conclusions A. Amount of risk capital is uniquely determined and depends only on riskiness of net assets.

B. Amount of risk capital is not affected by form of financing of net assets.

C. Risk capital is used to purchase asset insurance.

D. Economic costs of risk capital are spreads on price of asset insurance that stem from 1. Information costs. 2. Agency costs. E. Risk capital of multi-business firm is less than aggregate risk capital of businesses on stand-alone basis.

F. Full allocation of risk capital across individual businesses is generally not feasible.

G. Attempts can significantly distort true profitability of individual businesses.

SN LRM-100-14


A-4

VIII. Technical Appendix Risk Capital = A0F(1,1,0,T,σ) ≈ .4A0σ√T

where

F(S,E,r,T,σ) = Black-Scholes formula for European call option on stock.

S = Initial value of stock E = Exercise price r = Riskless rate T = Expiration date σ = Volatility of profits IX. Questions A. Define risk capital and how it differs from regulatory capital and cash capital? B. How is risk capital determined? C. How is risk capital accounted for in the calculation of profits? D. What is the economic cost of risk capital?

SN LRM-104-14


A-5

SN LRM-104-14 RETHINKING RISK MANAGEMENT

Note from the author: It is important to understand the costs that can be reduced by proper risk management, the link between risk management, risk-taking and the capital structure and finally the characteristics of VaR and how it can be improved. I. Introduction A. Apparent conflict between theory and current practice of corporate risk management. B. Theory suggests company facing large exposures can increase their market values by using derivatives to reduce exposures. C. Actual corporate use of derivatives 1. Large companies make far greater use of derivatives. 2. Many companies appear to be using derivatives for other goals than reducing variance. 3. Popularity of selective hedging as opposed to full-cover hedging. D. Different goal for corporate risk management: elimination of costly lower-tail outcomes. E. Risk management can change both capital and ownership structure. F. Value at Risk (VaR) measures 1. Not useful for most applications by non-financial companies. 2. Not consistent with new objective of risk management. G. Attention should be on evaluation and control of corporate risk-management activities. II. Risk Management in practice A. Wharton-Chase study 1. Most value-maximizing firms do not hedge. 2. Only one-third of companies ever used futures, forwards, options or swaps. 3. Large companies make greater use of derivatives. 4. Main uses a. To hedge contractual commitments. b. To hedge anticipated transactions expected to take place within a year. 5. Companies never use derivatives to a. Reduce funding costs. b. Hedge balance sheets, foreign dividends, economic or competitive exposures. 6. Over a third of users sometimes actively take positions that reflect their market views.

SN LRM-104-14


A-6

B. Dolde survey 1. Corporate use of derivatives requires considerable upfront investment. 2. Larger companies reported greater use of derivatives. 3. Almost 90% of users said they sometimes took a view. 4. Larger companies were more inclined to self-insure their rate risks. C. Metallgesellchaft 1. MGRM, US oil marketing subsidiary. 2. It took a far larger position than would have been consistent with a variance- minimizing strategy. 3. Traders thought they could benefit from their specialized information. 4. MGRM was hedged against changes in spot oil prices. 5. It had a long position in the basis. D. Daimler-Benz 1. Management attributed losses to exchange rate losses due to weakening dollar. 2. Analysts attributed decision to remain unhedged to the view of the company that the dollar would not decrease so much. III. The Perspective of Modern Finance A. Introduction 1. Pillars of modern finance theory are concepts of efficient markets and diversification. 2. Behind most large derivative losses, there are conscious decisions to bear significant exposures with hope of earning abnormal returns. 3. Attempt to earn higher returns generally means bearing large and unfamiliar risks. 4. Concept of market efficiency should discourage corporations from creating exposures to financial market risks. 5. Concept of diversification should discourage some companies from hedging financial exposures incurred through normal business operations. 6. Company’s cost of capital depends on strength of firm’s tendency to move with broad market (covariance) rather than its overall volatility (variance). 7. Major costs associated with higher variability a. Higher expected bankruptcy costs. b. Higher expected payments to corporate stakeholders. c. Higher expected tax payments. B. Risk Management Can Reduce Bankruptcy Costs

1. By eliminating bankruptcy costs value of firm’s equity is increased by

Bankruptcy costs probability of bankruptcy if firm remains unhedged.

2. This argument extends to distress costs in general.

SN LRM-104-14


A-7

C. Risk Management Can Reduce Payments to Stakeholders 1. It can also reduce required returns to owners of closely held firms. 2. Hedging financial exposures adds value by reducing owners’ risks. D. Risk Management Can Reduce Taxes 1. By reducing fluctuations in taxable income. 2. Because of progressivity or convexity of most tax codes. IV. Risk Management and Comparative Advantage in Risk-Taking A. The Importance of Understanding Comparative Advantage 1. Article from Braas and Bralver. 2. Most FX trading profits come from market making, not position taking. 3. Not understanding comparative advantage will a. Fail to generate consistent profit. b. Endanger the existing comparative advantage. 4. Best approach to determine when company should take risks is to implement a risk- taking audit: review of risk exposures. V. The Link Between Risk Management, Risk-Taking and Capital Structure A. Risk management can be viewed as a direct substitute for equity capital. B. Use of risk management to reduce exposures increases debt capacity. C. AAA Companies 1. Would not hedge aggressively. 2. Should consider substitution of debt for equity and increase leverage. 3. This allows for greater concentration of equity ownership. VI. Corporate Risk Taking and Management Incentives A. Study by Peter Tufano. B. Considerable variation in hedging behavior of 48 public gold mining companies. C. Only important systematic determinant of hedging decisions: Managerial ownership of shares. D. Greater share ownership leads to larger hedging of gold price exposure. E. Managerial compensation contracts that emphasize options were associated with less hedging. F. Asymmetric payoff structure of options increases willingness to take bets.

SN LRM-104-14


A-8

G. Tufano concludes that neither of strategies, no hedging or significant hedging, seems to increase shareholder value while both appears to serve managers’ interests. H. Given that a firm has chosen to concentrate equity ownership, hedging may be a value- adding strategy. I. If risk-taking within firm is decentralized, important to understand incentives of those who make decisions to take or lay off risks. VII. Measuring Risk or Improving on VaR A. VaR is used to quantify probability of lower-tail outcomes. B. VaR at 95% confidence level = Average – 1.65 x standard deviation. C. Dollar value of maximum expected losses = VaR x holdings. D. Special appeal of VaR: Ability to compress expected distribution of bad outcomes into a single number. E. Difficulties in extending VaR over long time horizons 1. Daily VaR can be relatively precise, but what about an annual VaR. 2. Reliance of VaR on normal distribution: tail probabilities are generally larger. F. An Alternative to VaR: Using Cash Flow Simulations to Estimate Default Probabilities 1. Assess probability of financial distress by conducting sensitivity analysis on expected distribution of cash flows.

2. Use Monte Carlo simulation techniques.

3. Advantages a. Ability to incorporate any special properties of cash flows. b. Ability to build serial dependence of cash flows. VIII. Managing Risk Taking A. To evaluate if a bet is worth taking, its expected profit must exceed increase in probability of financial distress times expected cost of financial distress. B. For AAA firm 1. Appropriate benchmark is expected gain adjusted for risk. 2. Abnormal or excess return should be measure for evaluating AAA bets. C. Incentive payments should encourage managers to take only those bets expected to increase shareholder wealth.

SN LRM-104-14


A-9

IX. Conclusion A. Primary goal of risk management is to eliminate probability of costly lower-tail outcomes. B. Moreover, it can help move firms toward their optimal capital and ownership structure. C. Some companies may have comparative advantage in bearing certain financial market risks. D. Important to evaluate managers’ bets on a risk-adjusted basis and relative to the market. X. Questions A. What are the costs that can be reduced by proper risk management? B. What is the link between risk management, risk-taking and the capital structure? C. How can VaR be used to measure risk and what can be done to improve VaR?

SN LRM-104-14


A-10

LRM-123-15


A-11

LRM-123-15 ENTERPRISE RISK MANAGEMENT

I. Introduction A. Goal is to help market participants better understand S&P’s approach to assessing

insurance companies’ enterprise risk management (ERM)

B. Scope—it applies to all global ratings

C. Criteria

1. S&P examines whether insurers execute risk management practices in a systematic, consistent ad strategic manner across the enterprise that effectively limits future losses with the insurers’ optimal risk/reward framework

2. ERM provides a prospective view of the insurer’s risk profile and capital need

3. ERM analysis is tailored to each insurer’s risk profile

4. Focus is on five sub-factors of enterprise risk management analysis

a. Risk management culture b. Risk controls c. Emerging risk management d. Risk models e. Strategic risk management

II. Assumptions

A. Determining an insurer’s risk management score

1. Overall score is

a. Ranked either very strong, strong, adequate with strong risk

controls, adequate and weak

b. Based on assessments of the five factors which are classified as positive, neutral or weak

2. The analysis is evidence based; a neutral score can mean that evidence

was insufficient to assign a positive or negative score

A-12 LRM-123-15


3. Very strong assessment

a. Guideline—positive score for all sub-factors and economic capital model is assessed either good or superior

b. What it means

i. Insurer has strong capabilities to consistently identify, measure and manage its risk exposures within its risk tolerances

ii. Risk control processes are leading edge, applied consistently and executed effectively

iii. Consistent evidence of the insurer’s practice of optimizing risk adjusted returns

iv. Risk and risk management heavily influence the insurer’s decision making

v. Insurer is unlikely to experience unexpected losses outside of risk tolerances

4. Strong assessment

a. Guideline—risk management culture, risk controls and strategic

risk management sub-factors are scored positives, one or both of the other two sub-factors is scored neutral and no factor is scored negative

b. What it means

i. Insurer has strong capabilities to consistently identify, measure and manage risk exposures within risk tolerances

ii. Clear evidence of maximizing risk adjusted returns, but shorter track record of success

iii. Risk and risk management are important considerations in insurer’s decision making

iv. Somewhat more likely to experience an unexpected losses

5. Adequate with strong risk control assessment

a. Guideline—Risk controls sub-factor is scored positive, strategic

risk management sub-factor is scored neutral and no sub-factor is scored negative

b. What it means

i. Has all the characteristics of the adequate assessment ii. Insurer has established a variety of risk controls that are

positive

LRM-123-15


A-13

6. Adequate assessment

a. Guideline—Risk controls and risk monument culture sub-factors are scored at least neutral; overall less than adequate with strong risk control

b. What it means

i. Insurer has strong capabilities to consistently identify, measure and manage risk exposures within risk tolerances

ii. Risk tolerance guidelines are less developed iii. Insurer demonstrates sufficient execution of existing risk

management program iv. Risk and risk management are often important

consideration in decision making v. More likely to incur unexpected losses

7. Weak assessment

a. Guideline—one or both of the risk controls and risk management culture sub-factors are scored negative

b. What it means

i. Insurer has limited capabilities to identify, measure and manage risk exposures across the enterprise

ii. Insurer demonstrates sporadic execution of its risk management program

iii. The insurer has not adopted a risk management framework

iv. Risk and risk management are sometimes considered in decision making

B. Risk management culture

1. ERM is well entrenched in the organization with a formal ERM

framework

2. Insurer has a clear vision of enterprise risk profile and risks are managed within risk tolerances

3. Insurer risk management framework is clearly communicated and linked to risk limits

4. Insurer has a culture of risk communication and information sharing

5. Incentive compensation supports ERM goals

A-14 LRM-123-15


C. Risk controls

1. All material risk identified 2. Insurer has a comprehensive risk limit system and formal breach

policies 3. Insurer uses multiple risk management strategies to manage exposure

within limits 4. Generally scored positive and no controls are negative

D. Emerging risk management—well established process to identify and monitor

emerging risks

E. Risk models

1. All material risks are captured 2. Insurer models have robust validations 3. Model limitations are understood and compensated for 4. Models perform stochastic and deterministic scenarios 5. Insurer uses model results in decision making

F. Strategic risk management

1. Track record of consistently using a risk vs reward decision making

process

2. Risk measurement significantly influences decisions around pricing, capital allocation, strategic planning reinsurance and asset allocation

III. Risk management culture A. Risk governance and organization structure

1. Positive rating if a formal well defined and indecent risk governance

and ERM organization structure exists

2. Neutral score if the process is new or is not fully comprehensive

3. Negative score if management displays a lack of understanding of the importance of ERM and has insufficient involvement with the ERM process

B. Risk appetite framework

1. Positive score means a well-defined risk appetite framework that

support the effective selection of risks commensurate with rewards

2. Neutral sub-factor means risk appetite is less clearly defined or communicated

3. Negative score means insurer has failed to demonstrate a clear understanding of their risk profile

LRM-123-15


A-15

C. Risk reporting and communication

1. A positive score means extensive and clear communications internally and externally around risk exposure and ERM practice

2. A neutral score means it does not fit in the other categories

3. Negative score is for insurers who use only very limited internal risk communications

D. Incentive compensation structures

1. A positive score alignment of compensation structure with metrics that

encourage long term goals rather than incentivizing excessive risks

2. Neutral score if compensation is not supported by robust reward metrics

3. Negative score means that short tem profitability or business volume is the key factor in compensation design

IV. Risk controls A. Positive if an effective risk control gram is in place to consistently identify,

measure ,monitor and control risk B. Neutral means that a generally effective risk control process is in place, but it is

less comprehensive, less effective or new

C. Negative assessment only occurs when a risk is a material exposure to the insurer and there are major deficiencies in the risk control process

V. Emerging risk management

A. Analyzes how the insurer addresses risks that are not a current threat to creditworthiness, but could become a threat in the future

B. It assess the level of preparedness if the risks materialized such as regulation, medical developments and macroeconomic changes

1. Positive if the insurer has processes to consistently identify, assess,

monitor and mitigate threats of emerging risks

2. Neutral core if some processes are in place but they are limited

3. Negative sore if no emerging risk management process

A-16 LRM-123-15


VI. Risk models A. Positive if risk model system capture’s material risk exposures and

interrelationships between risks

B. Neutral if processes are less comprehensive and robust

C. Negative if

1. Models are incomplete 2. Reasonableness of the methodologies and assumptions are

questionable 3. Risk models only satisfy regulatory requirements 4. Limited sensitivity and stress testing

VII. Strategic risk management

A. Positive if insurer executes consistent and effective risk/reward analysis on the

majority of the key areas of analysis

B. Neutral is some risk reward analysis exists but is not comprehensive

C. Negative if a risk reward optimization strategy is not used

VIII. Appendix I: Definitions A. Risk appetite is the framework that establishes the risks that the insurer wishes to

acquire, avoid, retain or reduce

B. Risk preferences are the qualitative risk appetite statements that guide the insurer in the selection of risks

C. Risk tolerance is the quantitative risk appetite statements that guide the insurer in

the selection of risks, typically specifying maximum acceptable losses; it translates qualitative risk statements into action by constraining an insurer’s exposures to risk

D. Risk limits are quantitative boundaries that serve to constrain specific risk taking

activities at the operational level within the business

LRM-123-15


A-17

IX. Appendix II: Risk controls of major risks A. Risk control assessments

1. For each of an insurer’s major risks, assign one risk control score by

assessing the overall effectiveness of the risk control process including

a. The quality of risk identification—a comprehensive process of identifying all risk exposures

b. Risk measurement and monitoring

i. Insurer monitors all significant risks on a regular basis using multiple measures

ii. The insurer uses a combination of stochastic analysis, deterministic sensitivity and stress tests

iii. Insurer has comprehensive risk reports that are updated frequently to reflect risk profile

iv. Risk exposure is clearly communicated to all levels in the organization

c. The comprehensiveness and robustness of risk limits and standards

i. Clearly documented and comprehensive risk limits with early warning systems

ii. Risk limits are related to risk tolerances and communicated

iii. Risk limits are expressed in multiple measures iv. Documents and communicates risk policies and has

formal product development policies to ensure products comply with risk standards

d. The rigor of the procedures to manage risks

i. Formal programs in place using multiple strategies to proactively manage risk

ii. Formal risk management structure iii. Clear rationales support risk management strategies iv. Risk management is a key consideration in pricing new

products v. Insurer has a good track record of not incurring losses

outside established risk limits vi. Situations outside the limits are constantly monitored

and resolved

A-18 LRM-123-15


e. The execution and the results of effectiveness of risk programs

i. Clear process to correct a breach of risk limits with early warnings

ii. Frequent monitoring of compliance against risk limits and policies

iii. Situations outside the limits are constantly monitored and resolved

iv. Risk exposures are managed within chosen risk limits

2. Risk learning

a. Defined process to analyze and learn from past losses b. Insurer performs back testing to ensure effectiveness

B. Credit risk controls

1. Credit risk is the exposure an insurer faces for incurring economic losses caused by the default of another company on its obligation or losses form the perceived or actual deterioration of another company’s creditworthiness

2. Positive assessment

a. Insurer has identified a captured all potential credit risk sources b. Insurer uses multiple metrics to measure credit exposure c. Insurer’s risk control framework takes codependences between

sources of credit into account d. Frequent stress testing e. Comprehensive credit risk limits are used f. Risk limits are expressed in multiple measurements g. Counterparty risk strictly managed through a centralized process

C. Interest risk controls

1. Processes of identifying and measuring exposures of assets and

liabilities to losses resulting from movements in interest rate components and managing and mitigating risks to be consistent with goals and risk appetite


a. Insurer has identified and captured all exposures from assets and liabilities to interest rate risk

b. All relevant component exposures are measured and monitored using multiple metrics

c. Risk limits are at sub-portfolio levels d. Stress testing is performed e. Multiple interest rate risk management strategies are used f. Product development works closely with risk management

LRM-123-15


A-19

D. Market risk controls

1. Market risk is capturing the exposure to equity, real estate and foreign

exchange risk and its ability to manage and mitigate risks


a. Insurer identified and captured equity, real estate and foreign exchange risk for all sources

b. Frequency of risk measurement is consistent with hedging strategy

c. Applied metrics capture all relevant equity risks d. Insurer uses comprehensive risk limits expressed in multiple

metrics e. Insurer effectively measures foreign exchange exposure f. Insurer applies hedging strategies and risk mitigation techniques

to ensure risk exposure are within risk limits g. Insurer has a clearly defined hedge program h. Insurer monitors hedge performance and frequently rebalances i. Insurer has well defined embedded risk mitigation j. Hedge performance, basis risk and attribution analyses are used

to support the hedge program k. Risk managers work with product mangers

E. Life and health insurance risk controls—mortality, longevity, morbidity and

policyholder behavior

1. Adverse deviations from actual experience to expected experience in pricing and reserving for mortality risk, longevity risk, morbidity risk and policyholder behavior risks


a. Insurer has identified and captured exposures from all sources and understands policyholder behavior risks

b. Insurer performs frequent and comprehensive experience studies to compare actual experience vs expected

c. Insurance has formal limits that are directly linked to its risk appetite

d. Insurer has clear underwriting standards and authorities that are well documented and communicated; compliance is monitored and audited

e. Insurer has a disciplined product development process and close monitoring of key profitability drivers

f. Insurer has a feedback loop to all areas of the company g. Pricing and valuation assumptions are prudently set and

refreshed frequently to reflect changes in experience and benefits

A-20 LRM-123-15


F. Property and casualty risk controls—reserve and claim managements risk

1. Definition

a. Reserve risk is the uncertainty surrounding the level of reserves ultimately needed to meet all liabilities and the timing of those liabilities

b. Claims risk arises when the claim paid deviate significantly from the insurer’s expectation due to irregularities in the claims process, insufficient rigor in the claims process or unexpected legislative, regulatory or court intervention in the claims process


a. Insurer has a track record of reserve releases consistent with target reserve levels and an effective feedback loop to underwriting and claims

b. Insurer has a centralized reserve function independently from the risk taking business function

c. Assumptions are robust and allow for emerging changes d. Insurer uses appropriate and extensive data in setting

assumptions, reconciles to ensure completeness and may supplement with external data

e. Stochastic reserve models are used to evaluate the risk of adverse reserve development

f. Insurer has deep n house expertise supplemented by external expertise

g. Insurer uses a robust review process h. Insurer has a well-defined and extensive claims management

framework with clear authority levels that are consistently applied

G. Property and casualty risk controls—underwriting, pricing and cycle

management risks

1. Definition

a. Underwriting risk is the risk that insurance coverage offered has a different risk profile than needed to achieve profitability

b. Pricing risk is the risk that the actual loss distribution will differ from pricing

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a. Track record of underwriting returns with low volatility b. Insurer uses a comprehensive system of underwriting authorities c. Insurer performs rigorous audits d. Underwriting has quality controls e. Insurer uses a portfolio approach to set underwriting targets f. Insurer has robust cycle management g. Insurer uses advanced analysis for pricing and has a stable record

of pricing across an underwriting cycle h. Insurer uses multiple risk management strategies

H. Property and casualty insurance risk controls—catastrophe risks

1. The risk that a single event or a series of events of major magnitude

over a short period leads to significant deviation in actual claims from expected claims. They are typically infrequent but significant in loss potential

2. Key areas of assessment are

a. The insurer’s risk tolerance for catastrophe risk b. Risk correlations c. Modeling risk by quantifying exposures related to a catastrophic

event


a. Insurer has a granular and up to date view of catastrophe risk exposure

b. Catastrophe risk tolerance is well designed and supported by a clear rational and analysis

c. Insurer has a comprehensive system of risk limits and risk taking is constrained by the limits

d. Insurer performs frequent and thorough analysis of concentration e. Insurer has deep in house expertise f. Insurer performs regular rigorous review of proprietary models g. Insurer performs validation of vendor provided models h. Insurer uses scenario/impact analysis i. Insurer uses portfolio based pricing

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I. Health insurance risk controls—underwriting, pricing, claims management and provider renewal risks

1. Risks include rising medical costs, changing regulations and legislation, less than perfect underwriting and pricing processes; some exposures are unique

2. Definition

a. Underwriting risk arises when the health insurance coverage offered has a different risk profile form the expected loss distribution in pricing

b. Pricing risk is the risk health insurance premiums is insufficient and cannot be adjusted quickly to cover the cost

c. Claim management risk is the risk of failures to identify claims abuse, mis-assessment of treatment necessity and claim cost development

d. Provider renewal risk arise when the health insurer experiences a drastic rise or sudden changes in health service cost of providers


a. Insurer uses a disciplined underwing process with clearly defined limits

b. The insurer performs active monitoring analysis of claim experience

c. The insurer performs reviews and audits of underwriting and claim management

d. Insurer performs an ongoing review of health care trends, medical advances and medical costs and assess their impact and mitigation strategies

e. Insurer staggers rate renewals throughout the year to facilitate prompt pricing adjustments

f. Insurer maintains effective communication with regulators and providers to avoid surprises

g. Insurer carefully selects reinsurance coverage, balancing risk retention and risk transfer

J. Operational risk controls

1. Operational risk is the risk of loss resulting from inadequate or failed

internal processes, people, systems or from external events and incudes reputational risk

2. Insurers are subject to vastly different operational risks, but the following are essential

a. Procedures in place to identify, monitor, assess and mitigate

operational risks b. A sound business continuity plan is in place

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a. Insurer has thoroughly defined all major operational risks using

its own experience b. For each key risk, risk owners are assigned, close monitoring is

in place, mitigation actions are initiated and progress monitored c. Insurer has comprehensive compliance standard that are clearly

documented, well communicated and subject to rigorous compliance reviews and audits

d. The insurer has effective internal audit and compliance functions that work closely with the ERM function

e. Business continuity and data recovery programs in place and regularly tested

f. Loss events are recorded and quantified g. No major loss from operations in recent years

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