Getting Paid for Risk Taking

Consideration for accepting a risk needs to be at a level that will sustain the business and produce a return that is satisfactory to investors.

Investors usually want additional return for extra risk.  This is one of the most misunderstood ideas in investing.

“In an efficient market, investors realize above-average returns only by taking above-average risks.  Risky stocks have high returns, on average, and safe stocks do not.”

Baker, M. Bradley, B. Wurgler, J.  Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly

But their study found that stocks in the top quintile of trailing volatility had real return of -90% vs. a real return of 1000% for the stocks in the bottom quintile.

But the thinking is wrong.  Excess risk does not produce excess return.  The cause and effect are wrong in the conventional wisdom.  The original statement of this principle may have been

“in all undertakings in which there are risks of great losses, there must also be hopes of great gains.”
Alfred Marshall 1890 Principles of Economics

Marshal has it right.  There are only “hopes” of great gains.  These is no invisible hand that forces higher risks to return higher gains.  Some of the higher risk investment choices are simply bad choices.

Insurers opportunity to make “great gains” out of “risks of great losses” is when they are determining what consideration, or price, that they will require to accept a risk.  Most insurers operate in competitive markets that are not completely efficient.  Individual insurers do not usually set the price in the market, but there is a range of prices at which insurance is purchased in any time period.  Certainly the process that an insurer uses to determine the price that makes a risk acceptable to accept is a primary determinant in the profits of the insurer.  If that price contains a sufficient load for the extreme risks that might threaten the existence of the insurer, then over time, the insurer has the ability to hold and maintain sufficient resources to survive some large loss situations.

One common goal conflict that leads to problems with pricing is the conflict between sales and profits.  In insurance as in many businesses, it is quite easy to increase sales by lowering prices.  In most businesses, it is very difficult to keep up that strategy for very long as the realization of lower profits or losses from inadequate prices is quickly realized.  In insurance, the the premiums are paid in advance, sometimes many years in advance of when the insurer must provide the promised insurance benefits.  If provisioning is tilted towards the point of view that supports the consideration, the pricing deficiencies will not be apparent for years.  So insurance is particularly susceptible to the tension between volume of business and margins for risk and profits,
and since sales is a more fundamental need than profits, the margins often suffer.
As just mentioned, insurers simply do not know for certain what the actual cost of providing an insurance benefit will be.  Not with the degree of certainty that businesses in other sectors can know their cost of goods sold.  The appropriateness of pricing will often be validated in the market.  Follow-the-leader pricing can lead a herd of insurers over the cliff.  The whole sector can get pricing wrong for a time.  Until, sometimes years later, the benefits are collected and their true cost is know.

“A decade of short sighted price slashing led to industry losses of nearly $3 billion last year.”  Wall Street Journal June 24, 2002

Pricing can also go wrong on an individual case level.  The “Winners Curse”  sends business to the insurer who most underimagines riskiness of a particular risk.

There are two steps to reflecting risk in pricing.  The first step is to capture the expected loss properly.  Most of the discussion above relates to this step and the major part of pricing risk comes from the possibility of missing that step as has already been discussed.  But the second step is to appropriately reflect all aspects of the risk that the actual losses will be different from expected.  There are many ways that such deviations can manifest.

The following is a partial listing of the risks that might be examined:

• Type A Risk—Short-Term Volatility of cash flows in 1 year

• Type B Risk—Short -Term Tail Risk of cash flows in 1 year
• Type C Risk—Uncertainty Risk (also known as parameter risk)
• Type D Risk—Inexperience Risk relative to full multiple market cycles
• Type E Risk—Correlation to a top 10
• Type F Risk—Market value volatility in 1 year
• Type G Risk—Execution Risk regarding difficulty of controlling operational
losses
• Type H Risk—Long-Term Volatility of cash flows over 5 or more years
• Type J Risk—Long-Term Tail Risk of cash flows over 5 years or more
• Type K Risk—Pricing Risk (cycle risk)
• Type L Risk—Market Liquidity Risk
• Type M Risk—Instability Risk regarding the degree that the risk parameters are
stable

See “Risk and Light” or “The Law of Risk and Light

There are also many different ways that risk loads are specifically applied to insurance pricing.  Three examples are:

  • Capital Allocation – Capital is allocated to a product (based upon the provisioning) and the pricing then needs to reflect the cost of holding the capital.  The cost of holding capital may be calculated as the difference between the risk free rate (after tax) and the hurdle rate for the insurer.  Some firms alternately use the difference between the investment return on the assets backing surplus (after tax) and the hurdle rate.  This process assures that the pricing will support achieving the hurdle rate on the capital that the insurer needs to hold for the risks of the business.  It does not reflect any margin for the volatility in earnings that the risks assumed might create, nor does it necessarily include any recognition of parameter risk or general uncertainty.
  • Provision for Adverse Deviation – Each assumption is adjusted to provide for worse experience than the mean or median loss.  The amount of stress may be at a predetermined confidence interval (Such as 65%, 80% or 90%).  Higher confidence intervals would be used for assumptions with higher degree of parameter risk.  Similarly, some companies use a multiple (or fraction) of the standard deviation of the loss distribution as the provision.  More commonly, the degree of adversity is set based upon historical provisions or upon judgement of the person setting the price.  Provision for Adverse Deviation usually does not reflect anything specific for extra risk of insolvency.
  • Risk Adjusted Profit Target – Using either or both of the above techniques, a profit target is determined and then that target is translated into a percentage of premium of assets to make for a simple risk charge when constructing a price indication.

The consequences of failing to recognize as aspect of risk in pricing will likely be that the firm will accumulate larger than expected concentrations of business with higher amounts of that risk aspect.  See “Risk and Light” or “The Law of Risk and Light“.

To get Consideration right you need to (1)regularly get a second opinion on price adequacy either from the market or from a reliable experienced person; (2) constantly update your view of your risks in the light of emerging experience and market feedback; and (3) recognize that high sales is a possible market signal of underpricing.

This is one of the seven ERM Principles for Insurers

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Explore posts in the same categories: Assumptions, Enterprise Risk Management, Profits, Tail Risk, Volatility

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