Operational Risk Management in a Property/Casualty Insurance Company Mark Verheyen, FCAS, MAAA Enterprise Risk Management Symposium May 2005 A Carvill service Operational Risk Management in a Property/Casualty Insurance Company Agenda Traditional (P/C) Insurance Company Risk Measures Operational Risk in an Insurance Company Operational Risk’s Impact on the Insurance Industry Quantification of Operational Risk in an Insurance Company Management of Operational Risk in an Insurance Company What are the traditional measures of risk in a Property / Casualty insurance company? Traditional Measures of Risk NAIC Risk Based Capital for Property / Casualty Insurers R0 – Subsidiaries and Affiliates R1 – Asset Risk – Fixed Income R2 – Asset Risk – Equity R3 – Credit Risk R4 – Underwriting Risk – Reserves R5 – Underwriting Risk – Premium Traditional Measures of Risk Best’s Capital Adequacy Ratio B1 - Fixed Income Securities B2 - Equity Securities B3 - Interest Rate Risk B4 - Credit Risk B5 - Loss + LAE Reserve Risk B6 - Premium Risk B7 - Business Risk – Off-Balance Sheet Items Traditional Measures of Risk Standard & Poor’s Capital Adequacy Ratio C1 – Asset Risk C2 – Credit Risk C3 – Premium Risk C4 – Loss + LAE Reserve Risk C5 – Business Risk What is Operational Risk in an Insurance Company? Operational Risk Underwriting Risk Reserving Risk Operational Risk is not separate and Operational Risk distinct from the more traditional risk categories. Rather, it overlaps these Asset Risk categories. Credit Risk Operational Risk How does the banking industry define Operational Risk? “Operational Risk is defined as the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk.” Basel Committee on Banking Supervision “International Convergence of Capital Measurement and Capital Standards” Operational Risk Banking (Basel) Insurance Corollary Mismarking Position (Intentional) Under-Reserving (Intentional) Model Errors / Misuse Under-Pricing, Under-Reserving (Unintentional) Outsourcing Delegation of Underwriting Authority Non-Client Counterparty Disputes Reinsurance Disputes Fiduciary Breaches Bad Faith Claims Fraud Fraud Anti-Trust Violations Anti-Trust Violations Natural Catastrophe / Terrorism Natural Catastrophe / Terrorism* * It is important to distinguish between the insurer’s operational exposure to natural catastrophe / terrorism and that exposure assumed from other parties as a covered insurance risk. Risks should be Serially Exclusive and Mutually Exhaustive (“SEME”). In other words, every risk falls in one and only one bucket. How Has Operational Risk Impacted the Insurance Industry? Operational Risk’s Impact “Failed Promises: Insurance Company Insolvencies” – a Congressional Report Failures attributed to: – Under-reserving – Under-pricing – Unsupervised Delegation of Underwriting Authority – Rapid Expansion – Reckless Management – Abuse of Reinsurance – Etc. Sounds like Operational Risk. Operational Risk’s Impact “The Failure of HIH Insurance” – a corporate collapse and its lessons. Failure attributed to: – Under-reserving – Under-pricing – Lack of Internal Controls – Expansion into Unfamiliar Markets – Mismanagement – Abuse of Reinsurance – Etc. Sounds like Operational Risk. Operational Risk’s Impact Prim ary Caus e s o f P/C Im pairm e nts “With the possible (1969 to 2002) Miscellaneous, exception of insolvency 9.8% due to catastrophe Im pairm ent of an Affiliate, losses, in A. M. Best’s 3.7% opinion, all the primary Catastrophe Losses, Deficient Loss Reserves, causes of insolvencies 6.9% 37.2% in this study were Reinsurance Failure, related to some form 3.7% of mismanagement.” – Significant Best’s Insolvency Change, 5.0% Study, Property Overstated Casualty U. S. Assets, 7.8% Insurers, 1969-2002 Alleged Fraud, 8.5% Rapid Grow th, 17.3% pçìêÅÉW=^KjK=_Éëí=`çãé~åó=Ó=Äó=éÉêãáëëáçå Sounds like Operational Risk. Operational Risk’s Impact An n u a l Nu m b e r o f P /C Im p a irm e n ts 65 60 =====================qçí~ä ===========================fã é~áêã Éåí=`çìåí=====^îÉê~ÖÉ 55 NVSV=íç=OMMOW===================UTN=======================ORKS 50 NVSV=íç=NVVMW===================QUN=======================ONKV 45 NVVN=íç=OMMOW===================PVM=======================POKR 40 35 30 25 20 15 10 5 0 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2002 pçìêÅÉW==^ KjK=_Éëí=`çãé~åó=J=Äó=éÉêãáëëáçå Impairments increase following prolonged soft markets. Why is Operational Risk tied to the Underwriting Cycle? How is Operational Risk Quantified in an Insurance Company? Quantification of Operational Risk Standard Fraudulent Processing Expenses Expenses Errors Covered Losses The significant sources of operational risk are Fraudulent Losses Total Losses Total Expenses implicitly included in regulatory and rating agency capital models. Processing Errors Underwriting Financial Errors Statements Policy Premium Regulatory / Pricing Rating Agency Total Premium Capital Models Processing Errors How is Operational Risk Managed in an Insurance Company? Management of Operational Risk Communication and discipline are key. U n d e rw ritin g g Plann cin Pri ing R e se rvin g Everyone needs to be aware of what is going on in the current underwriting environment and be realistic about what the results are. Management of Operational Risk “Compensation Structures and Underwriting Cycles: It’s About the Bonuses, Stupid” – Sean M. Fitzpatrick, “Fear is the Key: A Behavioral Guide to Underwriting Cycles” “Insurance companies create powerful incentives… for underwriters to sell as many policies as possible at whatever price the market will bear” Short-term incentives tend to be production based, while long-term incentives tend to be profitability based. Everyone needs to be aware of what the incentives are and how they impact behavior. Management of Operational Risk What are the Key Risk Indicators of Operational Risk in an Insurance Company? Production – hit ratios, retention ratios, item count, pricing levels (renewal business and new business), rate per unit of exposure Internal controls – audit results, audit frequency Staffing – employee turnover, training budget, premium per employee, policies per employee Claims – frequency, severity, new classes of loss Outside data sources – rating agencies, regulators, industry trade organizations, data warehousing firms Concluding Thoughts Operational risk isn’t a distinct class of risk that insurers are required to hold additional capital for. It is arguably the single largest threat to their solvency, though. Regulators and rating agencies implicitly include capital requirements for Operational Risk through the premium and reserve charges in their capital models. Operational risk management and quantification techniques used in banking and other industries do have applications in the insurance industry. Proactive communication and the monitoring of Key Risk Indicators can encourage changes in behavior in the underwriting cycle.
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