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 Asset Risk Credit Risk Operational Risk is not separate and distinct from the more traditional risk categories. Rather, it overlaps these categories.
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) Mismarking Position (Intentional) Model Errors / Misuse Outsourcing Non-Client Counterparty Disputes Fiduciary Breaches Fraud Anti-Trust Violations Natural Catastrophe / Terrorism Insurance Corollary Under-Reserving (Intentional) Under-Pricing, Under-Reserving (Unintentional) Delegation of Underwriting Authority Reinsurance Disputes Bad Faith Claims Fraud Anti-Trust Violations 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 Primary Causes of P/C Impairments (1969 to 2002) Miscellaneous, 9.8% Impairment of an Affiliate, 3.7% Catastrophe Losses, 6.9% Reinsurance Failure, 3.7% Significant Change, 5.0% Overstated Assets, 7.8% Alleged Fraud, 8.5% Rapid Growth, 17.3% Deficient Loss Reserves, 37.2% 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 pçìêåéw=^kjk=_éëí=`çãé~åó=ó=äó=ééêãáëëáçå Sounds like Operational Risk.
Operational Risk s Impact Annual Numbe r o f P/C Impairme nts 65 60 55 50 45 40 35 30 25 20 15 10 5 0 =====================qçí~ä ===========================fã é~áêã Éåí=`çìåí=====^îÉê~ÖÉ NVSV=íç=OMMOW===================UTN=======================ORKS NVSV=íç=NVVMW===================QUN=======================ONKV NVVN=íç=OMMOW===================PVM=======================POKR 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 Expenses Fraudulent Expenses Processing Errors Covered Losses Fraudulent Losses Total Losses Total Expenses The significant sources of operational risk are implicitly included in regulatory and rating agency capital models. Processing Errors Underwriting Errors Financial Statements Policy Premium Processing Errors Total Premium Pricing Regulatory / Rating Agency Capital Models How is Operational Risk Managed in an Insurance Company?
Management of Operational Risk Communication and discipline are key. U nderw riting Pricing Planning Reserving 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.