Financial Risk Management of Insurance Enterprises

1
Financial Risk Management of Insurance Enterprises

• Measuring a Firms Exposure to Financial Price
  Risk

2
Overview

• What is a risk profile?
• How do we measure risk exposure?
• What information sources are available to measure
  risk exposure?
• What internal measures are used?
• What market-based measures are used?

3
Key to analyzing risk exposure Correlation
Analysis

• Do cash flows fluctuate with some underlying
  financial variable?
• Do inflows decrease as interest increases?
• Do outflows increase as the exchange rate
  decreases?
• Does the firms stock price change as key
  variables change?

4
Correlation Review

• Definition degree of the relationship between
  variables
• If ? 0, no correlation (independence)
• If ? 1, there is perfect correlation
• In EXCEL, use CORREL function

5
Correlation Review (cont.)
6
Risk Profile

• Graphical summary of relationship between two
  variables
• Example As interest rates increase, SL value
  decreases

7
Risk Profile (Cont.)

• NOTE For SLs, this risk profile is apparent
  from the balance sheet
• The balance sheet lists long-term vs. short-term
  assets and liabilities
• Economic exposures require more work
• Example Construction company will be affected by
  higher interest rates
• Enter correlation analysis

8
Gap Analysis

• Gap analysis is frequently used in banking as a
  crude measure of interest rate exposure
• For a given maturity, the gap is defined as the
  value of assets with that maturity less the
  liabilities of the same length
• If a floating-rate note resets quarterly, it is
  put in the 3-month gap
• If gapgt0, firm benefits from increase in interest
  (Why?)

9
Sources of Information for Financial Risk Exposure

• Financial Statements (Note Beware of accounting
  tricks)
• Balance sheet - including notes
• Income statement - including notes
• Statement of changes in financial position
• Letter to shareholders
• Internally generated reports
• Stock price movements

10
Balance Sheet

• Liquidity risk
• Compare short-term assets vs. liabilities
• Indicates ability to survive short-term shocks
• Look at industry average for accounting ratios
• Leverage
• Review outstanding debt vs. equity
• Indicates cushion for longer maturity shocks
• Foreign assets/liabilities reveals FX exposure

11
Balance sheet (cont.)

• Interest rate exposure
• Review outstanding interest-bearing assets or
  liabilities
• Are they floating or fixed rate?
• Footnotes can illustrate exposures
• Explain questionable accounts
• Detail contingent exposures

12
Income Statement

• How well is firm handling debt payments?
• Is there any foreign income or expense?
• Can we determine any historical relationships?
• May need more frequent reports than annually

13
Other Announcements

• Can explain good/poor performance and the reason
  for it
• Can give hints on future
• Examples
• Letters to shareholders
• Press releases

14
Internal Measures

• Use detailed cash inflow/outflow reports to
  perform regressions against
• Interest rates
• Exchange rates
• Commodity or equity prices
• Monte Carlo Simulation
• Model financial results (need assumptions)
• Can be entire firm or a line of business

15
External Measures

• Based on market price of stock
• Why does State Farm not use this approach?
• Measure correlation of stock price with key
  financial variables
• Rt a biFit
• Rt is stock return bi is sensitivity measure to
  factor i Fit is level of factor i
• Duration measures change in value for a given
  change in the interest rate

16
In the first four lectures, we have constructed a
foundation...

• Why risk management is essential in a volatile
  financial world
• Why actuaries can play a key role in managing
  risk, but that they must learn the language of
  finance
• Why insurers can do a lot more to improve their
  risk management systems
• How to begin to analyze a firms exposure to
  financial risk

17
Next...

• We will build the second level of our pyramid and
  fill our toolbox with
• A review of cash flow valuation (Next time)
• A description of financial instruments used in
  financial risk management
• A description of the approaches used to hedge
  financial risk
• Use our tools to cap the pyramid

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