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Operational Risk Management in a Property/Casualty Insurance Company
Mark Verheyen, FCAS, MAAA
CAS Spring Meeting
May 2005
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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
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What are the traditional measures of risk in a Property / Casualty insurance company?
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Traditional Measures of Risk
NAIC Risk Based Capital for Property / Casualty Insurers
R0 – Subsidiaries and AffiliatesR1 – Asset Risk – Fixed IncomeR2 – Asset Risk – EquityR3 – Credit RiskR4 – Underwriting Risk – ReservesR5 – Underwriting Risk – Premium
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Traditional Measures of Risk
Best’s Capital Adequacy RatioB1 - Fixed Income SecuritiesB2 - Equity SecuritiesB3 - Interest Rate RiskB4 - Credit RiskB5 - Loss + LAE Reserve RiskB6 - Premium RiskB7 - Business Risk – Off-Balance Sheet Items
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Traditional Measures of Risk
Standard & Poor’s Capital Adequacy RatioC1 – Asset RiskC2 – Credit RiskC3 – Premium RiskC4 – Loss + LAE Reserve RiskC5 – Business Risk
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What is Operational Risk in an Insurance Company?
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Operational Risk
Underwriting Risk Reserving Risk
Credit RiskAsset Risk
Operational Risk
Operational Risk is not separate and distinct from the more traditional risk categories. Rather, it overlaps these categories.
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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”
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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.
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How Has Operational Risk Impacted the Insurance Industry?
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Operational Risk’s Impact
“Failed Promises: Insurance Company Insolvencies” – a Congressional ReportFailures attributed to:– Under-reserving– Under-pricing – Unsupervised Delegation of Underwriting Authority– Rapid Expansion– Reckless Management– Abuse of Reinsurance– Etc.
Sounds like Operational Risk.
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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.
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Catastrophe Losses,
6.9%
Impairment of an Affiliate,
3.7%
Reinsurance Failure,
3.7%
Significant Change,
5.0%
Overstated Assets,
7.8%
Alleged Fraud,8.5% Rapid Growth,
17.3%
Deficient LossReserves,
37.2%
Miscellaneous,9.8%
Primary Causes of P/C Impairments (1969 to 2002)
Source: A.M. Best Company – by permission
“With the possible exception of insolvency due to catastrophe losses, in A. M. Best’s opinion, all the primary causes of insolvencies in this study were related to some form of mismanagement.” – Best’s Insolvency Study, Property Casualty U. S. Insurers, 1969-2002
Sounds like Operational Risk.
Operational Risk’s Impact
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05
101520253035404550556065
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
Total Impairment Count Average1969 to 2002: 871 25.61969 to 1990: 481 21.91991 to 2002: 390 32.5
Annual Number of P/C Impairments
20
02
Source: A.M. Best Company - by permission
Impairments increase following prolonged soft markets. Why is Operational Risk tied to the Underwriting Cycle?
Operational Risk’s Impact
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How is Operational Risk Quantified in an Insurance Company?
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Covered Losses
Fraudulent Losses
Processing Errors
Total Losses
Policy Premium
Processing Errors
Total Premium
Standard Expenses
Fraudulent Expenses
Total Expenses
Processing Errors
Underwriting Errors
Financial Statements
PricingRegulatory /
Rating Agency Capital Models
Quantification of Operational Risk
The significant sources of operational risk are implicitly included in regulatory and rating agency capital models.
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Quantification of Operational Risk
NAIC RBC ModelPremium Risk– Base capital charge is derived using industry worst-case
loss ratio by line, adjusted for company experience
Reserve Risk– Base capital charge is derived using industry average
worst-case reserve development by line, adjusted for company experience
Growth Charge– Based on a regression against industry data applied to
company growth
Significant sources of operational risk are implicitly included in the regulatory and rating agency capital models.
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How is Operational Risk Managed in an Insurance Company?
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Management of Operational Risk
Underwriting
Pric
ing
Reserving
Planning
Communication and discipline are key.
Everyone needs to be aware of what is going on in the current underwriting environment and be realistic about what the results are.
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“For every clever person who goes to the trouble of creating an incentive scheme, there is an army of people, clever and otherwise, who will inevitably spend even more time trying to beat it.” – Levitt and Dubner, “Freakonomics”
“Insurance companies create powerful incentives… for underwriters to sell as many policies as possible at whatever price the market will bear” – Sean M. Fitzpatrick, “Fear is the Key: A Behavioral Guide to Underwriting Cycles”
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
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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 exposureInternal controls – audit results, audit frequencyStaffing – employee turnover, training budget, premium per employee, policies per employeeClaims – frequency, severity, new classes of lossOutside data sources – rating agencies, regulators, industry trade organizations, data warehousing firms
Management of Operational Risk
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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. These risk-based capital models can serve as a framework for company-specific models.
Proactive communication and the monitoring of Key Risk Indicators can encourage changes in behavior in the underwriting cycle.
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Mark Verheyen is a Vice President with ReAdvisory, the consulting arm of Carvill, one of the world's largest privately owned reinsurance intermediaries. He assists client companies in evaluating and structuring reinsurance programs, providing dynamic risk modelling and capital allocation services. Prior to joining ReAdvisory, he worked at both Ernst & Young and CNA Re.
Mark is a member of both the CAS Enterprise Risk Management Research Committee and the Committee on Reinsurance Research.
