If we sort risks by their nature, with a strong Balance Sheet vision :
• Asset risk : the risks related to the investments the insurance company makes.
• Liability risk : the risks for the company not to be able to assume its commitments, because of a liquidity shortage.
• Operational risk : the risks created by its way to do business

Insurance is characterised by its inverted cycle of production :
• Insurers first receive the premium before the claims
• they will know their profitability when claims will be known and paid, which can be very long, up to 40 years for longevity risk for instance.

The way to finance the capital in front of risk and uncertainty are :
• classically equity
• the numerous types of debts
• an alternative is to try to reduce risk and uncertainty (Risk Management)
• a specific insurance tool : reinsurance.

An insurer has various tools at its disposal :
1. Equity Issuance if the insurer is not a mutual company but a limited company.
2. Debt, with various types of debts, from the most senior ones, the subordinated debt to the most junior ones (bank facility) if we exclude the debt to the insured.
3. Reinsurance, insurance to a (generally) professional reinsurer, which is an insider as he will have access to numerous data internal to the company and the market.
4. Insurance Securitisation, close to reinsurance in the risk transferred but using a mechanism to transfer the debt into an asset (’security’) that can be then transferred and negotiated on a market.
5. a last item is risk-management itself : through a cost of implementation, reducing the risk and increasing transparency.

1. Underwriting risk (or liability risk),
2. Investment risk (or asset risk),
3. Credit risk,
4. Operational risk

The risk underwritten is not perfectly known to the insurer. This uncertainty comes from the fact that the insurer has limited information about his insured and a limited historical data.

Examples are :

  • climate change (cf Stern Report)
  • longevity improvement
  • obesity
  • nanotechnology
  • medical malpractices
  • financial bubbles

Successful organizations continually anticipate and manage a variety of change venues: economic changes due to globalization of markets, technological changes , market changes , political changes , social changes, and competitive intensity.

The organizational structure of an insurance company should support a sensible culture for dealing with risk. Ideally, a clear separation of roles of the risk owner, the risk taker and the risk manager functions should be established.

One Risk Management example can be a Product Approval Process that would define minimum requirements to ensure the appropriate profitability and risk control of underwriting. A key principle is that the implementation is a local responsibility subject to the Company Standard and guidelines.
This process allows to :
• a formal governance ensuring that a standardized process is implemented locally (including appropriate local sign-off),
• formalized local action plans ensuring that all lines/segments/products/offers are examined through risk profitability reviews
• valuation framework with risk-adjusted metrics.

Some properties can be defined from this definition :

  • ERM is not a department within a company but a process beyond the pure Risk-Management function. As a process that increases longterm value, ERM should be considered as a continuous improvement process and not as an once for eternity achievement. Clearly, experience shows that ERM maturity can’t be achieved without several tries and errors
  • Economic Capital model is not mentioned within this definition but risk appetite is basically ERM is the explicitness of the risk appetite of the company, not its optimisation.

The aim of ERM is to make all organizational levels work along side each other, dealing with specific risks, in order to provide:

  • A transparent account of the firm’s business model, including strategy, objectives, risk appetite and risk tolerances.
  • A method for identifying, assessing, analyzing, and measuring the key business risks in an organization, and a map of all sources of risk into an integrated framework:
    – comprehensive landscape of risks threatening a firm
    – list of positive and negative correlations among sources of risk
  • A set of risk valuation models for atypical risk dynamics
  • An open forum for discussing an organization’s risk capabilities, such as where it stands in terms of strategy, people, processes, technology and knowledge.

The level of capital (Net asset value) required for insurance undertakings to cope with their own risks, to be able to meet their commitments towards policyholder whatever event may occur.
This capital is called :
• Solvency (Required) Capital: when the economic capital is calculated for solvency purposes
• Economic Capital: if the capital required is assessed from an economic view, in comparison to a traditional regulatory view

An Economic capital is defined according to its mean features :

  • The Risk Measure . For instance,The risk measure of Solvency II SCR is the Value-at-Risk at 0.5%. Even if VaR is a classical Risk Measure, other measures can be found in Economic Capital Model.
  • The horizon of the measure : When we stop the simulation and look at the final balance sheet. Solvency II horizon is one-year but we can also find longer horizon.
  • Balance Sheet : is it an accounting or an economic balance sheet ? In the economic balance sheet, do we account future business profit or only future profit of existing business ?

The three pillars of solvency of Solvency I

  • Prudent provisions (1°of R. 331-1) (life & non-life)
  • Reliable, liquid and profitable assets (R.332-2 and following.)
  • By virtue of the regulations, companies have to hold, besides their technical reserves, a minimum amount of stockholders’ equity called statutory solvency margin, which is determined according to the level of their commitments. The latter are estimated from the annual premiums (or claims) in P&C insurance, and from the mathematical reserves in life insurance

The major critic of Solvency I comes from the increasing distance between the measure of Solvency and the real risk exposure :

  • no real segmentation of risks
  • no incitation to risk-management, except for reinsurance buying
  • The proximity of insurance products and financial products, banks’ regulation being closer to real risk (Basel II) thus creating a potential distortion of competitiveness
  • The lack of harmonization of the standards and the practices

In the 90’s, Rating Agencies have developed Factor-based solvency models for insurers. These models have been used extensively especially in the Reinsurance World.Since 2005, Standard&Poor’s has completed this model with the audit of internal ERM. They evaluate ERM quality in five areas:

  1. Risk Management Culture
  2. Risk Controls
  3. Emerging Risk Management
  4. Risk and Economic Capital Models
  5. Strategic Risk Management

The Solvency II Framework must:
• Provide supervisory authorities with the means to estimate correctly the global solvency of the insurance company (disclosure of solvency indicators inside and outside the company).
• Also cover qualitative aspects influencing the risk exposure of the company.
• constitute an incentive for companies to better measure and manage their risks

Solvency II is based on three Pillars :
• Pillar I, which focuses on quantitative requirements: valuing assets, liabilities and capital
• Pillar II, which focuses on supervisory activities: which provides qualitative review through the supervisory process including insurers’ system of governance in link with internal risk management processes : ORSA, actuarial function. Top management must show its ability to steer of the company.
• Pillar III, which addresses supervisory reporting and public disclosure of financial and other information by insurance companies

The practical method to calculate the Risk Margin is the following :

  1. Project the SCR, for non hedgeable risks for all future time periods, i.e, until the portfolio has run-off.
  2. Multiply each SCR by the CoC rate (6%)
  3. Discount the amounts calculated in the previous step at the risk-free rate (rt)
  4. Sum the discounted values

Although the insurance liabilities are not impacted, the management of claims can be impacted by the reinsurance contracts. There are three possibilities:
– the claims management is still done entirely by the insurer.
– the claims management is done entirely by the reinsurer. This is done in fronting in the case of an insurance captive.
– the claims management is done in common.

Risk can be classified into several distinct classes. The most important include the following:

  • Pure and speculative risk
  • Diversifiable risk and nondiversifiable risk
  • Enterprise risk
  • Systemic risk

Major risk-control techniques include the following:

  • Avoidance
  • Loss prevention
  • Loss reduction
    – Duplication
    – Separation
    – Diversification

Major risk-financing techniques include the following:

  • Retention
  • Noninsurance transfers
  • Insurance

Diversifiable risk is a risk that affects only individuals or small groups and not the entire economy. It is a risk that can be reduced or eliminated by diversification. In contrast, nondiversifiable risk is a risk that affects the entire economy or large numbers of persons or groups within the economy, such as inflation, war, or a business recession. It is a risk that cannot be eliminated or reduced by diversification.

An insurance plan or arrangement typically includes the following characteristics:

  • Pooling of losses
  • Payment of fortuitous losses
  • Risk transfer
  • Indemnification

The major social and economic benefits of insurance include the following:

  • Indemnification for loss
  • Reduction of worry and fear
  • Source of investment funds
  • Loss prevention
  • Enhancement of credit

From the viewpoint of a private insurer, an insurable risk ideally should have certain characteristics.

  • There must be a large number of exposure units.
  • The loss must be accidental and unintentional.
  • The loss must be determinable and measurable.
  • The loss should not be catastrophic.
  • The chance of loss must be calculable.
  • The premium must be economically feasible.

There are four steps in the risk management process:
1. Identify loss exposures.
2. Measure and analyze the loss exposures.
3. Select the appropriate combination of techniques for treating the loss exposures.
4. Implement and monitor the risk management program.

Two important factors that affect property and casualty insurance company pricing and underwriting decisions are the level of capacity in the insurance industry and investment returns.

There are various ways of classifying insurance companies. In terms of legal ownership and structure, the major types of private insurers can be classified as follows:

  • Stock insurers
  • Mutual insurers
  • Lloyd’s of London
  • Reciprocal exchanges
  • Blue Cross and Blue Shield plans
  • Health maintenance organizations (HMOs)
  • Other types of private insurers