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Part 1: qualitative
1. ERM
2. ORSA
3. Softskill training (pass)
4. Economic and supervisory capital, continuity analysis + role of supervision
5. Softskill training (pass)
Part 2: quantitative
6. Risk measures
7. Dependencies + risk capital
8. Standard model Solvency II
9. Capital allocation + performance measurement
10.Valuing insurance liabilities
11.Risk management game + case (grade)
Riskmanagement
Master in Actuarial Analytics
Lesson 1: Enterprise risk management (IAA: Chapter 1-5)
Content
1. Setting the scene
2. Governance and ERM framework
3. Risk management policy
4. Risk tolerance statement
5. Risk responsiveness and feedback loop
Setting the scene: What is ERM?
No universally accepted definition
Broad
β’ all risks faced by the insurer
β βdownsideβ and βupsideβ risks
β internal and external sources
β company-specific and systematic risks
β quantitative and qualitative risks
β’ interests of all stakeholders of the insurer
Setting the scene: What is ERM?
Process
β’ totality of systems, structures and processes to identify, treat, monitor, report and communicate all sources of risk
β’ systematic organisation of and coordination between risk functions (integrated versus βsilosβ)
Setting the scene: What is ERM?
holistic consideration of risk information relating to:
β’ past events (losses)
β’ current performances (risk indicators)
β’ future outcomes (risk profile or risk assessment)
ERM framework
ERM framework should be proportionate to
- Nature: product diversity
- Scale: small versus large insurer
- Complexity: local versus global
of risks to which the insurer is exposed to.
Governance and risk management
β’ Corporate governance - processes by which organisations are directed,
controlled and held to account
- relationship between board, managers and owners
β’ Risk management - enables and facilitates the exercise of direction,
control and accountability
- manifests as a board committee and/or board charter responsibility
Board
Ultimate responsible for ERM framework β’ Demonstrable support
β’ Approving the overall risk management strategy/policy
β’ Setting the risk appetite
β’ Overseeing the process of ensuring the βresponsible personsβ are fit and proper
β’ Monitoring key risk by ensuring the implementation of a suitable risk management and internal controls framework
Risk committee
Assisting the board in their responsibility
Responsibilities:
β’ Effectiveness of the risk management framework
β’ Compliance with supervisory requirements
β’ Establishment a suitable independent risk function, with authority, standing and resources to effectively execute its mandate
β’ Monitoring the adequacy of corporate insurance covers
Risk committee
Enablers β’ Establish direct reporting line between
committee and most senior risk executive β’ Schedule regular one-on-one meetings between
the chair of the committee and most senior risk executive outside formal meetings
β’ Arrange time for meetings without executive management
β’ Consult external experts β’ Report transparantly without βfilteringβ
Developing a risk function
In practice: fragmented risk structures β’ Actuarial/research function β’ Internal audit function β’ Business continuity team β’ Reinsurance department β’ Treasury and credit risk function β’ Capital management function β’ Market risk assessment function β’ Health and safety experts β’ Fraud and investigations experts β’ Compliance teams
Developing a risk function
Risk function act and is seen acting in a coordinated fashion (a common lens) β’ shared understanding of risk tolerance β’ quality and transparancy of risk information β’ alignment of incentives with management of risk β’ connection of risk with capital management β’ governance structures β’ clear accountabilities between line and risk
management β’ strong direct links with strategy and operations
Developing a risk function
β’ Risk tolerance
- Does a board-approved risk tolerance exist?
- If so, is it understood by people making day-to-day underwriting, investment and reinsurance decisions?
- Is it appropriate having regard to the insurerβs strategic objectives?
Developing a risk function
Projectmanagement required (no βquick fixβ)
β’ Money: manage costs/benefits
β’ Organisation: executive-level ownership
β’ Time: detailed planning with milestones
β’ Information: objective reporting (βbad newsβ)
β’ Capacity: experienced and skilled resources
β’ Quality: clear objectives of outcomes
Common risk language
Plethora of βcompetingβ risk language can undermine the effectiveness of ERM:
β’ confuse people not directly involved in ERM
β’ reinforce a βsiloβ approach
β’ focus on βformβ over βsubstanceβ
β’ proliferation of process inefficiencies and duplications
β’ make aggregation of risks difficult
Common risk language
Attibutes and practices:
β’ common risk categories
β’ βtop-downβ risk rating system
β’ standard templates
βUpsideβ risk management
Practices that support integration of the management of upside and downside risks:
β’ Ensuring risk function is involved in strategic planning
β’ Including both risks and opportunities in risk reports
β’ Reward systems that encourage calculated risk taking
β’ Reporting on emerging, industry-wide, cross-border and longer term risks
Risk culture
Behaviours:
1. feel confident to speak up (encouraging environment)
2. have skills, capability and empowerment to manage risk situations (training, role clarity and accountability)
3. improve prevention, detection and recovery of risks continuously
Risk management policy
β’ risk management philosophy
β Capital management
β Performance management
β Pricing
β Reserving
β’ mission, values and strategy
β’ scope
Risk management policy
β’ risk language
β’ risk appetite
β’ risk governance
β’ risk culture
β’ risk reporting and monitoring
β’ supervisory requirements
β’ process-level requirements
β’ process for reviewing and updating the policy.
Risk tolerance
β’ 3 β 5 years
β’ earnings volatility
β’ regulatory capital (supervisor)
β’ capital βstrengthβ for desired rating level (rating agency)
β’ economic capital for βrisk of ruinβ (policyholders)
β’ dividend paying capacity (shareholders)
Risk tolerance
β’ maximum exposure to aggregation of risk
β’ maximum acceptable net catastrophic loss
β’ minimum acceptable pricing principles
β’ descriptions of unacceptable operational risk scenarios
β’ βgo/no-goβ criteria for strategic projects
Limits
β’ 1 year, risk category level
β’ investment mandates
β’ concentration limits (business/products, geographies and counterparties)
β’ counterparty credit limits
β’ credit quality
β’ underwriting limits
β’ confidence interval for insurance reserves
Limits
β’ liquidity benchmarks
β’ limits on the use of financial derivatives
β’ operational risk policies:
β outsourcing
β business interruption
β fraud
β health & safety
β project delivery
Influences on risk profile
β’ Unexpected losses and significant control failures or incidents (looking back)
β’ Movements in key risk indicators (present)
β’ Outputs from periodic risk assessments at the enterprise and business unit levels that have regard to business as usual activities, new initiatives/strategies and external events (looking forward)
Feedback loop
β’ Establishment of thresholds for reporting significant issues
β’ Reporting of risk aggregations to identify where limits (and potentially risk tolerance) may have been exceeded
β’ Protocols for escalation of issues to various levels and management and, if necessary, supervisors
Emerging risks
Emerging risks are developing or already known risks which are subject to uncertainty and ambiguity and are therefore difficult to quantify using traditional risk assessment techniques
Emerging risks
β’ Reviewing press and trade publications
β’ Workshops
β’ Opinions of external experts
β’ Emerging risk initiative (http://www.croforum.org/emergingrisc.ecp)
β pandemy
β terrorism
β climate change & tropical cyclones
Risk management process
β’ Risk identification
β’ Risk evaluation
β’ Risk response
β’ Risk monitoring
β’ Capital allocation
β’ Risk-adjusted pricing
β’ Performance measurement o Return On Risk-Adjusted Capital = Profit/Capital
Risk identification
β’ Market risk
β’ Credit risk
β’ Liquidity risk
β’ Insurance risk (premium and reserve risk)
β’ Operational risk
β’ Concentration risk
β’ Reputational risk
β’ Strategic risk
Risk evaluation: qualitative
β’ Risk matrix
β’ Risk tree
β’ Check list (cause and effect)
β’ Scenario analysis
β’ Analysis of dependencies
β’ SWOT
Risk response
β’ Avoidance
β’ Reduction
β’ Transfer
β Co-insurance
β Reinsurance
β Derivatives
β Insurance-linked securities
Advantages of risk profiling process
β’ Awareness of the (relative) nature of risks
β’ Consistency and understanding by collating and presenting a shared view of the most significant risks from time to time.
β’ Transparency to the board and an opportunity for the board to review managementβs formal assessment of significant risks
β’ Efficiency by ensuring that management effort/risk mitigation is prioritised to the areas of greatest assessed risk
β’ Learning and continuous improvement through taking action to alter and ideally reduce the risk profile
β’ Culture of proactive risk management that supports innovation and sustainability
Risk profile
Inherent risk Residual risk Controls
High Low Effective
High High Ineffective
Low Low Over-controlled
Results of risk profiling process
β’ Descriptions of risks
β’ Categories of risk for aggregation
β’ Causes or conditions giving rise to a given risk occurring
β’ Consequences of risks (financial and non-financial terms)
β’ Rating criteria for risk assessment (financial and/or non-financial proxies for βhighβ, βmediumβ, or βlowβ risks)
β’ Inherent risk assessment (likelihood and impact of risk).
β’ Effectiveness of controls and/or risk mitigation strategies.
β’ Residual risk assessment
β’ Action(s) to bring unacceptable residual risk within limits
Riskmanagement
Master in Actuarial Analytics
Lesson 4: Economic and supervisory capital, continuity analysis and role of supervision
(IAA: Chapter 7 to 9)
Economic Capital Model
β’ Holistic assessment of key risk drivers
β’ Asset and liability projections
β’ Future balance sheets
β’ Profit and loss statements
β’ Cash flow statements
β’ Projected distributions of profit
β’ Capital and Return on Capital
Economic Capital Model Process
3. Simulation approach β Deterministic versus stochastic
4. Risk metrics β VaR versus TailVaR
β Time horizon
β Confidence level
5. Modelling criteria
6. Implementation β fully integrated versus univariate model
Purposes of Economic Capital Model
β’ Economic capital requirements
β’ Disaster Planning
β’ Investment strategy
β’ Mergers, acquisitions and divestments
β’ Capital allocation
β’ Reinsurance programmes
β’ Optimal business mix
β’ Reserving volatility
β’ Capital outflow / inflow policies
Continuity Analysis
β’ Ongoing versus run-off basis
β’ Time period of modelling: multi-year approach (medium term)
β’ Reliability and sufficiency of longer term forecasts
Management actions
β’ Premium setting
β’ Asset allocation
β’ Discretionary policyholder benefits
β’ Capital reduction / injection policies
β’ Risk mitigation strategy
Business Continuity Management
β’ An essential part of operational risk management.
β’ Business continuity planning enables to anticipate, identify and assess business interruption risks.
β’ A properly documented and tested Business Continuity Plan (BCP) reduces the impact of interruptions on key business processes and, most importantly, protects reputation.
β’ A robust BCP also allows to explain to stakeholders and industry supervisors that risks associated with potential business interruptions can be managed.
Crisis Management Planning
β’ A Crisis Management Plan minimises business impact and loss in the event of a significant incident by providing a clear and organised response strategy supported by predefined response procedures
β’ At the core of critical incident management is Business Continuity Management (BCM), which provides an organisation with a disciplined capability to continue to operate sustainably in the face of potential significant business disruption.
Role of supervisor
β’ Prudential supervision is accepted worldwide as an integral component of the regulation of financial institutions
β’ The fundamental premise underpinning the supervisory role is that the primary responsibility for financial soundness and prudent risk management within a supervised institution rests with the Board and senior management
β’ In this context the primary emphasis of supervision is on avoidance of problems rather than penalizing those who may be found to have caused problems
Role of supervisor
β’ Financial oversight
β’ Mandatory licensing
β’ Ongoing operational requirements e.g. prudential standards
β’ Procedures and processes for monitoring compliance with license conditions and ongoing operational requirements
β’ Where necessary, undertaking action either to force a non-compliant insurer into compliance or remove it from the industry
Risk-based supervision β’ Consideration of:
β the nature of insurerβs business
β strategic/business plans
β governance arrangements
β financial condition reports
β strategies and processes to manage risk
β’ Licensing and ongoing supervisory activities typically involve review of documents relating to these areas.
Supervisor Relationship Management Insurers should consider adopting a set of high-level principles to guide engagement with supervisors. In developing a set of appropriate principles, insurers should have regard to:
β’ Alignment with supervisory objectives
β’ Preservation and enhancement of corporate reputation
β’ Proactive and early engagement
β’ Communication transparency
β’ Relationship management accountability and coordination
Supervisor Relationship Management β’ Nature of interaction with supervisors
β Operational / procedural
β Non-standard / unusual
β Strategic
β’ Supervisory policy development
β’ Supervisory visits
Exercise
What are the model risks (limits, assumptions) of the economic capital model of your organisation?
Riskmanagement
Master in Actuarial Analytics
Lesson 6: Risk measures (EAA: 2.1 β 2.3 (except 2.2.4))
Measures based on moments
β’ standard deviation:
π π = πΈ π β πΈ(π) 2 = πππ(π)
β’ one-sided standard deviation:
π+ π = πΈ πππ₯ 0, π β πΈ(π)2
Measures based on moments
β’ partial moments
β h = 0: exceedance probability
β h = 1: mean excess
β h = 2: semi-variance
VaR, TailVaR and ES
πΈππΌ π = ππΌπππππππ πΌ π + 1 β ππΌ)πππ πΌ(π
with ππΌ =1βπ(πβ€πππ πΌ π )
1βπΌ
Continuous distribution: πΈππΌ π = πππππππ πΌ π
VaR, TailVaR and ES
π~Ξ¦π,π, g monotone increasing function:
πππ πΌ π(π) = π(π + πΞ¦0,1β1(πΌ))
πΈππΌ π(π) = πππππππ πΌ π π =
=1
1 β πΌ π π + ππ₯ π0,1(π₯)ππ₯β
Ξ¦0,1β1(πΌ)
VaR, TailVaR and ES
β’ Normal distribution (π π = π):
πππ πΌ π = π + πΞ¦0,1β1 πΌ
πΈππΌ π = πππππππ πΌ π = π + ππ0,1(Ξ¦0,1
β1 πΌ )
1 β πΌ
β’ Log-normal distribution (π π = ππ ):
πππ πΌ π = ππ+πΞ¦0,1
β1 πΌ
πΈππΌ π = πππππππ πΌ π =ππ+π
2/2
1 β πΌΞ¦0,1(π β Ξ¦0,1
β1 πΌ )
Riskmanagement
Master in Actuarial Analytics
Lesson 7: Dependencies and risk capital (EAA: 3.1, 3.3, 4.1-4.3 and 4.5)
Question 1: Value at Risk
ππ~ ln ππ , ππ
Ξ¦β1 0,99 β 2,326
Question 1: Calculate πππ 0,99(ππ)
Unit I ππ ππ π¬(πΏπ) π½ππ(πΏπ)
1 2 0,5 8,37 19,91
2 1 1 4,48 34,51
3 0,5 2 12,18 7954,67
Answer 1: Value at Risk
Answer 1: πππ πΌ π = ππ+πΞ¦β1 πΌ
β’ πππ 0,99 π1 = 23,64
β’ πππ 0,99 π2 = 27,83
β’ πππ 0,99 π3 = 172,78
Question 2: diversification
Correlation matrix
Question 2: Calculate πππ 0,99(π1 + π2 + π3) by making use of the square-root formula. What is the diversification effect? What are the assumptions?
1 0,5 0,7
0,5 1 0
0,7 0 1
Answer 2: diversification
β’ πππ 0,99 π1 + π2 + π3 = 199,27
β’ Diversification effect = 24,98
β’ Multivariate normal distribution
Cost of capital .
πΆππΆ = ππ + π
Methods for calculating spread: β’ opportunity cost
β’ CAPM: π = π½(ππ β ππ) with π½ =πΆππ£(ππ,ππ)
πππ(ππ)
β’ direct modelling
Cost of Capital (direct modeling)
ππ + π π = ππ + π 0 πΈ0 + ππ + π π (πΈπ β πΈπβ1)
π
π=1
Available capital
β’ Assets that cover liabilities
β’ Risk capital that serves as defence against risks
β’ Excess capital that has no business function
π΄π£πππππππ πππππ‘ππ = πππ΄ βπππΏ
β’ Insolvent: πππ΄ βπππΏ < 0
β’ Solvent: πππ΄ βπππΏ > πππ π πππππ‘ππ
Risk Capital
β’ Economic risk capital
β Run-off basis
β Going-concern basis
β Reference company basis
β’ Rating capital
β’ Solvency capital
Approaches to modelling risk capital
β’ Factor-based models
β’ Analytical models
β’ Stress tests (single scenario)
β’ Scenario-based models (multiple scenarios)
β Regulatory versus company-specific
β’ Historical
β’ Hypothetical
β’ Monte-Carlo
Riskmanagement
Master in Actuarial Analytics
Lesson 8: Standard model in Solvency II (IAA: 4.6.2 except 4.6.2.4)
Fundamentals
Non-life insurance:
β’ mainly factor based or analytic methods
Life insurance:
β’ mainly scenario-based methods
β’ change in net asset value
Fundamentals
β’ Economic balance sheet
ππ΄π = πππ΄ βπππΏ
β’ Run-off basis
β’ Risk measure
β One-year Value-at-Risk
β Confidence level: 99,5%
Solvency Capital Requirement
ππΆπ = π΅ππΆπ + ππΆπ ππ + π΄ππππ + π΄πππ·π
β’ π΅ππΆπ = Basic SCR
β’ ππΆπ ππ = Operational SCR
β’ π΄ππππ = βmin π΅ππΆπ β π΅ππΆπ π΄ππ , πΉπ·π΅ =
adjustment for future discretionary benefits
β’ π΄πππ·π = adjustment for deferred taxes
Riskmanagement
Master in Actuarial Analytics
Lesson 9: Allocation of capital (IAA: 5.1, 5.2.1) and performance measurment (IAA: 6.1-6.4)
Proportional capital allocation
Proportional capital allocation satisfies axioms 1 and 2 for positive subadditive risk measures
Question 3: capital allocation
Allocate the risk capital by:
1. Proportionally
2. Discrete marginally
Answer 3: capital allocation
1. Proportionally: 21,01; 24,73 and 153,53
2. Discrete marginally: 22,48; 7,84 and 168,95
Absolute performance measure
Economic value added
πΈππ΄π‘ = ππ‘ β πΆππΆπ‘ β πΈπΆπ‘
β’ ππ‘ =Net profit after tax
β’ πΆππΆπ‘ = πππ‘ + π π‘ (hurdle rate)
β’ πΈπΆπ‘ =economic capital
Riskmanagement
Master in Actuarial Analytics
Lesson 10: Valuing insurance liabilities (IAA: 4.4 and 6.6.4)
Valuing insurance liabilities
1. Best estimate perspective
2. Economic perspective
β Management actions
β Diversification effects
3. Balance sheet perspective
4. Fair value perspective ππππ π£πππ’π = πππΏ = πΈ(πΏ) +πππ(πΏ)
Market value margin
β’ hedgeable risks: replicating portfolio
β’ non-hedgeable risks (including base risk)
Valuation methods:
β’ Risk measure: πππΏπΌ = πππ πΌ(πΏ)
β’ Cost of capital
β’ Market consistent
Cost of capital method
πππ = πΆππΆπ‘ β π πΆπ‘(1 + πππ‘)
π‘
β
π‘=1
Simplifications:
β’ Fair value risk capital: π πΆπ‘ = ππΆπ π‘πΏ
β’ Constant cost of capital: πΆππΆπ‘ = 6%
β’ Risk driver: ππΆπ π‘+1πΏ =
πΈ(πΏπ‘+1)
πΈ(πΏπ‘)β ππΆπ π‘
πΏ
Market consistent valuation
The market consistent value of a company is a price at which the company could be sold to an independent rational investor who knows the company well.
β’ Hedgeable risks: replication with liquid financial instruments
β’ Non-hedgeable risks: no replication possible e.g. operational risk -> standardized procedures
Exercise: Scenario analysis
β’ β¬ 189 AAA EU-bonds β’ β¬ 63 BB EU-bonds (non-investment grade) β’ β¬ 56 corporate EU-bonds β’ β¬ 28 shares β’ β¬ 14 cash Solvency I: β’ Regulatory capital: β¬ 120 β’ Regulatory capital requirement coverage: 150% β’ Minimum regulatory capital requirement
coverage: 120%
Exercise: Scenario analysis
1. Shares crash: 40%
2. Euro-crisis: 50% BB EU-bonds and 30% EU-corporate bonds
3. Economic environment developes as planned positively. The insurance business remains constant.
Questions
1. Which of the three scenarios are appropriate for ORSA?
2. Calculate the stand-alone risk capitals for each scenario. Is the minimum regulatory capital requirement coverage met?
3. Place the three scenarios in a risk matrix
4. What measures could the insurer take for every scenario?
Answers
1. Scenario 1 and 2: risk profile Scenario 3: base
2. Minimum regulatory capital requirement = β¬ 120/150% x 120% = β¬ 96 β Scenario 1: β¬ 120 - β¬ 28 x 40% = β¬ 108,8
β Scenario 2: β¬ 120 - β¬ 63 x 50% - β¬ 56 x 30% = β¬ 71,7
β Scenario 3: β¬ 120
3. Risk matrix: likelihood and impact
Answers
4. Risk control measures
β’ Scenario 1: set control limits
β’ Scenario 2: β convert non-investment grade bonds to investment
grade bonds and/or hedge with CDS
β convert EU-corporate bonds to corporate bonds with higher ratings and/or lower concentration risk of EU-corporate bonds
β’ Scenario 3: risk management (reinsurance, product development, capital investments)