Risk Trading as ERM

In the recent post, Rational Adaptability, four types of ERM programs are mentioned. One of those four types of ERM is Risk Trading.

Modern ERM can be traced to the trading businesses of banks. Hard lessons from uncontrolled risk trading led to the development of processes and standards for controlling the traded risks. A major element in these systems is the function of valuing, or in other words, pricing of risks. For this discussion, all activities that include the deliberate acquisition of risks for the purpose of making a profit by management of a pool of risks to be risk trading. With that definition, insurance and reinsurance companies can be seen to be pure risk trading firms. Actuaries are at the heart of this activity as major players in the pricing and valuation of insurance risks. With this method of organizing risk management activities, it is clear that most actuarial activity is and has always been risk management. In fact, as is usually boasted, the actuarial profession probably has over 100 years more experience in risk management than any other field of risk management.

Risk assessment for pricing purposes involves the assessment of expected losses as well as the range of potential losses. The pricing process uses this information as well as the risk preference function of the risk trader to form a target price for a risk. This target price is compared to the market price. The risk trader will make decisions to buy or sell a risk depending on the relationship between the target price and the market price.

Some risk trading is not based on risk assessment but only on analysis of the market prices. This type of trading is only viable if there is a liquid market (or as some call it a “Greater Fool”).

In Insurance, risk pricing is most often not quite so tightly tied to market pricing because there are not usually not deep and liquid markets for insurance risks.  Instead, insurers tend to evaluate the expected claims to be paid plus expenses and then look at the risk margin that they would like to get for accepting the risk over and above those expected costs.  Evaluating and managing these risk margins has been the main concern of for the risk management of many insurers.

ERM changes risk pricing by introducing a consistent view of valuing risk margins across all risks. For actuaries and insurance products this has taken the form of economic capital and cost of capital pricing. Risk assessments are done that provide consistent information for all risks. Most commonly, the risk margins are then assessed relative to standard deviation of losses or in relation to extreme event losses stated in terms of Value at Risk or Expected Shortfall.

This post is a part of the Plural Rationalities and ERM project.

Explore posts in the same categories: Cultural Theory of Risk


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2 Comments on “Risk Trading as ERM”

  1. […] to support two of the four key ERM Strategies and is also needed to  apply an enterprise view to Risk Trading and Loss […]

  2. Jean-Pierre Berliet Says:

    Thank you for a very thoughtful post. From my standpoint, as an ex banker, I have long been puzzled by the reliance of insurers on measures of risk based on VaR. VaR was introduced to in banks to help control the risk involved in trading positions, where it is effective. Using VaR to measure the risk of other positions, that have inherently much longer maturities, and use VaR to estimate economic capital involves quite a leap of faith. In my judgment, our analyses and many of our interpretations are vitiated by fundamental errors of semantics and based on appearances of rigor.

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