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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/
~s-darcy/Fin432/2008/index.html
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
(2.00)
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
16.00
1926
1931
1936
1941
1946
1951
1956
1961
1966
1971
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1981
1986
1991
1996
2001
T-B
ill R
ate
Long-Term Interest
0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
16.00
1926
1931
1936
1941
1946
1951
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1961
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1971
1976
1981
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1991
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2001
T-B
on
d R
ate
Inflation
(15.00)
(10.00)
(5.00)
0.00
5.00
10.00
15.00
20.00
1926
1931
1936
1941
1946
1951
1956
1961
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1971
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1981
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1991
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Infl
ati
on
Rate
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
