actuarial approaches for measuring & managing financial

Actuarial Approaches for Measuring & Managing

Financial/Economic Risks

CASE Fall ’19, Atlanta, GASpeaker: Jim McNichols, ACAS, MAAA, MIAAHuggins Actuarial Consultants

October 7, 2019

Risk Measurement Construct

• Quantifying risk involves measuring an event in three dimensions:

– Likelihood of occurrence– Severity of consequence– Predictability of outcomes according to first two parameters

Classic Actuarial Risk Rating Approach

<= Cumulative Loss Distribution; orAggregate Loss Distribution

Risk Measurement Context

• Context is Key

– Process Risk– Parameter Risk– Model Risk

Risk Measurement Context

Risk versus Uncertainty

CLEMSON UNIVERSITY MASTERS LEVEL COURSE : CE 8490Enterprise Risk AnalyticsFall 2019

Risk: We know what the distribution of possible outcomes looks like,but we don’t know which outcome will result.

RISK v UNCERTAINTY

CLEMSON UNIVERSITY MASTERS LEVEL COURSE : CE 8490Enterprise Risk AnalyticsFall 2019

Risk: We know what the distribution of possible outcomes looks like,but we don’t know which outcome will result.

Uncertainty : We don’t know what the distribution of possible outcomes looks like,and we don’t know which outcomes will result.

RISK v UNCERTAINTY

Modeling Interest Rate Risk

k => speed of mean reversionb => grand mean

Measuring the Impact from Interest Rate Changes on the Value of the Bond Portfolio

Modeling Market

Price RiskAll these approaches involve Markov Chain Monte Carlo (MCMC) simulation modeling techniques.

Practical applications include:• Equity returns (capital modeling)• Commodity price risk (ERM)• FX translation risk (captives)

Practical Project #1 (Foreign Exchange (FX))

Markov Chain Monte Carlo “Stochastic” Modeling

MCMC “Stochastic” Modeling

Expected

Expected

Confidence Level 95%or 1 out of 20 years

Confidence Level 67%or 1 out of 3 years

Expected

Confidence Level 95%or 1 out of 20 years

Confidence Level 67%or 1 out of 3 years

Practical Project #1 (FX), continued

Practical Project #1 – FX, continued

Fundamental risk driver differs from traditional P&C risks

<= Traditional Property & Casualty Risk Profile(s)

<= Foreign Exchange risk exposures demonstrate excess “kurtosis”

Excess Kurtosis (i.e., values > 3.0) is the primary determinant for the quantum of the critical pricing variable, namely: the Risk Premium Multiplier

Practical Project #1 – FX, continued

Practical Project #1 – FX, continued

For qualifying risk pools~:The pricing structure contains two critical features:

1. Gross Premium = [Exposure] x (Call Option Rate) x {Risk Multiplier}2. Retro Premium Adjustment => provides risk sharing corridor

~ requires a necessary number of foreign operating units (usually 20+)AND a sufficient number of currency pairs (usually 12+).

Practical Project #1 – FX , continuedExcess Kurtosis (amounts > 3) is primary driver of the Risk Premium Multiplier

Analysis of Underlying Risk Processes

Normal v Leptokurtotic

Contagion & Liquidity Risk Elements necessitate introduction of:Premium Risk Multipliers and Retro Premium Adjustments

Single currency pair (i.e. USD_JPY), 1-year policy term, Foreign Exchange rate at inception = 110.50

Gross Premium = Exposure x Call Option Rate x Pool Risk Multiplier($25,000,000) x (3.425%) x (1.75) = $1.5 million <= defines gross written premium.

Gross Paid Loss determined as: [(Average Annual Foreign Exchange Rate / Foreign Exchange Rate at Inception) – 1] xExposure.

Retro Premium Adjustment Mechanism~- If actual loss ratio < 40%, then policyholder receives 70% of GWP in the form of a Return Premium.

- If actual loss ratio > 110%, then policyholder receives Zero Return Premium.

- If actual loss ratio in between 40% and 110%, then policyholder receives a partial Return Premium based upon a slidingscale reflecting the quantum of losses in excess of 40%.

~ Gearing of the Risk Premium Adjustment mechanism is mission critical!

Practical Project #1 – FX , continued

Other Risk Measurement and Management Considerations

Practical Project #1 – FX , continued

Risk pool demographics (large versus small policyholders)

Internal offsets (strong dollar versus weak dollar coverages)

Staggering of policy inception dates

Variable policy terms

Currency covariance profile

2012 Price Movements for USD v (EUR, CAD, JPY, AUD)

2014/2015 Price Movements for USD v (EUR, CAD, JPY, AUD)

Practical Project #2 (Recession Risk)

• Large US Corporations (i.e., manufacturing) form single parent captive,domiciled in the State of Vermont.

• Parent corporation has numerous operating companies based in the USA andthroughout the world.

• Actuaries work directly with corporate tax/treasury advisors to create the riskstructure, price the policies, and establish credible measures for the expectedpaid losses and return premium obligations to policyholders.

• Gross Premium = Exposure x actuarially determined rate.• Retro Premium Adjustments apply for favorable underwriting results.

Practical Project #2 (Recession), continued

Practical Project #2 (Recession), continued DEPENDENT FREQUENCY RISK PROFILE; and DEPENDENT SEVERITY RISK PROFILE Equates to CONSERVATIVE FREQUENCY SET; CONSERVATIVE SEVERITY SET More Complex to Model

DEPENDENT FREQUENCY RISK PROFILE; and INDEPENDENT SEVERITY RISK PROFILE Equates to CONSERVATIVE FREQUENCY SET; OPTIMISTIC SEVERITY SET Most Difficult to Model

INDEPENDENT FREQUENCY RISK PROFILE; and DEPENDENT SEVERITY RISK PROFILE Equates to OPTIMISTIC FREQUENCY SET; CONSERVATIVE SEVERITY SET Easiest to Model

INDEPENDENT FREQUENCY RISK PROFILE; and INDEPENDENT SEVERITY RISK PROFILE Equates to OPTIMIST FREQUENCY SET OPTIMISTIC SEVERITY SET More Complex to Model

Practical Project #2 (Recession), continued

Practical Project #2 (Recession), continued

Source: National Bureau of Economic Research (NBER)

Practical Project #2 (Recession), continued

Practical Project #3 (Credit Risk)

US Mortgage and Consumer Credit Risk Analyses

Current Expected Credit Losses (CECL)- FASB DEFERRAL for US Standards

Questions and Discussion

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