RISK Faced by INSURERs and REINSURANCE

Risks Faced by Insurers & Reinsurance

a) Contingency Risks
b) Investment Risks
c) Reinsurance as external source of capital
Risks – Faced by Insurers & Reinsurers
The business of insurance is based on dealing with uncertainty. Therefore, an insurer
needs to consider a wide range of possible risks and the outcome that may affect the
current and future financial position. The range of risks more importantly consist of -
o investment management risk,
o underwriting risk and Catastrophe risk, besides Actuarial risk,

o Credit risk, Market risk, Liquidity risk,

o Interest Rate Risk,

o Operational Risk,

o Foreign Exchange (Currency) Risk, Legal/Regulatory Risk,

o Technology Risk, Environmental Risk, Reputation Risk,
o Country Risk,
o Asset Liability Management (ALM) Risk,
Risks – Faced by Insurers & Reinsurers
Functions of Insurance Companies & Risk Thereof
The important activities of an insurance company are:

 Underwriting and
 Investment.

- Underwriting is heart and soul of insurance company, critical for business

development and growth. Investment and income thereof is the flesh and blood
which gives strength and nourishment. The risk involved in these two activities can
shake the foundation of the company and when combined with other risks
mentioned above it accelerates or accentuates deterioration and even demise of
the company.

- Credit Risk is inherent in lending and investment. It can also be caused by

reinsurers, brokers, agent and clients. Credit risk is default in payment or fall in the
credit quality. Concentration of investments in industry, economic sector and
geographical area are generally risky.
Risks – Faced by Insurers & Reinsurers

- Credit Risk is inherent in lending and investment. It can also be caused by

reinsurers, brokers, agent and clients. Credit risk is default in payment or fall in the
credit quality. Concentration of investments in industry, economic sector and
geographical area are generally risky.

- Credit risk can arise from excessive exposure to group companies. Perfunctory (
superficial ) understanding of the complexity and potential risks in Complex
derivative contracts can also cause credit risk.

- IRDA has prescribed taking this Risk in to account that no Insurance Company
can have more than 15% Exposure to any Group or Company
Risks – Faced by Insurers & Reinsurers
Market Risk

Market Risk is the risk that arise from market movements and volatility of prices of
equity or currency and changes in interest rates in the deals including derivative
contracts. They broadly result in changes in asset value or portfolio values.

o More specifically risk of loss on account of interest rate changes may affect the
future cash flows from assets (inflow) and the liabilities (outflow) in different scales
creating a mismatch. Likewise the currency risk arises from foreign exchange rate
movements and consequently the cash flow is affected.

o So also value of assets denominated in foreign currency including position in

foreign currency will create loss or mismatch. Yet another area of risk is the asset
held against policies issued with guaranteed payment. Asset value may suffer loss
on account of adverse interest change.
Risks – Faced by Insurers & Reinsurers
Liquidity Risk

Liquidity is concerned with the current and future maintenance of adequate levels of
cash and liquid assets. There is always a time Lag between receipt of premium and
payment of claims and hence there should be no liquidity problem. But there can
always be unanticipated claims or surrender of policies or claims on account of
catastrophes

o Liquidity risk in life insurance arise out of surrender of large number of policies and
in general insurance due to non-renewal of the policies and/or large claims.

o Liquidity risk may cause loss of asset value on account forced sale of assets, more
so if there is slump in the market. Although instead of sale of assets, a loan could
be raised to meet cash requirements the constraint may be non-availability of loan
or availability of loans only at high cost. A single or a few parties controlling major
share in business with substantial value can expose the insurer to liquidity risk.
Risks – Faced by Insurers & Reinsurers

Actuarial Risk

Actuarial risk arises in pricing (premium rate) due to variance in mortality rate, perils,
hazards etc. projected with actual position, (say early termination of the policies,
catastrophe etc.)

- Actuarial work involve a systematic study of risk and the consequent loss so as to
fix appropriate premium for insurance products. The calculations are based on
statistics, past experience and future probabilities. There are many uncertainties and
imponderables ( difficult to estimate ) in the calculations which causes actuarial risk.
Risks – Faced by Insurers & Reinsurers
Asset Liability Management Risk (ALM)

ALM does not imply that assets should be matched as closely as possible to
liabilities, but the mismatch shall be effectively managed to contain the damages if
any arising therefrom. The ALM framework should also consider any off-balance
sheet exposures. Right approach is to manage the insurer’s assets and liabilities
together.

o Some liabilities may have long durations such as product liability insurance and
whole-life policies and annuities. In such cases, assets with sufficiently long
duration may not be available causing a significant reinvestment risk. Return on
individual investment may or may not match corresponding liability. But overall
investment income should be sufficiently more than total liabilities.
Risks – Faced by Insurers & Reinsurers
Asset Liability Management Risk (ALM)

o ALM may need to address certain aspects of underwriting risk, uncertainty of

timing and size of future claim payments, especially for long- term non-life
business. Risk retention, Risk transfer, Expense control are important part of
managing risk.

- Reinsurance arrangements should be adequate and the claims by the insurer on its
reinsurers should be recoverable. ReInsurance programme shall consider level of
capital and financial strength of the reinsurer in order to decide the exposure to a
particular reinsurer.
Risks – Faced by Insurers & Reinsurers
Capital RISK
Insurer should be careful not to place undue emphasis on external ratings and set
out its own quantitative and qualitative risk assessment models and risk tolerance
levels in its business strategy. So also provide guidance for group relationship in
business, group risk tolerance and feedback mechanism. Responses to change as a
result of both internal and external events, new risks, new acquisitions, investment
positions, business lines, need to be decided by the board.

o Insurer need to regularly perform its Own Risk and Solvency Assessment (ORSA).
In the process of risk assessment and management of solvency position,
underwriting process, credit risk, market risk, operational and liquidity risks should
be reassessed. Risk management actions should be based on adequacy of its
economic capital and regulatory capital.

o Capital requirements set by the solvency regime, overall, risk management and
capital management are taken together to decide on financial resources it needs.
It cannot be assumed that new capital will be readily available.
Risks – Faced by Insurers & Reinsurers
Other Risks:
The Operational Risks in insurance include human failure, fraud, technology failure,
failed system and procedure. Violation of environmental laws and regulations. The
risks may be systemic risk or un-systemic risk.

- Systemic risk is industry-wide, market-wide or even countrywide, like, recession,

high inflation, civil disorder and chaos, war etc.

- Un-systemic risk is company specific management failure, huge fraud, etc.

Another important risk is asset liability mismatch.

 Assets generate income, and liabilities relate to payment obligations. Situations

can arise when asset value fall sharply, the payment obligations may rise steeply
on account of large claims.
 Technology Risk, Banks and insurance companies are system driven while
technology helps, to improve efficiency and speed, system breakdown can cause
serious set-back and business disruption.
Risks – Faced by Insurers & Reinsurers
Other Risks faced by Insurance Companies are as follows -

Cybersecurity/Cybercrime (operational risk)

The top risk encompasses insufficient cybersecurity measures that lead to

data/privacy breach, loss of records, or other event due to a hack/virus, stolen/lost
device, phishing attack, etc. These problems may be caused by malicious outsiders
combined with poor design or execution of security. They may lead to a significant
cost to remedy, repair and/or recover as well as reputational damage that could lead
to loss of customers.

o This risk has been a high concern over the past several years and most recently
has been prominent in the news. Since insurance is a data driven business,
cybersecurity is seen as a particularly sensitive area for insurers. Many boards are
very concerned about cybercrime, which helped elevate this to be the most
dangerous risk.
Risks – Faced by Insurers & Reinsurers
Pricing and Product-Line Profit (insurance risk)

The risk arising from the exposure to financial loss from transacting insurance and/or
annuity business where costs and liabilities experienced in respect of a product line
exceeds the expectation in pricing the product line - Newer product lines experience
losses due to the high expenses of operating or an under-scale business.

Insurers are always worried about their pricing and profitability; and the market price
is not always correct. There is a persisting temptation to label a jump in claims as a
temporary aberration or to cut rates to increase sales.

o Pricing and product-line profit issues are predominantly a higher-frequency and

lower-severity risk. Current conditions related to excess capacity as well as fairly
benign ( favorable) experience have in the past foreshadowed periods of
problems here.
Risks – Faced by Insurers & Reinsurers
IT Systems / Technology Gap (Operational Risk)

In the future, operational needs could exceed the existing IT infrastructure. When
technology initiatives are not successful and/or the technology required to meet
business objectives is not available, the firm risks missing client expectations.
System downtime and responsiveness are also major risks. Some insurers’
technology infrastructure relies on one primary vendor which could fail.

o Operational needs could, in the future, exceed the existing IT infrastructure. Many
insurers are struggling with this risk. They are committing major financial
resources to systems upgrades, but fear that they will still be behind the times
when the upgrade project is completed.

- Insurers are very highly dependent on their tech platform to make the business
work and see this as a do-or-die issue.
Risks – Faced by Insurers & Reinsurers
Competition (strategic risk)

The risk of the insurer’s relative market position being impacted by strategic
advances of other companies in the same markets. Those strategies might include
recruiting of company brokers and agents, an offering of a new product or benefit
design or simply cut-rate pricing.

o This risk exists for all businesses, but insurers are particularly at risk because of
low barriers to entry in many parts of the business. This risk is correlated with the
pricing and product-line profit risk and is driven by the same factors.
Risks – Faced by Insurers & Reinsurers

Legislative & Regulatory (operational risk)

The risk of loss associated with non-compliance with laws, rules, regulations,
prescribed practices or ethical standards within jurisdiction of operation –

o Ripple effects from the misselling provisions are expected to potentially impact the
way that insurers are regulated and taxed at higher levels.

o Withdrawal of Products due to New Guidelines

o Reduction in Distributor Commissions due to Regulations

o Legislative Changes can have a Huge Impact on the Insurers

Risks – Faced by Insurers & Reinsurers
Strategic Direction / Opportunities Missed (Strategic Risk)

Ineffective and inefficient strategy planning can result in too many major decisions
reached on an ad-hoc basis

o The risk of not having an effective and efficient strategic planning process and
culture to achieve important business objectives, which can result in too many
major decisions reached on an ad-hoc basis without sufficient consideration of
costs, benefits and alternatives. The opportunity cost of missing major initiatives
due to the lack of effective foresight and planning is real.

o Strategy is another important risk that applies to all businesses. Strategy is easy
to ignore in the heat of day-to-day businesses.

- That is why, for example, companies that are serious about planning take their
executives away from the work environment and ban smart phones for much of their
planning session.
Risks – Faced by Insurers & Reinsurers
Natural catastrophe (insurance risk)

Major storms including hurricanes, tornadoes, cyclones and hail storms can cause
intense insured losses in a concentrated or even sometimes a wide area.
Earthquakes are also a threat.

o Natural Catastrophe like Cyclone, Epidemic and Earthquake can happen at any
point in time causing a Huge Outgo in terms of Claim Payment and Insurers may
not be adequately prepared for it
Risks – Faced by Insurers & Reinsurers
Emerging Risks (unknown type of risk)

The term “emerging risks” encompasses the risk of loss from types of events that are
not currently on the risk register because they have never happened before, or
because they are considered extremely unlikely. These may be “unknown unknowns”
or Black-Swan type risks (an event which comes as a Surprise and has a Big Impact)

o Emerging risks are the 10th most dangerous risk according to the insurance risk
managers
Contingency Risks
Insurance that protects someone against risks that are not the usual areas dealt with
by Insurance Companies. Contingency Insurance is tailored meet the remote Risk of
an event.
For Eg –

 The organizers of the world's biggest sporting events take

out contingency insurance, which pays out if an event is interrupted, postponed,
or cancelled.

 Cancellation of events, film insurance and specialties, such as prize indemnity,

over-redemption, extended warranty, residual value insurance, etc., which may be
grouped together under the title of contingency covers.

 Banking cover, such as bankers’ blanket bond, computer crime, unauthorized

trading , bankers’ professional indemnity, cash-in-safe and cash-in-transit
insurance.
Contingency Risks

 Fine arts and special burglary insurances, such as jeweler's block.

 In addition to the above there are various optional extensions to policies that can
be arranged including but not limited to Terrorism, Political Violence, Civil
Commotion, War, Communicable Diseases, Employers and Public Liability.
Contingency Risks
 For Mergers and Takeovers –

Contingent insurance for Mergers & Acquisitions and other investment or financing
transaction encapsulates insurance for a broad range of contingent risks which may
be identified during due diligence conducted in the transaction process. It typically
consists of known identified legal risks, including:

– Litigation insurance

– Shareholder disputes

– Liquidation insurance/Successor liability

Contingency Risks
Besides this the Other type of Contingency Risk may cover –

 Litigation insurance
 Shareholder disputes
 Liquidation insurance / Successor liability
 Intellectual property or employment disputes
 Complex title risks.
Investment Risks of Insurance Companies
The Insurers Invest the Surplus net of income and claims paid in the Market. This is
prone to risk as any Other Investments done. The Major types of Investment Risk
faced by the Insurance Companies are as follows –
Market risk

The risk of investments declining in value because of economic developments or

other events that affect the entire market. The main types of market risk are equity
risk, interest rate risk and currency risk

- Equity risk – applies to an investment in shares. The market price of shares varies
all the time depending on demand and supply. Equity risk is the risk of loss
because of a drop in the market price of shares.

- Interest rate risk – applies to debt investments such as bonds. It is the risk of losing
money because of a change in the interest rate. For example, if the interest rate goes
up, the market value of bonds will drop.
Investment Risks of Insurance Companies
Market risk

- Currency risk – applies when you own foreign investments. It is the risk of losing
money because of a movement in the exchange rate. For example, if the U.S. dollar
becomes less valuable relative to the Indian Rupee, your U.S. stocks will be worth
less in INR.
Risks – Investment Risks of Insurance Companies
Liquidity risk
The risk of being unable to sell your investment at a fair price and get your money out
when you want to. To sell the investment, you may need to accept a lower price. In
some cases, such as exempt market investments, it may not be possible to sell the
investment at all.
Concentration risk

The risk of loss because your money is concentrated in 1 investment or type of

investment. When you diversify your investments, you spread the risk over different
types of investments, industries and geographic locations.

Credit risk

The risk that the government entity or company that issued the bond will run into
financial difficulties and won’t be able to pay the interest or repay the principal at
maturity. Credit risk applies to debt investments such as bonds. You can evaluate
credit risk by looking at the credit rating of the bond.
Risks – Investment Risks of Insurance Companies
Reinvestment risk

The risk of loss from reinvesting principal or income at a lower interest rate.

- Suppose you buy a bond paying 7%. Reinvestment risk will affect you if interest
rates drop and you have to reinvest the regular interest payments at 5%.
Reinvestment risk will also apply if the bond matures and you have to reinvest the
principal at less than 7%.

- Reinvestment risk will not apply if you intend to spend the regular interest
payments or the principal at maturity.
Risks – Investment Risks of Insurance Companies

Inflation risk

The risk of a loss in your purchasing power because the value of your investments
does not keep up with inflation. Inflation erodes the purchasing power of money over
time – the same amount of money will buy fewer goods and services. Inflation risk is
particularly relevant if you own cash or debt investments like bonds.

- Shares offer some protection against inflation because most companies can
increase the prices they charge to their customers. Share prices should therefore
rise in line with inflation.

- Real estate also offers some protection because landlords can increase rents over
time.
REINSURANCE – External Source of Capital
What is Reinsurance ??

Reinsurance occurs when multiple insurance companies share risk by purchasing

insurance policies from other insurers to limit the total loss the original insurer would
experience in case of disaster.

- By spreading risk, an individual insurance company can take on clients whose

coverage would be too great of a burden for the single insurance company to handle
alone. When reinsurance occurs, the premium paid by the insured is typically
shared by all of the insurance companies involved.

Reinsurance can help a company by providing: -

 Risk Transfer - Companies can share or transfer of specific risks with other
companies
REINSURANCE – External Source of Capital
What is Reinsurance ??

 Arbitrage - Additional profits can be garnered by purchasing insurance elsewhere

for less than the premium the company collects from policyholders.

 Capital Management - Companies can avoid having to absorb large losses by

passing risk; this frees up additional capital.
REINSURANCE – Types
Reinsurance is basically a form of coverage intended for insurance providers. This
type of policy reduces the losses sustained by insurance companies by allowing them
to recover all, or part, of the amounts they pay to claimants.

- Reinsurers help insurance providers avoid financial ruin in case a huge number of
policyholders turn out to make their claims during catastrophic events.

Below are some of the major types of reinsurance policies.

o Facultative Coverage

This type of policy protects an insurance provider only for an individual, or a specified
risk, or contract. If there are several risks or contracts that needed to be reinsured,
each one must be negotiated separately. The reinsurer has all the right to accept or
deny a facultative reinsurance proposal.
REINSURANCE – Types

o Treaty Reinsurance

Unlike a facultative policy, a treaty type of coverage is in effect for a specified period
of time, rather than on a per risk, or contract basis.

- For the duration of the contract, the reinsurer agrees to cover all or a portion of the
risks that may be incurred by the insurance company being covered.
REINSURANCE – Types
o Proportional Reinsurance

Under this type of coverage, the reinsurer will receive a prorated share of the
premiums of all the policies sold by the insurance company being covered.
Consequently, when claims are made, the reinsurer will also bear a portion of the
losses.

- The proportion of the premiums and losses that will be shared by the reinsurer will
be based on an agreed percentage. In a proportional coverage, the reinsurance
company will also reimburse the insurance company for all processing, business
acquisition and writing costs. Also known as ceding commission, such costs may be
paid to the insurance company upfront.
REINSURANCE – Types
o Non-proportional Reinsurance

In a non-proportional type of coverage, the reinsurer will only get involved if the
insurance company’s losses exceed a specified amount, which is referred to as
priority or retention limit.

- Hence, the reinsurer does not have a proportional share in the premiums and losses
of the insurance provider. The priority or retention limit may be based on a single type
of risk or an entire business category.
REINSURANCE – Types
o Excess-of-Loss Reinsurance

This is a form of non-proportional coverage. The reinsurer will only cover the losses
that exceed the insurance company’s retained limit.

- However, what makes this type of contract unique is that it is typically applied to
catastrophic events. It can cover the insurance company either on a per occurrence
basis or for all the cumulative losses within a specified period.

o Risk-Attaching Reinsurance

Under this type of contract, all policy claims that are established during the effective
period of the reinsurance coverage will be covered, regardless of whether the losses
occurred outside the coverage period.

- Conversely, no coverage will be given on claims that originate outside the coverage
period, even if the losses occurred while the reinsurance contract is in effect.
REINSURANCE – Types
o Loss-occurring Coverage

This is a type of treaty coverage where the insurance company can claim all losses
that occur during the reinsurance contract period.

- The important factor to consider is when the losses have occurred and not when the
claims have been made.
REINSURANCE – External Source of Capital
Reinsurance can help a company by providing: -

 Solvency Margins - The purchase of surplus gives relief to insurance Companies

and allows companies to accept new clients and avoid the need to raise additional
capital.

 Expertise - The expertise of another insurer can help a company obtain a proper
rating and premium.

Capital = Assets – Liabilities

Reinsurance helps the Insurance Companies by transferring the RISK to another

Bigger Company. This helps the Insurance Company to make Lesser provisioning for
Capital to meet Exigencies.
REINSURANCE – External Source of Capital

 Reinsurance helps the Insurance Companies to Lessen their Liability and hence
Creating Capital which otherwise would be Blocked and hence treated as an “
External Source of Capital “
REINSURANCE – External Source of Capital
Some believe reinsurance is relatively expensive compared to other forms of capital
–

 While it may seem more expensive, due to the efficiencies inherent in the
provision of reinsurance, it may actually be cheaper

̶ Reinsurers typically have greater debt capacity than primary carriers ( Insurance
Companies) due to greater diversification – can make more efficient use of
leverage in providing risk capital

̶ Reinsurance can give the insurance company access to the reinsurer’s lower cost
of capital
REINSURANCE – External Source of Capital

What Does This Mean For Underwriters?

It’s not only about risk selection ̶ it’s also about understanding capital allocation

 It’s about bringing the most suitable capital to risk, no matter what form

 Not only are they risk underwriters – they are capital allocators too