The Importance of Managing Risk Quality
One possible reason that insurers might need to regularly perform the difficult and expensive process of calculating Economic Capital is that they lack any significant Risk Quality control process. They do not know the quality of the risks that they write and they have no existing process for monitoring changes in risk quality and acting upon those changes to bring risk quality back into line.
What is this mysterious Risk Quality, you ask?
Risk Quality if the amount of risk per unit of business activity.
The bottom up risk management process would then be to define the acceptable levels of Risk Quality for a business and then to establish a risk underwriting process to determine the Risk Quality at time of consideration for acceptance, processes for modifying the inherent Risk Quality to achieve an acceptable Risk Quality at time of acceptance. Then during the exposure period, the Risk Quality would be monitored to determine whether it had changed and if there was a change that caused the residual risk to now be unacceptable, the risk manager would undertake to again take steps to bring the risk back into the acceptable range.
With the Risk Quality bottom up type risk management system, the responsibility of to central staff is to verify whether the risk quality pieces add up to an acceptable amount of risk. If they do, then the business unit managers have a clear process to manage. They have a risk budget in the aggregate. They know that their expected mix of business among the different classes of risk quality will fit with that budget, so their management process then can focus on the trade-offs between the different classes.
The quantum of risk can be calculated by a simple formula then:
Total Risk = Sum over all risk classes of (Risk per unit of business activity X amount of business activity) – diversification adjustment.
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