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Advancing Risk Management

Advancing Risk Management

by David Ingram

A discussion of the pillars required to build the needed paradigm for insurance company risk management.

One example of the difference between actuaries and the general population is when we refinance our mortgages, most of us check the calculation of the payment amount, not by looking it up in a table or using canned software, but by calculating it directly, "from first principles" as our college professors would have said.

This, among other things, illustrates the level of rigor and mastery that actuaries as a profession bring to our chosen fields. Actuaries have always approached insurance reserves and prices of insurance products with an unsurpassed attention to detail and quality.

In the field of risk management, such rigor and mastery is difficult to find. As recently as 1998, a Nobel Prize-winning pioneer of modern finance theory miscalibrated his risk management model on the way to the multi-billion dollar collapse of long-term capital management.

Banks are credited with creating scientific risk management in the late 1980s and early 1990s, but insurance companies and insurance actuaries have been using many of the risk management practices that banks have recently "discovered" since at least the 1970s, placing us in about the same position as the Native Americans whose continent was "discovered" by the Europeans in the 15th century.

Insurance companies do not need a transplant of bank risk management. They have different risk management problems and will continue to have different problems, even if the accounting profession brings us to a point where our accounting is (in their view) more consistent.

What insurance companies need is a new creation that builds off the good risk management work historically developed and implemented by actuaries and incorporates the new understanding of risks and markets that have grown over the past generation in banks and academia.

Several pillars will be required to build the needed paradigm for insurance company risk management:

  1. An understanding of how financial markets treat risk. Market prices can be decomposed into margins for expected losses and margins for risk. Sometimes insurance companies are in a position where they can think, in advance, of the market risk margin part of a security price as an excess margin they can divide, in some fashion, with their customers. Other times, that is a disastrously wrong thing to do.

    Also, market participants need to clearly understand when they are taking a different position regarding the price for risk than the market is implicitly taking. They need to be clear that their position is a deliberate, reasoned position, and not the result of an oversimplified financial model.

  2. The law of one price. As insurance products have become closer to pure financial instruments and further from being insurance risk transfer transactions, the closer we get to being able to replicate insurance products with market traded financial instruments. The law of one price then says that our price for the insurance product must be the same as the replicating basket of securities.

    Insurance pricing models and valuation systems that do not obey the law of one price will become increasingly suspect. Insurers who priced variable product benefits with models that differed significantly from the market are finding they cannot afford to go to market now to hedge risks they no longer want to retain.

  3. A model for viewing the insurance risk transfer portion of insurance company products on an equivalent basis with the market-traded elements of insurance products. This includes clear recognition that some insurance risks are diversifiable while others are not. Financial theory tells us we cannot get paid for taking diversifiable risks, but we should get paid for taking non-diversifiable risks.

    Valuation and pricing models should reflect both the expected losses as well as the level of uncertainty of these insurance elements in a way that is consistent with market treatment of uncertainties of other types of losses.

  4. An understanding of the interaction between risk and discount rates. When valuing a bond, it is a circular definition to say the cash flows should be discounted at the yield rate. As mentioned previously, the yield rate is a combination of factors, including risk relating to the type of bond, the sector, the economy and the specific company issuing the bond. The only situations where the yield of a bond or a portfolio of bonds and other securities is the exact correct discount rate to evaluate a stream of insurance cash flows is when those cash flows have the same duration, convexity, key rate durations and default risk.

    Insurance pricing has migrated from the use of an asset earnings rate to the use of a cost of capital rate for discounting. However, an average cost of capital rate is probably only the right discount rate for products with exactly "average" risk within the company. The treatment of risk in the liabilities to be discounted needs to be the opposite of the treatment of risk in the discount rate. If the cash flows are presented as an absolute certainty, then the discount rate needs to reflect the specific risk of the cash flows occurring at different times or at different levels. If the cash flows fully reflect all the risks of the product, then the discount rate needs to be a risk-free rate. Risk should be reflected once and only once.
  5. A mastery of stochastic scenario generators. Since many insurance risks and insurance products do not lend themselves to complete replication in the financial markets, stochastic simulation models are the most likely tools for evaluating risk. Choosing and calibrating models is a major discipline of its own. Markets, by their very nature, do not lend themselves to completely accurate modeling. In fact, there probably should be an axiom that if at any time market models seem to be becoming predictive, then the market is heading into a new regime. (Remember when everyone "knew" in the late 1990s that any market drop would be followed by a gain often twice as large as the drop?)
  6. A clear metric of risk in insurance companies. The most significant step that was taken in the development of bank risk management was the leap into a paradigm risk that was immediately carried to all levels of management. That paradigm, based on value-at-risk (VAR), is far from perfect, and many actuaries spend too much time focusing on the flaws of VAR.

    What is more important is the drastic shift in point of view regarding risk management that has taken place in banks since the implementation of VAR. This risk measure has facilitated the development of the entire risk management culture in banks. A new culture needs a language, and VAR is the language of risk management in banks.

    The insurance industry needs to find an equally clear metric for risk. Ultimately, risk management is trending toward a single platform for assessing risk. The risk metric chosen for life companies needs to be applicable across all the risks, products, investments and ventures of the firm.

  7. Management and communication expertise.
    For risk management to be effective, a risk management culture needs to be developed within companies. Managers at all levels need to embrace risk management as part of their jobs, not as being just the responsibility of the corporate risk manager. Risk and risk management activities need to be communicated clearly to the directors, all the way to unit supervisors and sales agents.

Advancing Risk Management
Actuaries are acting as scouts and wagon train leaders in the advancement of risk management. The scouts are finding the connections between the new risk management techniques and the needs of insurance companies. The wagon train leaders are bringing their companies into the new land of risk management.

This effort to advance both the leading edge and the average level of risk management practice for actuaries has been under way for some time now. Risk management materials have been included in the exam syllabus, as a part of the finance and investment exams as well as under the asset/liability management (ALM) topic and now as a separate exam. Risk management topics have become quite common at spring and Annual SOA meetings, sponsored by the Investment, Financial Reporting and Product Development Sections. The SOA Board of Governors and Strategic Planning Committee have identified risk management as one of the major new areas of practice for actuaries now and into the future.

Pushing Into Insurance Companies
Two forces are advancing the push for risk management in life insurance companies. The first is the progression of risk management in banking. Several prominent insurance companies have brought in executives from banking who have expectations of timely and effective risk management information and processes.

A chief actuary in such a company tells of her experience when one February the new CEO with a banking background said that he wanted a risk management report by "four ten." The actuary thought that April 10 was a quite ambitious deadline, but the CEO meant 4:10 that afternoon.

At the same time, stock and rating analysts who cover both insurance companies and banks are looking for evidence that insurance companies have as much mastery of their risks as banks seem to portray.

The second force driving the current interest in risk management is the losses that insurance companies have experienced over the last several years. Definitely not unprecedented, but certainly unexpected equity market losses have hit companies hard that have high concentrations of variable, segregated-fund or unit-linked business.

These products were originally touted as very low risk when they were new. "All" of the investment risk was being transferred to the policyholder, or so it was thought. Maybe that is largely true in the long term, but companies that wrote-off deferred acquisition costs or paid guaranteed minimum death benefit claims and setting up Actuarial Guideline 34 guaranteed minimum income benefit reserves while looking forward to C3 Phase 2 risk-based capital are certainly suffering in the short term.

The credit market losses were both unprecedented and unexpected. Insurance companies and actuaries had seen it as their right to be able to take a large portion of the credit spread into income. While corporate bond defaults averaged under 3 percent per year for the past 30 years, a recent four-year period saw junk bond defaults of a cumulative 31.8 percent, more than twice the level of the last several credit market downturns. The risk premium that had been paid to bondholders for many years to pay for the uncertainty of the timing and severity of credit losses was suddenly being collected back by the market.

Often the reaction of insurance companies, driven at least in part by rating agencies and regulators, is to flee any areas that cause problems. However, this time the losses come from areas that are key to many company's fundamental business strategy. A company cannot flee equity market risk without eliminating the entire variable product line. Corporate bonds are the largest component of insurance company general accounts. Risk management is needed to provide a framework for companies to convince themselves that they can stay in the variable products business and continue to be able to invest in bonds that provide the levels of spreads that support their businesses.

Conclusion
Risk management can be seen as a system that provides the sort of guidelines that football coaches use to determine that they will punt on fourth down, except when A, B or C occurs. These rules do not guarantee that they will win each and every game. But they do provide a generally accepted framework within which they expect to be able to win the most games over the course of the season. And, if followed, the rules provide cover when facing the sports writers after a loss.

Risk management for insurance companies needs to be developed to the point where insurance company executives are in the same position as football coaches who can use their rules as a starting point for determining their strategies and tactics and as a basis for explaining their actions to the sports writers. Actuaries need to attain a level of rigor and mastery of risk management to be able to support that kind of process.

David Ingram, FSA, FRM, PRM, is a consulting actuary with Milliman USA, New York. Ingram was the first chairman of the SOA Risk Management Section Council. He can be reached at: david.ingram@milliman.com.