The field of risk management has currently undergone a monumental change. Traditionally risk management was limited in scope to mitigate the exposure to possible losses to keep the premium revenues in line with the claim payments. However, an interesting trend emerged in the 1990’s as many insurance companies began to expand their scope of risk management to include their speculative financial risks, which they encountered in the financial markets, as well (Rejda: 62).
15 Moody’s investors Service, May 1998.
16 Jongeneel, O.C.W., Bancassurance: stale of staunch?, (2011) Master thesis, Erasmus University, p.1
21 Underwriting Risk
As stated, the insurance industry is traditionally a risk transfer mechanism to compensate for financial losses and spread the risk over the policy holders. Insurers carry out loss prevention and loss mitigation actions in
conducting their business and are incorporating this risk management as an essential element of their business model. Hence, insurers are risk carriers. In order to financially take on this task, the insurance company’s capital needs to hold a buffer against unexpected claims or losses. This buffer – referred to as risk bearing capital - is necessary if the insurer is to fulfil the legitimate claims of policyholders. As stipulated in the introduction, this principle is the primary function and lies at the core of the insurance industry.
Figure 2.6 - Risk management – Underwriting
Within the non-life insurance product range (property and liability insurance) this risk bearing capital is generally subject to market conditions. If the market is ‘soft’, insurance products can be purchased at favourable
conditions (i.e. lower premiums, more coverage). The competitive nature of the insurance industry has a synergetic effect in a ‘soft’ market and stimulates a further reduction of premiums and underwriting standards are usually less stringently applied. If the market is ‘hard’, more precaution is taken and the insurance coverage is limited in availability or may not even be affordable by the consumers (Rejda: 68).
The continued soft market of the late 1990’s tempted insurers to sell multiple-year insurance contract in an effort to lock in favourable conditions for both policyholder and insurer. Unfortunately the changing economic climate led to an increase in claims, but the multi-year contract period prohibits the insurer from increasing the premiums. Another aspect was the rise of claims against existing premium levels due to insufficient risk
monitoring. As a result the combined ratio (generally used KPI for non-life insurers) is greater than 1. This means that the ratio of paid losses and underwriting expenses is higher than the premium revenues (Rejda: 69). This situation is still very present today. In the Netherlands the Dutch organization which represents the insurance industry - Verbond van Verzekeraars only recently published the August 2012 Key results and concluded that 1 eurocent loss was made compared to 1 euro premium17.
Financial Risk Management
Insurers underwrite risks for which they assess premium rates that should reflect risk experience and exposure.
These premiums are pooled and become part of a fund of financial assets, which insurers invest to generate additional income to enhance their ability to meet their obligations to policyholders (i.e. insurance claims). In conclusion, insurers are not only risk managers and risk carriers, but institutional investors as well.
17 Key Facts Insurance in the Netherlands, August 2012, Verbond van Verzekeraars
22 Figure 2.7 - Risk management – Investments
According to the International Financial Services London (IFSL) over 24% of the global assets in 2010 were managed by insurance funds. The institutional investor role of insurers has become of significant importance to insurance operations. The market for conventional managed assets – which are pension funds, mutual funds and insurance companies - has doubled from 2000 up to 2010 (see figure2.8). Insurers generate revenues from both sides of the company, underwriting income (premiums -/- claims and other costs) on the insurance side, and investment income on the other side.
Figure 2.8 – Overview global fund management industry
The investment market with its shares, bonds and obligations can be characterised as volatile. By shifting the weight of the insurance activities to investment management, policy holders are now more exposed to the threat of the insurer not being able to meet its obligations in the case of insolvency, due to a lack of risk bearing capital. While the asset management part of the insurance company and its shareholders on their part are exposed to the risk of not receiving the expected return on their investments. Policyholders and investors have different ideas of what constitutes risk. However, by diversifying the portfolio of investments, company-specific risks could be minimized by the investor or shareholder. In contrast, the policyholder usually cannot diversify away company-specific risks.
Enterprise Risk Management (ERM)
Having discussed the changes in ownership and diversification of the insurance product portfolio, the contrast between the Arrow and Debreu’s framework and the reality of financial intermediation has become even more apparent in the area of risk management. In the past decade the most important change in intermediaries’
activities is the growth of the importance of risk management activities. Risk management has now become a
23 prominent activity of the industry and insurers gradually seem to start to adopt enterprise risk management. The lessons learnt by risk managers resulted in packaging all risks in a single and more holistic management
approach. That implies that newly developed risks, as a result of the earlier addressed technology transformation such as cybercrime and reputational damage through social media should be incorporated as well.
The challenge for the insurance industry is embedding risk management as a holistic concept in their mode of operation in order to guarantee all stakeholders’ interests. A 2011 research amongst risk managers by the Risk and Insurance Management Society (RIMS) found that 17% had fully implemented ERM and 37% partially18, compared to respectively 7% and 40% in 2007 this does not appear a swift adoption.