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