Operational Risk Management in a PropertyCasualty by ynf17415

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									     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%



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Operational Risk’s Impact
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                                                                                    1987

                                                                                           1989

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                                                          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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