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RSK4803 Topic 1 Learning Unit 3 summary notes
- Institution
- University Of South Africa (Unisa)
RSK4803 Topic 1 Learning Unit 3 summary notes
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Topic 6Learning unit 11
Conceptually, insurers can concentrate significant underlying risk in a pool where an insurer
has a pool of house owners and contents insurance concentrated in for example Cape St
Francis. A fire that destroys a large part of the town can have a significant impact on the
book that can be catastrophic for that insurer. As a risk management measure, the insurer
can use reinsurance to reduce (de-risk) the book by ceding a percentage of the book to a
reinsurer. To put it simply, the reinsurer acts as insurer for the insurance company.
Reinsurance is however not the only alternative available as a number of other types of
instruments or alternative risk transfer (ART) products can be used to protect insurers. Large
companies with sophisticated risk management departments have also started to use ART
as risk financing alternatives to supplement or replace traditional or standard insurance. This
topic will focus on the role of traditional insurers, the types of underwriting risk experienced
by them, and the reason for laying-off underwriting risk to reinsurers and capital markets.
• Explain underwriting risk from the perspective of the insurer and measures that can
be implemented by the insurer to manage the risk.
4.2 Credit risk
Credit risk is the risk due to uncertainty in a counterparty's (also called an obligor's or
credit's) ability to meet its obligations. In assessing credit risk from a single counterparty, an
institution must consider three issues:
Default probability: What is the likelihood that the counterparty will default on its obligation
either over the life of the obligation or over some specified horizon, such as a year?
Calculated for a one-year horizon, this may be called the expected default frequency.
Credit exposure: In the event of a default, how large will the outstanding obligation be when
the default occurs?
Recovery rate: In the event of a default, what fraction of the exposure may be recovered
through bankruptcy proceedings or some other form of settlement?
4.3 Market risk
This is the risk to an institution's financial condition resulting from adverse movements in the
level or volatility of market prices of interest rate instruments, equities and currencies.
Market risk is the risk that the value of an investment will decrease due to moves in market
factors. The three standard market risk factors are:
Equity risk is the risk that one's investments will depreciate because of stock market
dynamics causing one to lose money.
Interest rate risk is the risk that the relative value of an interest-bearing asset, such as a
loan or a bond, will worsen due to an interest rate increase. In general, as rates rise, the
price of a fixed rate bond will fall, and vice versa.
,Currency risk is a form of risk that arises from the change in price of one currency against
another. Whenever investors or companies have assets or business operations across
national borders, they face currency risk if their positions are not hedged.
4.4 Operational risk
Operational risk is the risk of loss resulting from inadequate or failed internal processes,
people and systems, or from external events. The committee indicates that this definition
includes legal risk but excludes systematic risk and reputational risk.
4.5 Liquidity risk
The risk that arises from the difficulty of selling an asset. An investment may sometimes
need to be sold quickly. Unfortunately, an insufficient secondary market may prevent the
liquidation or limit the funds that can be generated from the asset.
An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected
cash outflows, or some other event causes counterparties to avoid trading with or lending to
the institution. A firm is also exposed to liquidity risk if markets on which it depends are
subject to loss of liquidity.
In an insurance context, liquidity risk is exposure to loss in the event that insufficient liquid
assets will be available, from among the assets supporting the policy obligations, to meet the
cash flow requirements of the policyholder obligations when they are due.
5. Risk Measures:
6.1 Reinsurance:
Reinsurance is an insurance company’s own insurance. The insurance company passes on
some of its risks to another party – a reinsurer.
Reasons for using reinsurance:
An avoidance of large single losses
Smoothing of results
Availability of expertise
Increasing capacity to accept risk
Financial assistance.
6.2 Hedging:
In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the
risk in another investment. Hedging is a strategy designed to minimize exposure to an
unwanted business risk, while still allowing the business to profit from an investment activity.
A natural hedge is an investment that reduces the undesired risk by matching cash flows, i.e.
revenues and expenses. For example, writing both life insurance and life contingent
annuities for similar groups of policyholders may help to provide a hedge against the impact
of improving mortality.
, One of the oldest means of hedging against risk is the purchase of insurance to protect
against financial loss due to accidental property damage or loss, personal injury, or loss of
life.
Introduced in 2000 by the National Stock Exchange, derivatives are a different breed of
financial products whose value is derived from an underlying instrument-such as an index, a
stock, a currency or a commodity. Thus, instead of directly investing in a stock, you invest in
an instrument whose value is dependent on the price of that stock. Futures and options are
two popular and actively traded derivative instruments in the Indian stock market
In particular, we can use derivatives to reduce the exposure of our portfolio to the risk of
adverse movements in the market price of the underlying assets. If, for example, we are
concerned about falls in the investment market, we might buy put options. By guaranteeing
the price at which we can sell our assets, this removes the risk of market falls. We will still,
however, enjoy the resulting profits should the market instead go up. Derivative contracts
therefore give us more control over the market risks that we face; thereby increasing our
opportunity set of possible risk and return combinations. Moreover, if we hold suitable
derivatives and the underlying assets in appropriate combinations then we can sometimes
eliminate almost all of the market risk facing our portfolio – though other risks such as lack of
marketability or credit risk will remain.
6.3 Participating:
In a participating policy (also known as a with-profits policy), the insurance company shares
the excess profits (variously called dividends or refunds) with the policyholder. The greater
the success of the company's performance, the greater the dividend.
The premiums paid by with-profits, without-profits and non-profit policyholders are pooled
within the insurance company's life fund or general account. The company uses the pooled
assets to pay out claims and other settlements. A large part of the life fund is invested in
equities, bonds, property and more complex financial instruments to achieve capital growth.
The insurance company aims to distribute part of their profit to the with-profits policy holders
in the form of a bonus or dividend attached to their policy
5.2 Other Measures:
Insurance Risk Factor Profiling
Insurance Predictive Modelling
Insurance Scoring
5.2.1 Profiling of Risk Segments
Profiling is to identify factors and variables that best summarize the segments.
Profiling insurance risk factors is very important. The Pareto principle suggests that 80%-
90% of the insurance claims may come from 10%-20% of the insurance segment groups.
Profiling these segments can reveal invaluable information for insurance risk management.
Insurance providers often collect a large amount of information on insured entities. Policy
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