MANAGEMENT OF MARKET RISKS INSURANCE COMPANIES Iryna Nyenno, Doctor of Economics, Professor of the Department of Management and Innovations Foggia, 21. - презентация

1 MANAGEMENT OF MARKET RISKS INSURANCE COMPANIES Iryna Nyenno, Doctor of Economics, Professor of the Department of Management and Innovations Foggia, 21 – 28 th of February 2019

2 Content 1.The concept, content and objectives of the risk management system of insurance companies 2.On the situation (circumstances) of risk insurers – Risk fields common for insurers – History of risks in the insurance market – Specific internal risk fields of insurers 3.The role of reinsurance in the risk management system of insurance companies (ERM) 4.Formation of the insurers risk management system (ERM)

3 What is enterprise risk management (ERM)? «Enterprise risk management is a comprehensive, integrated strategy for managing an organizations main risks, with the ultimate goal of adding value in the short and long term in the interests of stakeholders.» Source: Munich Re, Knowledge in dialogue

4 Risk history 1) The great mathematicians of Egypt, Assyria, Greece, Rome and the scientists of the Middle Ages did not consider it necessary to spend their time studying the methods of risk measurement and management 2) The era of the Renaissance and the Reformation - Chevalier de Mere suggested the famous French mathematician Blaise Pascal to properly divide the pot interrupted in the middle of a dice game (probability calculation) - development of insurance - reduction of dependence on banking dynasties 3) By the beginning of the 18th century, mathematicians had developed almost all risk measurement tools that are used today: statistical sampling and statistical significance, applying the principles of probability theory in various fields, from law to technology, and also for the first time defined concepts such as normal distribution and standard deviation.

5 4) In 1738, the Swiss mathematician Daniel Bernoulli - the theory of utility. Based on this, a method of expected value or attractiveness of one or another outcome of events was developed. The idea of Bernoulli was that people often pay more attention to the size of the consequences of certain outcomes than their probabilities. 5) Regression, or return to the mean, Fran Galton. Galton's followers proved that the regression rule works in a wide variety of situations and can be used in meteorology, in the stock market, in gambling, in calculating the likelihood of accidents and in predicting fluctuations in business cycles. 6) The third component of risk measurement is diversification. In 1952, Harry Markowitz, a young postgraduate student at the University of Chicago, writes an article that provides a mathematical rationale for an investment diversification strategy. In this paper, he shows how to minimize deviations of return from the expected value by a well-planned distribution of investments. In 1990, Markowitz was awarded the Nobel Prize for theoretical and practical work in the field of asset portfolio selection. MBA RM 2013 Risk history

6 Risk history: Integrated Risk Management Since the 1990s, a reactive approach to risk assessment, based on control mechanisms, the creation of reserves for covering negative events and punishment, has been replaced by a proactive approach, in which a continuous analysis of business uncertainties and a constant assessment of new opportunities are carried out. Risk (F. Knight) - the possibility of positive (chance) and negative (damage) deviations in the process of activity from the expected values.

7 Types of risks: -Pure risks are risks that assume only the likelihood of losses; -Speculative risks are risks that open up the prospect of making a profit. -Non-insured risks are risks that most insurance companies avoid insuring due to the fact that the likelihood of losses associated with it is almost unpredictable.

8 Sales risks Consulting errors The level of competence of intermediaries Commission risks Risks of cooperation in the implementation Asset and liability management risks Computer risks Data loss Business Continuity Risk Software bugs Physical risks Human Resource Risks Quality - Qualification, Education Quantity - fluctuations lack of motivation Accounting risks Fast close procedures Insurers Risks :

9 Personnel: wage fund growth; the difficulty of recruiting qualified personnel; staff turnover; non-fulfillment of the planned tasks in terms of the deadlines; Financial: liquidity reduction; reduced financial sustainability; increase unprofitability; decrease in efficiency (turnover); decrease in profitability risk of bankruptcy. Political risks: changes in the legal framework; social unrest resulting in damage to the property interests of the enterprise; tax laws that would prevent further investment or profitable business management; Insurers Risks :

10 Underwriting risk (risk of insufficiency of premiums and reserves, catastrophic risk; risk of increased mortality, risk of increased life expectancy, risk of disability and damage to health, risk of increased business costs, risk of changes in the size of annuities, risk of cancellation of contracts, catastrophic risk, risk caused changes in expenses incurred in connection with servicing health insurance contracts, fluctuations in the frequency and severity of insured events, inaccurate estimates and projections regarding crumpets epidemics. Market risk (equity risk; interest rate risk; currency risk; spread risk; property risk; market concentration risk; counterparty default risk). Operational risk. Technical, non-technical, investment risks. Asset risk, insurance risk, operational risk (model of economic capital). Insurers Risks :

11 RISK SYSTEM Risks Net risks Speculative risks Natural and natural risks Transport risks Property risks Production risks Trading risks Financial risks Environmental risks Political risks Commercial risks The risks associated with the purchasing power of money Investment risks Inflationary and deflationary risks Currency risks Liquidity risks Risks of lost profits Yield reduction risks Risks of direct financial losses Interest risks Credit risks Exchange risks Bankruptcy Risks Selective risks

12 Risk probability

13 Stress eventВНАЗВНА 130% reduction in the market value of shares that are listed on the stock exchange ,9 240% reduction in the market value of non-listed shares44300,5 310% reduction in bond prices75950,9 4The increase in the exchange rate of foreign currencies relative to the hryvnia by 25% ,7 5Decrease in the exchange rate of foreign currencies relative to the hryvnia by 25% ,2 6Reduction in market prices for real estate by 25%142401,7 7Increase the total amount of payments on CTP by 40% ,7 8Increasing the total amount of payments on health insurance by 40% ,7 9Increased costs associated with servicing health insurance contracts by 10% 45160,6 Stress testing

14 What is risk management? Management of risks Risk response planning Identification of risk factors Monitoring and control Risk assessment Risk management planning

15 The risk management process includes: Risk management planning - planning risk management activities, including a set of methods, tools, and risk management organizations. Identifying risk factors - identifying the sources of risk that can affect a project, and documenting their characteristics. Risk assessment is a qualitative and quantitative analysis of risks in order to determine their impact on the organization. Risk response planning - development of measures to minimize the likelihood and mitigate the negative effects of risk events to reduce (optimize) risk exposure: risk rejection, insurance, hedging, diversification, formation of venture companies (risk transfer); self-insurance, reservation (risk acceptance); limiting (risk reduction)... Monitoring and controlling risk - monitoring the occurrence of risk events, identifying new risks, implementing a project risk management plan, and evaluating the effectiveness of actions to minimize risks. Risk financing - pre-event and post-event. Evaluating the effectiveness of risk management.

16 Risk management as a form of entrepreneurial activity: - Insurance market, stock exchanges, banks... "Money-RM-Money, retaining purchasing power" Professional associations of risk managers: -GARP (International Association of Risk Management Professionals); -PRMIA (International Association of Professional Risk Managers).

17 ERM – Enterprise Risk Management (ERM, IRM): … a process, effected by an entity's board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risks to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives. Source: COSO Enterprise Risk Management – Integrated Framework COSO.

18 Enterprise Risk Management: Levels of ERM activities in an organization: Enterprise level Division level Branch level Business process level Using portfolio approach ERM components:

19 Enterprise Risk Management: Integrated Framework (COSO ERM) The standard assumes that risks are linked to the goals of the organization, the achievement of which can be adversely affected by events associated with risks. Risk management is addressed at various organizational levels. As elements of the risk management structure, both process elements and organizational The standard is closely related to one of the most well-known standards in the field of internal control - COSO Internal Control.

20 ERM internal environment: Avoiding cumulative bankruptcy risk as the ultimate goal of ERM Implements a risk management philosophy, recognizing that expected and unexpected consequences can occur Implements a risk management culture (authority arising from risk liability) Considers other aspects of an organization that may affect risk management cultures.

21 Positioning options organization risk management: - non-existent system - management is not aware of the need to manage risks; - protection system - created as a reaction to the crisis situation in which the company fell; - related system - risk management is carried out formally; - strategic system - risk management is an integral part of the overall decision-making process.

22 Risk management framework DEPARTMENT OF RISK MANAGEMENT UNITS RISKS SHAREHOLDERS UNITS RISK REPORTING CONSTANT APPROVAL OF RISKS AND ACTIVITIES

23 MBA RM 2010 Examples of risk management development Production Natural / natural risks INSURANCE Market risks (price, currency, interest) Management of risks in making operational decisions Strategic Risks Management of risks when making strategic making COMPLEX RISK MANAGEMENT SYSTEM

24 Where does ERM come from? A quick look at the main stages of its development in Western Europe and the world Preliminary less complex disaster models Hurricane" Andrew " … / Europe: Investment losses seriously affect the insurance sector The growing importance of executive risk management (CRO) functions, the creation of a management system / reporting system The need for model development Establishment of the Basel II regime for banks More and more actions in the field of accounting and legislative regulation IAIS publishes a rating-related, three-part concept paper. First national standards such as ICAS in the UK S & P says it will take ERM programs into account when assigning ratings to insurers 2009 Europe: Approval of the Solvency II Directive Debate on the best implementation of measures and actuarial methods Solvency II Introduction Risk management tasks are still accomplished through a variety of functions. Events Trends Solvency I 2008 Bankruptcy Lehman brothers The global financial crisis, the increasing impact investment risks Comprehensive, sustainable business management

25 Prospects of ERM rating agencies on the agenda Effective enterprise risk management (ERM) is a common thread that connects balance stability, operational activities and business profile. Source: A.M.Best, Draft: Risk Management and Risk Management Companies, March 2007 We believe that there are many competitive advantages that can be learned from ERM"... S & P is beginning to emphasize strategic risk management, or "the process of using ERM will help you choose what kind of economic activity to do." Source: Michael J. Moody, Rough Notes: ERM - Time to take it seriously, April

26 Fundamentally oriented structure of Solvency II Competent and diligent authority Management prerequisites Transparent organizational structure Clear segregation of duties service instruction Regular checks Internal control system and Regulatory Compliance Unit Information, documentation, reports Risk management system Quantitative requirements Risk management function Contingency plans Internal model ORSA Actuarial function Outsourcing Principle of proportionality Internal audit Management Responsibility: Risk Strategy and Business Strategy Pillar 2: Management System: Summary Table of Extensive Requirements 26

27 Content 1.The concept, content and objectives of the risk management system of insurance companies 2.On the situation (circumstances) of risk insurers – Risk fields common for insurers – History of risks in the insurance market – Specific internal risk fields of insurers 3.The role of reinsurance in the risk management system of insurance companies (ERM) 4.Formation of the insurers risk management system (ERM)

28 Risk fields common to insurer 1.loss or depreciation of cash deposits in banks and other assets; 2.fuzzy, often far from optimal decisions of the legislative bodies and the government; 3.vague decisions and actions of shareholders; 4.extreme imbalances between capitalization (expected income and expenses) and liability (insurer's obligations); 5.irrational decisions (including statements) of company management; 6.loss of insured confidence and (often underestimated factor) reinsurers.

29 Boom period 29 What happens during the ascent?Risks / odds for insurance companiesTasks of the insurance company risk management system Availability of relatively cheap capital. Significant amounts of capital imports. Debt growth. Increase in equity through the use of cheaper risk capital. The increase in the size of capital, or, after the crisis, the recapitalization or attraction of new capital. Pay attention to guarantees for investors, etc. Fast inflow and high share of foreign currency funds Factors impeding the development of our own financial institutions Setting clear assignments and controlling capital raising. Mergers and AcquisitionsAbsorption riskRegulation of the sale of shares The rapid growth of investment in insurance companies and companies serving the insurance sector Accumulation of financial and insurance risks accompanying the process of investing in insurance companies Investments in insurance companies. Structuring groups and achieving real synergies in capital structure. The rapid growth in demand for insurance products. The emergence of new directions of insurance and insurance products. Growth in the volume of insurance products that combine risk taking with capital raising. Rapid growth, accompanied by: - stretching responsibility; - the acquisition of risks not measurable in medium term; - acquisition unwanted risks; - too wide participation in too wide spectrum various risks; - hazards associated with risk accumulation. Monitoring the company's business policy. Control of the structure in the formation of a portfolio of risks. Determination of acceptable risk parameters. Analysis of the effect of the "long tail" (long-tail- effect). Competitive advantages due to transparent pricing. Obtaining "optimal" risk capital (risk reinsurance). Optimal allocation of capital. Increment the reserve. A growing offer of insurance and other services. Excessive staff growth, growing bureaucracy.Control over expenses and combined ratio Growing demand for capital in the private and public sector The acquisition of insufficiently reliable and profitable securities and banking products and investments in them. Restructuring of investments. Control of guarantees against the risks of investment.

30 Crisis period 30 What happens during a crisis?Risks / Chances of Insurance CompaniesTasks of the insurance company risk management system Shortage of funds: rapid outflow or loss of capital. The credit crisis due to cessation of loans or high interest rates on loans. The fall in real income. Reducing the volume of bank deposits. Reducing the amount of insurance with new customers. Loss of previous clientele. Reduced profitability of insurance contracts. Reduced investment. High credit risks. There is the possibility of obtaining high returns from capital. Redistribution in part of the risks assumed, change in the parameters of acceptable risk. Capital transfer to stable or growing sectors. The pressure of competition. Dumping. Declining tariffs with increasing risks and lossesEstablishing a technical minimum for making a decision on withdrawal or expansion of activities, the adoption of counter-cyclical measures. The number of claims for claims settlement is growing. Increased incidence of fraud. Rising costs for damages. The disproportion between rising costs and declining premiums. Take measures to assess and limit the scope of potential losses. Immediately bring the underwriting process in line with the situation. Banking crisis. Crisis in securities trading. Loss of assetsContinuous monitoring. Expeditious restructuring of investments. Crisis among competitorsReducing the number of requirements imposed by other insurers. Mutual reinsurance of insurers is especially dangerous. Mergers and acquisitions of companies are possible (this also applies to your own company) In case of reinsurance of risks, limit the parameters of acceptable risks (propensity to take risks). Identify and exploit the potential of the crisis. Structuring groups and achieving real synergies in capital structure.

31 Crisis period (continued) 31 Reinsurance companies under pressure. Loss of capacity by reinsurers. Reinsurers are not able to pay in case of loss. The inability to use reinsurance as a source of replenishment of reserves. Rise in cost of "reinsurance capital". Mobilize your own reserves. Regrouping of optional reinsurance contracts. Ruble under pressure. Other currencies depreciate. Currency losses of up to 100% are possible.Analyze the consequences of willingness to take risks and take them into account in the underwriting process. Country rating is downThe insurer's rating decreasesAnalyze the effects of rising capital raised. The crisis of the financial system of the state. Budget deficit. Providing state assistance only when certain requirements are met. Where the state retreats, the emergence of new insurance products is possible. Tax pressure is growing. Anticipate and control the transition period. Analyze the risk load applied to these products and set limits. The propensity of politicians and policyholders to make radical and irrational decisions The financial burden on insurers. The collapse of the tariff system. Assess the impact on the risk situation of the insurance company.

32 Risk analysis and risk reporting Model of economic capital 32 Asset risk RISK Market risk Shares, property Interest Rate (ALM) Foreign exchange rate Credit risk Corporate Bonds Retrocession passed Other receivables Insured risk L&H Mortality / longevity Incidence Resilience P&C NatCat and other major losses Losses due to insufficient premiums Uncertainty of reserves Operational risk Business risk Changes in volume Changes in costs and margins during pricing Accident risk Fraud Errors System interrupts

33 Management of risks 33 Guaranteed success: effective interaction between a person and the system! The most important condition: quantitatively expressed circumstances Implementation of a comprehensive system of constraints and triggers which is well known and understood by decision makers covers the risks of underwriters, the risks of investors and their relationship Causes gradual and clear consequences; Example: traffic light "Exclusion zone" mandatory measures zone of validity measures valid for a limited period of time measures are not taken, but further developments are closely monitored there is no need for action Prerequisites 1. "Intelligence" system (shows an objective picture, interdependence, calibration) 2. Competent management: essential for understanding and validating results. The most important condition: quantitatively expressed circumstances Implementation of a comprehensive system of constraints and triggers which is well known and understood by decision makers covers the risks of underwriters, the risks of investors and their relationship Causes gradual and clear consequences; Example: traffic light "Exclusion zone" mandatory measures zone of validity measures valid for a limited period of time measures are not taken, but further developments are closely monitored there is no need for action Prerequisites 1. "Intelligence" system (shows an objective picture, interdependence, calibration) 2. Competent management: essential for understanding and validating results.... does not only mean taking a certain set of measures

34 From risk management to active portfolio management ERM allows you to manage your investment portfolio: clear identification of risks and the possibility of measuring them Determine a sustainable and cost-effective relationship between risk and return through balancing – Fast economic returns and long-term business prospects – Various risks and areas / segments not related to each other – Various investment risks – Reasonable combination of investment risks and risks of underwriting Development of convenient risk management and incentive systems ERM integration into overall management strategy ERM allows you to manage your investment portfolio: clear identification of risks and the possibility of measuring them Determine a sustainable and cost-effective relationship between risk and return through balancing – Fast economic returns and long-term business prospects – Various risks and areas / segments not related to each other – Various investment risks – Reasonable combination of investment risks and risks of underwriting Development of convenient risk management and incentive systems ERM integration into overall management strategy 34 Effective risk management is the key to success and stability from both a defensive and an offensive point of view. Turning ERM into a success factor in business: Investment portfolio management!

35 Definition: measures of risk, confidence level and time horizon 35 For example., Risky value, at a confidence level of 99.5% for one year means: ruin every 200 years. For example., Risky value, at a confidence level of 99.5% for one year means: ruin every 200 years.

36 Risk appetite Risk appetite is a limit on the level of risk that an organization is willing to accept in order to achieve its goals. How much are you willing to lose? And how often? Example: Manage an insurance company so that the result of the 1 in 25 years scenario will lead to maximum losses - a loss of 1bn. (= zero profit) 36

37 probability Damages 900 million.99.5%Current average Event 1 in 25 years 1 billion New Business Average Risk capital new business Associated RC limit Criterion Appetite Measurement 37 Potential for new business Current risk capital

38 Content 1.The concept, content and objectives of the risk management system of insurance companies 2.On the situation (circumstances) of risk insurers – Risk fields common for insurers – History of risks in the insurance market – Specific internal risk fields of insurers 3.The role of reinsurance in the risk management system of insurance companies (ERM) 4.Formation of the insurers risk management system (ERM)

39 Qualitative effect of reinsurance: Reinsurance can be used as a means of minimizing risk, for example, in relation to liquidity risk. In addition, reinsurance can improve quality risk management by supporting the process (ie, underwriting, claims settlement) and, second opinion, through advice and assistance in improving the process. There is no additional charge, as these additional services are usually provided for by the reinsurance contract. Compared to third-party consulting services that must be additionally paid by the insurer, the quality of the reinsurer's advice is radically different: The reinsurer shares the risk of the assignor, sharing the result of the underwriting under the reinsurance contract (the principle Follow the fate). 39 The best services give better protection for both parties.

40 Insurers / captives can improve risk-based return by choosing diversified reinsurers 40 Main insurer Reinsurance company Diversification of reinsurance companies is usually higher than that of insurers, thanks to: The insurer's reserve capital exceeds the capital requirements of the reinsurance company Undoubtedly mutually beneficial situation - the game is not a zero amount RISK TRANSFORMATION The number of individual risks Geographical coverage (global business model) Combination of products and specializations m Risk capital (gross) 130 Risk capital (net) 60 Reserve capital 70 m Add. risk capital <70 Prize Above the RoRaC Illustrative

41 Risk modeling Significant factor competitiveness lies in finding the right balance between flexibility and stability Risk management Intellectual system consisting of triggers, restrictions and measures... In cooperation... with responsible leadership actions Elements of the advanced ERM system 41 Risk management culture as a solid foundation Identifying risks and early warning A comprehensive review is needed, but with special attention to the main issues cycle ERM Risk strategy Incentive systems Adequate at risk Goal: long-term value creation! Clear boundaries give accurate signals for the inner & outer world and define the framework for operational action Risk modeling Risk management Risk Detection & Early Warning Steady a responsibility

42 Topic: Solvency Counseling Optimal ERM measures for small and medium-sized insurance companies Establish the role of executive risk managers (CROs) and merge existing risk management operations in the central group Create a risk committee (s) to facilitate decision making and risk management dialogue Stimulate the development of a common risk culture through training and communication Control & Processes Create a framework for strategic risk management (definition of the term risk appetite based on the top-down principle, in accordance with the selected criteria) with reference to the Strategic Business Plan. Get tangible risk limits from strategic risk appetite Risk strategy Create market valuation methods (especially liabilities) Strengthen opportunities for stochastic risk modeling based on market valuation of assets and liabilities Improve the quality of design of risk models and controllability of data flows Risk models Create a framework for intra-company controls to link top-level risk management tools with everyday processes Periodically improve internal controls Intrafirm controls Create coherent internal risk reporting that would satisfy the needs of various stakeholders from one comprehensive source of information. Improve the transparency of external risks based on the structure of reporting on internal risks. Risk transparency There is no universal ERM program - measures depend on the structure, complexity and size of the business

43 Primary Value: Sustainable Responsibility Risk Management Culture: Responsibility is a fundamental principle. General provisions: when making decisions regarding short-term or long-term risks for a company, it is necessary to take into account the state of the market and society In relation to risk management: – Clear definition and delimitation of the term "risk appetite" – All key business procedures must consider risks, for example Product development, underwriting, sales, administration Accounting and other external reports Clear documentation of risks and control procedures – Risk management should occur outside ivory towers and silos Risk management: independent, but involved in the daily activities of the enterprise Regular rotation of employees between the Risk Management department and Business General provisions: when making decisions regarding short-term or long-term risks for a company, it is necessary to take into account the state of the market and society In relation to risk management: – Clear definition and delimitation of the term "risk appetite" – All key business procedures must consider risks, for example Product development, underwriting, sales, administration Accounting and other external reports Clear documentation of risks and control procedures – Risk management should occur outside ivory towers and silos Risk management: independent, but involved in the daily activities of the enterprise Regular rotation of employees between the Risk Management department and Business 43 Essential condition: Clear guidance instructions (tone on top)

44 Workflows and IT systems (data banks, modeling software) Focus on enterprise technology in risk management 44 Data collection and assessment Projection on future income and liabilities Merge by segment, adjustment (extrapolation of IBNR) Reporting and control Workflows must be supported by integrated data banks and efficient IT systems. Data availability and quality are still critical.

45 ERM: Practical Examples of Business Integration 45 The enterprise risk management system is fully integrated into our business strategy and daily activities.

46 Quantitative reinsurance effect PODRA - on the platform of PillarOne PODRA (PillarOne Dynamic Reinsurance Analysis) is a service developed by Munich Re to describe and measure the risks of underwriting in the field of property insurance and accident insurance. The methodology is based on the publicly available software platform PillarOne.RiskAnalytics. Munich Re initiated and sponsored a project to create this program. Description of the project, its scheme, features, software downloads and other information can be found at All PillarOne applications include a license for open source software that provides free use of the resource. 46