The Primary Sources of Market Risk in Insurance - Market risks represent potential economic losses arising from adverse changes in the fair value of financial instruments and other economic assets and liabilities due to changes in financial variables such as interest rates and stock prices. Property and Casualty (PC) insurers’ exposures to market risks relate primarily to the investment portfolio, which is exposed to interest rate risk, prepayment risk, credit risk, liquidity risk, and equity price risk.
Life and Health (LH) insurers have significant exposures to market risks due to their reserve liabilities and asset management income in addition to exposures in the investment portfolio. Accordingly, as discussed in the “Risk Management” subsection below, when evaluating market risks LH insurers focus on asset-liability management and also consider potential effects on fee income. There are some primary sources of market risk as described below.
1. Interest Rate Risk
The first primary source of market risk in insurance could be explained that the fair value of fixed rate investments fluctuates in response to changes in market interest rates. Increases or decreases in prevailing interest rates generally translate into decreases or increases, respectively, in the fair value of these instruments. For floating or variable interest rate instruments, the value effect of fluctuations in interest rates is generally limited because the discounted cash flows move in the same direction as the change in the discount rate. However, the cash flows of many variable and even floating rate instruments adjust only partially (e.g., due to caps or floors) or with substantial delays to changes in market rates, leaving significant fair value sensitivity to interest rates. In addition, changes in interest rates often affect or are correlated with changes in other determinants of fair value, including the creditworthiness of issuers, credit spreads and, primarily, the value of prepayment options.
2. Prepayment and Extension Risks
Prepayment risk is the risk that borrowers may repay loans or other borrowed funds earlier than expected to take advantage of a decline in interest rates. This represents a significant risk to the investor because fixed income instruments increase in value when interest rates decline. Extension risk is the risk that borrowers will repay at a slower pace than expected when interest rates increase and the value of the investments declines. Prepayment and extension risks are significant especially for instruments that can be prepaid at low or no penalty, such as callable bonds and many residential mortgages, MBS, and CMOs.
3. Credit Risk
Credit risk relates to fluctuations in the value of investments due to issuer or borrower default, or to changes in the perceived likelihood of default or recovery rates. Changes in credit spreads due to changes in market sentiment toward risk are generally considered part of interest rate risk.
4. Liquidity Risk
Liquidity risk affects insurers in several ways. At the company level, liquidity risk refers to the possibility of having insufficient liquid resources to meet obligations as they come due. This risk is particularly relevant for PC insurers because both the frequency and magnitude of PC claims are more volatile compared to LH claims. At the instrument level, liquidity risk relates to the ability (or lack thereof) to sell an instrument at market price in a timely fashion.
5. Equity Price Risk
Equity price risk is the potential economic loss from adverse changes in stock prices. Most insurers hold relatively small amounts of equity securities and so are not particularly sensitive to equity price risk. However, many LH insurers face significant equity price risk due to various guarantees that they provide on variable life insurance, annuities and other products. Also, the fee income that LH insurers generate for managing separate account assets and assets under management (AUM) depends on the size of these portfolios and therefore on the performance of equity markets.
6. Downgrade Risk
This also becomes the primary sources of market risk in Insurance. Rating agencies, including Moody’s, S&P, Fitch and A.M. Best, play a particularly important role for insurers. Unlike non-financial companies for which ratings are important primarily for transactions in capital markets, insurers’ ratings directly affect their operations. A key determinant of the quality of insurance policies is the financial stability of the insurer, especially for long-duration or long-tail policies. Thus, a rating downgrade may have severe consequences for insurers.
To determine an insurer’s rating, rating agencies perform a comprehensive analysis. For example, on their web page A.M. Best state “Our rating process involves a comprehensive quantitative and qualitative analysis of a company’s balance sheet strength, operating performance and business profile. This includes comparisons to peers and industry standards as well as assessments of operating plans, philosophy and management. Where the rating is assigned to a debt security, it also includes a review of the specific nature and details of the security.” The primary determinant of the rating is capital adequacy.
This also becomes the primary sources of market risk in Insurance. Rating agencies, including Moody’s, S&P, Fitch and A.M. Best, play a particularly important role for insurers. Unlike non-financial companies for which ratings are important primarily for transactions in capital markets, insurers’ ratings directly affect their operations. A key determinant of the quality of insurance policies is the financial stability of the insurer, especially for long-duration or long-tail policies. Thus, a rating downgrade may have severe consequences for insurers.
To determine an insurer’s rating, rating agencies perform a comprehensive analysis. For example, on their web page A.M. Best state “Our rating process involves a comprehensive quantitative and qualitative analysis of a company’s balance sheet strength, operating performance and business profile. This includes comparisons to peers and industry standards as well as assessments of operating plans, philosophy and management. Where the rating is assigned to a debt security, it also includes a review of the specific nature and details of the security.” The primary determinant of the rating is capital adequacy.
Rating agencies evaluate this aspect by assessing the NAIC risk-based capital ratios, calculating proprietary risk-based capital ratios based on their own risk factors, reviewing other financial ratios, and conducting proprietary stress tests. For example, A.M. Best calculates a capital adequacy ratio based on factors for investment risk, credit risk and underwriting risk, and Moody’s uses a risk-adjusted capital model that employs Monte Carlo simulations to assess investment, reinsurance, reserve, and underwriting risks.