Finance 432 - Managing
Financial Risk for Insurers
Professor 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
Technical Problems
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Let me know (s-darcy@uiuc.edu) if you
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What You Need to Be in this Course
Familiarity with insurance terminology
Fin 230 or 232
Understanding of investment instruments
Fin 300
Strong math skills
Calculus through Math 245
Statistics through Math 308
Linear algebra - Math 315 or 383
Spreadsheet 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+)
(2.00)
2001
1996
1991
1986
1981
1976
1971
1966
1961
1956
1951
1946
1941
1936
1931
1926
T-Bill Rate
Short-Term Interest
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
0.00
2001
1996
1991
1986
1981
1976
1971
1966
1961
1956
1951
1946
1941
1936
1931
1926
T-Bond Rate
Long-Term Interest
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
0.00
(5.00)
(10.00)
(15.00)
2001
1996
1991
1986
1981
1976
1971
1966
1961
1956
1951
1946
1941
1936
1931
1926
Inflation Rate
Inflation
20.00
15.00
10.00
5.00
0.00
Merrill Lynch Credit Default Swaps
1/05–1/08 (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: Overview
 On-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 course
 Duration:
•
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 returns
 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
 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)
 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 Risk
 Standards
•
•
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
•
•
•
Position limits
Asset/liability management goals
Use of derivatives
 Incentive
•
guidelines and strategies
schemes
Design compensation to allow employee to
accept risk
Insurance Risk Classification
 C-1:
•
•
C-1 reviews the left side of the balance sheet
Asset value may deviate from current market
value
 C-2:
•
•
Asset default risk
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:
•
•
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:
•
•
Asset/liability mismatch risk
Miscellaneous risk
Beyond insurer ability to predict/manage
Legal risk, political risk, general business risk
Risk Management Systems by
Type of Risk - Actuarial Risk
 Definition:
Uncertainty in loss distribution
 Hedging 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
•
•
•
Options are much less of an issue
Underwriting standards are most important
Potential incentive problem with agents’
compensation
 Potential
•
•
insurance
improvements
Agreement on discount rate for liabilities
Cash flow sensitivities - need more data
Risk Management Systems by
Type of Risk - Systematic Risk
 Definition:
•
•
Market risk - Interest rate risk, Basis risk, and
Inflation risk (especially for P/C)
Undiversifiable but can be hedged
 ALM
is now given much attention
 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)
 Assets
•
Insurers have good systems to monitor asset
systematic risk, especially fixed income assets
 Asset/liability
•
•
Focus has been on surplus effects
Analysis done on each line of business
 Potential
•
•
management
improvements
Need for integrated approach
Use market-based valuation techniques
Risk Management Systems by
Type of Risk - Credit Risk
 Definition:
Failure of counterparty
performance
 Insurers 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 Risk
 Definition:
Demand for immediate cash
 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)
 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)
Conclusions
 Insurers
have a long way to go to manage
financial risk
 Even the best systems are inadequate
 Small insurers lag behind
 Piecemeal 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