Lessons for Insurers (5)
In late 2008, the The CAS, CIA, and the SOA’s Joint Risk Management Section funded a research report about the Financial Crisis. This report featured nine key Lessons for Insurers. Riskviews will comment on those lessons individually…
5. It is important to develop a counterparty risk management system and establish counterparty limits.
Insurers need to fully understand several things about both credit and reinsurance to get this right.
First of all, in a credit or reinsurance situation, the insurer is usually trading uncertainty in the “expected” range of probabilities for a potential loss at a very high attachment point, the failure point for the counterparty.
Second of all, the insurer needs to recognize that the failure of their counterparty usually does not in any way change their obligation. When an insurer buys a bond, they are usually responsible to make payments to their policyholder regardless of whether the bond is good. When an insurer buys reinsurance they are still responsible to pay claims whether or not the reinsurer is able to meet its obligations.
Recognize that in almost all cases, the standard risk management terminology is flawed. Risk is usually not transferred.
The other consideration that is important to insurers is that they need to look for counterparty exposures everywhere in their operations. In each of their insurance lines as well as in every part of their investment portfolio. In firms where traditionally insurance and investments are treated as completelyt separate silos, risk managers are finding that both sides of the house are sometimes dealing with the exact same counterparties. Aggregation and management of these concentrations is key.
And finally to scare you completely, a good way to think of counterparty risk is that you are bring a fraction of the entire balance sheet on to your balance sheet in return for a contingent payment. So that should make you very interested in transparency. Or maybe not. Maybe you close your eyes when you drive around sharp curves also.