Insights into Risk Management in the Insurance Industry

The survey conducted by E&Y, reveals the current thinking and expectations of executives across the globe.

Macroeconomic trends and slow rates of growth are viewed as the leading risk for insurance companies. Customer focus — improved distribution and product development — dominates the list of opportunities.

Broadly speaking, Non –life Insurance companies are exposed to the following six types of financial risk:

  1. Liquidity /Funding Risk :

Maintenance of sufficient liquidity remains a sine quo non of the organization. Liquidity in the organization can be defined as the ability of the company to meet commitments when due and also to undertake new transactions when desirable. To avoid this risk, the Investment department should assess /monitor the liquidity position and share of volatile liabilities in the total liabilities of the insurance companies vis a vis the market liquidity /interest rate movement and initiate prompt action to cover the risk

2. Credit Risk :

Credit risk covers all risks related to a borrower not full filing his obligations on time. Credit risk is not only confined to the risk of non –payment by the borrower but also the risk of payments being delayed thereby affecting the cash-flow problems. Credit risk is also known as default risk

Credit risk management involves three key principles:

  1. Selection
  2. Limitation and
  3. Diversification

Now there is a provision of credit rating, Exposure norms to ensure that the credit risk is mitigated to a large extent,

3. Investment Risk :

The process of identification, analysis, and either acceptance or mitigation of uncertainty in investment decision-making comprises the process of investment risk management. Simply put risk management is a two-step process –determining what risks exist in an investment and then handling those risks in a way best suited to organization investment objectives

a. Duration gap:- The duration gap is the difference between the duration of assets and liabilities , this a financial and accounting term and is typically used by banks, pension funds, and other financial institution to measure their risk due to changes in the interest rate

b. Convexity gap:- Convexity is a measure of the curvature in the relationship between bond prices and bond yields that demonstrates how the duration of a bond changes as the interest rate changes

c. Sharpe ratio:- The Sharpe ratio is a measure of risk. The sharp ratio is a ratio of return versus risk

d.Tracking error:- Tracking error is the difference between a portfolio’s returns and benchmark or index it was meant to mimic or beat. Tracking error sometimes called active risk

4. Interest-rate Risk:

Fluctuations in interest rates, being a very common phenomenon, thus lead to a host of risks of different dimensions to which assets and liabilities of banks are perennially exposed. Interest rate risk arises from holding assets and liabilities with different principal amounts, maturity dates, or re-pricing dates.

Interest rate risk can be broadly classified into Mismatch risk or Gap risk, Basis risk, Net interest position risk, Embedded option risk, Yield curve risk, Price risk, and Reinvestment risk.

5. Exchange rate Risk: If assets and liabilities are denominated in different currencies, the ability to meet the liability with the cash flow from the assets and spread earned depends on the prevailing exchange rate among the currencies involved.

6. Market Risk:- Market risk caused due to investor reaction to events. The events may be tangible or intangible. Tangible events are real in nature like the reaction of investors to changes in the economic environment thus leading to a change in expectation of corporate profitability and thus return from equities. On the other hand, intangible events are related to market psychology.

Financial Risks –Life insurance

Risk Appetite framework for Life insurance Companies:

Risk appetite relates to the willingness of the life insurance company to take controlled and well-understood risks in the pursuit of broader business objectives. The key considerations in determining the risk appetite are

  • Policyholders and shareholders understanding and expectation of acceptable risks and the appropriate management of those risks
  • Expected outcomes and returns for policyholders, shareholders, and clients
  • The required capital to support risk-taking activities
  • The culture of the organization, its staff, and management capabilities
  • The insurance company’s long-term strategic priorities

To ensure risk taken is consistent with these considerations, management’s decisions are made in accordance with formally documented delegated Authorities which are approved by the board. This ensures that decisions are made at the appropriate level of management.

Thus, Risk appetite is the level of aggregate risk that an organization can undertake and successfully manage over an extended period of time.

Process of Risk Appetite Framework

The Objective of the risk appetite process is to ensure that the financial and nonfinancial risk position on the following key financial indicators is monitored and they are used as the basis of decisions on appropriate limits to risk exposure

Key financial parameters:-

The four key financial indicators whose impact will be measured by applying the shocks are

  1. Earning — Statutory Earnings have been taken as a measure
  2. Value — Market Consistent Embedded Value
  3. Solvency:- Statutory Solvency Position
  4. Liquidity:- Excess Liquidity

Application of shocks on financial parameters

Typically, the following shocks are considered and applied to the key financial indicators

  1. 25% crash in the equity indices in 1 in 20 and 40% crash in equity indices in 1 in 200 scenario
  2. Interest rates up or down by 300 bps. in 1 in 20 and 500 bps.in 1 in 200 scenario
  3. Increase in credit spreads by 75 bps in 1 in 20 and 150 bps in 1in 200 scenario
  4. Credit defaults at 1% and 2% respectively
  5. Inflation of 60+bps
  6. Deflation represents a decrease in the general price level of goods and services and occurs when the inflation rate falls below 0%. When inflation reduces the value of money over time, deflation increases the real value of money. However, deflation increases the real value of debt and may aggravate recessions and lead to a deflationary spiral. Hard and soft deflation scenario is also tested with a hard and soft crash
  7. Further, the impact of high-level changes in mortality risk factors are also measured — increase or improvement in mortality, increase or decrease in lapsation, increase in expense, etc.,

Setting up alerts and limits

An alert is an early welcome indicator while limits are boundaries. Any result within an alert position is usually green, While any result between alert and limit is amber, while any result beyond the limit is considered as red.

Conclusion:-

A preexistence of a proper risk management culture underpins a risk management framework. Risk management-related communications and taking strict actions for violations, including disciplinary actions send the right signals across the organization. On the positive side, good risk management communication acts as an educative tool to assist the functional heads to build a solid risk management framework.

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