Sample Paper on Risk Management in Insurance Companies

Abstract

The aim of this paper is to examine the risk management practices of insurance companies. Numerous insurance firms have indicated their risk appetite levels, which make it possible for them to recognize risks that should be absorbed and those to be transferred. Additionally, the insurance sector has no adequate personnel with the necessary risk management skills and does not manage risks proactively; instead, they do so in a volatile response to regulatory directives. Efficient management of risks by insurers increases the penetration of insurance globally. More so, risk management is a vital concern for the existence and profitability of the insurance industry and for socio-economic growth and development of the entire economy. As major risks underwriters, insurance firms should implement good practices or quality processes in managing financial risk.

Risk Management and its Importance 

 

Insurance companies acquire profits through managing several forms of risks, such as the risk of dying at a young age, experiencing a loss because of man-made or natural disasters, outliving assets, and losing income capacity through business interruptions. Risks result in uncertainty, which exposes firms to volatility. Risk management refers to the process through which organizations systematically recognize, gauge, and manage the several forms of risk inherent within their processes (Best). The main aims of a perfect risk management program are managing an organization’s exposure to probable earnings and capital volatility and maximizing value to an organization’s numerous stakeholders (Grossi 5).

Nevertheless, it is significant to note that the aim of risk management is not to eradicate risk and volatility but to comprehend it. Risk management enables companies to identify and quantify their risks; set risk tolerances according to their overall corporate objectives; and take the necessary actions to manage risk according to the objectives. If conducted in the right way, risk management encourages an operating environment that supports strong financial controls and risk mitigation, including prudent risk-taking to grab market opportunities (Grossi 6).

Other aims of risk management are reducing foreign exchange losses, minimizing the volatility of cash flows, protecting earning fluctuations, increasing profitability, and ensuring survival of a firm. Moreover, risk management assists organizations to meet their goals, which in the case of propriety insurers include maximizing shareholder value (Oscar and Abor 29). Additionally, risk management is an essential part of the operations of every firm and its fundamental objective is to facilitate other management activities to attain an organization’s stated goals effectively.

The Major Types of Risks the Companies Might Face 

Actuarial Risk

This kind of risk emerges from raising funds by issuing insurance policies and other liabilities. The risk involves a firm paying too much for the finances it obtains, or the risk of a firm getting very little for the risks it has purposed to absorb. In cases where an insurer invests finances in effectively traded securities, he/she anticipates to have a zero net economic profit averagely. However, when the insurer pays too much for these finances, it is not possible for it to obtain a suitable profit in the long-term. An additional feature of actuarial risk entails the underwriting losses exceeding the ones anticipated at any particular period. This might be because the expectations may be founded on insufficient information of the loss distribution. Additionally, the losses may exceed their projections since losses fluctuate around their mean. The extent to which they differ from the mean is determined by the features of the loss distribution, which is based on the nature of the risks insured (Babbel and Santomero 11).

Systematic Risk

This refers to the risk of asset and liability value variations linked to systematic factors. It is also referred to as the market risk. Thus, the risk can be evaded but cannot be diversified fully. Moreover, systemic risk is also regarded an undiversifiable risk. The majority of investors assume this form of risk in cases where assets held or claims supplied change in value because of different economic factors. In the insurance sector, systematic risk occurs in three forms: viz., changes in the level of interest rates, basis risk, and inflation, particularly for property or casualty insurers (Babbel and Santomero 11).

Due to insurers’ reliance on the systematic aspects, many of them work towards approximating the effect on the given systematic risks on performance, try to hedge against them, and therefore restrict the sensitivity of their financial performance to changes in the undiversifiable factors (Babbel and Santomero 11).

Credit Risk

This denotes the risk that a lender will not perform according to its obligations. Credit risk may emerge from failure or reluctance of the lender to perform in the pre-committed contract manner. This affects the investor holding the bond or the lender of a loan contract, including other investors and lenders to the creditor. Thus, the financial state of the borrower, including the present value of any fundamental collateral is of substantial interest to an insurer who has invested in the bonds or engaged in a direct loan (Babbel and Santomero 12).

The actual risk from credit is the deviance of the portfolio performance from its projected value. Therefore, credit risk is diversifiable but hard to eradicate wholly since general default rates show much fluctuation. This occurs because part of the default risk may arise from the systematic risk pointed above. Additionally, the distinctive nature of certain portions on the losses continues to be a challenge for creditors despite the advantage of diversification on total uncertainty. This applies for insurers who take on highly illiquid assets. In these particular cases, the credit risk is not easily transferred, and accurate approximations of loss are hard to estimate (Babbel and Santomero 12).

Liquidity Risk

This is the risk of a funding catastrophe. Such a case would certainly be related to unanticipated event like a large claim or a write down of assets, loss of confidence, or a legal crisis. Since insurers function in markets with several grouped claims because of natural calamities, or high requests for policy withdrawals and surrenders because of variations in interest rates, tier liabilities can be considered liquid. Nevertheless, their assets are at times less liquid, especially in cases where they invest in private placements and real estate (Babbel and Santomero 12).

Operational Risk

This risk is related to problems of correctly processing claims and correctly processing, settling, and taking or making delivery on trades in exchange for cash. It also occurs in record keeping, processing system failures, and compliance with several regulations. Therefore, individual operating challenges are small probability events for well-run firms but they expose a firm to consequences that can be expensive (Babbel and Santomero 12).

Legal Risks

These risks are prevalent in financial contracting and are distinct from the lawful implications of credit and operational risks. New decrees, court sentiments, and regulations can make officially well-established transactions argumentative even when all parties have previously performed sufficiently and are wholly in a position to perform in the future. For instance, variations in the application of statutes of limitations for filing suits have affected losses emanating from property/liability policies. Moreover, alterations in joint and numerous liability regulations have as well changed the distribution of risks that the insurance policies can cover (Babbel and Santomero 12). Another form of legal risk emanates from the activities of an institution’s management, employees, and agents. Additionally, fraud, violations of laws, and other activities can result in catastrophic losses.

 The Process of Risk Management

Generally, the management of an insurance company depends on several techniques in the risk management systems. Nevertheless, a common practice has emerged and four components have been regarded vital steps to implementing an extensive risk management system. The tools are intended for measuring risk exposure, defining procedures to manage the exposures, limiting the exposures to acceptable levels, and encouraging decision makers to manage risk in a way that is consistent with an organization’s goals and objectives. They include the following:

Standards and Reports

Firstly, this control strategy entails two distinct conceptual activities, namely standard setting and financial reporting. The two are highlighted together since they are the sine qua non of all risk management systems. Underwriting standard, risk classification, and standards of review are customary tools of risk control. Additionally, consistent assessment and rating of exposures of numerous types are vital for the management to comprehend the risks on all sides of the balance sheet and the level in which the risks should be mitigates or absorbed (Babbel and Santomero 8).

Standardization of financial reporting is important since outside audits, regulatory reports and ratings agency assessments are significant for investors to measure asset quality and organization level risk. Nevertheless, the form of information gathered and the way it is assembled and presented in statutory accounting report is insufficient for the objective of managing an insurance firm (Dowd et al. 11).

Underwriting Authority and Limits

 

Another procedure for internal control of active management is the utilization of position limits and minimum standards for engagement. Based on the latter, the domain of risk taking is limited to clients or assets that meet the prespecific quality standard. Even for eligible ones, restrictions are imposed to cover exposures to counterparties, credits, and general position concentrations relative to several forms of risks. Generally, every individual who can commit capital, whether on the asset or liability side of the ledger, has a clear limit. This is applicable to underwriters, portfolio managers, lenders, and traders. Moreover, summary report indicates limits, including current exposure by business unit on a periodic basis. In big companies that have many positions, correct and timely reporting is hard but highly essential.

Investment Guidelines and Strategies

 

Investment procedures and commended positions for the near future are the third technique normally utilized. Strategies are defined based on concentration and devotion to certain regions on the market, the level of desired asset/ liability mismatching or exposure to interest rate risk, and prerequisite to evade the systematic risks of a certain kind. The restrictions result in passive risk avoidance and divergence since managers usually function within position limits and prescribed regulations. Furthermore, guidelines provide firm level advice as to the proper level of active management, considering the condition of the market and the readiness of senior management to absorb the risks inferred by the collective portfolio. These forms of guidelines extend to organization level hedging and asset/liability matching. Moreover, securitization and derivative activities are fast growing techniques of position management open to participants purposing to minimize their exposure to conform to the management’s strategies. Additionally, underwriting standards and strategies are required to make sure that the risks accepted adhere to the parameters that the insurer in able and ready to accept. They as well promote better pricing of commodities and prevent any underwriter from compromising the future solvency on an organization (Babbel and Santomero 8).

Incentive Schemes

 

For a firm to join incentive compatible contracts with senior management, line managers, and sales agents and make reimbursement associated with the risks borne by these people, the need for elaborate and expensive controls is reduced. Nevertheless, the incentive contracts should be in line with the insurers’ financial objectives and need appropriate internal control systems. Tools, such as underwriting risk and loss analysis, investments risk analysis, distribution of costs, and the setting of required returns to numerous parts of the organization are important. Moreover, well-invented systems align the objectives of managers with other stakeholders in a proper manner. In addition, several financial disasters can be traced to the absence of incentive compatibility higher than their anticipated returns (Babbel and Santomero 8).

Conclusion

The study shows that many efforts towards risk management in the insurance companies are a reactive response to the supervisory directives of the National Insurance Commission (NIC), instead of self-driven. This indicates that some insurers have not recognized the significance of instituting self-driven risk management practices. Therefore, it is important for all insurance firms to take a more proactive approach in the management of risk.

Works Cited

Babbel, David F., and Anthony M. Santomero. Risk Management by Insurers: an analysis of the process. Wharton Financial Institutions Center, Wharton School of the University of Pennsylvania, 1996.

Best, A. M. “Risk management and the rating process for insurance companies.” (2008).

Dowd, Kevin, et al. “Risk management in the UK insurance industry: the changing state of practice.” International Journal of Financial Services Management 3.1 (2008): 5-23.

Grossi, Patricia. Catastrophe modeling: a new approach to managing risk. Vol. 25. Springer Science & Business Media, 2005.

Oscar, K., and J. Abor. “Risk Management in the Ghanaian Insurance Industry.” (2013).