Operational Risk Management in a
Property/Casualty Insurance Company
Mark Verheyen, FCAS, MAAA
CAS Spring Meeting
May 2005
A Carvill service
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 Affiliates
R1 – Asset Risk – Fixed Income
R2 – Asset Risk – Equity
R3 – Credit Risk
R4 – Underwriting Risk – Reserves
R5 – Underwriting Risk – Premium
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Traditional Measures of Risk
Best’s
B1
B2
B3
B4
B5
B6
B7
Capital Adequacy Ratio
- Fixed Income Securities
- Equity Securities
- Interest Rate Risk
- Credit Risk
- Loss + LAE Reserve Risk
- Premium Risk
- Business Risk – Off-Balance Sheet Items
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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
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What is Operational Risk
in an Insurance Company?
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Operational Risk
Underwriting Risk
Reserving Risk
Operational Risk
Asset Risk
Credit Risk
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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 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.
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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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Operational Risk’s Impact
Primary Causes of P/C Impairments
(1969 to 2002)
Miscellaneous,
9.8%
Im pairm ent
of an Affiliate,
3.7%
Deficient Loss
Reserves,
37.2%
Catastrophe
Losses,
6.9%
Reinsurance
Failure,
3.7%
Significant
Change,
5.0%
Overstated
Assets,
7.8%
Alleged Fraud,
8.5%
“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
Rapid Grow th,
17.3%
Sounds like Operational Risk.
Source: A.M. Best Company – by permission
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Operational Risk’s Impact
Annual Number of P/C Impairments
2002
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
Average
25.6
21.9
32.5
1979
1977
1975
Total
Im pairm ent Count
871
481
390
1973
1971
1969 to 2002:
1969 to 1990:
1991 to 2002:
1969
65
60
55
50
45
40
35
30
25
20
15
10
5
0
Source: A.M. Best Company - by permission
Impairments increase following prolonged
soft markets. Why is Operational Risk tied
to the Underwriting Cycle?
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How is Operational Risk Quantified
in an Insurance Company?
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Quantification of Operational Risk
Standard
Expenses
Fraudulent
Expenses
Covered
Losses
Fraudulent
Losses
Total Expenses
Total Losses
Processing
Errors
The significant sources
of operational risk are
implicitly included in
regulatory and rating
agency capital models.
Processing
Errors
Underwriting
Errors
Financial
Statements
Policy
Premium
Pricing
Total Premium
Regulatory /
Rating Agency
Capital Models
Processing
Errors
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Quantification of Operational Risk
NAIC RBC Model
Premium 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
Communication and discipline are key.
Pric
in
Plannin
g
g
Underwriting
Reserving
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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Management of Operational Risk
“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 longterm incentives tend to be profitability based.
Everyone needs to be aware of what the incentives are and how they
impact behavior.
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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
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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 companyspecific 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.
mverheyen@readvisory.com
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