Financial Risk Management by Insurers: An Analysis of the Process

Abstract

On-site visits to financial service firms were conducted to review and evaluate their risk management systems. In the insurance sector, this evaluation covered prominent life/health and property-liability insurers, both in the United States and abroad. The information obtained covered both the philosophy and the practice of financial risk management. This article outines the results of this investigation. It reports the state of risk management techniques in the industry. It reports the standard of practice and evaluates how and why it is conducted in the particular way chosen. In addition, critiques are offered where appropriate. We discuss the problems which the industry finds most difficult to address, shortcomings of the current methodology used to analyze risk, and the elements that are missing in the current procedures of risk managment.The past decade has seen a dramatic rise in the number of insolvent insurers. The ostensible causes of these insolvencies were myriad. Some of the insolvencies were precipitated by rapidly rising or declining interest rates. Others resulted from losses on assets such as junk bonds, commercial mortgages, collateralized mortgage obligations, real estate, and derivatives.Mispricing of insurance policies, natural catastrophes, and changes in legal interpretations of liability and the limits of coverage hurt still others. The "churning" of policies by unscrupulous sales agents, insolvencies among the reinsurers backing the policies issued, noncompliance with insurance regulation, and malfeasance on the part of officers and directors of the insurance companies affected some as well. But despite the numerous and disparate apparent causes of these insolvencies, the underlying factor in all of them was the same: inadequate risk management practices. In response to this, insurers almost universally have embarked upon an upgrading of their financial risk

Adverse Selection and the Opaqueness of Insurers

“…Several researchers explain how outdated or nonrepresentative actuarial methods and interest rate structures applied by life insurers introduce risk to embedded options such as policy loans, settlement options, and surrender or renewal provisions. Insurers can protect against such risk by revising policy provisions and using more sophisticated technology (Santomero and Babbel, 1997;Grosen and Jorgensen, 2002), as well as by hedging with derivatives (Hentschel and Smith, 1997). We have no way to estimate the risk engendered by embedded options, so to the extent that they are in place, opaque, and not fully hedged, these options can confound our results.…”

The basis risk of catastrophic-loss index securities

“…VaR is used extensively by financial institutions to measure potential losses or profits from their trading operations and other risky activities (Santomero 1997).…”

Mechanisms of Protection from Interest Rate Risk with Reference to the Life Insurance Market in Montenegro

“…Life insurance companies focus mainly on interest rate risk on a business line, while non-life insurance company observe a significantly wider range of risks and, therefore, develop special techniques of assets and liabilities management and for multiple lines of businesses. Santomero and Babbel (1997) presented an extensive analysis of financial risk management as performed by insurers.…”