Finance 432 - Managing Financial Risk for Insurers Professor Stephen P. D’Arcy Course Introduction Financial Risk Management by Insurers: An Analysis of.

Finance 432 - Managing Financial Risk for InsurersProfessor Stephen P. D’Arcy

Course Introduction

Financial Risk Management by Insurers: An Analysis of the Process by Santomero and Babbel

Course Website

http://www.business.uiuc.edu/

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What You Need to Be in this CourseFamiliarity with insurance terminology

Fin 230 or 232Understanding of investment instruments

Fin 300Strong math skills

Calculus through Math 245Statistics through Math 308Linear algebra - Math 315 or 383Spreadsheet competence

Why study financial risk management?

• Deal with financial market volatility• Protect balance sheet from exposure to

financial risk• Understand derivative instruments and

other risk management products• Avoid misuse of derivatives

– Accounting scandals– Excessive exposure to risk– Misleading financial analysts’ reports

Why the increased volatility?

• Foreign Exchange– Breakdown of Bretton Woods (early 1970s)

• Interest rates– New Fed policy (late 1970s)

• Commodity prices– OPEC shock (1970s)

• New securities– Subprime mortgage crisis (2007+)

Short-Term Interest

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Long-Term Interest

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Inflation

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Merrill Lynch Credit Default Swaps1/05–1/08 (Source: Bloomberg)

Examples and Applications

• Savings and loan industry

• Life insurance industry

• Recent financial disasters

The Savings & Loans Business - The Good Years

• S&L assets mostly long term maturity mortgages

• S&L liabilities usually short term savings deposits

• Pre-1980s, upward sloping yield curve is formula for success– Earn 6%, Pay 3%

The Savings & Loans Business - The Bad Years

• Was the S&L position a bomb waiting to detonate?

• 1980s - the yield curve inverts– Still earn 6%, but pay

12%

Insurers’ exposure in the 1980s

• Life insurers allowed policyholder loans

• Loan rates had a ceiling fixed by the contract at issue– Prior to 1980s, the ceiling exceeded rates

available on earning assets

• Disintermediation– Money flowed out of life insurers into short

term instruments such as money market funds

Responses to financial volatility

• Derivative products– Forwards and futures– Swaps– Options

• Application of risk management concepts to a firm’s balance sheet

• Finance 432 and seminars in financial risk management

Recent Disasters

• Long Term Capital Management

• Telecommunications industry

• Enron

• Amaranth

• Subprime mortgages

Santomero & Babbel: OverviewOn-site review of current financial risk

management systems and processes• Includes life/health and P/C insurers

What risks are being managed?What are the shortcomings of current

approaches to risk management?What does the future hold?

Definitions - We will cover some of these terms later in the courseDuration: Measures interest rate sensitivity

• Duration can change due to options

Hedge: A security or technique used to neutralize a risk exposure

Basis risk: Uncertainty that hedges do not correlate with the underlying risk exposure

Asset/liability management (ALM): Equating the interest rate sensitivities of assets and liabilities

First: Why do we care about risk?Risk is synonymous with the volatility

(standard deviation) of returnsFour 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 riskMany 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)Insurers retain risks which cannot be

transferred efficiently• Education to investors may be prohibitively

expensive• Insurers are in business to be risk managers

Initial approaches to manage resulting risk• Standardize contracts• Diversify assets and liabilities

Techniques to Measure and Monitor RiskStandards and reports

• Consistent techniques of evaluating risk exposures

• Reporting beyond statutory reports (especially more frequently)

Underwriting limits• Underwriting standards and risk classifications

Techniques to Measure and Monitor Risk (continued)Investment guidelines and strategies

• Position limits• Asset/liability management goals• Use of derivatives

Incentive schemes• Design compensation to allow employee to

accept risk

Insurance Risk ClassificationC-1: Asset default risk

• C-1 reviews the left side of the balance sheet• Asset value may deviate from current market

value

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)

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

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 RiskDefinition: Uncertainty in loss distributionHedging actuarial risk is difficult

• Amount to hedge• Policyholder can lapse

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)

Property/Casualty insurance• Options are much less of an issue• Underwriting standards are most important• Potential incentive problem with agents’

compensation

Potential improvements• Agreement on discount rate for liabilities• Cash flow sensitivities - need more data

Risk Management Systems by Type of Risk - Systematic RiskDefinition:

• Market risk - Interest rate risk, Basis risk, and Inflation risk (especially for P/C)

• Undiversifiable but can be hedged

ALM is now given much attentionLiabilities

• 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)

Assets• Insurers have good systems to monitor asset

systematic risk, especially fixed income assets

Asset/liability management• Focus has been on surplus effects• Analysis done on each line of business

Potential improvements• Need for integrated approach• Use market-based valuation techniques

Risk Management Systems by Type of Risk - Credit RiskDefinition: Failure of counterparty

performanceInsurers may not be able to transfer some

credit risk due to private placements 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 RiskDefinition: Demand for immediate cashP/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)Life insurance business is long-term with

fewer liquidity risks• Surrender charges• Very little event risk• Policy loan rate / crediting rate

Liquidity risk analyzed by ALM committee• Stress testing various scenarios (NY Reg. 126)

ConclusionsInsurers have a long way to go to manage

financial riskEven the best systems are inadequateSmall insurers lag behindPiecemeal approach is inappropriate

• Need to develop firm level aggregate risk• Capital can then be allocated based on the risks

of individual insurer activities

Next time...

• A survey of financial topics

• Actuaries in finance

• Finance vs. insurance