Académique Documents
Professionnel Documents
Culture Documents
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Topic
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Executive Summary
What Is Risk?
How Insurance Works?
Introduction To Risk Management
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9
10
Other Risks
Potential Risk Treatments
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21
11
24
12
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36
15
44
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Conclusion
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Bibliography
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EXECUTIVE SUMMARY
Risk, in insurance terms, is the possibility of a loss or other adverse event that has the
potential to interfere with an organizations ability to fulfill its mandate, and for which an
insurance claim may be submitted.
Risk management ensures that an organization identifies and understands the risks to
which it is exposed. Risk management also guarantees that the organization creates
and implements an effective plan to prevent losses or reduce the impact if a loss
occurs.
A risk management plan includes strategies and techniques for recognizing and
confronting these threats. Good risk management doesnt have to be expensive or time
consuming; it may be as uncomplicated as answering these three questions:
1. What can go wrong?
2. What will we do, both to prevent the harm from occurring and in response to the
harm or loss?
3. If something happens, how will we pay for it?
Risk management provides a clear and structured approach to identifying risks. Having
a clear understanding of all risks allows an organization to measure and prioritize them
and take the appropriate actions to reduce losses. Risk management has other benefits
for an organization, including:
Saving resources: Time, assets, income, property and people are all valuable
resources that can be saved if fewer claims occur.
Protecting the reputation and public image of the organization.
Preventing or reducing legal liability and increasing the stability of operations.
Protecting people from harm.
Protecting the environment.
Enhancing the ability to prepare for various circumstances.
Reducing liabilities.
Assisting in clearly defining insurance needs.
An effective risk management practice does not eliminate risks. However, having an
effective and operational risk management practice shows an insurer that your
organization is committed to loss reduction or prevention. It makes your organization a
better risk to insure
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WHAT IS RISK?
The Concise Oxford Dictionary defines risk as hazard, a chance of bad consequences,
loss or exposure to mischance. In a discussion with students taking a course on
financial risk management, ingredients which typically enter are events, decisions,
consequences and uncertainty. Mostly only the downside is mentioned, rarely a
possible upside. For financial risks, the subject of this book, we might arrive at a
definition such as any event or action that may adversely affect an organizations ability
to achieve its objectives and execute its strategies or, alternatively, the quantifiable
likelihood of loss or less-than-expected returns. But while these capture some of the
elements of risk, no single one sentence definition is entirely satisfactory in all contexts.
People seek security. A sense of security may be the next basic goal after food,
clothing, and shelter. An individual with economic security is fairly certain that he can
satisfy his needs (food, shelter, medical care, and so on) in the present and in the
future. Economic risk (which we will refer to simply as risk) is the possibility of losing
economic security. Most economic risk derives from variation from the expected
outcome. One measure of risk, used in this study note, is the standard deviation of the
possible outcomes. As an example, consider the cost of a car accident for two different
cars, a Porsche and a Toyota.
In the event of an accident the expected value of repairs for both cars is 2500. However,
the standard deviation for the Porsche is 1000 and the standard deviation for the Toyota
is 400. If the cost of repairs is normally distributed, then the probability that the repairs
will cost more than 3000 is 31% for the Porsche but only 11% for the Toyota.
Modern society provides many examples of risk. A homeowner faces a large potential
for variation associated with the possibility of economic loss caused by a house fire. A
driver faces a potential economic loss if his car is damaged. A larger possible economic
risk exists with respect to potential damages a driver might have to pay if he injures a
third party in a car accident for which he is responsible.
Historically, economic risk was managed through informal agreements within a defined
Community. If someones barn burned down and a herd of milking cows was destroyed,
the community would pitch in to rebuild the barn and to provide the farmer with enough
cows to replenish the milking stock. This cooperative (pooling) concept became
formalized in the insurance industry. Under a formal insurance arrangement, each
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insurance policy purchaser (policyholder) still implicitly pools his risk with all other
policyholders. However, it is no longer necessary for any individual policyholder to know
or have any direct connection with any other policyholder.
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Risk management also faces difficulties in allocating resources. This is the idea of
opportunity cost. Resources spent on risk management could have been spent on more
profitable activities. Again, ideal risk management minimizes spending and minimizes
the negative effects of risks.
Principles of risk management
The International Organization for Standardization (ISO) identifies the following
principles of risk management:
Risk management should:
Create value
Be an integral part of organizational processes
Be part of decision making
Explicitly address uncertainty
Be systematic and structured
Be based on the best available information
Be tailored
Take into account human factors
Be transparent and inclusive
Be dynamic, iterative and responsive to change
Be capable of continual improvement and enhancement
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Risk Control
Risk Financing
Administration
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As we noted in Table 1.2, Examples of Pure versus Speculative Risk Exposures, risk
professionals often differentiate between pure risk that features some chance of loss
and no chance of gain (e.g., fire risk, flood risk, etc.) and those they refer to as
speculative risk. Speculative risks feature a chance to either gain or lose (including
investment risk, reputational risk, strategic risk, etc.). This distinction fits well into
Figure 1.3, Roles (Objectives) Underlying the Definition of Risk. The right-hand side
focuses on speculative risk. The left-hand side represents pure risk. Risk professionals
find this distinction useful to differentiate between types of risk.
Some risks can be transferred to a third partylike an insurance company. These third
parties can provide a useful risk management solution. Some situations, on the other
hand, require risk transfers that use capital markets, known as hedging or
securitizations. Hedging refers to activities that are taken to reduce or eliminate risks.
Securitization is the packaging and transferring of insurance risks to the capital markets
through the issuance of a financial security. We explain such risk retention in Chapter 4,
Evolving Risk Management: Fundamental Tools and Chapter 5, The Evolution of Risk
Management: Enterprise Risk Management. Risk retention is when a firm retains its
risk. In essence it is self-insuring against adverse contingencies out of its own cash
flows. For example, firms might prefer to capture up-side return potential at the same
time that they mitigate while mitigating the downside loss potential.
In the business environment, when evaluating the expected financial returns from the
introduction of a new product (which represents speculative risk), other issues
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concerning product liability must be considered. Product liability refers to the possibility
that a manufacturer may be liable for harm caused by use of its product, even if the
manufacturer was reasonable in producing it.
Table 1.2, Examples of Pure versus Speculative Risk Exposures provides examples of
the pure versus speculative risks dichotomy as a way to cross classify risks. The
examples provided in Table 1.2, Examples of Pure versus Speculative Risk Exposures
are not always a perfect fit into the pure versus speculative risk dichotomy since each
exposure might be regarded in alternative ways. Operational risks, for example, can be
regarded as operations that can cause only loss or operations that can provide also
gain. However, if it is more specifically defined, the risks can be more clearly
categorized.
The simultaneous consideration of pure and speculative risks within the objectives
continuum of Figure 1.3, Roles (Objectives) Underlying the Definition of Risk is an
approach to managing risk, which is known as enterprise risk management (ERM).
ERM is one of todays key risk management approaches. It considers all risks
simultaneously and manages risk in a holistic or enterprise-wide (and risk-wide) context.
ERM was listed by the Harvard Business Review as one of the key breakthrough areas
in their 2004 evaluation of strategic management approaches by top management.[9] In
todays environment, identifying, evaluating, and mitigating all risks confronted by the
entity is a key focus. Firms that are evaluated by credit rating organizations such as
Moodys or Standard & Poors are required to show their activities in the areas of
enterprise risk management. As you will see in later chapters, the risk manager in
businesses is no longer buried in the tranches of the enterprise. Risk managers are part
of the executive team and are essential to achieving the main objectives of the
enterprise. A picture of the enterprise risk map of life insurers is shown later in
Figure 1.5, A Photo of Galveston Island after Hurricane Ike.
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Brand risk
Operational risk: mistakes in process or procedure that Credit risk (at the individual
cause losses
enterprise level)
Mortality and morbidity risk at the individual level
wars,
Speculative RiskPossible
Gains or Losses
Investment risk
Research
risk
and
development
Within the class of pure risk exposures, it is common to further explore risks by use of
the dichotomy of personal property versus liability exposure risk.
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Intellectual property
Pure and speculative risks are not the only way one might dichotomize risks. Another
breakdown is between catastrophic risks, such as flood and hurricanes, as opposed to
accidental losses such as those caused by accidents such as fires. Another
differentiation is by systemic or non diversifiable risks, as opposed to idiosyncratic or
diversifiable risks; this is explained below.
F) Diversifiable and Non diversifiable Risks
As noted above, another important dichotomy risk professionals use is between
diversifiable and non diversifiable risk. Diversifiable risks are those that can have their
adverse consequences mitigated simply by having a well-diversified portfolio of risk
exposures. For example, having some factories located in non earthquake areas or
hotels placed in numerous locations in the United States diversifies the risk. If one
property is damaged, the others are not subject to the same geographical phenomenon
causing the risks. A large number of relatively homogeneous independent exposure
units pooled together in a portfolio can make the average, or per exposure, unit loss
much more predictable, and since these exposure units are independent of each other,
the per-unit consequences of the risk can then be significantly reduced, sometimes to
the point of being ignorable. These will be further explored in a later chapter about the
tools to mitigate risks. Diversification is the core of the modern portfolio theory in finance
and in insurance. Risks, which are idiosyncratic (with particular characteristics that are
not shared by all) in nature, are often viewed as being amenable to having their financial
consequences reduced or eliminated by holding a well-diversified portfolio.
Systemic risks that are shared by all, on the other hand, such as global warming, or
movements of the entire economy such as that precipitated by the credit crisis of fall
2008, are considered non diversifiable. Every asset or exposure in the portfolio is
affected. The negative effect does not go away by having more elements in the
portfolio. This will be discussed in detail below and in later chapters. The field of risk
management deals with both diversifiable and non diversifiable risks. As the events of
September 2008 have shown, contrary to some interpretations of financial theory, the
idiosyncratic risks of some banks could not always be diversified away. These risks
have shown they have the ability to come back to bite (and poison) the entire enterprise
and others associated with them.
Table 1.3, Examples of Risk Exposures by the Diversifiable and Non diversifiable
Categories provides examples of risk exposures by the categories of diversifiable and
non diversifiable risk exposures. Many of them are self explanatory, but the most
important distinction is whether the risk is unique or idiosyncratic to a firm or not. For
example, the reputation of a firm is unique to the firm. Destroying ones reputation is not
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a systemic risk in the economy or the market-place. On the other hand, market risk,
such as devaluation of the dollar is systemic risk for all firms in the export or import
businesses. In Table 1.3, Examples of Risk Exposures by the Diversifiable and Non
diversifiable Categories we provide examples of risks by these categories. The
examples are not complete and the student is invited to add as many examples as
desired.
Table 1.3. Examples of Risk Exposures by the Diversifiable and Non diversifiable
Categories
Diversifiable RiskIdiosyncratic
Risk
Reputational risk
Market risk
Brand risk
Regulatory risk
Political risk
Legal risk
or
technical
Operational risk
Strategic risk
Longevity risk at the individual
level
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Diversifiable RiskIdiosyncratic
Risk
G) Enterprise Risks
As discussed above, the opportunities in the risks and the fear of losses encompass the
holistic risk or the enterprise risk of an entity. The following is an example of the
enterprise risks of life insurers in a map in Figure 1.6, Life Insurers Enterprise Risks
Since enterprise risk management is a key current concept today, the enterprise risk
map of life insurers is offered here as an example. Operational risks include public
relations risks, environmental risks, and several others not detailed in the map in
Figure 1.4, Risk Balls. Because operational risks are so important, they usually include
a long list of risks from employment risks to the operations of hardware and software for
information systems.
Figure 1.6. Life Insurers Enterprise Risks
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Other Risks
A) ASSET RISK
Both life and general insurers hold investments to support their policy liabilities and
capital and are subject to a range of asset risks. These risks include:
Concentration risk arising from inadequate diversification (or excessive exposure to
a particular asset or obligor);
Credit risk the risk of default by obligors, counterparties or reinsurers;
Liquidity risk the risk of insufficient liquidity to meet obligations when required;
Market risk the risk of an adverse movement in the market value of assets not
matched by an equal and offsetting reduction in the market value of liabilities; and
Realization risk where asset values are dependent on the continuing operation of the
business.
These risks are common to other types of financial institution also. While each of these
risks requires management, different sectors of the financial system need to focus on
those risks that are most important for them. In banking, the most significant risk is the
credit risk stemming from banks lending activities. The liquidity risk that flows from
banks deposit-taking business is also important. In the insurance sector, the
characteristic asset risk is market risk. This is because insurers can, and often do,
choose to invest policyholders money in ways that do not match policy obligations. The
extent of this mismatching behaviour differs across insurers. Some insurers do not
mismatch at all, while others may mismatch on a large scale and in doing so introduce
substantial market risk.
The resilience of an insurer in the face of market risk can be usefully examined with the
help of a simple model .Of course, focusing only on those risks that are characteristic of
a given industry is unwise. For this reason, the banking sector is now sharpening its
focus on the risks involved in other areas such as trading. Similarly, as insurers become
more involved in lending, and more exposed to counterparty risks in their use of
derivatives for asset management, the insurance sector will need to improve its credit
risk management practices.
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B) Operational Risk
Like any business, insurance companies face a number of other risks, mainly
operational in nature (or else arising through the premium rating process which requires
assumptions to be made about operational matters, such as the level of expenses or
the rate of policy attrition).
These risks include:
Mistakes in promotional material or poor sales practices;
Unsound product design;
Errors in premiums or unit prices;
Errors in effecting reinsurance;
High rates of policy attrition;
Unanticipated expense overruns; systems failure;
Ill-disciplined investment activity; and fraud.
As with insurance and asset risks, both good management and capital are needed to
cope with risks such as these.
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Ideal use of these strategies may not be possible. Some of them may involve trade-offs
that are not acceptable to the organization or person making the risk management
decisions. Another source, from the US Department of Defense, Defense Acquisition
University, calls these categories ACAT, for Avoid, Control, Accept, or Transfer. This
use of the ACAT acronym is reminiscent of another ACAT (for Acquisition Category)
used in US Defense industry procurements, in which Risk Management figures
prominently in decision making and planning.
A) Risk avoidance
This includes not performing an activity that could carry risk. An example would be not
buying a property or business in order to not take on the legal liability that comes with it.
Another would be not flying in order not to take the risk that the airplane were to be
hijacked. Avoidance may seem the answer to all risks, but avoiding risks also means
losing out on the potential gain that accepting (retaining) the risk may have allowed. Not
entering a business to avoid the risk of loss also avoids the possibility of earning profits.
Hazard Prevention - Hazard prevention refers to the prevention of risks in an
emergency. The first and most effective stage of hazard prevention is the elimination of
hazards. If this takes too long, is too costly, or is otherwise impractical, the second
stage is mitigation.
B) Risk reduction
Risk reduction or "optimization" involves reducing the severity of the loss or the
likelihood of the loss from occurring. For example, sprinklers are designed to put out a
fire to reduce the risk of loss by fire. This method may cause a greater loss by water
damage and therefore may not be suitable. Halon fire suppression systems may
mitigate that risk, but the cost may be prohibitive as a strategy.
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Acknowledging that risks can be positive or negative, optimizing risks means finding a
balance between negative risk and the benefit of the operation or activity; and between
risk reduction and effort applied. By an offshore drilling contractor effectively applying
HSE Management in its organisation, it can optimise risk to achieve levels of residual
risk that are tolerable.
Modern software development methodologies reduce risk by developing and delivering
software incrementally. Early methodologies suffered from the fact that they only
delivered software in the final phase of development; any problems encountered in
earlier phases meant costly rework and often jeopardized the whole project. By
developing in iterations, software projects can limit effort wasted to a single iteration.
Outsourcing could be an example of risk reduction if the outsourcer can demonstrate
higher capability at managing or reducing risks.[11] For example, a company may
outsource only its software development, the manufacturing of hard goods, or customer
support needs to another company, while handling the business management itself.
This way, the company can concentrate more on business development without having
to worry as much about the manufacturing process, managing the development team,
or finding a physical location for a call center.
C) Risk sharing
Briefly defined as "sharing with another party the burden of loss or the benefit of gain,
from a risk, and the measures to reduce a risk."
The term of 'risk transfer' is often used in place of risk sharing in the mistaken belief that
you can transfer a risk to a third party through insurance or outsourcing. In practice if
the insurance company or contractor go bankrupt or end up in court, the original risk is
likely to still revert to the first party. As such in the terminology of practitioners and
scholars alike, the purchase of an insurance contract is often described as a "transfer of
risk." However, technically speaking, the buyer of the contract generally retains legal
responsibility for the losses "transferred", meaning that insurance may be described
more accurately as a post-event compensatory mechanism. For example, a personal
injuries insurance policy does not transfer the risk of a car accident to the insurance
company. The risk still lies with the policy holder namely the person who has been in
the accident. The insurance policy simply provides that if an accident (the event) occurs
involving the policy holder then some compensation may be payable to the policy holder
that is commensurate to the suffering/damage.
Some ways of managing risk fall into multiple categories. Risk retention pools are
technically retaining the risk for the group, but spreading it over the whole group
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involves transfer among individual members of the group. This is different from
traditional insurance, in that no premium is exchanged between members of the group
up front, but instead losses are assessed to all members of the group.
D) Risk retention
Involves accepting the loss, or benefit of gain, from a risk when it occurs. True self
insurance falls in this category. Risk retention is a viable strategy for small risks where
the cost of insuring against the risk would be greater over time than the total losses
sustained. All risks that are not avoided or transferred are retained by default. This
includes risks that are so large or catastrophic that they either cannot be insured against
or the premiums would be infeasible. War is an example since most property and risks
are not insured against war, so the loss attributed by war is retained by the insured.
Also any amounts of potential loss (risk) over the amount insured is retained risk. This
may also be acceptable if the chance of a very large loss is small or if the cost to insure
for greater coverage amounts is so great it would hinder the goals of the organization
too much.
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In the 1990s, new areas of risk management began to emerge that provide managers
with more options to protect their companies against new kinds of exposures. According
to the Risk and Insurance Management Society (RIMS), the main trade organization for
the risk management profession, among the emerging areas for risk management were
operations management, environmental risks, and ethics.
As forecast by RIMS, risk managers of corporations started focusing more on verifying
their companies' compliance with federal environmental regulations in the 1990s.
According to Risk Management, risk managers began to assess environmental risk
such as those arising from pollution, waste management, and environmental liability to
help make their companies more profitable and competitive. Furthermore, tighter
environmental regulations also goaded businesses to have risk managers check their
compliance with environmental policies to prevent possible penalties for noncompliance.
Companies also have the option of obtaining new kinds of insurance policies to control
risks, which managers and risk managers can take into consideration when determining
the best methods for covering potential risks. These nontraditional insurance policies
provide coverage of financial risks associated with corporate profits and currency
fluctuation. Hence, these policies in effect guarantee a minimum level of profits, even
when a company experiences unforeseen losses from circumstances it cannot control
(e.g., natural disasters or economic downturns). Moreover, these nontraditional policies
ensure profits for companies doing business in international markets, and hence they
help prevent losses from fluctuations in a currency's value.
Risk managers can also help alleviate losses resulting from mergers. Stemming from
the wave of mergers in the 1990s, risk managers became a more integral part of
company merger and acquisition teams. Both parties in these transactions rely on risk
management services to determine and control or prevent risks. On the buying side, risk
managers examine a selling company's expenditures, loss history, insurance policies,
and other areas that indicate a company's potential risks. Risk managers also suggest
methods for preventing or controlling the risks they find.
Finally, risk managers have been called upon to help businesses manage the risks
associated with increased reliance on the Internet. The importance of online business
activities in maintaining relationships with customers and suppliers, communicating with
employees, and advertising products and services has offered companies many
advantages, but also exposed them to new security risks and liability issues. Business
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Clash is a similar concentration risk that occurs when one or more business units insure
more than one line of business for the same policyholder which could be affected by the
same claim or incident. This could lead to a higher than intended aggregate loss.
Reasonable foresee ability and a large dose of common sense, together with an
effective name clearance system and an agreed exposure limit are the keys for
Underwriting and RM in managing these exposures.
Exposure to systemic risk arises from both natural and man-made catastrophic events.
Monitoring and managing risk accumulations requires detailed data (see below), models
and an underwriting infrastructure that spans all lines of business and all business units
that write policies in potentially exposed locations. Critical from a RM perspective is the
ability to monitor accumulations across lines of business and locations and to intervene
when aggregate limit boundaries are breached. Mitigation actions might include simply
abstaining from additional underwriting commitments (or no renewing existing
commitments upon expiry) or purchasing additional treaty or facultative reinsurance for
peak exposures. The critical element is having the infrastructure to identify unintended
accumulations across multiple business units and all lines of business.
The concentration risk of natural catastrophes arises primarily from exposure to
earthquakes, floods and windstorms. Property damage and business interruption
accumulations are typically modeled by using sophisticated commercial modeling tools
(RMS, AIR, EQECAT, etc.). Systemic risk also includes additional lines of business,
such as workers compensation, employers liability, accident and health, group life,
marine, and automobile physical damage. These exposures may not be coded to
location in the same detail as property policies, nor be subject to the same modeling
capability. As such, RM needs to be comfortable that processes are in place and
effective to identify peak property exposures through name and location clearance
systems in order to allow for identification of significant exposures to non-property lines
of business at the same location.
Man-made catastrophic events can similarly impact all lines of business. This category
includes events ranging from terrorism, primarily, to a train accident involving toxic
chemicals.
Terrorism exposures are generally divided into two categories:
conventional attacks (conventional bomb, aircraft used as a missile) and nonconventional (nuclear, chemical, biological, radiological NCBR e.g. a dirty bomb).
Property and business interruption policies may or may not include coverage for a
terrorist act or coverage for NCBR. Policies covering worker compensation or
employers liability, by their nature, may provide coverage for all such events. From a
RM perspective, its important that data be captured identifying policies with NCBR
coverage. It is also vital that the same infrastructure and modeling capability for
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monitoring and managing accumulations noted for natural catastrophes be in place for
man-made catastrophic exposures.
Stress Scenarios
Stress scenarios are especially necessary for determining aggregate limit boundaries
for natural and man-made catastrophic events and guiding decisions on purchasing
reinsurance protections. For example, in addition to considering the results generated
from the modeling tools, the ERM framework for Lloyds includes consideration of
specific Realistic Disaster Scenarios as a test of exposures under extraordinary
circumstances.
Further, RM is uniquely positioned in many insurance organizations to consider the
interaction of risks from different organizational silos in stress scenarios. Very low
probability events, like a 1 in 250 year windstorm or earthquake, a significant terrorism
incident, or a pandemic will require RM to have considered not just the underwriting risk
but to have incorporated the potential impact on the investment portfolio, liquidity,
reinsurance recoverable, and business continuity both from a holding company and
individual subsidiary legal entities level. Mitigation actions may then involve internal or
commercial reinsurance, standby credit, and/or similar arrangements to balance the
potential exposures and financial stress the organization faces.
Data Capture
Accurate, thorough, relevant, detailed data capture is key to measuring, modeling and
managing the risks of unintended exposure accumulations. RM needs to ensure that
adequate auditing is in place to allow reliance on the data collected. Similarly, RM
needs to be comfortable that underwriting has the processes in place to monitor and
manage individual account underwriting across multiple business units, policyholders
and lines of business to stay within agreed risk limits. Name clearance systems,
allowing each underwriter participating on a policyholders program to see all the
commitments to that policyholder, are an effective tool in this regard, as are systems to
monitor accumulations by class and line of business.
Detailed data capture is especially critical for monitoring property accumulations for
catastrophic exposure to both natural and man-made events. Granular data including
the policyholders type of business, number of employees, construction type and age,
values insured, business interruption coverage and limits, and so forth, for each precise
location (street address, latitude and longitude) are critical. Experience from many
insurers examining losses from Katrina has shown that modeled catastrophic exposures
were understated. One reason for this was incomplete data capture of insured
locations. Risk needs to be comfortable that data capture is complete and audited as
necessary for the modeled accumulations to be meaningful.
RM must also be forward thinking about data capture. It is not sufficient to think about
capturing data for risks that are current and obvious, but to also think about where the
emerging risks are arising and what data is necessary to assess these risks.
Reinsurance Risk
Reinsurance is a widely used and valuable tool for mitigating peak risks on both
individual accounts and portfolios. Inherent in reinsurance are several risks of concern
to the Risk Officer.
First and foremost RM must be attentive that the reinsurance purchased is actually
providing the appropriate coverage to mitigate the peak risks. In this regard, there
needs to be strong communication between underwriting and the reinsurance buying
function to ensure that underwriters are aware of the provisions of the reinsurance
treaties being purchased. In particular, awareness of exclusions or special acceptance
criteria is vital. On the facultative side, underwriters or facultative buyers must be
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trained to have coverage afforded by the facultative reinsurance be concurrent with the
terms of the underlying policy.
procedures are in place so all such arrangements receive appropriate oversight and
monitoring.
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Emerging Risks
Emerging risks are exposures which may develop or already exist. They are difficult to
quantify, may have a high loss potential and are marked by a high degree of
uncertainty. Risks involving emerging technologies or environmental changes require
identification, assessment, monitoring and mitigation. Examples of such emerging risks
would include nanotechnology, pandemics, genetically modified foods, changes in
weather patterns, and so forth. RM needs to ensure that Underwriting identifies
coverage triggers, lines of business potentially exposed, limits, accumulation potential
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across lines of business and policy years, reinsurance applicability and monitors
developments broadly in the insurance, healthcare and legal arenas. Mitigation actions
need to be agreed with Underwriting regarding coverage, limit and volume restrictions,
reinsurance protection and monitoring of potential accumulations. RM is a key driver in
determining the importance of identifying emerging risks, designing actions to contain
unintended accumulations and monitoring that risk measures are effectively in place.
Correlated Risk
Assessing the degree of correlation between lines of business and for each line to other
risk types is a critical requirement. It is necessary to determine risk capital and optimize
the mix by line, limits exposed and volume in order to minimize required capital through
diversification. Relevant experience may well be very limited for analyzing correlations,
especially at the critical stress levels most important to risk capital determinations.
Hence, RM generally needs to work closely with Underwriting to judgmentally assess
and agree the degree of correlation.
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RoE
Target
Time
Medium term
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Key risks faced by insurance sector globally - 18 March 2010 (Speech by Ken
Hogg, Director, Insurance Sector, FSA Insurance Sector Conference )
Last week we published our Financial Risk Outlook (FRO), outlining the main risks and
issues present in our operating environment, affecting firms, markets and consumers. It
includes chapters on the key prudential and conduct risks facing the financial sector, as
well as macro-prudential analysis.
Alongside this we also published Sector Digests, giving extra focus to the risks specific
to each financial sector. These reports are important as they outline the key risks facing
the FSA in our regulation of firms.
Want I want to do this morning is highlight some of the key insurance risks from these
reports, and outline what steps you can take to mitigate the risks. Ive got half an hour to
fill and, given the diversity between the risks facing the different parts of the insurance
sector, Im afraid to say Im going to need it.
But please be aware that what you hear today is only the edited highlights to fully
understand our focus and priorities this year, and the context in which well be making
decisions and taking action in the insurance space, theres no substitute for adding the
FRO and the Insurance Sector Digest to your reading list.
Capital and solvency
The first risks I want to highlight today relate to capital and solvency. Because although
the economic environment is more benign than this time last year, there are still many
short and longer-term prudential risks facing firms in this sector.
While our central scenario is one of steady recovery, there is still uncertainty around the
shape and pace of that recovery.
I joined the FSA in July, and since then the FTSE has risen by about 34% and bond
spreads are making their way back to pre-crisis levels. This has eased the immediate
pressure, but were not necessarily out of the woods yet.
As we travelled down the curve, the macroeconomic changes affected insurers in
different ways. The most marked difference being between the impact on the life sector,
where capital levels came under pressure and the non-life sector, where reserve
releases continued to support results, cushioning the impact of investment and
underwriting losses.
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But this is only half of the story. And even though we are now recovering, this economic
crisis has left behind a hangover for both parts of the sector, which will affect capital and
solvency positions for some time to come.
As Jon Pain highlighted in his earlier speech, when combined with the regulatory
developments coming this way in the next few years, without a change in firms
strategies and plans, many UK businesses will find it difficult to ever return to the levels
of income and profitability enjoyed before the crisis. I will return to this longer term
picture later.
Life insurers
In the life sector, the greatest challenges have been for those most exposed to falls in
asset values, widening bond spreads and low interest rates. In other words annuity
providers and with-profits firms.
Although some of these pressures have now eased, in the event of a further economic
decline, some of these firms may find it difficult to take actions to further conserve or
raise additional capital. So a key priority is to pay careful attention to capital
management and planning, with a particular focus on the risk of a further downturn in
the economy.
And what might that look like?
Firstly, its about monitoring your solvency position. Conditions can change very quickly
and being slow to realise whats happening and slow to respond could make a big
difference to both the capital conserving options available and the opportunity cost to
shareholders and policyholders of taking those actions. As Jon mentioned earlier,
regular and on-going stress testing is an important part of planning ahead.
Secondly, you need to exercise care in the valuation of assets and liabilities, and ensure
they are appropriately matched by duration. Annuity providers in particular remain
exposed to renewed widening of bond spreads.
Under Solvency II, a key issue is the extent to which annuity writers are able to reflect
the illiquid nature of their liabilities in their valuation. The recent industry/CEIOPS joint
task-force report on this thorny question suggests it should be possible to find
prudentially sound approaches to incorporating an allowance for illiquidity into the
Solvency II framework. The report is a positive step and gives the European
Commission a good basis on which to put forward proposals that will ensure future
retirees receive a fair deal.
And while not related to economic conditions, it is also important that annuity providers
continue to keep pace with changes in life expectancy. Although most have already
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strengthened assumptions in this area, we expect that you will need to continue to do
so.
Thirdly, guarantees and options must be appropriately valued and your stress and
scenario testing needs to show to what extent they remain affordable as economic
conditions change.
And finally, in raising additional capital, insurers considering innovative ways of
leveraging capital need to ensure that there is genuine risk transfer and that Mergers
and Acquisitions (M&A) transactions financed through debt dont diminish the overall
quality of capital. Weve already seen examples in some insurers and intermediaries of
how leveraged transactions have put pressure on cash flows, particularly in stressed
conditions, and we do not want to see this replayed across the sector.
So for the life sector as a whole, prudential challenges continue to loom large for 2010.
Capital management and capital planning are key to restoring the sectors strength and
for preparation to withstand any further economic shocks.
General insurers
The impact of the financial crisis on the general insurance sector was less immediate
and less significant, but the prolonged recession and the slow and uncertain recovery
have increased the prudential risks in this sector.
Firstly, the long-term structural changes to the economy arising from the financial crisis
may fundamentally alter the characteristics of risks insured by the industry. Pressure on
corporate clients to drive down costs and squeeze out margins could increase their
risks, which could in turn lead to a pick-up in insurance claims across commercial lines,
from business interruption to product and employers liability. Given that pricing
decisions rely on backward-looking data, how are you going to take account of the
changes to the trading environment in making future decisions on reserving, pricing and
underwriting?
Secondly, an economic downturn also tends to have an impact on peoples propensity
to claim, with increases in the number, size and type of claims.
This happens for a number of reasons:
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Firms should take care not to underplay this risk, they should ensure they are
monitoring trends and building this into decisions on reserving.
In this context then, the third risk I want to highlight is the re-emerging issue of reserving
adequacy. Recent years have seen record reserve releases, but this is likely to be
unsustainable in the claims environment Ive just described coupled with lower
investment returns and competitive pressures on price.
A more limited scope for reserve releasing, combined with lower investment returns
across the asset classes, will require firms to focus more on underwriting for profit. Any
loss of pricing discipline in this kind of environment could quickly eat into capital, and
firms need to be vigilant against the temptation to under price new business to remain
competitive.
And finally, further sizeable movements in exchange rates remain a risk to profitability
and capital. Any firm with a significant currency mis-match either on its balance sheet or
its P&L must continue to be prepared for the possibility of major shifts in either direction
especially given the uncertain macroeconomic conditions.
So while the journey into recession was less risky for the General Insurance (GI) sector,
some significant hangover effects remain.
Solvency II
But of course, as important as all these prudential risks are, the single biggest
prudential challenge for all firms in the insurance sector is Solvency II. As Jon
mentioned, Solvency II will radically alter the capital adequacy regime for the European
insurance industry.
The Individual Capital Adequacy Standards regime in the UK is a strong foundation on
which to make the transition to Solvency II, but the new directive goes much further.
The requirements for delivering and demonstrating the standards of risk management
and governance will be challenging, and especially so for groups that operate in multiple
countries. Solvency II will require greater disclosure and transparency, together with
additional and more frequent reporting.
Although there are some material technical issues that are not yet finalised, firms should
not be waiting for these to be resolved. There are bigger risks associated with
inadequate engagement than with managing through the uncertainty.
Thats all I want to say on Solvency II for now, because after the coffee break there is a
panel session on how far the UK has come in preparing for Solvency II and how much
there is still left to do. This is a chance for us to discuss and debate what material
challenges remain and what the FSA and you can do to ensure we manage this risk.
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Insurance intermediaries
My final comments on risks to capital and solvency concern intermediaries operating in
the insurance markets.
There is a risk that some firms in this sector dont have a realistic assessment of the
amount of financial resources required to run their business and that as a result some
firms are not meeting our threshold condition requirements. We published a Dear CEO
letter about this risk last month and later today it will be the subject of a panel
discussion.
This is an ongoing issue in this sector, but one we are now more concerned about given
the continuing challenges in the economic environment.
Another source of risk in this sector, which is also exacerbated by market conditions, is
the reliance of the broker business model on growth through acquisitions financed
through debt. In the current environment increased risks abound: servicing debt or
interest payments; the availability and cost of refinancing maturing debt; and goodwill
write-downs, pose a real challenge to the future viability of this business model.
Consumers
The second set of risks I want to highlight today are to do with consumers.
Across many parts of the life sector, the financial crisis and the following recession
appear to have reduced consumer demand for insurance products.
In the life sector, UK new business levels were down for the major groups in 2009 and
cash outflows from the existing book continue to exceed new inflows. At the same time,
the savings rate is up from -0.7% at the start of 2008 to 8.6% at the end of Q3 last
year. So although people are saving more, there is not much evidence that savings are
flowing into the insurance sector.
In the non-life sector there is also evidence to show consumers are becoming more
willing to drop incidental or non-compulsory insurance cover in order to save money.
ABI data from research carried out in June 2009 suggested that 22% of consumers
surveyed had stopped taking out home contents insurance and 17% had stopped taking
out buildings insurance.
And for intermediaries competing for commercial business, the drop in economic activity
in areas like construction and shipping has left the same number of firms chasing less
business.
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This is all bad news. Consumer behaviour is difficult to predict and its difficult to
influence. When the economic environment does pick up, how are you going to attract
them back and how are you going to get by in the meantime? Heres my list of dos and
donts.
One: Do review your strategies and plans for new business. Perhaps it was good
fortune, but my years leading marketing and strategy were when consumer demand
(and capital) was more bountiful. However, in the last couple of years in Chief Financial
Officer (CFO) roles, I have worked closely with sales and marketing directors on getting
the right new business mix and design in this new, challenging environment, so I
appreciate how much of a challenge this is.
Two: Do manage the temptation to adopt aggressive, high-growth strategies to
compensate for business lost during the recession. Or at least where you diversify into
new markets and new products, make sure youve sufficient understanding at all
levels in the business of the risks inherent in these new activities. And where you
grow by M&A, treat your new and existing customers fairly throughout the process, and
in-line with what they were promised when they bought their policy. Ensure you keep a
close eye on operational integrations to avoid adverse consequences for customer data
and service.
Three: Do focus on restoring consumer confidence by providing products that
consumers want and reducing the risk of them buying products they dont need. Your
products must offer real benefits to customers and the risks and limitations must be
made clear. They should be designed, targeted and marketed appropriately and in the
panel session on our approach to conduct issues later today youll find out more about
what the FSA intends to do to check that this is the case.
Now on to the donts. And Ive taken great care to ensure theyre only equal in length to
my dos.
One: Dont be tempted to seek to bolster your margins by taking actions that could
cause consumer detriment. Examples might include: unfairly rejecting legitimate claims;
reducing claims payments; or applying unfair contract terms. This is the lose/lose/lose
option. Its an unsustainable way to run your business; you risk further damaging
consumer confidence in your industry and you will attract unwanted attention from us.
Two: Dont take steps to conserve capital in a way that is unfair to policyholders. The
risk of detriment to with-profits policyholders is a perennial issue, caused by a number
of features inherent in the running of a with-profits fund. But this risk becomes more
acute in recessionary or volatile market conditions for example, if this exposes
expensive guarantees that are not self-supporting. You have discretion to offset some of
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with it a change in the UKs regulatory approach. And whichever political party wins the
day, a tougher taxation environment also appears inevitable.
You dont need me to tell you that the combination of all of these changes and all this
uncertainty, together with the uncertainty in the macroeconomic outlook, make for
extremely challenging times at the moment. But for the life sector in particular, they give
rise to a significant question over the sustainability of certain business models.
The agents of change are the 2012 trio of RDR, NEST and Solvency II. Both the RDR
and NEST will change the deal between consumers and the industry. Potentially leading
to changes in consumer behaviour and preferences, and changes in the kinds of
products and markets attractive to firms. Solvency II invites a much closer relationship
between the kind of business a firm does and how much capital it holds. And this will
lead, in some cases, to certain types of business being more expensive to write than
under the existing regime.
Each of these initiatives has very good reasons for being and presents a wealth of
opportunity as well as risk. But of course it is the risks that I am focused on today.
In order to rise to these challenges and keep your business viable, youll need to
undertake regular and challenging reassessments of your strategy and the adequacy of
your resources to deliver that strategy. Ask yourself if your strategy remains fit for
purpose among all this change. If not, re-evaluate.
Well be doing some analysis of our own of what the world might look like for the life
sector in 2012 and beyond. And if youve chosen to attend The future of life insurance
panel after lunch you will have the chance to share your views on the issue.
Close
So in summary, whether its capital, meeting the needs of consumers or keeping pace
with the changing regulatory landscape, risks and challenges abound. As I said at the
start, even though youve patiently listened to me for nearly half an hour, this was the
edited highlights! Id really encourage you to take the time to read our digest in full and
think about the risks your business faces. After lunch therell be copies for everyone to
take home.
I look forward to maintaining a constructive and open dialogue with you as we work
together to address these risks.
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A final trend in risk management has been the advent of nontraditional insurance
policies, providing risk managers with a new tool for preventing and controlling risks.
These insurance policies cover financial risks such as corporate profits and currency
fluctuation. Consequently, such policies ensure a level of profit even if a company
experiences unexpected losses from circumstances beyond its control, such as natural
disasters or economic problems in other parts of the world. In addition, they guarantee
profits for companies operating in international markets, preventing losses if a currency
appreciates or depreciates.
Article
Risk management is our strength: Bajaj Allianz
L.N. Revathy
"We are concentrating on health insurance. We hope to achieve Rs 100 crore
premium from the health segment this fiscal," says Mr Krishnamoorthy Rao.
Coimbatore , Aug. 26
BAJAJ Allianz General Insurance Company says that risk management has been its
greatest strength. The company, which has managed to book underwriting profits from
first year of operation, attributes its success to initiation of adequate control measures
and adoption of the right tools for managing the risks.
Speaking to Business Line, Mr Krishnamoorthy Rao, Head (Underwriting), said the
company introduced better claims control measures in every segment, be it motor,
health or travel. "We are concentrating on health insurance. This is a growing market.
About 8-10 per cent of our premium income is from health. We hope to achieve Rs 100
crore premium from the health segment this fiscal."
The company has formed an in-house health assessment team comprising qualified
medical professionals and paramedical staff. "We have until now been working with
third party administrators (TPAs). For better controls, we formed this team, who can
interact with the hospital and try and fix the unnecessary procedures, if any," Mr
Krishnamoorthy said.
He conceded that the premiums were high in the health segment because of low
volumes and rising healthcare cost.
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For motor, the company has gone to the extent of recruiting experienced service
engineers for better claims control. "While the public sector general insurance
companies leave it to the surveyors to assess the damage/loss, we have our own team
of engineers. This has to a large extent helped in better claims control and in reducing
the cost of servicing the policy," he said.
The insured list includes fleet operators as well. "The problem with most fleet operators
is more in third party claims than own damages. Further, the delay in settling the claims
adds to the cost by way of interest. We try and clamp down on such expenses," he said.
Conceding that both health and motor cover are high-risk segments, Mr Krishnamoorthy
said the company restricted itself from greater exposure in Kerala market, where the
third party claims were high. "You cannot avoid taking a risk, but better controls and
management is essential. We are in the process of educating the people of Kerala," he
said.
"The cost of issuing a policy has fallen with the adoption of technology. It has also
helped in bridging the time gap and has enabled the survey team upload the report
directly into the system," he said in reply to a query.
Yet another potential area for exposure is the travel segment, he said and added the
company regularly rolled out products/package.
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billion. If it rises to 6%, then the premium volume would rise to USD 121 billion. This
thought experiment above does not even address the two future potential growth
drivers: private pensions and health insurance. Given that Indians are already spending
5% of their income out of pocket for health care, this could easily add another USD 30
to 40 billion by 2020. This will raise the premium volume to USD 135 to USD 160 region
by 2020.
The insurance business is at a critical stage in India. Over the next two decades we are
likely to witness high growth in the insurance sector for three reasons. Financial
deregulation always speeds up the development of the insurance sector. Growth in
income also helps the insurance business to grow. In addition, increased longevity and
aging population will also spur growth in health and pension segments.
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Conclusion
Insurance is a valuable risk-financing tool. Few organizations have the reserves or
funds necessary to take on the risk themselves and pay the total costs following a loss.
Purchasing insurance, however, is not risk management. A thorough and thoughtful risk
management plan is the commitment to prevent harm. Risk management also
addresses many risks that are not insurable, including brand integrity, potential loss of
tax-exempt status for volunteer groups, public goodwill and continuing donor support.
People are now more likely to sue. Taking the steps to reduce injuries could help
in defending against a claim.
Courts are often sympathetic to injured claimants and give them the benefit of the
doubt.
Organizations and individuals are held to very high standards of care.
People are more aware of the level of service to expect, and the recourse they
can take if they have been wronged.
Organizations are being held liable for the actions of their employees/volunteers.
Organizations are perceived as having a lot of assets and/or high insurance
policy limits.
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Bibliography
www.globalfinancialed.org/.../MFO_Risk%20Manage%20CN.pdf
www.cholarisk.com/files/RiskManagementandInsurancePlanning.doc
www.en.wikipedia.org/wiki/Risk_management
www.en.wikipedia.org/wiki/Risk_management
www.irmi.com/online/insurance-glossary/default.aspx
www.bajajallianz.com
www.apra.gov.au/RePEc/RePEcDocs/.../risk_insurance_sector.pdf
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