Part Guidance Note GGN 220.3 - Insurance Act 1973 - Determination of Prudential Standards - GPS 110 - Capital Adequacy for General Insurers; GPS 120 - Assets in Australia for General Insurers; GPS 210 - Liability Valuation for General Insurers; GPS 220 - Risk Management for General Insurers; GSP 230 - Reinsurance Arrangements for General Insurers; GPS 410 - Transfer and Amalgamation of Insurance Business for General Insurers and Transitional Prudential Standard GPS 900- Early Approvals of Auditors and Actuaries (07/02/2002) - Guidance Note GGN 220.3

Guidance Note GGN 220.3

Balance Sheet and Market Risk

The Board and senior management of an insurer must develop, implement and maintain a risk management and control system to address balance sheet and market risks. Balance sheet and market risks include, but are not limited to, insurance and investment risks, and the risks associated with underwriting, claims management, product design and pricing, liquidity management and the use of derivatives. Some of these risks have been discussed in detail elsewhere in GPS 220 Risk Management and the guidance notes. This Guidance Note brings together some of that discussion, and provides guidance on some of the balance sheet and market risks that an insurer’s risk management and control systems need to address.

Insurance

Insurance risk is the risk that the true value of insurance liabilities, both outstanding claims liability and premiums liability, will be greater than the estimated value of insurance liabilities. Insurance risk is one of the most significant risks to which an insurer is exposed. To this end, an insurer’s risk management and control system must include a process for ongoing review and appraisal of the liability valuation framework (ie assumptions made, reinsurance recoveries estimated, etc). In conducting this review, consideration should be given to emerging pricing and claim payment trends.

Investment

Investment risk refers to the possibility of an adverse movement in the value of an insurer’s on-balance sheet assets and/or certain off-balance sheet obligations. Investment risk derives from a number of sources, including market risk (eg equity, interest rate and foreign exchange risk), credit risk, investment concentration risk and asset and liability mismatch risk.
An insurer’s risk management system should document clearly the investment decision making framework, and include information on the process for monitoring, controlling and reporting investment exposures (eg asset allocations, liability portfolio matching criteria, limit structures and dealing authorities, and performance analysis). Requirements in respect of credit risk, concentration risk, liquidity risk and derivatives risk are provided elsewhere in this Guidance Note and Guidance Note GGN 220.4 Credit Quality.

Underwriting

Underwriting is the process by which an insurer determines whether and under what conditions to accept a risk. Weaknesses in the controls and systems surrounding the underwriting process can expose an insurer to the risk of unexpected losses which may threaten the capital position of the insurer.
At a minimum the risk management and control system for underwriting must consist of policies and procedures including:

(a) a statement of the insurer’s willingness and capacity to accept risk;

(b) the classes and characteristics of insurance business that the insurer is prepared to underwrite including:

(i) geographical areas;

(ii) the types of risks that may be underwritten; and

(iii) criteria for the use of policy exclusions and reinsurance;

(i) the criteria for assessing risk;

(ii) the method for monitoring emerging experience; and

(iii) the method by which emerging experience is taken into account in updating the underwriting process;

(d) appropriate approval authorities and limits to those authorities that are definitive and specific (including controls surrounding delegations given to intermediaries of the insurer);

(e) concentration limits; and

(f) methods for monitoring compliance with underwriting policies and procedures such as:

(i) internal audit;

(ii) peer review of policies underwritten;

(iii) assessments of brokers’ procedures and systems to ensure the quality of information provided to the insurer is of a suitable standard; and

(iv) in the case of reinsurers, audits of ceding companies to ensure that reinsurance assumed is in accordance with treaties in place.

Claims Management

Claims management is the process by which insurance companies fulfil their contractual obligations to policyholders. When a loss occurs under an insurance policy the insurer must:

(a) verify the contractual obligation to pay the claim;

(b) make an assessment of the claims liability, including loss adjustment expenses; and

Weaknesses in the controls and systems surrounding the claims management process can expose an insurer to the risk of unexpected losses. These losses may threaten the capital position of the insurer.
At a minimum, the risk management system for claims management must consist of policies and procedures including:

(a) clearly defined and appropriate levels of delegations of authority;

(b) claim settlement procedures, including claim determination and investigation procedures and the criteria for accepting or rejecting claims;

(d) methods for monitoring compliance with claims management processes and procedures such as:

(i) internal audit;

(ii) peer review of claims paid;

(iii) assessments of brokers’ procedures and systems to ensure the quality of information provided to the insurer is of a suitable standard; and

(iv) in the case of reinsurers, audits of ceding companies to ensure that the value of claims paid is in accordance with treaties in place.

Product Design and Pricing

The pricing of an insurance product involves the estimation of claims and costs arising from that product and the estimation of investment income arising from the investment of premium income attaching to the product. Pricing risk may occur where the claims, costs or investment returns arising from the sale of a product are inaccurately calculated.
At a minimum the risk management system for product design and pricing must consist of policies and procedures including:

(a) product lines that the insurer is prepared to engage in or has chosen not to engage in;

(b) clearly defined and appropriate levels of delegation for approval of all material aspects of product design and pricing;

(c) processes for assessing risks, including, risks arising from: inflation; anti-selection; technology changes; catastrophes; legal decisions; changes in government policy; and investment returns;

(d) requirements for limiting risk through, for example, diversification, exclusions and reinsurance;

(e) processes to ensure that policy documentation is adequately drafted to give legal effect to the proposed level of coverage under the product;

(f) how emerging experience is to be reflected in price adjustments;

(g) how the insurer’s product pricing responds to competitive pressures; and

(h) methods for monitoring compliance with product design and pricing policies and procedures.

Liquidity

An insurer should have sufficient liquidity to meet all cash outflow commitments to policyholders (and other creditors) as and when they fall due. The nature of insurance activities means that the timing and amount of cash outflows are uncertain. This uncertainty may affect the ability of an insurer to meet its obligations to policyholders or may require insurers to incur additional costs through, for example, raising additional funds at a premium on the market or through the sale of assets.
At a minimum the risk management system for liquidity must consist of policies and procedures including consideration of:

(a) the level of mismatch between expected asset and liability cash flows under normal and stressed operating conditions;

(b) the liquidity and realisability of assets;

(d) the uncertainty of incidence, timing and magnitude of insurance liabilities;

(e) the level of liquid assets held by the insurer; and

(f) other sources of funding including reinsurance, borrowing capacity, lines of credit and the availability of intra-group funding.

Derivatives

Derivative transactions are financial contracts and include a wide assortment of instruments such as forwards, futures, swaps, options and other similar transactions.
At a minimum, the risk management and control system must consist of policies and procedures including:

(a) a statement of the insurer’s objectives in using derivatives;

(b) the risk tolerances of the insurer and a limit framework consistent with those risk tolerances;

(d) consideration of worst case scenarios and sensitivity analysis and reporting of that analysis.

Guidance Note GGN 220.3Guidance Note GGN 220.3

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