Measuring Risk The Measurable and the Unmeasurable

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Measuring RiskThe Measurable and the Unmeasurable
Steve White
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Background Solvency II Framework
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Solvency II overall objective

• Establish a solvency system that is matched to
  the true risks of an insurance company

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Looking at the Solvency II QIS 3
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Market Risk
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Market risk

• Function of SCRmkt
• Exposure to market risk is measured by the
  impact of movements in the level of financial
  variables, such as stock prices, interest rates,
  real estate prices and exchange rates.

• Modules in SCRmkt
• Mktint interest rate risk. Approach that
  simulates both upward and downward shocks to
  yield curve.
• Mkteq equity risk. Approach that simulates a
  downward shock to the market value of equities,
  while taking account of the offsetting effect on
  the value of derivaties and short positions.
• Mktprop property risk. Approach that simulates
  a downward shock to the market value of property
  exposures.

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Market risk

• Modules in SCRmkt
• Mktsp spread risk. Approach that simulates a
  widening of
• credit spreads, using a function that depends on
  the market
• value, rating and effective duration of credit
  exposures.
• Mktconc risk concentrations. Approach under
  investigation, where (financial) exposures in
  excess of predefined thresholds would be subject
  to an additional capital requirement.
• Mktfx currency risk. Approach that simulates a
  shock to exchange rates.

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Market RiskConsiderations

• Asset Modeling
• Requires an Economic Scenario Model
• Economic Impact on Liabilities must be consistent
  (correlated) with the parameters in the asset
  model

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Credit Risk
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Credit Default risk module

• SCRdef
• counterparty default risk is the risk of default
  of a counterparty to risk mitigating contracts
  like reinsurance and financial derivatives.
• probability of default (PD) must be assessed
  somehow

• Work in progress
• Can be modeling similar to a bond default model
  with the probability of default PD being derived
  from the reinsurance company rating

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Credit Default risk module

• Work in progress
• Consider modeling each reinsurer separately to
  pick up the effect of concentration risk
• Consider correlation effect between reinsurers
• Consider building in a probability of downgrade
  and increased likelihood of default based on
  external events either economic or natural peril
  catastrophes

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Operational Risk
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Operational and Strategic RiskA.M. Best Study

• With the possible exception of insolvency due
  to catastrophe losses, in A.M. Bests opinion,
  all the primary causes of insolvencies in this
  study were related to some form of
  mismanagement.
• -- A.M. Best

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Operational risk module

• Capital charge is calculated by multiplying the
  total earned gross premium and total gross
  technical provisions by factors, and taking the
  maximum.
• A very approximative approach (due to lack of
  operational loss data)
• An RBC like calculation

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Operational RiskRisk Mapping
1. Losing Key Employees 2. Inadequate Employee
Training 3. Inadequate Employee Recruiting 4.
Employee Burnout 5. Lack of Brand
Recognition 6. Inadequate Geographic
Marketing 7. Over Promising 8. Lack of
Customer Diversification 9. Contract
Non-Renewal 10. Unfavorable Politics 11.
Predatory Pricing
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High
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29
18
35
1
9
43
8
41
13
15
28
20
22
26
42
24
31
21
37
19
B4
36
45
16
17
Severity
44
46
32
3
5
6
23
4
2
7
B11
33
14
30
39
B11
34
40
27
12
38
47
25
Low
Moderate
Low
High
Frequency