Risk Management Indian Insurance Essay Example
Risk Management Indian Insurance Essay Example

Risk Management Indian Insurance Essay Example

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  • Pages: 17 (4437 words)
  • Published: November 26, 2017
  • Type: Research Paper
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The text below discusses the keywords enterprise risk management, insurance industry, solvency-II, three pillar approach, insurance industry–value drivers, financial risk, operational risks, business risks, committee of sponsoring organizations of the treadway commission, enterprise risk management framework, capital requirement, supervisory review process, asset liability management, risk-based marketing, performance management, and external rating. The paper is divided into the following sections: The first section discusses the types of risks present in the insurance business. The second section focuses on the individual impact that each of these risks has on insurance firms. Challenges faced by insurance firms include reliability and availability of actuarial data on the liability side, unregulated pricing in long-term contracts, and volatility in credit and interest rate markets on the asset side. The text also considers whether Indian insurance firms


face any unique risks and discusses risk minimization approaches adopted by Indian firms.

The text discusses various aspects of the Indian insurance industry, including regulations, risk management, and the importance of risk in the business model of insurance companies. It raises questions about the level of regulations compared to foreign firms and suggests considering measures to avoid a crisis in the insurance sector. The text emphasizes the need for insurers to appropriately manage and price risks, as their business model relies on pooling and managing risks. Actuaries use a classification system proposed by the Society of Actuaries’ Committee on Valuation and Related Problems to categorize risks for insurance purposes [Black & Skipper,1997].

The categories of risks in the insurance industry are known as C-1, C-2, C-3, and C-4, named after the recommendations made by the Committee. To start, we will define these risks according to the

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industry itself:

C-1 risk (asset risk) is the possibility of the insurer experiencing a loss in asset value due to investments in stocks, bonds, mortgages, and real estate. This risk arises when borrowers fail to meet their obligations to the company.

C-2 risk (pricing risk) is the risk of the insurer incurring financial losses on its products due to significant differences between its actual experience with mortality or expenses and what was originally expected. If the insurer's pricing is based on insufficient assumptions, it may struggle to fulfill its obligations to policy owners.

C-3 risk, also known as interest-rate risk, occurs when fluctuating interest and inflation rates cause the insurer to experience financial losses on its products. If the impact of these fluctuating rates is different on the insurer's assets compared to its liabilities, the values of these assets and liabilities will change by different amounts. This discrepancy in value changes could potentially lead to the insurer facing insolvency. On the other hand, C-4 risks, referred to as general management risks, arise from the insurer's ineffective practices in managing its overall business operations. These risks encompass factors such as tax and regulatory changes, inadequate training provided to employees and sales agents, as well as instances of fraud perpetrated by managers or other employees.

A key aspect of asset risk for insurers in India is that 85% of their total investable assets must be invested in government or government-approved securities. Consequently, the default risk associated with insurers' assets is relatively low in India. One specific category of asset risk is credit risk, which pertains to the possibility that a borrower will fail to fulfill its obligations as defined in the

pre-agreed contractual manner. This credit risk can arise due to either the borrower being incapable or unwilling to perform as initially committed.

The financial condition of the borrower and the current value of any underlying collateral are important to investors and lenders. This includes the investor holding the bond, lender of a loan contract, and other investors and lenders to the creditor. Insurers who have invested in bonds or participated in a direct loan have a significant interest in these factors. The main risk of credit is the difference between the actual portfolio performance and its expected value. While credit risk can be diversified, it is challenging to completely eliminate it due to the fluctuation in general default rates. Additionally, some of the default risk may be attributed to systematic risk. Despite the positive impact of diversification on overall uncertainty, creditors still face issues with idiosyncratic losses, especially insurers dealing with illiquid assets.

In situations like this, it is challenging to transfer credit risk and accurately estimate potential losses. Risk management is carried out at four levels: 1. The national regulator determines solvency margins and other limits. 2. Within individual firms, risk management involves: a) reporting results to internal management and outside statutory agencies, b) disclosing information to shareholders, c) conducting audits, d) implementing conservative or aggressive policies, e) establishing limits set by senior management/board of directors, f) constructing models and testing scenarios. Is compensation tied to risk-adjusted return on equity? There is no regulation from shareholders since none of the life insurers are publicly listed.

The IRDA regulations do not provide specific guidelines for risk management that must be followed. However, the Singapore MAS has a clearly

defined handbook of guidelines for insurers. The IRDA is still determining the importance of different sectors and how to prepare accounts. A comparative analysis is conducted on asset risk and the measures taken by insurers in India and abroad to quantify and mitigate this risk.

Regulations in the Indian insurance industry differ from regulations abroad. The financial view of risks in the insurance sector can be categorized into six types: 1) Actuarial risk, 2) Systematic risk, 3) Credit risk, 4) Liquidity risk, 5) Operational risk, and 6) Legal risk.

Actuarial risk involves the risk of overpaying or receiving inadequate funds when raising capital through insurance policies and other liabilities. To earn a satisfactory profit in the long run, insurers should invest their funds in efficiently traded securities, ensuring a zero net economic profit on average. Paying too much for these funds will hinder the ability to generate a satisfactory profit. Additionally, underwriting losses may exceed projected expectations due to insufficient knowledge of the loss distribution.

Second, losses in the normal course of business may exceed expectations because they vary around their average value. The extent of their deviation from the average will depend on the characteristics of the loss distribution, which are influenced by the risks insured. Systematic risk, also known as market risk, refers to the risk of changes in asset and liability values related to systematic factors. While it can be hedged to some extent, it cannot be completely eliminated through diversification. All investors are exposed to this type of risk whenever the value of assets or claims can change due to broader economic factors. Systematic risk can manifest itself in various forms.

Three main concerns for

the insurance sector include variations in interest rates, basis risk, and inflation. Insurance companies try to estimate and hedge against these systematic risks to limit the impact on their financial performance. They track and manage each risk individually, including interest rate risk, although they cannot do so perfectly.

Insurers closely monitor their basis risk, which refers to the risk that yields on different financial instruments such as corporate bonds, mortgages, and common stocks, do not move in sync. This exposes the insurer to market value fluctuations that are independent of liability values. Insurers aim to manage and limit their exposure to basis risk. Additionally, inflation risk can also impact the frequency and severity of insurance claims, thereby affecting expected losses.

The presence of inflation, whether it be in repair costs, medical costs, or other areas, is a concern especially when insurance policies are based on replacement cost. All three of these risks contribute to performance variation. Additionally, liquidity risk arises from potential funding crises caused by unexpected events such as large claims, asset write downs, loss of confidence, or legal issues.

Insurers face potential challenges in managing their assets and liabilities. They may encounter clustered claims from natural catastrophes or mass requests for policy withdrawals and surrenders due to changing interest rates. While their liabilities can be somewhat liquid, their assets, especially those invested in private placements and real estate, may be less liquid. To handle any cash demands efficiently, insurers must maintain sufficient liquidity. Without adequate liquidity, an insurer that is otherwise solvent may be forced to sell illiquid assets at discounted prices, resulting in significant losses, further cash demands, and potential insolvency. Operational risk also creates

additional challenges for insurers, such as accurately processing claims and trades, settling and delivering on transactions for cash, ensuring proper record-keeping, addressing processing system failures, and complying with regulations. Although individual operational problems are unlikely to occur for well-run organizations, they expose firms to potentially costly consequences.

7) Legal risks in financial contracting are inherent and distinct from the legal consequences of credit and operational risks. Changes in legislation, court decisions, and regulations can bring into question previously established transactions, even if all parties have consistently performed and are fully capable of continued performance. Another type of legal risk stems from the actions of an institution's management, employees, and representatives. Fraud, violations of laws or regulations, and other wrongdoing can result in significant losses. Even if an insurance company fulfills all contractual obligations, extensive litigation can arise if some policyholders had different expectations or interpretations regarding the performance of their policies compared to what was specified in the contracts.

Insurance Risk Management Systems

We outline the necessary methods to mitigate the specific risks faced by insurers. One significant risk to consider is actuarial risk. Insurers often raise funds through issuing insurance policies rather than seeking capital in the competitive market. These policies involve the payment of lump sum or periodic premiums, but the exact amount and timing of fund repayment may be uncertain, occurring anywhere between a month to over 20 years later. Pricing of these policies takes into account both expected losses and the returns an insurer can generate from the funds during the policy's lifespan or until benefits are paid out. Thus, the interest assumption used in determining insurance prices is crucial. However, two factors

complicate this process.

Insurers are unable to synthesize forward interest rates to lock in a spread due to uncertainty regarding future periodic premium payments. Moreover, loss distributions can undergo significant changes over time due to the evolution of information and the shifting economic environment. However, insurers are generally effective in managing actuarial risk. In the past, this approach was sufficient, but it was not equipped to handle the interest rate volatility that started in the late 1970s. Life insurance policies include various options for both the insured and the insurer, such as settlement options, policy loan options, over-depositing privileges, and surrender or renewal privileges. Additionally, the insurer has discretionary dividend and crediting rate options.

In stable interest rate environments, the utilization of policy owner options is based on individual or family circumstances. Therefore, utilization rates are relatively consistent and can be predicted. However, when interest rates are volatile, these options become more valuable and their utilization rates can vary greatly. Traditional actuarial methods, which relied on stability, were unable to accurately value these options, resulting in many policies being underpriced. Thankfully, most sophisticated life insurers now utilize standard valuation methods that explicitly value these embedded options. As a result, insurers are able to estimate the cost of various option-like provisions in all types of life insurance policies using advanced software. This software utilizes modern stochastic valuation techniques, similar to those used in pricing fixed income and mortgage-backed securities, to determine the values of insurance policies in a manner consistent with valuing the assets.

Undoubtedly, this signifies a significant advancement in the tools utilized by insurers for risk management. The availability of valuation software aligned with contemporary valuation principles

marks a crucial progression, and forthcoming software will undoubtedly address the deficiencies of current versions. The utilization of reports and standards for underwriting various risks, including life/health and property/casualty risks, is a customary practice. Base rates can be influenced by multiple factors, such as age, gender, occupation, education, health status and history, property attributes, nature of business, and more. These base rates are then adjusted based on experience factors.

The premiums charged for insurance policies are influenced by various factors such as past claims and driving behavior. Although the fair premiums should be adjusted based on interest rates, in reality, they do not often reflect the current interest rates. This is because it can be administratively burdensome to update insurance premium schedules whenever interest rates change. Insurers typically set underwriting limits and have authority only up to a certain amount. While insurers are more efficient in tracking sales commissions, they may struggle to monitor losses associated with specific sales agents or underwriters. Nevertheless, many prominent life/health and property/casualty insurers are closely monitoring the performance of their sales and underwriting staff.

If the experience deviates from the usual, it is common to impose restrictions on further sales or more stringent limitations on underwriting. Alternatively, there could be increased oversight over the activities of these sales agents and underwriters. The most concerning issue in terms of actuarial risk is likely the misalignment of incentives between the insurance firm's owners and its sales and marketing staff. There is significant room for improvement in this aspect. The typical approach involves paying commissions for new policy sales, with a heavy front-loading of commissions on multi-period contracts, especially for life/health products. This

creates a strong incentive for agents to maximize their business sales, regardless of whether it is profitable for the company or not.

It also provides strong incentives for replacing current policies, which have seen commission rates drop to low single digit percentages, with new policies that offer commissions ranging from 20 to 100% of first year premiums. Sales managers and marketing personnel are often rewarded based on the volume of sales, and even senior management may have their compensation tied to sales growth. It has been observed that rapid growth is often correlated with insolvency. It's important to note that the fastest growing aspect is the accumulation of liabilities, not assets. One way to encourage rapid growth is to underprice liabilities. Therefore, employees and agents who have their compensation tied to sales growth are advocates for more "competitively-priced" insurance policies.

Senior management often comes from a sales background and shares the belief that what benefits insurance agents also benefits the company. The pricing actuaries, responsible for overseeing this area, face strong pressure to modify their assumptions in order to competitively price the company's products. Although it may become evident over time if insurance policies are mispriced, the immediate advantages of higher commission earnings and growth are considered. The sales side possesses a significant advantage in determining policy prices as sales agents often work for multiple insurers and can divert new business to them. Additionally, they can transfer existing business away from the company before it covers the initial heavy policy costs if they can demonstrate that policy prices or illustrations are more favorable elsewhere. While many insurance firms recognize this discrepancy of interests, they feel hindered by

regulations concerning commission schedules. Ultimately, insurers offering non-economic policies will go bankrupt.

The insurer faces a dilemma when trying to price its policies rationally in the long run. They can either temporarily lower their prices and hope to outlast the irrational players, then restore sensible pricing, or write every little business and lose their distribution force. Neither option is appealing. It is crucial for effective asset management to have access to software that can compute measures of effective duration and convexity for liabilities. Using simple duration may result in significant errors as it does not fully take into account the interest rate sensitivity of cash flows for assets or liabilities. Asset values are influenced by several risks, including basis risk, default risk, liquidity risk, call risk, prepayment risk, extension risk, sinking fund options, convertibility, real estate risk, and equity risk. However, many of these risks are essentially different forms of interest rate risk, highlighting the importance of accurate measurement. While some insurers excel in measuring interest rate risk on the asset side of the balance sheet, others have significant room for improvement.

The common practice among property/casualty insurers was to use interest rate futures, swaps, and options to manage the risk to acceptable levels. They also used options and futures to protect against equity market risks when the insurer had a large position in common stocks. These protective measures were implemented and adjusted based on market conditions and the insurer's appetite for equity risk. Asset/Liability Management involves estimating the durations and convexities for each line of business and asset class. These estimates are then weighted by the fair value of liabilities or market value of assets to

calculate overall asset and liability duration and convexity estimates. Taking leverage into account, insurers can determine surplus duration and convexity metrics.

It is crucial to regularly analyze the interest rate risk, summarizing asset durations and convexities on a weekly basis and liabilities on a monthly or quarterly basis. However, for interest rate futures and options, more frequent reports are necessary due to their significant impact on overall interest rate risk. To ensure accurate risk assessment, the same measure of risk assessment should be used for both the asset and liability sides of the balance sheet. For instance, if effective duration and convexity estimates are used for liabilities, the asset side should also use effective measures rather than Modified Macaulay duration measures. Risk-based capital context allows for setting limits on individual asset holdings, industry concentration, and asset types such as mortgage-backed securities and collateralized mortgage obligations. These limits can be implemented in two different ways.

One possible approach is to set a limit on the level of duration mismatch that is allowed, either for specific product lines or for the overall combination of assets and liabilities. For example, a company might apply these restrictions based on individual products, allowing a duration mismatch of up to one year for participating whole life products, but only 1/10 of a year for GICs. Another company may not impose restrictions on duration mismatches for each individual product, but instead sets limits on an aggregate portfolio level.

Credit risk is a key focus for insurance firms, as well as rating agencies and regulatory authorities. These entities produce regular reports on a weekly and monthly basis to monitor the credit risk associated with their assets.


of relying on outside rating agencies for its overall credit risk plan, the company has a target rating to achieve. However, they acknowledge a problem with this approach: default rates and volatility do not increase linearly as the rating decreases step by step. Additionally, the incentive structure rewards portfolio managers for booking high investment yields, leading to a credit barbell approach. Unlike other financial institutions, liquidity is not a significant concern for many insurance firms because their policies are typically less liquid than their assets. For example, life insurance companies issue policies with high surrender charges.

These charges are present in the schedule of cash build-up, either explicitly or implicitly. For example, a single premium deferred annuity with annual crediting rate reset and a seven-year maturity may have surrender charges that start at 7-10% in the first year and decrease gradually until they reach zero at maturity. Similarly, universal life and whole life products often have low surrender values in the initial years of a policy but increase rapidly thereafter. Insurers also consider other risks, such as operating risk, which is inherent to their business, and they use standard risk avoidance techniques to mitigate these concerns.

Standard business judgment is applied to evaluate the expenses and advantages of risk reduction expenditures, system designs, and operational redundancy in this field. Although commonly referred to as risk management, this practice differs significantly from the management of financial risk discussed in this context. However, there are also other risks, which are somewhat less defined but equally significant. These risks include legal, regulatory, reputational, and environmental risks. Significant time and resources are dedicated to safeguarding the company's franchise value from deterioration

in each of these risk areas.

These risks, which are difficult to measure financially in advance, are typically not dealt with in a formal and structured manner. However, it is important for senior management in the insurance company to not overlook them. To address this, controls can be implemented in the centralized computer system. For example, if an agent exceeds the allowed number of address changes, disbursements, policy lapses, or sales, the computer will not process the policy until further investigation is conducted by the auditing department. These measures are not communicated to either the customer or the sales agent. Instead, a compliance division can be introduced to work alongside the internal audit group and enhance their role.

This department will be responsible for providing insurance to the field force and also training sales agents so that they can better represent the company’s products. The goal of these measures is to reduce the likelihood of class action lawsuits in the future. Enterprise Risk Management (ERM) is a comprehensive approach to managing the risks that businesses face in a rapidly changing environment. While sensible businesses have been practicing risk management techniques for years, ERM has only recently gained significant attention from the business and academic communities and is now becoming a new discipline. Rating agencies now often include an ERM evaluation as part of their rating review of insurance companies. Traditionally, risk management is focused on managing and controlling potential losses.

An enterprise exists within a larger universe that includes numerous potential projects, risks, and opportunities, as well as external players like customers and competitors. Additionally, external financial and economic forces impact the enterprise within the broader social and

political environment. The risk profile of the firm may differ from that of the larger universe, depending on its activities, how it conducts them, and how it interacts with the larger universe. ERM for insurance companies requires consideration of a fundamental difference from other industries: insurance products involve assuming someone else's risk for a fee, while other industries primarily manage risks relevant to their specific business processes. The development of an ERM framework requires a structured approach. The following methodology can be used to create a framework for implementing ERM, which can later be customized to meet the organization's specific needs.

The Steps:

  • Set strategy and objectives;
  • Identify risks;
  • Assess risks;
  • Treat risks;
  • Control risks; and
  • Communicate and monitor

Risk Dynamics ; Theory of ERM:

The five principles of risk dynamics that collectively form a theoretical basis of enterprise risk management. Principle #1: Risk dynamics exist as objective states of nature, of which we can gain more knowledge through experience, insights, and modeling of internal forces within the system. A major challenge of ERM is to understand the various forces within risk dynamics, to measure and predict the strength and the direction of the forces, and to form a disciplined approach to react to them (avoid, divert, or manage the forces). Principle #2: An enterprise has multiple risk dynamics at multiple levels with multiple forces. Firstly, there are local risk

dynamics that are inherent to the business operations. Such forces include competitive forces in the local market and local culture.

Furthermore, on a macro-level (specifically at the segment and company level), there are significant external factors that affect the entire sector or enterprise, such as the interest rate environment and market competition. Principle #3 states that both market valuations and internal valuations greatly influence the dynamics of the enterprise. The results of market valuations directly affect the values of an enterprise's assets and liabilities.

Enhancing asset liability management practices is crucial for firms to better deal with volatile market valuations. Principle #4 emphasizes the significance of properly constructed risk metrics and valuation models in understanding risk dynamics and as powerful and essential tools. It is important to develop risk metrics and models at different levels in order to utilize diverse information. Risk valuation models serve two purposes: i) assessing the firm's risk profile and capital needs, and ii) facilitating the efficient allocation of resources. Principle #5 highlights that actions taken by key participants in risk dynamics have a significant impact on the behaviors of these dynamics. A comprehensive understanding of risk dynamics requires a close examination of the psychological and behavioral characteristics of various players, as well as their interactions with each other and with the different forces involved.

ERM functions as the core system for an enterprise, serving as its brain and nerve system. The management information it provides is crucial for the survival of a firm. It allows management to identify essential signals and effectively respond to the external environment. Along with data on risk exposures and positions, general information holds immense value. ERM should aid

in recognizing and prioritizing the dominant risks that pose a threat to the firm, among countless risks and opportunities. Furthermore, it should establish a feedback loop with business managers, allowing for prompt communication and facilitating corrective actions. While some events may be completely unexpected, many risks become apparent through early warning signals.

Corporations often disregard these signals due to a lack of mechanisms to heed them. Coordination and Harmony: Risk integration involves more than just bringing together different business units, but rather the coordinated efforts of all major units working towards the firm's overarching goals. ERM Organization: Regardless of the enterprise's size and complexity, ERM's management aspect ultimately relies on individual actions within various roles. Establishing clear roles and responsibilities for key players, such as the board, senior management, risk owners, and internal auditors, is a necessary first step. The firm should appoint a risk champion to lead and drive the ERM effort throughout the organization.

Such risk champions are often referred to as Chief Risk Officers and they have the role of being advocates and internal consultants. One aspect of their responsibility is the development of risk valuation models for various types of risks such as market risk, credit risk, interest rate risk, competition risk, and loss development risk. These models should follow certain principles in order to effectively manage a company's enterprise risk. These principles include integrated valuation, forward-looking approach, model robustness and benchmarking, understanding of risks, commitment to risk management, and monitoring of behaviors.

The system of risk dynamics for insurers involves external players as well:

  • 1. External Players

Rating agencies, regulators, and stock analysts are internal players that are influenced by competitive market pressure.

Also, the Board of Directors, senior management, actuaries, the Claims Department, and the Investment Department are internal players. All these players, along with external shocks, exert forces.

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