CS-19: Risk Tolerances and Limits

CS-19: Risk Tolerances and Limits Fred Tavan, FSA FCIA Assistant Vice President, Canada Life ERM Symposium, Washington DC July 29, 2003

Introduction • Net Risk • Uses of Exposure Limits • Application types • Determination of Limits

Net Risk • Net Risk = Inherent Risk mitigated by Controls • Inherent Risk = Severity * Probability • Both Severity and Probability are levers • Can put exposure limits on the severity and/or probability

Exposure Limits • RM technique of placing limits on risk exposure metrics to achieve strategic or operational objectives • Used to reduce expected cost of risk • May also be used to reduce variance of cost of risk • Can be applied in many different ways

Application Types • Limit cost of specific event by setting max. acceptable loss • Limit exposure to a specific risk type as a % of total risk • Limit exposure in any specific instance of a risk type • Limit exposure in contractual agreements

Application Types • Limit exposure by placing a cap or floor on a specific risk metric • Limit exposure through pricing by adjusting prices up or down • Limit operational risk

Limiting Specific Event(s) • Example: • Company should not expose itself to any loss on any one risk in an amount exceeding more than 10% of its surplus

Limits that vary by Mgmt. Level • Examples: • Exposure to any one risk exceeding 8% of surplus requires Board approval • Exposure to any one risk exceeding 5% of surplus requires Sr. Mgmt. approval • Exposure of any one risk exceeding 1% of surplus requires approval of Business Line Mgmt.

Limits on specific instance • Examples: • Company shall not acquire more than 3% of its admitted assets in investments of all kinds issued or guaranteed by a single person • $10 million acquisition limit on investment grade and $5million on high yield bonds • Limit is on management actions and not on actual exposure

Contractual Limits • Examples: • Retention limits on life insurance • Cap on disability benefits • Cap on dental benefits • Exclusion clauses

Limits on various Risk Metrics • Examples: • Limit on exposure to interest-rate risk set in terms of duration mismatch • May have separate limits for key rate duration • Limit may involve combination of duration and dollar duration

Limits on Product Exposure • Example: • Co. has a certain planned target risk-based capital ratio • Co.’s plan based on certain amount of capital being allocated to the GIC line • The GIC line has a minimum ROC target • If sales are better than expected then ROC target raised and vice versa

Limits on Operational Risk • Examples: • No more than 24 hour downtime for critical systems used in day-to-day operations • Systems can include cheque writing systems, call center, web site • Turnover of key staff limited to no more than 20% per year • No more than 5 unsigned reinsurance treaties at any one time

Determination of Limits • Depends on a number of factors: • Are there any regulatory limits? • At what level of management will limits apply? • What are the company’s competencies? • What is the company’s tolerance for publicly reporting large losses? • What is the purpose of setting the limit?

Determination of Limits (cont’d) • How bad can things get? • What are the available data and resources? • How do limits impact capital requirements? • What is the impact on operations?

SOA Website • Detailed paper can be found at: • http://www.soa.org/sections/rmtf/exposure_limitations.

CS-19: Risk Tolerances and Limits