A risk policy specifies which risks a company will be willing to assume and which risks it will not. The risk policy of an insurance company focuses on:
- creating and protecting shareholders’ value from the volatility of its financial results, and
- containing the impact of this volatility on the cost of its capital and thus also, the cost of its risk capacity
Since insurance contracts involve assumption of insurance and investment risks, risk policies of insurance companies must include distinct insurance and investment components.
Insurance risk policy
To develop its insurance risk policy, a company needs to takes into account its ability to establish and sustain a competitive advantage by leveraging superior capabilities (e.g. underwriting expertise, claim management, risk management, etc.). It must evaluate the attractiveness of individual insurance markets based on analysis and assessment of key factors that shape business strategy, including:
- Market structure and characteristics (size in premium revenue, number of accounts, distribution of exposures by location, industry, etc.)
- Revenue growth potential
- Business acquisition and underwriting expenses
- Changes in customer needs and value perceptions
- Assessment of relative competitive positions
- Loss frequency and severity, and expected loss ratio
- Correlations with macro economic factors (e.g., inflation and GDP growth rates), and other markets served by the company.
- Systemic insurance risk
- Availability, cost and anticipated use of reinsurance
Insurance companies can use data available from public and private sources (e.g., brokers) to estimate the level and volatility of revenues and earnings associated with specific exposure types, i.e. to develop an “ex-ante” assessment of the risks it considers accumulating. The underlying loss distributions can then be used to develop estimates of i) capital intensity, ii) the impact of the accumulation of specific exposures on the company’s risk profile, iii) the utilization of its risk capacity and iv) financial performance under alternative risk policies. In every situation, there is a need to verify that a company’s capital and earnings base are sufficient relative to limits written and the probable maximum loss of the portfolio to protect the company’s ratings and ensure the viability of the company as a going concern.
Investment risk policy
The investment risk policy needs to address the following two effects of investment value volatility that might cause:
- The absolute market value of invested assets to fall in a given time period, thereby reducing available capital and risk capacity
- Changes in the market value of invested assets relative to the value of liabilities that increase the volatility of the company’s capital position, thereby also increasing the probability of downgrading, or of intervention by regulators in company management
These effects of investment value volatility are addressed through reinsurance and asset strategies that contain the volatility of net assets. Insurance companies determine the extent and manner in which these strategies can be optimized, and supplemented in certain cases by arrangement of back-up lines of credit, through analysis of the volatility of their cash flows, taking into consideration the execution of their strategy, the potential liquidity and value volatility of their invested assets and the payment patterns of their liabilities. Note that liabilities of insurance companies, unlike bank demand deposits and overnight funding, are a source of relatively stable funding. Many companies take investment positions that take advantage of this relative illiquidity to create value.
The objective of an investment risk policy is to guide management in ascertaining when, to what extent and how a company should deviate from investing in a portfolio that replicates its liabilities. Its investment risk policy, at a minimum, should specify:
- Which asset classes are permissible, by type, rating class, liquidity, etc.
- Which risk types may be assumed to enhance returns, given a company’s risk capacity (e.g. interest rate, credit, inflation, currency, beta, idiosyncratic, liquidity, etc.)
- How much of the assets may be invested in alternative assets, including illiquid positions (e.g. venture capital, real estate, hedge funds, funds of funds, etc.)
- Guidelines for diversification within and between asset classes
- How much volatility in investment income and portfolio value is consistent with the respective solvency and value risk tolerances of the company’s stakeholders
- Guidelines for using hedging strategies, and controlling counterparty risk
To develop this policy, a company needs to simulate the impact of alternative guidelines in relation to liabilities and the risk capital consumed, assess their contribution to economic objectives, and identify the range of acceptable asset allocations and strategies. Ultimately, the policy should provide a framework within which a company can determine how much of its return to seek through investment in risk-free instruments, or instruments that provide extra “market return” (beta) or even additional skill-based returns (alpha).
Revision of risk policy
Although it is widely recognized that an insurance company needs to develop its risk policy when it starts operating, there is no consensus on how often an established company needs to revise its risk policy.
Many insurance companies review their risk policy when they are contemplating an acquisition or entering a new business. Because such decisions can have a significant impact on their risk profile, companies often perform detailed pro-forma actuarial analyses to develop the risk insights they need before making a commitment. However, when no significant change in business portfolio is contemplated, insurance executives are often reluctant to invest time to revisit their company’s risk policy.
The recent crisis suggests, however, that there is hardly any activity of greater importance to the survival and success of insurance companies.
February 14, 2011
Note: This article is abstracted from the “Risk Management and Business Strategy in P/C Insurance Companies” briefing paper published by Advisen (www.advisen.com) and available at the Corner Store.