1. Financial Risk Management of Insurance Enterprises
Use of Financial Derivatives by US Insurers 1

2. Overview
Over the past few weeks, we have introduced the basic financial derivatives used to manage financial risk
Cummins, Phillips, and Smith review the use of these basic derivatives in the insurance industry 2

3. Review of Insurer Function
Risk bearing and risk pooling
Insurers accept risk of loss in return for premiums
Insurers diversify risk by writing policies on independent risks
Intermediation
Insurers issue “debt” contracts in the form of policies and invest proceeds in assets
Earn a spread of asset return less debt yield 3

4. Financial Risk Management Needs
Matching interest rate sensitivities of assets and liabilities is known as asset-liability management (ALM)
Existing assets may not allow insurers to exactly match the liability cash flow
If cash flows of assets and liabilities match, then their interest rate sensitivities must also match 4

5. Financial Risk Management Needs (p.2)
ALM becomes more difficult if options in policies exist which may alter cash flow
e.g., the right to lapse or the right to borrow against cash value
Derivatives can be used in two ways:
To offset any options in the insurer’s policies
To adjust the interest rate sensitivity of assets/liabilities more cheaply than direct investment 5

6. Hypotheses Explaining Use of Derivatives
Size is positively related to usage
Human capital economies of scale
Organizational form (stocks vs. mutuals)
Stock companies have comparative advantage to take up risky business due to ease of monitoring by owners
Line of business
Life insurers have more exposure to interest rate risk 6

7. Hypotheses Explaining Use of Derivatives (p.2)
Amount of asset/liability mismatch
Difficult to determine given lack of financial data
Maturity of bonds is used as a proxy
Use of derivatives may be related to asset risk
As percentage of equities or foreign assets increase, so does use of derivatives
Asset holdings can affect amount of options bought for protection or sold for income enhancement
Use of reinsurance hedges underwriting risk and may be substitute for derivatives 7

8. Data of the Study 1994 annual statements filed with NAIC
1,760 life insurers and 2,707 PC insurers
Categories of derivatives included:
Options, caps, and floors owned
Options, caps, and floors written
Collars, swaps, and forward agreements
Futures contracts
What is special about each of the groups?
Credit risk and one- vs. two-sided performance 8

9. Types of Contracts Used
“Most popular” types of contracts are ranked by notional amounts
Tables 3-4 and Tables 5-6 report type of contract two ways
At end of year (snapshot of protection provided at one point in time)
Opened in 1994 (can be skewed by length of contract) 10

10. Types of Contracts Used (p.2)
Swaps, caps, and forwards are the most popular derivatives among insurers
Less use of options and futures
Still, notional amount of call options written is noteworthy
May be income enhancement strategies such as a covered call 11

11. Table of Results - Average Values

12. Results 12% of life insurers and 7% of PC insurers use derivatives
About the same number of users for each
Stock insurers use derivatives more
Life insurers: 16% of stock companies, 7% of mutuals
PC insurers: 10% of stock companies, 4% of mutuals
As the size of companies increase, so does the proportion of derivatives users 9

13. Results (p.2) Derivatives can provide liquidity protection
Insurers with a higher percentage of assets in privately-placed bonds use derivatives
Insurers with more short term investments do not use derivatives
Users of derivatives have longer bond maturities than non-users
Insurers may try to pick up yield but use derivatives to hedge interest sensitivity
Insurers who use reinsurance less use derivatives more

14. Underlying Assets of the Derivatives - Life Insurers
Options in life insurer policies make liabilities very interest rate sensitive
Companies with higher reserves in GICs, whole life, and group annuities are users of derivatives
Companies with higher reserves in group life are not
Life insurers overwhelmingly use derivatives to manage interest rate risk
Caps/floors
Interest rate swaps
Options and/or futures positions on bonds 12

15. Underlying Assets of the Derivatives - PC Insurers
PC insurers have higher percentage of assets in equities
Use of equity options both provide protection and enhance income
PC insurers do use FX forwards
Foreign subsidiaries’ hedge 13

16. Counterparty Exposure
Top dealers (counterparties) are mostly investment banks
e.g., Prudential Bache, Goldman Sachs, Salomon Brothers, Bankers Trust
Prudential Bache was counterparty to 36.8% of contracts opened during 1994
Top exchanges are Chicago Board of Trade, Chicago Board of Options Exchange, and New York Stock Exchange

17. Finance 432 First Exam Tuesday, February 27, 2007 1-2:20 pm 429 Armory

18. First Exam Details Exam is open book, open note.
Test covers material from lectures 1-11 and assignments 1-3.
Exam tests your ability to perform calculations and to explain financial risk management concepts.
Test taking advice:
First answer all the questions you can without relying extensively on your notes.
Then work on the remaining questions if time permits.

19. Pre-Exam Office Hours 311 Wohlers Hall
Friday, February pm
Monday, February :30 pm