Canadian Institute of Actuaries Casualty Actuarial Society JOINT RISK MANAGEMENT SECTION Society of Actuaries ISSUE 24 MARCH 2012 EDITOR’s NOTE 3 Letter from the Editors By Ross Bowen and Pierre Tournier CHAIRPERson’s CORNER 4 How Is Your Risk Appetite These Days? By Stuart Wason RISK IDENTIFICATION 5 The Financial Crisis: Why Won’t We Use the F-(raud) Word? By Louise Francis 8 Who Dares Oppose a Boom? By David Merkel RISK QUANTIFICATION 12 Credit Crisis Lessons for Modelers By Parr Schoolman RISK RESPONSE 14 Five Factors That Courts Consider When Deciding Whether to Enforce Limitation of Liability Provisions in Professional Service Agreements By Joshua D. Maggard, Esq. RISK CULTURE AND DISCLOSURES 19 Insurance Companies’ Highly Controlled Use of Derivatives Has Also Resulted in Protection from the Rogue Trader Problem By Ed Toy 28 Perfect Sunrise: A Warning before the Perfect Storm By Max J. Rudolph Issue Number 24 • MARCH 2012` Published by the Joint Risk Management Section Council of Canadian Institute of Actuaries, Casualty Actuarial Society and Society of Actuaries. Canadian Institute of Actuaries 2012 SECTION LEADERSHIP Casualty Actuarial Society JOINT RISK MANAGEMENT SECTION Society of Actuaries Newsletter Editors Ross Bowen e: [email protected] ARTICLES NEEDED FOR RISK MANAGEMENT Pierre Tournier e: [email protected] Officers Your help and participation is needed and Please send an electronic copy of the article to: Stuart F. Wason, FSA,CERA, FCIA, MAAA, welcomed. All articles will include a byline to HONFIA, Chairperson Stephen P. Lowe, FCAS, ASA, CERA, MAAA, give you full credit for your effort. If you would Ross Bowen, FSA, MAAA Vice Chairperson like to submit an article, please contact Ross Allianz Life Insurance Co. of North America Jason Alleyne, FSA, FCIA, FIA, Co-Treasuer Bowen, editor, at [email protected]. ph: 763.765.7186 Mark J. Scanlon, FSA, CERA, FIA, MAAA, e: [email protected] Co-Treasurer The next issues of Risk Management will be published: Council Members Ross Bowen, FSA, MAAA Susan Cleaver, FCAS, MAAA PUBLICATION SUBMISSION Eugene Connell FCAS, ASA, CERA, FCIA, MAAA DATES DEADLINES Louise Francis, FCAS, MAAA Glenn Meyers, FCAS, ASA, CERA, MAAA August 2012 May 1, 2012 Peter A. Schindler, FSA December 2012 September 3, 2012 David Serge Schraub, FSA, CERA, MAAA Frank Zhang, FSA, MAAA PREFERRED FORMAT SOA Staff In order to efficiently handle articles, please Kathryn Baker, Staff Editor use the following format when submitting e: [email protected] articles: Robert Wolf, Staff Partner e: [email protected] • Word document • Article length 500-2,000 words Sue Martz, Project Support Specialist e: [email protected] • Author photo (quality must be 300 DPI) • Name, title, company, city, state and email Julissa Sweeney, Graphic Designer • One pull quote (sentence/fragment) e: [email protected] for every 500 words This newsletter is free to section members. • Times New Roman, 10-point Current issues are available on the SOA website • Original PowerPoint or Excel files (www.soa.org). for complex exhibits To join the section, SOA members and non- If you must submit articles in another man- members can locate a membership form on the ner, please call Kathryn Baker, 847.706.3501, Joint Risk Management Section Web page at http://www.soa.org/jrm at the Society of Actuaries for help. This publication is provided for informational and educational purposes only. The Society of Actuaries makes no endorsement, representation or guarantee with regard to any content, and disclaims any liability in connection with the use or misuse of any information provided herein. This publication should not be construed as professional or financial advice. Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries. © 2012 Society of Actuaries. All rights reserved. 2 | MARCH 2012 | Risk management CHEAIDITORSPERRs’SON note’S CORNER Letter from the Editors By Ross Bowen and Pierre Tournier WELCOME TO THIS ISSUE OF RISK events are endemic to human nature. He presents his MANAGEMENT! thoughts to regulators for creating an early warning system to detect potential asset bubbles. In this issue our submissions will discuss a variety of topics, from drivers of the financial crisis to the risks “Credit Crisis Lesson for Modelers” by Parr Schoolman actuaries face when working in a consulting position. discusses the challenges and pitfalls of modeling com- plex systems on sparse data. Specifically, the paper We are proud to republish the top three papers from the looks at the sub prime bubble and how both insufficient most recent call for papers, “Risk Management: Part data and model simplification led to modeling error. Two–Systemic Risk, Financial Reform, and Moving Forward from the Financial Crisis,” which were origi- “Five Factors That Courts Consider When Deciding nally published in January 2011. These papers are: Whether to Enforce Limitation of Liability Provisions in Professional Service Agreements” by Joshua Maggard - First Prize: “The Financial Crisis: Why Won’t We use reviews some of the legal risks the F-(raud) Word?” By Louise Francis professional service firms face. - Second Prize: “Perfect Sunrise – A Warning Before the This paper provides examples Ross Bowen, FSA, CFA, MAAA, Perfect Storm” By Max Rudolph of how service agreements can is vice president, profitability - Third Prize: “Who Dares Oppose a Boom?” By David be structured to mitigate future management at Allianz Life Insur- Markel litigation. ance Co. of North America in Min- neapolis, Minn. He can be reached Louise Francis’ winning paper, “The Financial Crisis: “Insurance Companies’ Highly at [email protected]. Why Won’t We Use the F-(raud) Word?” is about the Controlled Use of Derivatives role of moral hazard in the financial crisis. Incentives, Has Also Resulted in culture and regulation of market participants are tied to Protection from the Rogue behavior that contributed to the financial crisis. Trader Problem” by Ed Toy Pierre Tournier, FSA, CERA, is an is a fascinating commentary assistant actuary in the profitabil- “Perfect Sunrise: A Warning Before the Perfect Storm” on how sound regulation has ity management area at Allianz by Max Rudolph comments on the cyclicality of booms reduced insurers’ exposure to Life Insurance Co. in Minn. He can and busts over the last 100 years. This paper first frames rogue trading, while others in be reached at pierrectournier@ the discussion from a behavioral perspective, and then the financial services indus- hotmail.com. poses possible solutions to reduce these systemic driv- try have suffered humiliating ers. and crippling losses due to employee malfeasance. This paper reviews past banking David Merkel’s paper, “Who Dares Oppose a Boom?” trading scandals and compares them to the environment was also recognized in the call for papers. It discusses present in insurance companies. the cause of the recent boom and bust, and why such Enjoy this issue. Risk management | MARCH 2012 | 3 CHCAIHRAISPERPERRSONSON’S’ SCO CORRNENERR How is Your Risk Appetite These Days? By Stuart Wason DEFINING OUR APPETITE FOR RISK IS A FUN- more densely populated with structures being built on DAMENTAL ELEMENT of risk management (ERM). increasingly challenging terrain (hillsides, flood prone Risk appetite defines the risks we are prepared to land, etc.). When combined with increasingly volatile assume (or alternatively those we deliberatively choose and changing weather patterns yet continuing high not to assume) as well as the overall magnitude or size customer expectations for loss coverage, there is a need of those risks that we are prepared to manage. I am sure for property and casualty insurers to regularly review that events of the last few years have caused many a their risk appetites. risk manager or insurer to question their previous ERM risk appetite statements. For life insurers, the examples may be different but the importance of properly defining risk appetite Closely associated with risk appetite is the accompa- remains the same. The inexorable shift in customer nying need for risk tolerances or limits to be applied base brought about by demographic trends (e.g., baby for the risks assumed. One analogy that helps to make boom, Generation X, etc.) has shaped the products clear the difference between risk appetite and risk toler- sold by insurers over the decades. Recent decades have ance is highway driving speed. For example, a driver witnessed the increasing sale of wealth management may make a conscious decision to travel at speeds that products including increasingly complex versions of exceed the speed limit (i.e., their risk appetite) however, variable annuity products (at least in North America). to avoid undue risk to others on the road or speed- These very popular products have also exposed writ- ing tickets, the driver ers of these products to non-diversifiable market risk, limits their excess Stuart F. Wason, FSA, CERA, FCIA, sometimes in considerable amounts. These products over the speed limit MAAA, HONFIA, is senior director mark a change from “traditional” life insurance prod- to 10 or 20 kilome- at the Office of the Superintendent ucts commonly considered to constitute diversifiable ters (for those metric of Financial Institutions Canada in risks (at least with respect to mortality). However, as users!) per hour (i.e., Toronto, ON. He can be reached we experience continued market turbulence, increasing their risk tolerance). [email protected]. asset default risk on many fronts and a long continuing period of very low interest rates, the blocks of in-force As fundamental ele- traditional insurance face significant economic chal- ments of ERM, the determination of risk appetite and lenges. Several life insurers and their boards have had risk tolerances properly require board level approval. to react quickly in recent years to these significant Consequently, we might hope that once put in place, changes in their risk exposures.