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

1. 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

2. Course Website http://www.business.uiuc.edu/ ~s-darcy/Fin432/2008/index.html

3. Technical Problems Some links may not work Let me know (s-darcy@uiuc.edu) if you have problems

4. 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

5. 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

6. 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+)

7. Short-Term Interest

8. Long-Term Interest

9. Inflation

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

11. Examples and Applications • Savings and loan industry • Life insurance industry • Recent financial disasters

12. 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%

13. 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%

14. 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

15. 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

16. Recent Disasters • Long Term Capital Management • Telecommunications industry • Enron • Amaranth • Subprime mortgages

17. 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?

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. Insurance Risk Classification • C-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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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.

31. 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?)

32. 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)

33. 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

34. Next time... • A survey of financial topics • Actuaries in finance • Finance vs. insurance