Life Insurance Risk Management Essentials

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1 Michael Koller Life Insurance Risk Management Essentials 4y Springer

2 1 What is Risk Management Introduction Raison D'etre of Risk Management The Role of Risk Management Three Lines of Defence in Risk Management Principles Risk Categories Risk Management Process Risk Management Policies and Risk Landscape 9 2 The Role of the Balance Sheets and of Capital The Balance Sheet of an Insurance Company Role of Valuation, Valuation Methods Principle of No Arbitrage Reconciliation of Balance Sheets Bonds Shares Other Assets Insurance Liabilities Life Insurance Model Capital Insurance Pure Endowment Annuities Cash Flows and Valuation Primer on Life Insurance Risks Shareholders Equity and Capital 44

3 Accounting Principles Statutory Accounting IFRS and US GAAP Accounting Embedded Value and Economic Accounting Economic Valuation / Market Consistent Embedded Value Valuation Methodology Revisited Formulae Examples Annuity Capital Protection 61 Risk Appetite and Tolerance Risk Capacity and Risk Appetite Limit Systems Hedging Strategies and Response Strategies Introduction: Use of Capital Definition of the Risk Factors Considered Probability Density Functions per Risk Factor , Valuation Methodology Risk Measures Risk Measures Value at Risk (VaR) Tail Value at Risk (TVaR) Relationship Between Value at Risk and Expected Shortfall What Is a Stress Scenarios Mathematically 83 Key Insurance Processes and Their Risks Capital Allocation and Planning Process Economic Capital Calculation Process ALM and Bonus Setting Process Product Design Process 94 Financial Risks and Their Modelling The Model Underlying Financial Risks Approximations Concrete Implementation Interpreting the Results Notation Ill Scenarios What Can and What Cannot Be Done with This Reporting Example 113

4 xiii Summary Decomposition of VaR Figures Scenarios ICA Capital Stress Tests Limits Summary Reporting Example Insurance Risks Method for Allocation of Capital Steps Required Probability Density Functions per Risk Factor Diversification Stochastic Models Used Mortality Longevity Concrete Example: An Annuity Portfolio Formulae Application to Insurance Linked Securities Statistics Allocation of Risk Capital in Proportion to Premium Reporting Templates Operational Risks Introduction : Risk Appetite ' Risk Measurement and Exposure Controlling Process in General and Embedding Risk Policies Strategy & Planning ( Distribution Management Brand & Marketing Communications Corporate Social Responsibility Environment /6 Regulatory Information Technology Financial Crime Business Protection People Outsourcing Communications 157

5 xiv Contents Legal Financial Reporting External Auditor Taxation General Insurance Reserving Life Reserving Capital Management Credit Market Derivatives Liquidity Foreign Exchange Mergers & Acquisitions Risk Management & Internal Control Life Insurance Risk Life Insurance Product Development & Pricing Unit Pricing General Insurance Underwriting General Insurance Reinsurance General Insurance Claims Capital Models and Integrated Risk Management Introduction Bringing the Puzzle Together Diversification Risk Adjusted Performance Metrics Introduction Performance and Value Metrics IBNR Reserves Financial Options Frictional Capital Costs Duration of Projection Formulae 179 ' Example Examples Capital Allocation Process Risk Management in a Group and Intra-group Transactions Introduction Risk and Capital Transfer Instruments 191

6 xv Internal Loans Internal Hybrids Cashpools Guarantees GI / Life Reinsurance Contracts Ranking of RCTI's Modelling Products and Their Risks Nuptualite Index Linked Products and Other Contractual Issues Variable Annuities Investment Guarantees and Bonus Rates Longevity and the Ability to Forecast Long Term Care Imperfect Cash Flows Matching Emerging Risks What Are Emerging Risks and Why Are They Important? What Process Is Needed for Emerging Risks? Regulatory View on Risk Management: Solvency II Introduction What Is Solvency II? Economic Balance Sheet and Prudence Risk Modelling and Internal Models.: Good Regulation Swiss Solvency Test Solvency II Standard Model Structure of the Model! Market Submodule Quo Vadis? Governance and Organisation Governance Definitions Generic Governance Escalation Processes Effective Governance Risk Governance and Oversight Framework Principles of Effective Oversight 247

7 xvi Contents 15.5 Board Oversight Management Oversight Why Risk Management Committees Are Important How Do Risk Management Committees Work Terms of Reference of a Risk Committee Roles and Responsibilities Duties of the Line Management Duties of the Chief Risk Officer Duties of the Group Internal Audit Risk Relevant Parts Within Job Descriptions Decomposition of the Risk Management Process Data and Systems 259 A Stochastic Processes 261 A.I Definitions 261 A.2 Markov Chains with Countable State Space 264 A.3 Mean Excess Function 266 A.4 Deterministic Cash Flow Streams 268 A.5 Random Cash Flows 269 B Application of the Markov Model to Life Insurance 271 B.I Traditional Rating of Life Contracts 271 B.2 Life Insurance Considered as Random Cash Flows 272 B.3 Reserves, Recursion and Premiums 274 C Abstract Valuation 277 C.I Framework 277 C.2 Cost of Capital 281 C.3 Inclusion in the Markov Model 287 C.4 Asset Liability Management 289 D An Introduction to Arbitrage Free Pricing 297 D.I Price Systems 297 D.I.I Definitions 297 i D.1.2 Arbitrage 299 D.1.3 Continuous Case 302 D.2 The Black-Scholes Set Up 303 D.2.1 Endowment Policies 306 D.2.2 Term Insurance 307 D.3 Thiele's Differential Equation 308

8 xvii E An Introduction to Stochastic Integration 313 E.I Stochastic Processes and Martingales 313 E.2 Stochastic Integral 315 E.3 Properties of the Stochastic Integral 319 F CERA Comparison 323 F.I Enterprise Risk Management Concept and Framework 323 F.2 ERM Process (Structure of the ERM Function and Best Practices). 324 F.3 Risk Categories and Identification 324 F.4 Risk Modelling and Aggregation of Risks 325 F.5 Risk Measures 325 F.6 Risk Management Tools and Techniques 326 F.7 Economic Capital 326 References 327 Index 331

Actuarial Risk Management

ARA syllabus Actuarial Risk Management Aim: To provide the technical skills to apply the principles and methodologies studied under actuarial technical subjects for the identification, quantification and