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Financial Risk

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AIG is special case it issued credit default swaps (CDS) through investment subsidiary. ... Managing Credit Risk. Firms collect & monitor information about ... – PowerPoint PPT presentation

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Title: Financial Risk


1
Financial Risk Its Management
and then the second group comes in row,
row, row your boat
  • RMI 4700
  • Insurance Operations
  • Robert Klein

Revised 10/30/09
2
Topic Objectives
  • What are the risks associated with financial
    intermediation?
  • What types of risks are
  • important to insurers and why?
  • How do these risks vary among institutions?
  • What are the principles and objectives of
    financial risk management?
  • What are implications of current financial crisis?

3
What is Financial Risk?
  • Any risk that can result in financial loss could
    be viewed as a financial risk.
  • In practice, we tend to define some risks as
    financial and others as operational.
  • We will focus on the most significant financial
    risks but we also need to recognize that certain
    operational risks can have financial consequences
    and should be managed with financial risks in a
    coordinated strategy with a comprehensive focus.

4
Current Financial Crisis
  • Investment banks others invested in securities
    that bundled mortgages other loans.
  • Many mortgages were not underwritten properly
    were collateralized with inflated property
    values.
  • Default risk for these securities was much higher
    than their credit ratings indicated investors
    assumed.
  • When real estate prices dropped default risk rose
    substantially ? securities market value fell
    precipitously
  • Concerns about the credit worthiness of these
    types of assets has led to cascading problems in
    financial markets and the economy.

5
Implications for Insurers
  • Insurers have not had large exposures in
    subprime mortgages but some have been hurt.
  • AIG is special case it issued credit default
    swaps (CDS) through investment subsidiary.
  • Monoline financial guaranty insurers also have
    been severely affected.
  • Insurers have been further affected as declines
    in asset values spread to other investments,
    e.g., stocks.
  • Life insurers have been much more affected than
    P-C insurers because of their asset structures
    and interest rate guarantees for certain products.

6
Systemic Contagion Risk
  • Systemic risk refers to the possibility that
    problems in one sector can cause problems in
    other sectors.
  • Example AIG CDS supported large amount of
    mortgage-backed securities. When it could not
    meet collateral calls, this threatened many
    institutional investors in these securities.
  • Contagion risk refers to the possibility that
    problems of a few firms can undermine confidence
    in other firms.
  • Example When some life insurers began suffering
    asset problems this generated concerns about
    other life insurers.

7
Lessons
  • Insurers are exposed to both systemic and
    contagion risk.
  • Systemic risk can lead to cascading problems that
    affect even safe assets, e.g., blue chip
    stocks.
  • Contagion risk can lead to run on the bank
    scenarios to which life insurers are especially
    vulnerable.
  • Insurers must be aware of and manage both kinds
    of risk.
  • Importance of Enterprise Risk Management (ERM)
    which involves comprehensive approach to RM
    including both quantitative qualitative methods.

8
Interest Rate Risk
  • Arises from mismatch between maturity or duration
    of assets liabilities.
  • Market Value Risk
  • Changing interest rates affect market value of
    assets liabilities.

Refinancing Risk, i.e. short-funded
Increase in interest rates decrease value of
assets held to pay liabilities potential
shortfall and losses.
Liabilities
Assets
Reinvestment Risk, i.e., long-funded
Decrease in interest rates means that reinvested
assets will earn lower return potential
shortfall and losses.
Liabilities
Assets
9
Insurance Illustrations
  • Case I Property-Casualty Insurer
  • Insurer invests reserves for physical damage auto
    claims in 2-year bonds.
  • Claims must be paid at end of year 1, but an X
    increase in interest rates causes market value of
    bonds to fall to X by end of year 1.
  • Insurer sells bonds at a lower price suffers
    X short-fall that it must fund from its surplus.
  • Case II Life Insurer
  • Investing policy reserves from whole life
    contracts in short-term bonds.

10
Managing Interest Rate Risk
  • Conventional approach is to match maturity of
    assets and liabilities.
  • However, this reduces potential profits from
    asset transformation.
  • Right strategy depends on type of firm and its
    objectives.
  • If principal function of insurer is to pay claims
    contingent on insured events, arguably matching
    strategy will be more predominant.
  • However, exact matching by insurers may not be
    optimal.
  • Better strategy is to match duration of
    assets/liabilities consider convexity.

11
Market Risk
  • Arises from actively trading assets liabilities
    their derivatives.
  • Should not be a significant issue for an insurer
    if it is not engaging in speculation to partially
    fund its obligations to insureds.
  • Consequently, insurance regulators more
    comfortable with insurers using derivatives for
    hedging purposes than for speculation.
  • Note insurers with various kinds of assets still
    subject to declines in their values (due to
    factors beyond interest rate changes), i.e.,
    decline in stock prices, decline in real estate
    values.

12
Illustration Executive Life
  • Had 60 of assets in junk bonds.
  • Market assessment of credit quality of junk bonds
    dropped.
  • Forced to liquidate large junk bond portfolio in
    bad market.

Michael Milken
13
Credit Risk
  • Arises from chance that promised cash flow from
    securities may not be fully paid.
  • Possibility of default on interest, principal or
    both.
  • Higher risk with long-term securities, such as
    those owned by life insurers.
  • Firms will require higher risk premium on
    securities with higher default risk.

p1
probability p
Return Distribution of Risky Debt
Return
P
PI
14
Managing Credit Risk
  • Firms collect monitor information about issuers
    to assess default risk.
  • Rating agencies (e.g., SP) assist in providing
    information.
  • Life insurers historically heavy investors in
    private (not publicly traded) securities as they
    are information intensive. This has changed
    somewhat.
  • Financial institutions can diversify better than
    households and limit firm-specific risk.
  • FIs still exposed to systematic risk.

15
Off Balance Sheet Risks
  • By definition, do not appear on balance sheet.
  • Contingent assets liabilities potentially
    affecting future balance sheets, e.g., letters of
    credit, loan commitments, derivatives.
  • Problem fee income may appear on balance sheet
    but not potential losses
  • Hence, particularly important for monitors
    regulators to identify.
  • Limited recognition in insurer risk-based capital
    (RBC) formulas costly for regulators to assess
    difficult to accommodate within formula
    approach.

16
Liquidity Risk
  • Arises from need for cash to pay claims on
    assets.
  • Sale of low-liquidity assets in short time frame
    can decrease price obtained.
  • Liquidity risk can compound if there is a run on
    the bank triggered by crisis in confidence.
  • Life insurers experienced this to a limited
    extent when asset values declined in late 1980s,
    early 1990s.

17
Other Risks
  • Technology Risk
  • Benefits of technology not realized, breakdown,
    or improve competitors position.
  • Operational Risk
  • System breakdowns, e.g., rolling blackouts in CA
    knocked out insurer home offices.
  • Foreign Exchange Risk (currency interest)
  • Increases with mismatch of denominations/maturitie
    s of assets
  • liabilities.
  • Country or Sovereign Risk

Perhaps we should tell the international investme
nt community that we are sorry.
18
Insolvency Risk
  • Insufficient capital to absorb losses.
  • Insurance Definitions
  • Insolvency assets less than liabilities
  • Impairment surplus below regulatory requirement.

Gentlemen, yours is going to be one of this
periods seminal bankruptcies.
  • In insurance, regulators (and statutory
    accounting) tend to assess solvency from
    liquidation perspective if insurer was
    liquidated today, would liabilities exceed assets.

19
Mark to Market
  • Accounting rules on asset valuation can have
    significant implications for FIs.
  • FIs have been forced to significantly lower value
    of assets in instable market.
  • Issue If FIs hold on to assets, their ultimate
    market values may rise considerably.
  • FASB may has relaxed market valuation rules which
    has eased pressures on FIs.

20
Interaction of Risks
  • Independence of individual risks, decreases
    overall risk.
  • Positive correlation of individual risks
    increases overall risk.
  • Factors Affecting Overall Risk
  • discrete risks affecting one or more
    assets/liabilities
  • events
  • macroeconomic changes
  • September 11 and financial crisis example.

21
Questions?
  • What opportunities are created by these risks for
    insurance?
  • What are the downside or risk management
    implications for insurers?
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