Michael Koller Life Insurance Risk Management Essentials 4y Springer
1 What is Risk Management 1 1.1 Introduction 1 1.1.1 Raison D'etre of Risk Management 1 1.1.2 The Role of Risk Management 3 1.1.3 Three Lines of Defence in Risk Management 4 1.2 Principles 4 1.2.1 Risk Categories 5 1.3 Risk Management Process 6 1.4 Risk Management Policies and Risk Landscape 9 2 The Role of the Balance Sheets and of Capital 15 2.1 The Balance Sheet of an Insurance Company 15 2.2 Role of Valuation, 16 2.2.1 Valuation Methods 16 2.2.2 Principle of No Arbitrage 17 2.2.3 Reconciliation of Balance Sheets 19 2.3 Bonds 19 2.4 Shares 30 2.5 Other Assets 32 2.6 Insurance Liabilities 33 2.6.1 Life Insurance Model 34 2.6.2 Capital Insurance 36 2.6.3 Pure Endowment 39 2.6.4 Annuities 39 2.6.5 Cash Flows and Valuation 41 2.6.6 Primer on Life Insurance Risks 43 2.7 Shareholders Equity and Capital 44
Accounting Principles 47 3.1 Statutory Accounting 48 3.2 IFRS and US GAAP Accounting 49 3.3 Embedded Value and Economic Accounting 51 3.3.1 Economic Valuation / Market Consistent Embedded Value 51 3.3.2 Valuation Methodology Revisited 55 3.4 Formulae 57 3.5 Examples 58 3.5.1 Annuity 58 3.5.2 Capital Protection 61 Risk Appetite and Tolerance 65 4.1 Risk Capacity and Risk Appetite 65 4.2 Limit Systems 70 4.3 Hedging Strategies and Response Strategies 72 4.4 Introduction: Use of Capital 74 4.4.1 Definition of the Risk Factors Considered 75 4.4.2 Probability Density Functions per Risk Factor 75 4.4.3, Valuation Methodology 76 4.4.4 Risk Measures 77 4.5 Risk Measures 78 4.5.1 Value at Risk (VaR) 80 4.5.2 Tail Value at Risk (TVaR) 80 4.5.3 Relationship Between Value at Risk and Expected Shortfall 81 4.5.4 What Is a Stress Scenarios Mathematically 83 Key Insurance Processes and Their Risks 85 5.1 Capital Allocation and Planning Process 87 5.2 Economic Capital Calculation Process 90 5.3 ALM and Bonus Setting Process 91 5.4 Product Design Process 94 Financial Risks and Their Modelling 97 6.1 The Model Underlying Financial Risks 97 6.2 Approximations 100 6.3 Concrete Implementation 103 6.4 Interpreting the Results 110 6.4.1 Notation Ill 6.4.2 Scenarios 112 6.4.3 What Can and What Cannot Be Done with This 112 6.5 Reporting Example 113
xiii 6.5.1 Summary 113 6.5.2 Decomposition of VaR 114 6.5.3 Figures 116 6.5.4 Scenarios 117 6.5.5 ICA Capital 119 6.5.6 Stress Tests 120 6.5.7 Limits 121 6.6 Summary Reporting Example 121 7 Insurance Risks 123 7.1 Method for Allocation of Capital 123 7.1.1 Steps Required 124 7.1.2 Probability Density Functions per Risk Factor 124 7.1.3 Diversification 124 7.2 Stochastic Models Used 124 7.2.1 Mortality 124 7.2.2 Longevity 131 7.3 Concrete Example: An Annuity Portfolio 133 7.3.1 Formulae 135 7.3.2 Application to Insurance Linked Securities 137 7.3.3 Statistics 140 7.3.4 Allocation of Risk Capital in Proportion to Premium 143 7.3.5 Reporting Templates 144 8 Operational Risks 147 8.1 Introduction : 147 8.2 Risk Appetite ' 149 8.3 Risk Measurement and Exposure 150 8.4 Controlling Process in General and Embedding Risk Policies 151 8.4.1 Strategy & Planning ( 152 8.4.2 Distribution Management 152 8.4.3 Brand & Marketing Communications 153 8.4.4 Corporate Social Responsibility 153 8.4.5 Environment 154 8.4/6 Regulatory 154 8.4.7 Information Technology 154 8.4.8 Financial Crime 155 8.4.9 Business Protection 156 8.4.10 People 157 8.4.11 Outsourcing 157 8.4.12 Communications 157
xiv Contents 8.4.13 Legal 158 8.4.14 Financial Reporting 158 8.4.15 External Auditor 158 8.4.16 Taxation 159 8.4.17 General Insurance Reserving 160 8.4.18 Life Reserving 160 8.4.19 Capital Management 160 8.4.20 Credit 161 8.4.21 Market 162 8.4.22 Derivatives 162 8.4.23 Liquidity 163 8.4.24 Foreign Exchange 164 8.4.25 Mergers & Acquisitions 164 8.4.26 Risk Management & Internal Control 165 8.4.27 Life Insurance Risk 165 8.4.28 Life Insurance Product Development & Pricing 166 8.4.29 Unit Pricing 166 8.4.30 General Insurance Underwriting 166 8.4.31 General Insurance Reinsurance 167 8.4.32 General Insurance Claims 168 9 Capital Models and Integrated Risk Management 169 9.1 Introduction 169 9.2 Bringing the Puzzle Together 170 9.3 Diversification 172 10 Risk Adjusted Performance Metrics 175 10.1 Introduction 175 10.2 Performance and Value Metrics 176 10.2.1 IBNR Reserves 177 10.2.2 Financial Options 177 10.2.3 Frictional Capital Costs 178 10.2.4 Duration of Projection 179 10.2.5 Formulae 179 ' 10.2.6 Example 180 10.3 Examples 182 10.4 Capital Allocation Process 184 11 Risk Management in a Group and Intra-group Transactions 189 11.1 Introduction 189 11.2 Risk and Capital Transfer Instruments 191
xv 11.2.1 Internal Loans 192 11.2.2 Internal Hybrids 193 11.2.3 Cashpools 193 11.2.4 Guarantees 193 11.2.5 GI / Life Reinsurance Contracts 194 11.3 Ranking of RCTI's 195 11.4 Modelling 195 12 Products and Their Risks 197 12.1 Nuptualite 198 12.2 Index Linked Products and Other Contractual Issues 200 12.3 Variable Annuities 202 12.4 Investment Guarantees and Bonus Rates 207 12.5 Longevity and the Ability to Forecast 212 12.6 Long Term Care 213 12.7 Imperfect Cash Flows Matching 218 13 Emerging Risks 223 13.1 What Are Emerging Risks and Why Are They Important? 223 13.2 What Process Is Needed for Emerging Risks? 225 14 Regulatory View on Risk Management: Solvency II 227 14.1 Introduction 227 14.2 What Is Solvency II? 229 14.3 Economic Balance Sheet and Prudence 231 14.4 Risk Modelling and Internal Models.: 232 14.5 Good Regulation 233 14.6 Swiss Solvency Test 234 14.7 Solvency II Standard Model 237 14.7.1 Structure of the Model! 238 14.7.2 Market Submodule 239 14.8 Quo Vadis? 242 15 Governance and Organisation 243 15.1 Governance 243 15.1.1 Definitions 244 15.1.2 Generic Governance 245 15.1.3 Escalation Processes 246 15.2 Effective Governance 246 15.3 Risk Governance and Oversight Framework 247 15.4 Principles of Effective Oversight 247
xvi Contents 15.5 Board Oversight 247 15.6 Management Oversight 248 15.7 Why Risk Management Committees Are Important 248 15.8 How Do Risk Management Committees Work 249 15.9 Terms of Reference of a Risk Committee 249 15.10 Roles and Responsibilities 253 15.10.1 Duties of the Line Management 253 15.10.2 Duties of the Chief Risk Officer 254 15.10.3 Duties of the Group Internal Audit 256 15.10.4 Risk Relevant Parts Within Job Descriptions 257 15.11 Decomposition of the Risk Management Process 258 15.11.1 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
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