risk management in life & geanaral insurance

8/16/2019 Risk Management in Life & Geanaral Insurance

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LIFE INSURANCE

An insurer involved in the business of life insurance is required to invest and keep invested at all times

assets, the value of which is not less than the sum of the amount of its liabilities to holders of life insurance

policies in India on account of matured claims and the amount required to meet the liability on policies of life

insurance maturing for payment in India, reduced by the amount of premiums which have fallen due to the

insurer on such policies but have not been paid and the days of grace for payment of which have not expired and

any amount due to the insurer for loans granted on and within the surrender values of policies of life insurance

maturing for payment in India issued by him or by an insurer whose business he has acquired and in respect of

which he has assumed liability. Every insurer carrying on the business of life insurance is required to invest and

at all times keep invested his controlled fund (other than funds relating to pensions and general annuity business

and unit linked life insurance business in the following manner, free of any encumbrance, charge,

hypothecation or lien! (such as funeral expenses are also sometimes included in the benefits.

RISK ASSOCIATED IN LIFE INSURANCE AND ITS MANAGEMENT

Managing enterprise risk:

"he recent volatility in the capital markets and the consequent adverse developments across the

financial services industry have stimulated interest in more sophisticated risk#management techniques. $avingspent our careers working in or for the life insurance industry, focusing on the pricing and valuation of lifeinsurance and annuity products, we believe that much of the fundamental exposure facing life insurers arisesfrom a failure to adequately understand the risks that are assumed. %uch lack of understanding results in pricing products incorrectly.

&ertainly, there are many types of risk, and each must be addressed to fulfill the requirements of a fullenterprise#risk#management (E' solution. $owever, when focusing on the underlying drivers of primary risk,we believe that understanding which risks are being taken, charging a suitable price to offset them, and thenmanaging the business to keep risks within the expected range)these factors together present the ultimatechallenge.

Pricing risk:

It relates directly to the long#term nature of a life insurance or annuity#type policy. *y contrast, acandy bar manufacturer presumably knows or can ascertain all the costs associated with the development,manufacture, and distribution of the candy bar when setting its price. If any of the knowable costs change, thatinformation can be used to ad+ust the price of the product. nlike a candy bar manufacturer, -the cost of goodssold- inherent to a life insurance policy will probably not be known with certainty for many years and should be

pro+ected over a long period of time when setting the policy price. "he failure to fully appreciate the risks beingtaken, not to mention their value, can lead to the underpricing of the policy itself and the companys ultimatelyincurring a loss on the sale. /iven the sophistication of the insurance marketplace, the more underpriced a product is, the more policies a company may sell. 0hile some elements of a life insurance policy may not be

guaranteed and can be ad+usted based upon events subsequent to the sale, the management of thesenonguaranteed elements creates risk. A companys inability or unwillingness to manage such nonguaranteed

elements can also lead to losses.

Market-ia!i"it# risk

It occurs when a company cannot find a market for and sell its policies to a given constituency on

a profitable basis. An insurance company will fail if it cannot find a continuing market for the products it sells. Italso faces strategic risk from choosing the wrong markets in which to participate. "hese risks are closely relatedto and arise from pricing risk. "here may be a market for a particular product at a given price that is not profitable, based upon the efficiencies and risk management competencies that the issuing company brings tothe table. 1ikewise, a market for that particular product may evaporate if a company, when charging a price it believes to be profitable, cannot communicate the products value to potential clients. &onsequently, there is a


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natural friction in the management of each of these risks. 2bviously, the ability to sell products that are profitable is the key to the long#term sustainability of a company.

Asset-re"ate$ risks

"hey are associated with the products sold by a life insurance company. /iven the long#term nature ofa life insurance contract and the level premium charged for what is normally an increasing risk (i.e., mortalityincreasing with attained age, a life insurance company typically accumulates a substantial number of assets

(premiums to invest. "he higher the rate it assumes it can earn on the assets, the lower the premium it maycharge. "he ability to meet the assumptions utili3ed with respect to investment return will determine whether the policy is as profitable as it was pro+ected to be in the pricing process.

%uccessful risk management requires that the assumed investment rate (for guaranteed premium products andthe investment spread (for nonguaranteed products are set consistent with the company4s realistic ability to

achieve both ob+ectives. any of the historical failures of life insurance companies can be traced to theassumption of an unrealistically high investment rate5investment spread that resulted in investment in assets

with excessive duration mismatch or dubious quality, or that became extremely illiquid. A -run on the bank- can +eopardi3e even the best#managed company. "his risk can be reduced by avoiding excessive concentration inany one asset class and taking care to anticipate and plan for liquidity requirements under a range of differentscenarios.

-'eaching for yield- to meet assumptions that were set during the pricing process has been a primary cause oflife insurance company impairments over the last 67 years. Examples of this include investing in real estate tosupport interest rates credited on guaranteed#investment contracts, in +unk bonds to support interest ratescredited on universal#life and deferred#annuity contracts, or, more recently, in long#term assets supported byshort#term borrowing to extract the difference in yield.

"hose responsible for product development, pricing, and overseeing the overall risk#management function in acompany generally recogni3e the impact of interest#rate movement and its potential negative effect on the pro+ected profitability of certain types of products within certain markets. $owever, many of the assumptionswith respect to policyholder behavior are still based on informed +udgment rather than reliable experience.&onsequently, the sensitivity of results under differing environments should be assessed and reflected in the product#development and pricing processes, because these form a key part of the risk#management process of

the company.

RISKS ASSOCIATED %IT& OT&ER PRICING ASSUMPTIONS

Lapse rates

any of the most popular products being sold today (e.g., long#term care, level#premium term, no#lapse#guarantee universal life are lapse supported (i.e., profits increase if the ultimate#duration lapse rate isincreased. 1apse support has had a negative connotation among some, with an implication that the pricing ofsuch products was somehow flawed. $owever, lapse support is a consequence of the products design.%pecifically, any coverage that charges level premiums for an increasing exposure (i.e., increasing probability of

claim, without providing nonforfeiture values commensurate to the -equity- the policyholder has generated inthe policy, will be lapse supported. 8rofits increase as the ultimate#lapse rate increases, because fewer policyholders are in force in policy durations for which the revenue collected is less than the benefits andexpenses paid.

&onversely, if lapse rates in ultimate durations are less than were assumed in the pricing process, the

profitability of the product will suffer. In some instances, the repercussions can be quite substantial, with

reductions in the ultimate#lapse rates wiping out the pro+ected profit of the product and creating a substantialloss. "his has been particularly true with no#cash value life insurance (i.e., term to 9:: sold in &anada severalyears ago and in the early#generation product offerings of longterm#care policies in the nited %tates.


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&onsumers, or their agents or brokers, tend to recogni3e a good deal when they see it, and do not lapse these policies, with lapse rates for some of them falling below 9; annually.

Assuming a low rate of ultimate lapse in the pricing process produces a higher premium, given a stated profitob+ective with all other assumptions remaining equal. &onsequently, the natural friction between the salabilityand the profitability of the product emerges during the pricing process. "he risk#management process should

recogni3e this and avoid the utili3ation of unrealistically aggressive (i.e., high ultimate#lapse rates in the pricingof these products.

M'rta"it# ass()pti'ns

Insured mortality has improved significantly over the last 67 years. "he extrapolation of thisimprovement into the future during the pricing process creates risk for the insurance company. It follows that ifany pro+ected mortality improvement does not emerge, the negative impact can be significant if ultimate#lapserates also fall below pricing assumptions. "he splitting of cohorts into more underwriting classes, the uncertainimpact of medical technology, and the lack of credible mortality experience for older ages have resulted in the

development of assumptions based on informed +udgment rather than historical experience. "his makes themonitoring of experience as it emerges critical to the risk#management process. 'isk management may require

the hedging or balancing of this risk among different lines of business.

Seere eents

"he effect of infrequent but severe events, such as epidemics or terrorist attacks, should be considered in both the risk#management process and the product#development5pricing process. "he cost of stop#lossreinsurance can be incorporated into the pricing of life insurance products to reflect this risk.

Ne* !(siness

"he absolute level of new business produced can have a significant impact on surplus levels. "actics such

as the financing of new agents and the payment of annuali3ed first year commissions can produce a substantial

effect on the level and quality of new business produced.

C'(nterpart# risk

"he potential negative consequences of counterparty risk have become clear over the past several months,

as financial institutions with the highest ratings have failed or were acquired or bailed out in some form.$istorically, the biggest counterparty risk within life insurance companies was associated with cededreinsurance. "he risk#management process should consider the reinsurers ability to pay claims, even duringtimes of economic or catastrophic distress. 'isk management should also assure that pricing the guaranteesembedded in variable annuity products with living#benefit guarantees recogni3es the cost charged by well#capitali3ed, reliable counter parties.

&e$ging c'st '"ati"it#

%tock#market volatility directly affects the cost of hedging the risks embedded in variable#annuity productswith living#benefit guarantees. As market volatility increases, the cost of hedges increases. 8roduct pricingshould reflect the long#term nature of these guarantees and the volatility of the cost of hedging them.

Risk c'ntagi'n

"he correlation of various risks has historically been underappreciated. "he implosion of the subprimemortgage market led to the bursting of the housing bubble, which resulted in the tightening of credit standards,reduced consumer spending, increased stock#market volatility, decreased interest rates and increased interestspreads, asset devaluation and illiquidity, and recession. &ausation can be debated, but the correlation of theseevents cannot. "he magnitude of these developments occurring together is much more virulent than the effect of

each occurring separately. "he subtle interactions between risk factors often go unnoticed until emergence of acomplex pattern that can be difficult to understand and anticipate.


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Ac+(isiti'ns

In an acquisition exercise, the premiums are set and the amount to be paid for the business is determined.

"he primary ob+ective during an acquisition process is not for the company to understand the risks of the entity being purchased, but rather to understand how the risk profile of the new combined post#acquisition entity isdifferent when compared with the pre #acquisition risk profile. "he new entity will entail different risks and,

presumably, different skills, so successful integration requires these to be optimally allocated and priced into theacquisition.

RISK MANAGEMENT IN GENERAL INSURANCE:

S'"enc# Margin F'r)("a :

I''.

A"ternate Risk Manage)ent :

"hese are several alternate risk management strategies such as risk transfer (reinsurance, risk hedging through

interest ratio etc. longevity bonds and managing financial market risks.

S'"enc# I:

%olvency 9 is based on minimum solvency standards. "he solvency directive adopted in 6::6 left the solvency

calculation unchanged but only ad+usted some other components. %olvency requirements should be fulfilled at

all times rather than only at the time the financial statements are drawn up.

All life insurers are required to /old capital of at least the %olvency 9 minimum guarantee fund, or the %olvency

required solvency margin plus the resilience capital requirement. %olvency capital requirement will be

calculation by applying either the standard approach or the insurers won internal risk model.


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%olvency I require insurers to hold capital funds equal to the required solvency margin or the minimum

guarantee fund, whichever is the higher. %olvency for non#life insurance is defined as the higher of the premium

and the claim index.

8remium Index ? 9@; of gross premium x retention rate

&laims Index ? 6; of gross claim x retention rate

'etention >et claims #r /ross claims (= year average but not less than 7:;

%olvency I for 1ife Insurance is 'equired %olvency argin

B; x gross mathematical provision x retention rate mathematical provision C =; x capital at risk x retention

rate capital at risk.

S'"enc# II :

%olvency II requires adequate capital backing for the volatility of claims. "he assess which lives of business

may exhibit above#average volatility the loss rations of five non#life lives of business.

European nion (E adopted solvency I 6::6 which was converted to solvency II in early 6::=. E

commission is expected to adopt the solvency II directive in mid 6::D. After its adoption by E 8arliament and

the council of inisters, the implementation is scheduled to be complete by 6:9:.

2ne of the ob+ectives of %olvency II is to establish a solvency capital requirement which is better matched to the

risks of an insurance company. "he characteristic of solvency II are based on principles and not rules.

"hese are two levels of capital requirements under solvency II, i.e. "he inimum &apital 'equirement (&'

and %olvency &apital 'equirement. &' is the minimum level below which ultimate supervisory action will be

triggered.

%&' should deliver a level of capital that enables an insurance undertaking to absolute significant unforeseen

losses and gives reasonable assurance to policy holders that payment will be made as they fall due.

%olvency II deals with quantitative requirements, supervisory review powers and for insurers internal control

and risk management and disclosure and transparency to reinforce market mechanism and risk based

supervisors. It reinforces on risk5return fundamentals.

IRDA R'"e :

"he reporting framework for published accounts for insurance companies in prescribed by the I'


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"he I'


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%o, they were given freedom in 8olicy wording. I'

risk management in life & geanaral insurance

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