Bank of Montreal 2010 Annual Report Download - page 90

MANAGEMENT’S DISCUSSION AND ANALYSIS
MD&A
Model Risk
BMO uses models that range from the very simple to those that value
complex transactions or involve sophisticated portfolio and capital
management methodologies. These models are used to guide strategic
Model risk is the potential loss due to the risk of a model not
performing or capturing risk as designed. It also arises from
the possibility of the use of an inappropriate model or the
inappropriate use of a model.
decisions and to assist in making daily lending, trading, underwriting,
funding, investment and operational decisions. Models have also been
developed to measure exposure to specific risks and to measure total risk
on an integrated basis, using Economic Capital. We have strong controls
over the development, implementation and application of these models.
BMO uses a variety of models, which can be grouped within
six categories:
• valuation models for the valuation of assets, liabilities or reserves;
•
risk exposure models measuring credit risk, market risk, liquidity risk and
operational risk, which also address expected loss and its applications;
Business Risk
Business risk arises from the specific business activities of
a company and the effects these could have on its earnings.
Business risk encompasses the potential causes of earnings volatility
that are distinct from credit, market or operational risk factors.
It identifies
factors related to the risk that volumes will decrease
or margins will shrink without the ability to compensate for this
decline by cost cutting.
BMO faces many risks that are similar to those faced by non-
financial firms, principally that our profitability, and hence value, may
be eroded by changes in the business environment or by failures of
strategy or execution. Sources of these risks include, but are not limited
to, changing client expectations, adverse business developments and
relatively ineffective responses to industry changes.
Within BMO, each operating group is responsible for controlling
its respective business risk by assessing, managing and mitigating
the risks arising from changes in business volume and cost structure,
among other factors.
Insurance Risk
Insurance risk consists of:
• Claims risk – The risk that the actual magnitude or frequency of
claims will differ from the levels assumed in the pricing or underwriting
process. Claims risk includes mortality risk, morbidity risk and natural
catastrophe risk.
• Policyholder behaviour risk – The risk that the behaviour of policy-
holders relating to premium payments, withdrawals or loans, policy
lapses and surrenders and other voluntary terminations will differ
from the behaviour assumed in the pricing calculations.
• Expense risk – The risk that actual expenses associated with acquiring
and administering policies and claims processing will exceed the
expected expenses assumed in pricing calculations.
Insurance risk approval authority is delegated by BMO’s Board of Directors
to senior management. A robust product approval process is a corner-
stone for identifying, assessing and mitigating risks associated with
new insurance products or changes to existing products. This process,
combined with guidelines and practices for underwriting and claims
management, promotes the effective identification, measurement and
management of insurance risk. Reinsurance, which involves transactions
that transfer insurance risk to independent reinsurance companies,
is also used to manage our exposure to insurance risk by diversifying
risk and limiting claims.
Insurance risk is monitored on a regular basis. Actuarial liabilities
are estimates of the amounts required to meet insurance obligations.
Insurance risk is the risk of loss due to actual experience being
different than that assumed when an insurance product was
designed and priced. Insurance risk exists in all our insurance
businesses, including annuities and life, accident and sickness,
and creditor insurance, as well as our reinsurance business.
Liabilities are established in accordance with the standards of practice
of the Canadian Institute of Actuaries and the CICA. The liabilities are
validated through extensive internal and external reviews and audits.
Assumptions underlying actuarial liabilities are regularly updated to
reflect emerging actual experience. The Appointed Actuary of our
Canadian insurance subsidiaries is appointed by the boards of directors
and has statutory responsibility for providing opinions on the adequacy
of provisions for the policyholder liabilities, the solvency of the insurance
company and fairness of treatment of participating policyholders. In
addition, the work of the Appointed Actuary is subject to an external,
independent review by a qualified actuary every three years in accor-
dance with OSFI Guideline E-15.
The Board of Directors establishes approval authorities and
limits and delegates these to the management teams of the insurance
subsidiaries. The boards of directors of our insurance subsidiaries are
responsible for the stewardship of their respective insurance companies.
Through oversight and monitoring, the boards are responsible for
determining that the insurance subsidiaries are managed and function
in accordance with established insurance strategies and policies.
ER&PM is responsible for providing risk management direction and
independent oversight to the insurance businesses. This group also has
the approval authority for activities that exceed delegated authorities
and limits of the boards of the insurance companies, or that expose
BMO to significant risk.
Our insurance subsidiaries provide independent evaluation and
reporting on insurance risk exposures to their boards of directors and at
the enterprise level, including reporting to both Private Client Group
management and the Risk Review Committee of the Board of Directors.
Reporting includes an assessment of all risks facing the insurance
subsidiaries, including top-line and emerging risks.
88 BMO Financial Group 193rd Annual Report 2010