Financial Risk

1
Financial Risk Its Management
and then the second group comes in row,
row, row your boat

• RMI 4700
• Insurance Operations
• Robert Klein

Revised 10/30/09
2
Topic Objectives

• What are the risks associated with financial
  intermediation?

• What types of risks are
• important to insurers and why?
• How do these risks vary among institutions?
• What are the principles and objectives of
  financial risk management?
• What are implications of current financial crisis?

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What is Financial Risk?

• Any risk that can result in financial loss could
  be viewed as a financial risk.
• In practice, we tend to define some risks as
  financial and others as operational.
• We will focus on the most significant financial
  risks but we also need to recognize that certain
  operational risks can have financial consequences
  and should be managed with financial risks in a
  coordinated strategy with a comprehensive focus.

4
Current Financial Crisis

• Investment banks others invested in securities
  that bundled mortgages other loans.
• Many mortgages were not underwritten properly
  were collateralized with inflated property
  values.
• Default risk for these securities was much higher
  than their credit ratings indicated investors
  assumed.
• When real estate prices dropped default risk rose
  substantially ? securities market value fell
  precipitously
• Concerns about the credit worthiness of these
  types of assets has led to cascading problems in
  financial markets and the economy.

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Implications for Insurers

• Insurers have not had large exposures in
  subprime mortgages but some have been hurt.
• AIG is special case it issued credit default
  swaps (CDS) through investment subsidiary.
• Monoline financial guaranty insurers also have
  been severely affected.
• Insurers have been further affected as declines
  in asset values spread to other investments,
  e.g., stocks.
• Life insurers have been much more affected than
  P-C insurers because of their asset structures
  and interest rate guarantees for certain products.

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Systemic Contagion Risk

• Systemic risk refers to the possibility that
  problems in one sector can cause problems in
  other sectors.
• Example AIG CDS supported large amount of
  mortgage-backed securities. When it could not
  meet collateral calls, this threatened many
  institutional investors in these securities.
• Contagion risk refers to the possibility that
  problems of a few firms can undermine confidence
  in other firms.
• Example When some life insurers began suffering
  asset problems this generated concerns about
  other life insurers.

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Lessons

• Insurers are exposed to both systemic and
  contagion risk.
• Systemic risk can lead to cascading problems that
  affect even safe assets, e.g., blue chip
  stocks.
• Contagion risk can lead to run on the bank
  scenarios to which life insurers are especially
  vulnerable.
• Insurers must be aware of and manage both kinds
  of risk.
• Importance of Enterprise Risk Management (ERM)
  which involves comprehensive approach to RM
  including both quantitative qualitative methods.

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Interest Rate Risk

• Arises from mismatch between maturity or duration
  of assets liabilities.

• Market Value Risk
• Changing interest rates affect market value of
  assets liabilities.

Refinancing Risk, i.e. short-funded
Increase in interest rates decrease value of
assets held to pay liabilities potential
shortfall and losses.
Liabilities
Assets
Reinvestment Risk, i.e., long-funded
Decrease in interest rates means that reinvested
assets will earn lower return potential
shortfall and losses.
Liabilities
Assets
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Insurance Illustrations

• Case I Property-Casualty Insurer
• Insurer invests reserves for physical damage auto
  claims in 2-year bonds.
• Claims must be paid at end of year 1, but an X
  increase in interest rates causes market value of
  bonds to fall to X by end of year 1.
• Insurer sells bonds at a lower price suffers
  X short-fall that it must fund from its surplus.
• Case II Life Insurer
• Investing policy reserves from whole life
  contracts in short-term bonds.

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Managing Interest Rate Risk

• Conventional approach is to match maturity of
  assets and liabilities.
• However, this reduces potential profits from
  asset transformation.
• Right strategy depends on type of firm and its
  objectives.
• If principal function of insurer is to pay claims
  contingent on insured events, arguably matching
  strategy will be more predominant.
• However, exact matching by insurers may not be
  optimal.
• Better strategy is to match duration of
  assets/liabilities consider convexity.

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Market Risk

• Arises from actively trading assets liabilities
  their derivatives.
• Should not be a significant issue for an insurer
  if it is not engaging in speculation to partially
  fund its obligations to insureds.
• Consequently, insurance regulators more
  comfortable with insurers using derivatives for
  hedging purposes than for speculation.
• Note insurers with various kinds of assets still
  subject to declines in their values (due to
  factors beyond interest rate changes), i.e.,
  decline in stock prices, decline in real estate
  values.

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Illustration Executive Life

• Had 60 of assets in junk bonds.
• Market assessment of credit quality of junk bonds
  dropped.
• Forced to liquidate large junk bond portfolio in
  bad market.

Michael Milken
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Credit Risk

• Arises from chance that promised cash flow from
  securities may not be fully paid.
• Possibility of default on interest, principal or
  both.
• Higher risk with long-term securities, such as
  those owned by life insurers.
• Firms will require higher risk premium on
  securities with higher default risk.

p1
probability p
Return Distribution of Risky Debt
Return
P
PI
14
Managing Credit Risk

• Firms collect monitor information about issuers
  to assess default risk.
• Rating agencies (e.g., SP) assist in providing
  information.
• Life insurers historically heavy investors in
  private (not publicly traded) securities as they
  are information intensive. This has changed
  somewhat.
• Financial institutions can diversify better than
  households and limit firm-specific risk.
• FIs still exposed to systematic risk.

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Off Balance Sheet Risks

• By definition, do not appear on balance sheet.
• Contingent assets liabilities potentially
  affecting future balance sheets, e.g., letters of
  credit, loan commitments, derivatives.
• Problem fee income may appear on balance sheet
  but not potential losses
• Hence, particularly important for monitors
  regulators to identify.
• Limited recognition in insurer risk-based capital
  (RBC) formulas costly for regulators to assess
  difficult to accommodate within formula
  approach.

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Liquidity Risk

• Arises from need for cash to pay claims on
  assets.
• Sale of low-liquidity assets in short time frame
  can decrease price obtained.
• Liquidity risk can compound if there is a run on
  the bank triggered by crisis in confidence.

• Life insurers experienced this to a limited
  extent when asset values declined in late 1980s,
  early 1990s.

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Other Risks

• Technology Risk
• Benefits of technology not realized, breakdown,
  or improve competitors position.

• Operational Risk
• System breakdowns, e.g., rolling blackouts in CA
  knocked out insurer home offices.
• Foreign Exchange Risk (currency interest)
• Increases with mismatch of denominations/maturitie
  s of assets
• liabilities.
• Country or Sovereign Risk

Perhaps we should tell the international investme
nt community that we are sorry.
18
Insolvency Risk

• Insufficient capital to absorb losses.

• Insurance Definitions
• Insolvency assets less than liabilities
• Impairment surplus below regulatory requirement.

Gentlemen, yours is going to be one of this
periods seminal bankruptcies.

• In insurance, regulators (and statutory
  accounting) tend to assess solvency from
  liquidation perspective if insurer was
  liquidated today, would liabilities exceed assets.

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Mark to Market

• Accounting rules on asset valuation can have
  significant implications for FIs.
• FIs have been forced to significantly lower value
  of assets in instable market.
• Issue If FIs hold on to assets, their ultimate
  market values may rise considerably.
• FASB may has relaxed market valuation rules which
  has eased pressures on FIs.

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Interaction of Risks

• Independence of individual risks, decreases
  overall risk.
• Positive correlation of individual risks
  increases overall risk.
• Factors Affecting Overall Risk
• discrete risks affecting one or more
  assets/liabilities
• events
• macroeconomic changes
• September 11 and financial crisis example.

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Questions?

• What opportunities are created by these risks for
  insurance?

• What are the downside or risk management
  implications for insurers?