Here is a compilation of essays on ‘Investment Risk Management’ for class 11 and 12. Find paragraphs, long and short essays on ‘Investment Risk Management’ especially written for school and college students.
Essay on Investment Risk Management
Essay Contents:
- Essay on Introduction to Investment Risk Management
- Essay on the Investment Management by Insurers
- Essay on the Investment Risk Management Framework
- Essay on the Functions of Investment Risk Management
- Essay on the Market Risk of Investment Risk Management
- Essay on the Credit Risk of Investment Risk Management
- Essay on the Liquidity Risk of Investment Risk Management
- Essay on the Policy Documentation of Investment Risk Management
- Essay on the Reports of Investment Risk Management
Essay # 1. Introduction to Investment Risk Management:
The purpose of prudential regulation is to protect the rights of policy holders and ensure the continuing ability of insurers to meet their contractual and other financial obligations to the policyholders.
The characteristics of the insurance liabilities arising out of policies issued and the assets backing those liabilities are the most important sources of risks to insurers hence Investment management should be undertaken as part of the overall asset liability management of the insurer in order to control the risks associated with investment activities.
The insurer’s investment risk management approach is, referred to as the “prudent person” approach. Risk management is the process whereby the insurer takes action to assess and control the impact of risks and potential future events that could be detrimental to the insurer.
Investment risk management addresses the events that would weaken or adversely affect its performance and financial position. Market risk impacts investments, including stocks, as well as the bond portfolios. Credit risk is present in the insurer’s lending activities. Liquidity risk lies in maintenance of appropriate levels of cash and liquid assets to meet claim payments particularly large claims.
Several other risks, including operational and legal risk, affect insurer’s activities. Investment risk management is primarily through compliance of regulatory restrictions on the categories of assets for investment and the specific requirements on matching the assets and liabilities.
However Investment risk management involve many more things in addition to regulatory requirements. Financial services sophistication made financial markets, more diverse and complex. The inclusion of derivatives as part of the portfolio invited more complex risks and accordingly quality and quantity of resources should be appropriate to the nature and complexity of business.
Investments risk should be considered in conjunction with other principles, standards and guidance, in particular the principles on capital adequacy and solvency and stress testing.
Essay # 2. Investment Management by Insurers:
The nature of liabilities is the deciding factor in developing investment policies by an insurer, in order to meet its contractual liabilities to policyholders. The insurer should manage its assets in a sound and prudent manner, taking into account the profile of its liabilities, its solvency position and its risk-return profile. It forms the essence of the insurer’s asset liability management policies.
Insurers are, by nature, risk transformers and their primary function is risk mitigation, taking into account there:
1. Product and underwriting policies
2. Reinsurance policies
3. Asset liability management policies
4. Solvency level policies
Insurers should manage their business taking into account all risks. Investment risk management, includes market risk, credit risk, liquidity risk and Operational risk. Operational risks can be described as risks of direct or indirect loss resulting from inadequate or failed internal processes, people or systems.
They would include, for example, risk arising from failure of corporate governance, systems, outsourcing arrangements and business continuity planning. The investment policies should ensure that the insurer holds sufficient assets of appropriate nature, term and liquidity to meet the liabilities as and when they become due.
The investment decisions should conform to the legal, regulatory, accounting and taxation requirements. The timing and amount of insurance claim payment is usually uncertain.
It is important to assess the volatility of its cash income together with the volatility of its cash outflows, with regard to size and frequency of both expected and exceptional situations, investment policies would therefore expected to address each of the following areas:
1. Asset and liability mix
2. Financial market environment
3. Eligible asset classes
4. Strategic asset allocation
5. Conditions under which the insurer can pledge or lend assets
6. Maximum allowed deviation from strategic asset allocation
7. Capital considerations
8. Solvency and liquidity considerations
9. Concentration risk
10. Risk parameters, including the investment risk management policies
Essay # 3. Investment Risk Management Framework:
The framework should adhere to regulatory requirements in relation to investment policies, asset mix, valuation, diversification, asset and liability matching and risk management.
The framework should include- market, credit, liquidity and other investment risk management strategies.
The framework should also include criteria for measuring investment risks viz:
1. Market risk
2. Credit risk
3. Liquidity risk
4. Operational risk
5. Reputation risk
The Board of directors’ and senior management’s responsibilities, segregation of duties and appropriate controls of back office / front office work in trading, should be laid down in the framework. Besides it should facilitate compliance of policies, control procedures, including risk tolerance, reporting format and frequency.
The quality of the assets and related risks should be clearly communicated and understood throughout the organisation. Investment policies are generally drawn by the senior management and the Board will have to approve those policies and also review it periodically.
Essay # 4. Functions of
Investment Risk Management:
In order to manage investment risk insurer should clearly identify, measure, monitor and control the risks inherent in the investment portfolio. The methods and tools used to measure those risks should be appropriate to the nature and complexity of the risks assumed. Investments risk exposures should be clearly defined and measured, using appropriate risk measurement methods on an ongoing basis.
An insurer needs to measure and document the overall risk in its business, which includes the risk in investment portfolio. Insurer should measure the risk inherent in all investment activities including on and off- balance sheet. Sophistication for analysis should commensurate with the potential materiality of exposures.
The investment risk management function should assess the appropriateness of the asset allocation. Once the insurer identified the most risky scenarios. It should ensure the effective management of those high-risk situations. Insurers should have contingency plans containing action to be taken under extreme scenarios.
An insurer should make independent, ongoing assessment of its investment risk and report to the board of directors. Every investment decision should have adequate documentation demonstrating that the decision is in compliance with the investment policies and the investment risk management framework.
There should be governance procedures on the investment decision, choice of markets and sectors and stock selection. The recommendation and rationale for the investment decision, other possible alternatives and also why the recommended strategy was chosen indicating, the level of risk that will result from the investment decision should be documented.
The procedures and formats for reporting and the method for classifying assets and the basis for valuing assets that are not regularly traded should be prescribed.
An insurer should ensure that exceptions to policies, procedures and limits are reported in writing in a timely manner covering the key elements of the policies such as:
1. Target markets and approved products
2. Portfolio concentration limits
3. Approval authority limits
4. Investment limits
5. Rating systems
Essay # 5. Market Risk of Investment Risk Management:
Market risk arise in the insurer’s operations through volatilities in financial markets that cause changes in asset values, products or portfolio valuations. Market risk is the risk to an insurer financial condition flowing from adverse movements in the level or volatility of market prices viz. interest rates or exchange rates.
It includes the exposure to derivatives and movements in the price of the underlying instrument. General market risk (on all investments) and specific market risk (on each investment) should be examined thoroughly independent of each other.
Identification of Market Risk:
Market risk includes:
1. Interest Rate Risk:
Risk of losses resulting from movements in interest rates; and the extent of future cash flows from assets and liabilities.
2. Equity Risks:
Risk of losses resulting from movements of market price of equities.
3. Currency Risk:
Risk of losses resulting from movements in exchange rates; to the extent that cash flows, value of assets and liabilities in different currencies and position in currencies that can have an adverse impact on the insurer.
Measurement and Management of Market Risk:
Insurer should be able to measure its market risk across interest rate, currency rate, equity and bond values. There are methods to hedge market risk by using appropriate derivative products for hedging. Market risk limits should be periodically reviewed. An insurer should also use stress testing to determine, amongst others, the potential effects of large and unusual of change in market rates.
Essay # 6. Credit Risk of Investment Risk Management:
Credit risk is the risk of financial loss resulting from default or adverse movements in the credit quality of securities, debtors or counterparties, reinsurance contracts, derivative contracts or intermediaries to whom the company has an exposure.
Extending credit through investment in debentures and lending activities form an important part of the business. Credit risks may also arise from reinsurers, brokers, agents and clients although such risks are not included as “Investment Risks”.
A. Credit risk includes:
1. Default risk- risk of an insurer not receiving, or receiving with delay, or receiving partially, the cash it is entitled.
2. Downgrade Risk:
It indicates fall in credit quality and the probability of future default.
3. Indirect Credit:
Risk that arise due to market perception of increased risk.
4. Concentration Risk:
Risk of increased exposure to losses on account of substantial investments in a particular geographical area, economic sector, counterparties, or connected parties.
Credit may be extended, on a secured or unsecured basis, by way of instruments such as reinsurance ceded, premiums for hedging vehicles, mortgages, bonds, asset-backed securities, private placements, leases, stock lending and derivatives. Unsecured credit is more risky than secured one.
B. Identification of Credit Risk:
The general areas of credit risk which an insurer encounter should be identified. The type of credit activity, type of collateral security, types of borrowers should be specified. Insurer is exposed to counterparty credit risk when dealing with reinsurers and brokers. Transactions and exposures and also potential exposures to group companies should be taken into account.
In this regard the insurer should have policies on exposures to the group companies. Procedures should also be in place for assessing the credit worthiness of counterparties to whom the insurer is exposed.
Procedures should exist for identifying and reporting potential problems of credit in case of sticky account and a “Watch List” shall be prepared to monitor them and there should be a remedial process for difficult accounts. Insurers should have policies for approval and monitoring of collateral and it should cover valuation of collateral.
C. Measurement and Management of Credit Risk:
Credit exposure should be within the overall policy based on:
1. Type of primary and collateral security
2. Single counterparties and connected counterparties
3. Industries or economic sectors
4. Geographic regions.
Measurement tools to determine the insurer’s credit risk exposure include:
a. Internal ratings
b. External ratings
c. Stress testing
d. Concentration aggregations
Credit risk exposure will be compared with the limits outlined in the investment policies.
D. Rating System of Credit Risk:
The term “rating system” comprises of the methods, processes, controls, data collection and information systems that support the assessment of credit risk, assignment of internal risk ratings and quantification of default and loss.
“Rating grade” is defined as an assessment of credit risk on the basis of a specified and distinct set of rating criteria. The grade definition should include both a description of the degree of credit risk and the criteria used to distinguish the level of the credit risk.
While assigning ratings insurers should:
1. Take all relevant information into account and ensure that such information is current.
2. Verify the integrity of data and borrower.
3. Be more conservative where the information is insufficient or incomplete.
An external rating may be an additional factor in determining the internal rating.
Essay # 7. Liquidity Risk of Investment Risk Management:
Liquidity is concerned with the current and future maintenance of appropriate levels of cash and liquid assets. The business of insurance usually involves a time lag between the receipt of cash (premium income) and payment of expenses and policy benefits. So liquidity stress conditions may be more due to unanticipated large claims.
Liquidity risk is the risk that an insurer, though solvent, not having sufficient liquid assets to meet its obligations (such as claims payments and policy redemptions) when they fall due. The liquidity profile of an insurer is a function of its assets and liabilities.
A. Liquidity risk includes:
1. Liquidation Value Risk:
The risk that arise due to unexpected timing or amount of cash needed that may require liquidation of assets when market conditions are unfavourable.
2. Affiliated Investment Risk:
Relates to the risk of an investment in a group institution that may be difficult to sell.
3. Capital Funding Risk:
The risk that the insurer not being able to obtain sufficient outside funding, as its assets are illiquid.
B. Identification of Liquidity Risk:
The most striking example of loss due to liquidity risk is large claims arising out of catastrophes, such as storms, earthquakes etc. This event may require insurer to pay a large amount of claims within a short period of time. This situation can cause a substantial stress on liquidity, “cash claims” from reinsurer could be considered as a form of liquidity hedge within the context of liquidity management.
There are different levels of liquidity management, including:
1. Day-to-day cash management
2. Stress testing and scenario analysis, including an analysis of catastrophe risk.
A single or a few parties who control large volume of business can cause liquidity risk. A low credit rating of the insurer, formal or informal may limit its access to capital markets for cash. If an insurer is too small, it may not have all the funding choices that are available to larger insurers, when several insurers are faced with a large liquidity constraint marketplace may not be able to meet the volume excepting at a high cost.
To the extent the cash requirement are predictable, immediate demands on cash should not pose undue liquidity risk for an insurer. But an un-predictable cash demand is a big risk. Lack of diversity in business lead to increased liquidity risk and so also concentration of illiquid assets.
C. Other Reasons for Liquidity Risk are:
1. Negative publicity
2. Problems faced by many insurers simultaneously
3. Deterioration of the economy
4. Abnormally volatile or stressed markets.
D. Measurement and Management of Liquidity Risk:
Measurement tools are:
(i) Cash flow modelling and
(ii) Liquidity ratios.
Cash flow modelling is done to assess the magnitude of deficits, surpluses and the ability to raise contingent funding to meet the needs of the insurer.
Stress testing will reveal a variety of future scenarios that the insurer may face and the probability of liquidity constraint at a time when it may prove to be costly to raise cash. The insurer shall take steps to ensure that it will have sufficient cash and short-term liquid assets on hand to meet unexpected, but not highly unlikely, liquidity requirements.
Use of liquidity ratios addresses the need for liquidity by establishing a normal expected amount of liquidity that would be required to meet the demands of the underlying liability portfolio. Taking this as the minimum level of required liquidity and adding an appropriate margin to cover unexpected liquidity requirements will define the required liquidity ratio.
Insurers may be able to obtain emergency liquidity funding in the event of a catastrophe by drawing cash in advance under their reinsurance policies. Insurer should have a liquidity contingency plan to be implemented in the event of its usual liquidity management fails to meet demands.
Essay # 8. Policy Documentation of Investment Risk Management:
1. Insurer’s investment risk management policies, including the insurer’s tolerance and limits for managing its market, credit and liquidity risks.
2. Insurer’s asset liability management procedures.
3. Insurer’s investment policies, including its identification, monitoring and control procedures,
4. Insurer’s procedures for the approval of counterparties, including details on selecting and monitoring external asset managers
5. The insurer’s procedures for seeking approval to use new investment instruments.
All of them should be duly documented.
Essay # 9. Reports of
Investment Risk Management:
The reports from the insurer on investment risk management shall, at a minimum, cover the following details and commentary on investment activities during a time period and the end position of the relevant period:
1. Details of positions by asset type
2. Concentration analysis
3. Breach of regulatory or internal limits in the given period and subsequent actions taken, where appropriate. Investment activities planned for future.
A. Market Risk Report:
The report should cover the following:
1. Specific details relating to market risks types such as interest rate risk, equity and currency risk.
2. Interest rate risk and consequent mismatch in the cash flow and value of assets and liabilities.
3. The income on the investment portfolio need to be explained. The sources of return (income) shall be identified and checked whether the income was in line with the market.
Two types of reporting will provide helpful information:
(i) Performance contribution- (total returns)
(ii) Performance attribution- Detailed analysis of excess returns and facilitating factors for such return
B. Credit Risk Report:
The report should deal with:
1. Specific details relating to credit risk such as credit exposures, including the group, counter parties and geographical area.
2. Details of credit decisions, taken during the period.
3. Information relevant to assess current credit quality.
C. Liquidity Risk Report:
The report should contain the specific details relating to future cash flows, Expected premium income, liability payments, expenses, payments resulting from lapses of policies, investment income and repayment of principal by debtors. Stress testing shall be done to get an insight into the liquidity risk under difficult conditions.
To recapitulate the range of risks in investments that affects the insurers are:
a. Investment Risks:
There are various kinds of risk which are directly or indirectly associated with the insurers’ investment management. They affect the performance, returns, liquidity and structure of an insurer’s investments. Such risks can have a substantial impact on the asset side of the balance sheet and the company’s overall liquidity, and it can potentially lead to the company being over indebted or insolvent.
The investment risks include:
1. Market risk
2. Credit risk
3. Liquidity risk
4. Operational risk
b. Asset Liability Management Risk:
The risk refers to the management of an insurer’s assets with specific reference to the characteristics of its liabilities so as to optimize the balance between risk and return. The insurer’s policy with respect to its asset liability management processes will include measures to be used to assess the degree of risk that the insurer is assuming and constraints or boundaries on the value of these measures.
Asset liability management will form part of the overall investment risk management framework and will provide direction for investment activities with reference to the demands of the insurer’s liability portfolio.
c. Default Risk:
The risk that an insurer not receiving the cash flows or assets to which it is entitled because the party with whom the insurer has a bilateral contract defaults on one or more obligations.
d. Downgrade or Migration Risk:
The risk that changes the probability of future default by the party which will adversely affect the present value of the contract with that party.
e. Interest Rate Risk:
The risk of exposure to losses resulting from movements in interest rates.
f. Counterparty Credit Risk:
The risk that a counterparty not being able or willing to pay amounts due to the insurer as they fall due.
g. Concentration Risk:
The risk of losses due to increased exposures or concentration of investments in a geographical area, economic sector or individual entities. Concentration risk may exist either at the entity level or the group level or both.
h. Capital Funding Risk:
The risk that the insurer not be able to obtain sufficient outside funding at the time it needs, (for example, to meet an unanticipated large claim).
i. Blind Investments (or Pools):
Risks on portfolio of investments managed by an external investment manager. The pool may consist of investments whose general characteristics are known to the pool participants, but the specific holdings are not always known. It may also consist of a pool of capital not yet invested, but with a mandate to be invested by the manager in certain investment vehicles in which the manager has specialised expertise.
j. Value at Risk:
It is a method to measure the potential financial loss in the investment portfolio or on the whole balance sheet. Value at risk provides an estimate of the worst expected loss over certain period of time at a given confidence level. For example, a 12 month value at risk with a 95% confidence level of Rs. 1 Crore means that an insurer would only expect to lose more than Rs.1 Crore only 5% of the time or once in 20 years.