Here is an essay on the risks faced by insurance companies.
Introduction to the Risks Faced by Insurance Companies:
The business of insurance is based on dealing with uncertainty. Therefore, an insurer needs to consider a wide range of possible risks and the outcome that may affect the current and future financial position. The range of risks more importantly consist of investment management risk, underwriting risk and Catastrophe risk, besides Actuarial risk, Credit risk, Market risk, Liquidity risk, Interest Rate Risk, Operational Risk, Foreign Exchange (Currency) Risk, Legal/Regulatory Risk, Technology Risk, Environmental Risk, Reputation Risk, Country Risk, Asset Liability Management (ALM) Risk, etc.
Functions of Insurance Companies:
The important activities of an insurance company are:
(i) Underwriting and
(ii) Investment.
Underwriting is heart and soul of insurance company, critical for business development and growth. Investment and income thereof is the flesh and blood which gives strength and nourishment. The risk involved in these two activities can shake the foundation of the company and when combined with other risks mentioned above it accelerates or accentuates deterioration and even demise of the company.
Credit Risk is inherent in lending and investment. It can also be caused by reinsurers, brokers, agent and clients. Credit risk is default in payment or fall in the credit quality. Concentration of investments in industry, economic sector, counterparty and geographical area are generally risky.
Credit risk can arise from excessive exposure to group companies. Perfunctory understanding of the complexity and potential risks in Complex derivative contracts can also cause credit risk.
Market Risk is the risk that arise from market movements and volatility of prices of equity or currency and changes in interest rates in the deals including derivative contracts. They broadly result in changes in asset value or portfolio values.
More specifically risk of loss on account of interest rate changes may affect the future cash flows from assets (inflow) and the liabilities (outflow) in different scales creating a mismatch. Likewise the currency risk arises from foreign exchange rate movements and consequently the cash flow is affected.
So also value of assets denominated in foreign currency including position in foreign currency will create loss or mismatch. Yet another area of risk is the asset held against policies issued with guaranteed payment. Asset value may suffer loss on account of adverse interest change.
Liquidity Risk:
Liquidity is concerned with the current and future maintenance of adequate levels of cash and liquid assets. There is always a time Lag between receipt of premium and payment of claims and hence there should be no liquidity problem. But there can always be unanticipated claims or surrender of policies or claims on account of catastrophies.
Liquidity risk in life insurance arise out of surrender of large number of policies and in general insurance due to non-renewal of the policies and/or large claims.
Liquidity risk may cause loss of asset value on account forced sale of assets, more so if there is slump in the market. Although instead of sale of assets, a loan could be raised to meet cash requirements the constraint may be non-availability of loan or availability of loans only at high cost. A single or a few parties controlling major share in business with substantial value can expose the insurer to liquidity risk.
Many times small insurance companies or lowly rated companies, suffer liquidity risk because it is difficult for them to raise cash at short notice. Lack of diversity, or over concentration in assets (investments) or in liabilities (under- writings) causes liquidity risk. Above all reputation loss of the company, serious problems in insurance industry as a whole, deterioration of the economy and abnormal or highly volatile market will also cause liquidity problems.
Acturial Risk:
Acturial risk arises in pricing (premium rate) due to variance in mortality rate, perils, hazards etc. projected with actual position, (say early termination of the policies, catastrophe etc.). Acturial work involve a systematic study of risk and the consequent loss so as to fix appropriate premium for insurance products. The calculations are based on statistics, past experience and future probabilities. There are many uncertainties and imponderables in the calculations which causes acturial risk.
Asset Liability Management Risk (ALM):
ALM does not imply that assets should be matched as closely as possible to liabilities but the mismatch shall be effectively managed to contain the damages if any arising therefrom. The ALM framework should also take into account any off-balance sheet exposures. Right approach is to manage the insurer’s assets and liabilities together.
Some liabilities may have long durations such as product liability insurance and whole-life policies and annuities. In such cases, assets with sufficiently long duration may not be available causing a significant reinvestment risk. Return on individual investment may or may not match corresponding liability. But overall investment income should be sufficiently more than total liabilities.
ALM may need to address certain aspects of underwriting risk, uncertainty of timing and size of future claim payments, especially for long-tail non-life business. Risk retention, risk transfer, expense control are important part of managing risk. Reinsurance arrangements should be adequate and the claims by the insurer on its reinsurers should be recoverable. Resinsurance programme shall consider level of capital and financial strength of the reinsurer in order to decide the exposure to a particular reinsurer.
Risk and Capital:
Insurer should be careful not to place undue emphasis on external ratings and set out its own quantitative and qualitative risk assessment models and risk tolerance levels in its business strategy. So also provide guidance for group relationship in business, group risk tolerance and feedback mechanism. Responses to change as a result of both internal and external events, new risks, new acquisitions, investment positions, business lines, need to be decided by the board.
Insurer need to regularly perform its own risk and solvency assessment (ORSA). In the process of risk assessment and management of solvency position, underwriting process, credit risk, market risk, operational and liquidity risks should be reassessed. Risk management actions should be based on adequacy of its economic capital and regulatory capital.
Capital requirements set by the solvency regime, overall, risk management and capital management are taken together to decide on financial resources it needs. It cannot be assumed that new capital will be readily available.
Other Risks:
The operational risks in insurance include human failure, fraud, technology failure, failed system and procedure. Violation of environmental laws and regulations. The risks may be systemic risk or un-systemic risk. Systemic risk is industry-wide, market-wide or even countrywide, like, recession, high inflation, civil disorder and chaos, war etc. Un-systemic risk is company specific management failure, huge fraud, etc. Another important risk is asset liability mismatch.
Assets generate income, and liabilities relate to payment obligations. Situations can arise when asset value fall sharply, the payment obligations may rise steeply on account of large claims. In these days, Banks and insurance companies are system driven while technology helps, to improve efficiency and speed, system breakdown can cause serious set-back and business disruption. Cypher crime is also another danger.
Regulations for Insurance Business Risk:
In the interest of safety of insurance companies and more importantly to protect, insurance policy holders, every country has established regulators with set rules and regulations to govern them and ensure safety, integrity and transparency in business. In addition globally there is an institution known as International Association of Insurance Supervisors.
They issue elaborate guidelines to insurance companies in order to improve operational standard, market discipline, reporting transparency and capital requirements. While they are not mandatory, most countries have accepted them voluntarily. Besides many countries like U.K., USA etc. have their own institutionalized mechanism for the same purpose.
Enterprise Wide Risk Management (EWRM):
Enterprise wide risk management (EWRM) is a planned approach that aligns strategy, technology and people for managing risk. EWRM also known as “The enterprise risk management” is a holistic, integrated, process for managing a range of risks including finance and non-finance risks with a view to maximize value for the enterprise as a whole.
Accordingly steps are to be taken to acquire data on the insurance company, its clients, reinsurers and the market environment in order to analyse information across the business focusing on government policies and social conditions.
Insurance is pooling and spreading of risk to mitigate adverse financial consequences to the policy holders and the insurer and for this purpose a thorough understanding of risk types, their characteristics, interdependence, the source of the risks, and their potential impact are essential. Insurer should exhibit understanding of the enterprise risk issues and display willingness and competence to address them.
The ultimate purpose of insurance is to protect the interest of policy holders including capital of the company by using the resources, efficiently. That means protecting the policy holders, share-holders and the staff whose interests are interdependent and to this end appropriate approach is enterprise risk management (ERM).
ERM is primarily meant to focus on all actions insurer takes to manage its risks on an ongoing basis and ensure that it stays within its risk tolerance level. It calls for rigorous enforcement of risk management strategies not only to identify the risks but also carry out the difficult task of measuring and mitigating them.
ERM links day to day administration with long term business goals. At a minimum it involves integrated management of underwriting risk, market risk, credit risk, operational risk, liquidity risk and reputation risk. It aims to identify both strength and weakness in governance, business development and control functions.
The insurer should also assess external risk which can pose significant threat to its business. Catastrophe risk, and market risk can pose serious problem in stressed situations. ERM involves measuring analyzing and modeling so as to help identifying causes of risks, the level of risks, relationship between risks and assessment of economic impact and on the balance sheet.
ERM focusses not merely on accounting and regulatory requirements, but on non-economic issues also. ERM demands consistency in qualitative and quantitative assessments so as to help the insurer to understand the positive or negative changes and accordingly prioritize the risk management measures.
Computer generated models for assessment and measurement, however, sophisticated may not replicate the real world. So both internally developed and externally sourced models should be used wherever the risk is not easily quantifiable. Qualitative assessment should also be done. ERM covers group companies risk also.
ERM cover policies on risk retention, risk management, strategies including reinsurance and use of derivatives. Risk management policies should address relationship, between product development, pricing, marketing, claim payment and investment management. It should also cover relationship between the insurer’s risk appetite and risk management process. Insurer should demonstrate its ability to manage the risk on long term under a range of plausible adverse scenarios.
Risk Management in Insurance Companies:
In insurance companies, three important areas of risks are:
A. Underwriting risk,
B. Catastrophe risk,
C. Investment risk
A. Management of Underwriting Risks:
Underwriting should focus more on right selection of risks. Covering a large number and enlarging the operational area and multiplying the products are essential so that law of average will work in favour of insurance company.
The basic principles involved in management of underwriting risk consist of:
(i) Law of large numbers
(ii) Sharing the losses of the unfortunate few by many others
(iii) Perfect actuarial calculations to fix insurance premium
(iv) Reinsurance.
Accordingly the first step is to cover large number of people or prospects, secondly enlarge geographical area of business as wide as possible and thirdly to diversify the business by introducing several products. The simple logic is when the number is large all of them will not suffer loss simultaneously. So also if the coverage is in a wide area consisting different regions of the country or even different countries risk get diffused.
Risks of large magnitude including natural calamities are not likely to affect the whole area with equal intensity in all areas. Similarly a wide range of products means risk of different nature and all of them will never happen together.
Large number, wide area and multiple products are well suited where the individual risks covered are small and medium range. But when the individual risk covered is for large amount, there should be periodical check on risks and risk management practices of the insured.
Reinsurance is a time tested method to spread risk assumed by primary insurance companies. No insurer can afford to retain all the risks underwritten. It is extremely important that an insurer transfers its risks.
Almost all the insurance companies have reinsurance arrangements with major Reinsurers A portion of the risk is ‘ceded’ to them. Such an arrangement enables an insurer to multiply his risk bearing capacity and it gives global character to insurance business.
Pooling the risk is another way. Usually aviation insurance is jointly done by more than one company. So also terrorism insurance and motor third party liability is done by pooling arrangement so as to share the loss in an equitable way among several insurers.
Fraudulent claims are sources of substantial drain on the profit of insurance companies. Here the insurers should make systematic study of frauds in terms of products and in terms of specific region or locality and then take proper precaution. Periodically they should check the efficacy of their underwriting practices and claim processing procedures.
Adverse Selection:
Adverse selection is the tendency of persons with a higher than average chance of loss to seek insurance at standard rates. It happens when the buyers know more about their expected losses and do not disclose all that they know about their insurability, especially if the insurers fail to ask. They would try to secure most favourable terms to cover their risks.
Seeking extensive information in the proposal form may prove expensive for the insurer. Thus, adverse selection arises because it is too laborious to collect all information on the insured perfectly. Adverse selection cannot be fully eliminated. But, such trend if not controlled by careful underwriting it will result in higher than expected claim and in the extreme cases may even lead to breakdown of insurance mechanism.
Adverse selection is the first and foremost risk in insurance business. Life Insurance business apparently consist of single product i.e. life cover. But in reality the products get multiplied by adding new features and consequently the risks increase in different dimensions. General Insurance comprises of wide range of products and therefore insurer faces varieties of risks.
In health insurance even if the initial checking is perfect the person covered may thereafter expose himself to higher risk by change in lifestyle, attitude and activities. Motor accidents occur because of poor maintenance of roads by the government and a substantial increase in traffic without increased in road network.
It is also due to ineffective check over vehicle drivers on their fitness and mental conditions during the policy period. In view of enormous increase in type of machineries, complexity of operations and ever changing technology, there is a steep increase of both physical and moral hazards in engineering insurance sector.
In respect of fire insurance failure to use fire detection and warning equipment’s, fire control devices and other safety measures enhances risk to insurance companies. Agriculture is fraught with the risks of unpredictable weather, climate and rainfall and also natural calamities like, flood cyclone, earthquake etc. which no one can predict or prevent. So risk management in agriculture insurance is complex and difficult to manage.
Moral hazard it is another area of concern for insurers. Moral hazard is suspected when there is ground to doubt about the buyer’s intention on availing insurance protection. The underwriter has to take into account not only the nature of the risk at the time of proposal but also on an ongoing basis as it is likely to change over time.
In life insurance, moral hazard can be doubted when insurance is applied for a large sum (compared to the income) or at advanced age or nomination is in favour of a stranger. In fire insurance history of frequent accidents in the premises of the proposer may indicate presence of moral hazard. While moral hazard refers to lack of integrity on the part of the proposer and hide the severity of the risk, it can also arise due to casual attitude about risk because of the existence of insurance.
Examples of morale hazard include leaving the car an unlocked with key or not taking care to lock the office before leaving. Insurers manage to control the risk of moral hazards through various policy provisions like policy limits, restrictive clauses, deductibles, waiting periods, exclusions etc. It is well established practice among the insurers to call for special inspection reports from marketing officials where the moral hazard is suspected.
In order to improve risk management practices insurers shall either independently or collectivity conduct studies on various products and risks associated with them, in terms of area, infrastructure and people covered and draw appropriate guidelines to help the operating staff to assess the risks precisely.
IRDA guidelines on product development (file and use guidelines) focus on policy holder’s protection and only passing references have been made on risk management.
The policy conditions and warranties included in the policy help the insurer to contain risk but it is rather a negative way to manage risk and enlarging the scope of conditions and warranties will reduce the value of insurance to the policy holder.
Insurance companies do not have the practice of visiting the persons and inspecting subject matter of risk (motor car, factory, building, business stocks etc.,) periodically to check the status of risks covered and deficiency if any. In addition to these steps a detailed analysis of claims paid should be made periodically on the causes of accident, destruction, loss etc. and draw conclusions to reduce the effect and impact of the perils.
Actuary Role and Acturial Risk:
The actuarial department has a key role in fixing price (premium) in such way that both the insurer and the insured are benefited to the maximum.
The person who determines the appropriate premium is known as an actuary. An actuary is a highly skilled mathematician and statistician. Besides pricing and underwriting he is involved in all insurance operations, including planning, product development, marketing, investments and research.
He studies important statistical data and determine the rates that would be adequate to meet all the claims and expenses as they occur and provide for a profit margin. The actuary causes periodical valuation of assets and liabilities of the company and decides the reserves to be maintained, surplus to be distributed, compiles data and certifies various abstracts and schedules/statements to be submitted to comply with the Regulatory demands. IRDA regulations stipulate that a life insurer shall not carry on business of insurance without an appointed actuary duly approved by the Authority.
Life insurance companies, under the supervision of an actuary, estimate at the beginning of each financial year, the number of death claims that can be expected during the year. The actual claim experience during each year is then compared with that estimated at the beginning of that year to check whether there is any significant variation between the estimate and the actual position.
If there is a significant variation and it persists year after year, it would indicate the need for revision of the Mortality table in use. Insurer should cause to find out whether there is fall in the quality of business procured or laxity in underwriting standards.
Other Risks:
Interest Risk:
Traditionally- Life insurance is a long term contract and the average term is about 15 years. A level premium (constant rate) is charged throughout the term. It cannot be revised based on current risk status. The insurer has to manage so that the yield from investments is not lower than the interest rate assumed in determining the premium rates. The yield generally, will depend upon—the investment climate, the interest rate movements and restrictions stipulated by Regulatory authority.
The interest rate fluctuations may have a negative impact on the solvency of the organization and for instance, if the insurer has a capital equivalent of 20% of their assets, even a 10% decline in asset values on account of interest rate fluctuation will result in a 50% decline in capital. Also, with rising interest rate.
Policyholders may prefer to apply for loans on the policies, exercise withdrawal options or even opt to surrender policies. In the case of a well-established life insurance company, premium and investment income may be adequate to meet the increased outflow. In a different scenario, viz. weak company or stressed scenario “forced sale of assets”, discounted at a higher rate may become necessary to meet the payments thus causing loss to the company.
Legal or Regulatory risks relate to financial risks faced by insurers due to non-compliance with Regulatory provisions that may lead to massive fines imposed by Authority. Litigations by the policyholders based on their expectations about the performance of the contract and violations of laws or regulations fall in this category.
Operational risk is the risk of loss resulting from inadequate or failed internal processes and systems. It is also caused by external events. Scope of operational risk is very wide. It includes fraud risk, communication risk, documentation risk, competence risk, external events risk etc. These reflect inadequate internal control and laxity in complying with standards and regulations.
How risks are managed?
The financial management of an insurance company is more challenging today than it was decades ago. The liberalization reforms in Finance and Insurance sectors that followed led to intense competition among insurers. They also have to respond to the increased competition from other financial intermediaries such as banks, stock market and mutual funds. The policy holder expects the premium to be low and benefits attractive and in the case of traditional life insurance policies a reasonable return on their savings.
Risks are managed by putting in place, robust and efficient mechanisms for identification, assessment, quantification of exposures are essential in determining the extent to which the risk should be mitigated or absorbed, secondly by establishing underwriting limits and authority levels and thirdly business being restricted to those exposures that pass, specified quality standards.
Underwriting process is well settled both in terms of law and practice and all insurers are familiar with them. Still adverse selection is common and perhaps inevitable. It is always true that insured knows more about the risk he carries than the insurer who is supposed to know.
There is always information gap both at the time of underwriting for first time and also thereafter at the time of renewal. It is not uncommon for an insured to buy insurance with fraudulent intention, either on his own or in collusion with the agent or broker. Insurance agent or broker collects all possible information from insured and supplements it with outside enquiry and market information.
Usually the information collected in life and health insurances include Age/Sex/Physical condition/Personal History/Family History/ Medical History/Disease/Habits/Lifestyle/Job or Occupation/ Income/ Area of Residence/Moral hazard etc. If it is commercial segment it is all about business, if it is automobile it is all about Car/Bus/ Truck and related matters and so on. The risks have to be assessed and premium fixed, based on risk.
The risk level varies from individual to individual starting from low to medium and also high. No insurer can select only low risk and do business. It is always a mix of standard and substandard groups. What is within the purview of the insurer is its proportion and hence aim for a fair mix of all groups.
The law of large number is very important, because loss arising out of unfortunate few will be paid out of premium income from fortunate lot who are large in number. Concentration in one or two products, in one or two areas or getting major share of business from one or two sources is highly risky.
Insurance risks in underwriting are managed and mitigated by:
(i) Charging Risk related premium,
(ii) Stipulating deductibles,
(iii) Conditions, and Warranty clauses in the insurance contract
(iv) Pooling and sharing business with other companies and
(v) Reinsurance
The solution to the problems lies in trained, knowledgeable and committed staff, good work culture, and standard of ethics in the organization, meticulous data collection, data analysis and sound M.I.S., in addition to proper check and control at various levels will help to trim the risk.
B. Measuring and Managing Catastrophe Risk:
The second area of risk is catastrophe risk which relate to insurance claims arising out loss suffered by the policy holders on account of natural calamities like, flood, cyclone, earthquake, tsunami etc. In such cases the claim will be very large causing stress on insurance companies.
Catastrophe Risk arise out of natural calamities like Flood, Cyclone, Hurricane, Earthquake, Tsunami etc.
Reinsurance companies are concerned with the risk of catastrophe loss and they are working out method to control their exposure. Primary companies managed their catastrophe exposures simply by purchasing appropriate reinsurance and ignored their concentrations of exposure.
Many insurance companies do not know the extent of their exposure concentrations. Reinsurance companies suffered huge loss, and hence reacted swiftly by steeply raising prices and retentions with restriction on limits. Regulators were also concerned about companies’ abilities to manage the catastrophe exposure.
With advancement in computer technology, new quantitative tools and catastrophe simulation models have helped to estimate potential losses in a way that truly reflects the long term frequency and severity distributions. Use of simulation modeling involves simulating the physical characteristics of a specific catastrophe, determining the damage to exposures, and calculating the potential insured losses from these damages.
With regard to Catastrophe exposure management must begin with the availability and accuracy of exposure data. Identifying insurance cover written and location of risks are important. The risk is distinguished between personal property and commercial property, while modeling personal lines, the property insured may cause only a moderate problem, but can cause major distortions when modeling commercial lines and more so in a complex commercial property cover.
It is the reinsurers who suffered more on account of claims on catastrophe losses. It usually involves large number of claims and huge amount in aggregate and hence reinsurance has become more restrictive and costly. The real problem in the past was lack of data and lack of system support to forecast damages.
It was worsened by practical inability of the insured and insurer to control the risk. But today although prevention of risk is still difficult, forecasting and measuring the damages are easy. System and technology can be used in modeling and assessing potential damage. Every insurer and reinsurer should get fully equipped as otherwise they are bound to suffer big loss.
C. Investment Risk:
The third area of risk is the investment risk. Investments generate a substantial portion of the income of the company. The investments are made out of the money received as premium from the policy holders. The company should therefore have a prudent investment policy emphasizing on safety and income, besides complying with regulations on investment which are compulsory.
Investment policy should outline its approach towards inherently risky financial instruments such as derivatives, hybrid instruments that embed derivatives, private equity, hedge funds, etc. Investment policy should also set out the guidelines for the safe-keeping of assets including custodial arrangements.
Investments in an unregulated market or subject to less governance need to be given special consideration particularly on the aspects of source, type and quantum of risk. While risk arising from the domestic investments is easy to predict and in contrast complex investments in a number of currencies and different markets may complicate an insurer’s investment strategy. Internal expertise and competence at all levels of the organization to handle complex investment, stress testing as well as contingency planning should be ensured. Derivatives policy should be clear particularly for ‘over-the-counter’ derivatives in order to assess the counter party risk.