Reliance on Risk Management

Many life insurance firms may not really be aware of the degree to which they are exposed to risk.

When these firms write a life insurance policy, they are immediately exposed to a significant amount of gross risk.  Looking at the entire liability book, the risk is immense.  Many multiples of capital.

I  am not talking about the fact that face amounts of insurance far exceed premiums.  What I am trying to point out is that there is a very large amount of risk created by accepting premiums with the guarantee of certain surrender values.  (There is somewhat more mortality risk there than many insurers may realize, but it is not significant on a gross basis compared to the interest rate risk on the cash values.)

Insurers tend to forget about this because there is a very longstanding practice of offsetting that risk by investing funds (called the assets) of the life insurer.

The folks who are insisting on market value accounting for insurance liabilities are trying to point out this fact of life.

In many markets, the insurer will then take investment risk – credit or market – with the investments and finally they will do something further that deeply offends the market value folks.

They will split some of the money that they are paid in risk premium with their policyholder/customer.

This practice can probably be traced back to the time when the predominant form of life insurance was mutual life insurance.  Under that structure, the policyholder is thought to share the risk of the insurance company, and it therefore makes sense that they would share in the risk premium.

Non-mutual firms found that they could not compete with this because most customers did not understand that they had the choice of one level of return within their insurance policy at a certain level of risk and a lower level of return with a lower amount of risk. The customers usually just saw the net return.  Risk was not communicated well.  Usually risk was communicated very vaguely while return seemed to be really tangibly conveyed.

So what the market value folks are trying to accomplish is to overcome hundreds of years of confusion about the actual level of risk of an insurer.

You see, risk premiums are usually collected in advance of losses.  If an insurer is paying some fraction of its risk premiums to its customers, and it does not have a loss sharing mechanism as is fundamental to a mutual insurance scheme, then it is acting similarly to a leveraged hedge fund.

The resources of the insurer to absorb losses is the capital, but the exposure to losses extends to a much larger pool of insured funds.

So the market valuing of insurance liabilities is really a risk recognition exercize.  It is trying to make a point, that point being that the practices of insurers have evolved to become much riskier than what they had been in the past.  And the mark to market system would force insurers to acknowledge that additional risk at the point at which they decide to tak on the risk.

Now, it appears that IFRS accounting is heading a different direction.  The IASB seems to be backing away from a full mark to market system for assets.  This will wreck havoc on the balance sheets and income statements of the insurers who will be marking their liabilities but not their assets to market.

Sort of like the mess that has existed in the other direction for some time not, were insurers in many situations have been marking assets, but not liabilities to market.

Insurance has a reputation for totally opaque financial reporting.  It seems that this reputation will continue to be well deserved.

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Comprehensive Actuarial Risk Evaluation

The new CARE report has been posted to the IAA website this week.

It raises a point that must be fairly obvious to everyone that you just cannot manage risks without looking at them from multiple angles.

Or at least it should now be obvious. Here are 8 different angles on risk that are discussed in the report and my quick take on each:

1. MARKET CONSISTENT VALUE VS. FUNDAMENTAL VALUE   –  Well, maybe the market has it wrong.  Do your own homework in addition to looking at what the market thinks.  If the folks buying exposure to US mortgages had done fundamental evaluation, they might have noticed that there were a significant amount of sub prime mortgages where the Gross mortgage payments were higher than the Gross income of the mortgagee.
2. ACCOUNTING BASIS VS. ECONOMIC BASIS  –  Some firms did all of their analysis on an economic basis and kept saying that they were fine as their reported financials showed them dying.  They should have known in advance of the risk of accounting that was different from their analysis.
3. REGULATORY MEASURE OF RISK  –  vs. any of the above.  The same logic applies as with the accounting.  Even if you have done your analysis “right” you need to know how important others, including your regulator will be seeing things.  Better to have a discussion with the regulator long before a problem arises.  You are just not as credible in the middle of what seems to be a crisis to the regulator saying that the regulatory view is off target.
4. SHORT TERM VS. LONG TERM RISKS  –  While it is really nice that everyone has agreed to focus in on a one year view of risks, for situations that may well extend beyond one year, it can be vitally important to know how the risk might impact the firm over a multi year period.
5. KNOWN RISK AND EMERGING RISKS  –  the fact that your risk model did not include anything for volcano risk, is no help when the volcano messes up your business plans.
6. EARNINGS VOLATILITY VS. RUIN  –  Again, an agreement on a 1 in 200 loss focus is convenient, it does not in any way exempt an organization from risks that could have a major impact at some other return period.
7. VIEWED STAND-ALONE VS. FULL RISK PORTFOLIO  –  Remember, diversification does not reduce absolute risk.
8. CASH VS. ACCRUAL  –  This is another way of saying to focus on the economic vs the accounting.

Read the report to get the more measured and complete view prepared by the 15 actuaries from US, UK, Australia and China who participated in the working group to prepare the report.

Assumptions Embedded in Risk Analysis

The picture below from Dour VanDemeter’s blog gives an interesting take on the embedded assumptions in various approaches to risk analysis and risk treatment.

But what I take from this is a realization that many firms have activity in one or two or three of those boxes, but the only box that does not assume away a major part of reality is generally empty.

In reality, most financial firms do experience market, credit and liability risks all at the same time and most firms do expect to be continuing to receive future cashflows both from past activities and from future activities.

But most firms have chosen to measure and manage their risk by assuming that one or two or even three of those things are not a concern.  By selectively putting on blinders to major aspects of their risks – first blinding their right eye, then their left, then by not looking up and finally not looking down.

Some of these processes were designed that way in earlier times when computational power would not have allowed anything more.  For many firms their affairs are so very complicated and their future is so uncertain that it is simply impractical to incorporate everything into one all encompassing risk assessment and treatment framework.

At least that is the story that folks are most likely to use.

But the fact that their activity is too complicated for them to model does not seem to send them any flashing red signal that it is possible that they really do not understand their risk.

So look at Doug’s picture and see which are the embedded assumptions in each calculation – the ones I am thinking of are the labels on the OTHER rows and columns.

For Credit VaR – the embedded assumption is that there is no Market Risk and that there is no new assets or liabilities (business is in sell-off mode)

For Interest risk VaR – the embedded assumption is that there is no credit risk nor new assets or liabilities (business is in sell-off mode)

For ALM – the embedded assumption is that there is no credit risk and business is in run-off mode.

Those are the real embedded assumptions.  We should own up to them.