Financial Risk Management of Insurance Enterprises Financial Risk Management by Insurers: An Analysis of the Process

Santomero & Babbel: Overview b On-site review of current financial risk management systems and processes Includes life/health and P/C insurers b What risks are being managed? b What are the shortcomings of current approaches to risk management? b What does the future hold?

Definitions - We will cover some of these terms later in the course b Duration: Measures interest rate sensitivity Duration can change due to options b Hedge: A security or technique used to neutralize a risk exposure b Basis risk: Uncertainty that hedges do not correlate with the underlying risk exposure b Asset/liability management (ALM): Equating the interest rate sensitivities of assets and liabilities

First: Why do we care about risk? b Risk is synonymous with the volatility (standard deviation) of returns b Four potential reasons for managing risk: Managerial self-interest Nonlinear taxes (convex tax structure) Costs of bankruptcy (direct and indirect) Imperfect capital markets

Insurers are faced with risk b Many risks can be shifted to others Reinsurance Catastrophe bonds/futures/options Derivatives can alleviate interest rate risk and other risks Variable/universal life shifts investment risk Outright sale of assets or liabilities

Insurers are faced with risk (continued) b Insurers retain risks which cannot be transferred efficiently Education to investors may be prohibitively expensive Insurers are in business to be risk managers b Initial approaches to manage resulting risk Standardize contracts Diversify assets and liabilities

Techniques to Measure and Monitor Risk b Standards and reports Consistent techniques of evaluating risk exposures Reporting beyond statutory reports (especially more frequently) b Underwriting limits Underwriting standards and risk classifications

Techniques to Measure and Monitor Risk (continued) b Investment guidelines and strategies Position limits Asset/liability management goals Use of derivatives b Incentive schemes Design compensation to allow employee to accept risk

Insurance Risk Classification b C-1: Asset default risk C-1 reviews the left side of the balance sheet Asset value may deviate from current market value b C-2: Liability pricing risk C-2 looks at the right side of the balance sheet Liability cash flows may deviate from our best estimate

Insurance Risk Classification (p.2) b C-3: Asset/liability mismatch risk C-3 looks at interaction of both sides of the balance sheet Recognizes that asset values and liability values do not always move together b C-4: Miscellaneous risk Beyond insurer ability to predict/manage Legal risk, political risk, general business risk

Risk Management Systems by Type of Risk - Actuarial Risk b Definition: Uncertainty in loss distribution b Hedging actuarial risk is difficult Amount to hedge Policyholder can lapse b Life insurance Historically, use low interest rates and high mortality Modern approach recognizes options value

Risk Management Systems by Type of Risk - Actuarial Risk (p.2) b Property/Casualty insurance Options are much less of an issue Underwriting standards are most important Potential incentive problem with agents’ compensation b Potential improvements Agreement on discount rate for liabilities Cash flow sensitivities - need more data

Risk Management Systems by Type of Risk - Systematic Risk b Definition: Market risk - Interest rate risk, Basis risk, and Inflation risk (especially for P/C) Undiversifiable but can be hedged b ALM is now given much attention b Liabilities Increased use of option-adjusted duration P/C has not been concerned with durations

Risk Management Systems by Type of Risk - Systematic Risk (p. 2) b Assets Insurers have good systems to monitor asset systematic risk, especially fixed income assets b Asset/liability management Focus has been on surplus effects Analysis done on each line of business b Potential improvements Need for integrated approach Use market-based valuation techniques

Risk Management Systems by Type of Risk - Credit Risk b Definition: Failure of counterparty performance b Insurers may not be able to transfer some credit risk due to private placements b Insurers have monitored credit risk very closely Internal ratings Watch ratings agencies: Standard & Poor’s, Moody’s, NAIC, etc.

Risk Management Systems by Type of Risk - Liquidity Risk b Definition: Demand for immediate cash b P/C insurers are exposed to event or catastrophe risks Diversify business Reinsure to limit individual exposures Hold large surplus (Marketing impact?)

Risk Management Systems by Type of Risk - Liquidity Risk (p.2) b Life insurance business is long-term with fewer liquidity risks Surrender charges Very little event risk Policy loan rate / crediting rate b Liquidity risk analyzed by ALM committee Stress testing various scenarios (NY Reg. 126)

Conclusions b Insurers have a long way to go to manage financial risk b Even the best systems are inadequate b Small insurers lag behind b Piecemeal approach is inappropriate Need to develop firm level aggregate risk Capital can then be allocated based on the risks of individual insurer activities

In the first three lectures, we have constructed a foundation... w Why risk management is essential in a volatile financial world w Why actuaries can play a key role in managing risk, but that they must learn the language of finance w Why insurers can do a lot more to improve their risk management systems

Next... w We will build the second level of our pyramid and fill our toolbox with: A review of cash flow valuation (Next time) A description of financial instruments used in financial risk management A description of the approaches used to hedge financial risk Use our tools to cap the pyramid You are here