Extreme Events – Specimen Answer A.8.2(d) – Answer/Hints

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Q. Summarise the main risks to which the following types of entity might be most exposed (and which it would be prudent to provide stress tests for if you were a risk manager for such an entity): (d) A non-life insurance company


         i.            Market risk. Non-life insurers tend to invest less in equities than life insurers and tend to have shorter duration fixed income portfolios, given the typically shorter-term nature of their liabilities. They are therefore usually less exposed to market risk than is usually the case with life insurance. However, there are exceptions, e.g. some long-tail business lines or ones in which the precise timing of payments is particularly important.


       ii.            Credit risk. Most life insurers have a relatively diversified policyholder base. This may be less true for non-life insurers. They can often also be quite dependent on the continued creditworthiness of reinsurers.


      iii.            Liquidity risk. As with life insurance, liquidity risk is usually thought of as less relevant to general insurers than to most other types of financial services entities. However, some business activities that non-life insurers can be involved with can be more sensitive to liquidity risk, particularly if other market participants are requiring that the insurer posts collateral (plus haircuts) to protect them against possible default by the insurer. This can potentially require the insurer to have funding lines in place in order to be able to fund delivery of collateral if needed, and if these lines dry up then the insurer can be left in an exposed position.


     iv.            Insurance risk. The nature of insurance involves the assumption and pooling of risk. Unlike life insurance, most such risks in non-life insurance end up falling on the shareholder (only typically obliquely falling on policyholders and then only in a generalised kind of fashion via the workings of the insurance cycle). If the firm prices these risks wrongly, or if strong selection effects mean that the firm ends up insuring the least profitable market segments, then this can rapidly undermine the firm’s business model. Many lines of business also have a ‘catastrophe’ component (i.e. some likelihood of very large adverse claims, even if likelihood is small), so variability of outcomes can also be a problem for inadequately capitalised companies that do not effectively hedge such risks (e.g. by using appropriate reinsurance programmes).


       v.            Operational risk. Like other financial services organisations, non-life insurers are also exposed to operational risks. It is perhaps more common for these to involve systematic failures in business model design and execution although outright fraud has felled some such insurers.


P.S. Similar types of risk (but in other guises) usually arise with other types of financial services entities, which may be one contributory factor in the increasing popularity of the discipline of Enterprise Risk Management.


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