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Risk Management & Insurance

Introduction into Risk Management, Risk Identification, and Risk Valuation Risk Management methods Selected topics

Introduction into Risk Management, Risk Identification, and Risk Valuation Risk Management methods Selected topics

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Jasmin Brander
Jasmin Brander

Kartei Details

Karten 71
Sprache English
Kategorie Finanzen
Stufe Universität
Erstellt / Aktualisiert 06.05.2014 / 20.05.2015
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3.3) Risk Management Techniques - Risk Financing

Options

Formally and graphically explain the put-call-parity

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Assumptions:

  • No arbirage and no transaction costs (b-a-spread) (holds more or less for vanilla market)
  • Equal strike price and expiry date for put and call option

 

3.3) Risk Management Techniques - Risk Financing

Options

Cox Rubinstein Model (Binomial Model):

  • Explain general set up
  • Formally explain how to derive the option price (simple way!!)
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General Set Up

  • Preference-free valuation: shift from physical (risk-adjusted) measure to risk-neutral measure (thus, you use the risk-free rate to discount and the probabilities are risk-neutral)
  • Idea: creation of a replicating (hedging) portfolio with an underlying and a loan
  • For set up s. picture (put option because that's the most basic one)

Formal derivation

Don't use complicated formula! Very simple, just put (p*pu+(1-p)*pd)/(1+r)T=p0 into solver (s. picture)

3.3) Risk Management Techniques - Risk Financing

Options

Black-Scholes Model:

  • Explain general set up
  • Explain the Geometric Brownian Motion formally

 

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General Set Up

  • Assumes that it is possible to perfectly hedge the option payoffs
  • Hence also here: preferences don't matter; investors are risk-neutral
  • You don't use BS-model to calculate plain vanilla call-option prices (they are perfectly liquid and have a market price) but you USE PRICES to price other, illiquid, assets.
  • Can be viewed as the continuous time extension

Assumption that stock price follows a Geometric Brownian Motion

s. picture

-> Important to remember: there's a drift term and a diffusion term and it all follows a Wiener Process

3.3) Risk Management Techniques - Risk Financing

Options

Explain and derive the Black Scholes Model (Price for call and put option, for d1 and for d2)

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  • The formula expresses the call value as the current stock price times a probability factor N(d1), minus the discounted exercise payment times a second probability factor N(d2)
  • N(d2) is the risk-adjusted probability that the option will be exercised
  • N(d1) is the factor by which the PV of contingent receipt of the stock exceeds the current stock price. The PV of contingent receipt of the stock is not equal to but larger than the current stock price multiplied by N(d2). The reason for this is that the event of excercise is not independent of the future stock price.

-> for an example look at the back of the slides!

3.3) Risk Management Techniques - Risk Financing

Options

Show how you can use the Put-Call-Parity to derive the put (call) from the call (put) price

Remember Put-Call-Parity: C0+B0=S0+P0

Now simply take X*e-rT for the Bond

C0=P0-X*e-rT+S0

and

P0=C0+X*e-rT-S0)

 

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer

  • Define ART
  • List the four main reasons for the advent of ART

 

 

  • ART are techniques other than traditional (re)insurance that provide coverage for insurance risks
  • Offered by reinsurance companies or by accessing the capital markets directly

Main reasons for the advent of ART

  • Increasing desaster frequency/severity and growth of property value in exposed areas
  • Limits in reinsurance capacity, especially during hard markets
  • Drawbacks of traditional reinsurance contracts (single year, sigle peril, single trigger)
  • Technological advances facilitating data collection and risk modeling

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer

Draw an overview over the ARTs and explain the four "products" of self insurance and hybrids

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Self-insurance programs

  • Companies set aside some of their equity in reserves to cover for future losses
  • Save transaction costs of dealing with insurance company

Captives

  • Formalized self-insurance programs (in a subsidiary)
  • May also insure risks from third parties and hedge themselves in the insurance market

Blended Covers

  • Modification of traditional reinsurance that covers wider variety of risks and maturities
  • Multi-year, multi-line, and multi-trigger products (or combinations)

Reinsurance Sidecars

  • SPV that protects through quota share reinsurance
  • SPV holding company funds itself by issuing equity and debt securities to investors

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS)

  • Give a definition of ILS
  • Describe ILS from the investor's perspective

Definition

  • Alternative for buying insurance: Financial instrument whose value is predominantly driven by insurance risks
  • Risk transfer for sponsors: frees up risk bearing capacity and may provide capital relief
  • Very low correlation with other asset classes -> it does NOT react with stock market crashes!

ILS from the investor's perspective

  • Attractive risk-return profile: competitive expected returns, low volatility
  • Considerable diversification potential: low correlation with other asset classes
  • Excess spread over corporate bonds: new, illiquid (now there's a fairly liquid market), and sudden-death premiums

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS)

 Listthe different ILS types that exist (for non-life and life risks, respectively)

Non-Life Risks

  • Catastrophe Bonds (quite liquid)
  • Catastrophe Derivatives
  • Non-Cat Property-Casualty Bonds

Life Risks

  • Mortality and Longevity Bonds
  • Mortality and Longevity Derivaties
  • Life Settlements (secondary market for life insurance contracts if you don't need it anymore)

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS) - Catastrophe Derivatives

  • Define catastrophe derivatives
  • Explain the two ways how they are traded

Definition: Catastrophe Derivatives

  • Derivative contracts whose underlying is an index of insurance losses or disaster severity
  • Used to hedge property-catastrophe exposure (e.g. cat bonds) or for speculation
  • The underyling is not traded and thus physical delivery impossible
  • Options, futures, swaps are feasible

Trading

  • Over the counter (OTC): direct trading between counterparties
  • Exchange-traded: contracts intermediated by an organized exchange

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS) - Catastrophe Derivatives

  • List three Exchange-traded cat derivatives
  • List three OTC cat derivatives

Exchange-traded:

  • Chicago Hurricane Index (CHI) Binary Options
  • CHI Futures and options
  • Hurricane Futures

OTC:

  • Industry Loss Warranties (ILWs)
  • Catastrophe Swaps
  • Customized OTC cat derivatives

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS) - Catastrophe Derivatives

Industry loss indices and parametric indices (underlyings of cat derivatives) play a crucial role in achieving....

  • Rapid Settlement
  • Objectivity
  • Standardization
  • Simplicity
  • Transparency

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS)

  • Define indices for ILS and derivatives
  • List and explain the four quality dimensions

Definition: Indices for ILS and derivatives

  • Objectively-defined and quantifiable measures; readily observable
  • Differentiated into industry loss indices and parametric indices (aggregate physical parameter values, e.g. wind speeds for hurricanes)

Quality Dimensions

  • Accuracy: index values should be reliable and subject to as little revision as possible
  • Granularity: high geographic and business line resolution to minimize basic risk
  • Timeliness/frequency: responsive and published without great delays
  • Index history: the more data available, the better possibilities for risk assessment

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS) - Cat Bonds

  • Define cat bonds (esp. covered territory and reference peril)
  • List the two cat bond functions

 

Definition: Cat Bonds

  • Financial instrument (securitization) whole values are mainly driven by catastrophe risks
  • Designed to HEDGE SPONSORS against losses caused by (natural) disasters
  • Covered Terriroy: Geographic area in which cat need to occur
  • Reference Peril: Type of disaster covered by transaction

Functions

  • Direct transfer of natural catastrophe risk to the capital markets (like reinsurance; you get reimbursed for what you have to pay to your customers)
  • Liability-hedge: ex-ante supply of debt capital to (re) insurer through SPV

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS) - Cat Bonds

List the four most common combinations of territory and peril

 

 

  • US Wind (95% of all; ususally Florida and Gulf Coast with severe windstorms)
  • US Earthquake (California)
  • Europe Wind (North Atlantic regions, i.e. northern and western Europe with cyclones)
  • Japan Earthquake

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS) - Cat Bonds

List the six reasons why cat bonds are the most successful form of ILS to date

  • Insurance loss potentials from natural catastrophes are on the rise globally (more values in disaster-prone areas such as the Gulf Coast , and climate change)
  • Size of global capital markets can absorb losses from mega-events (huge market compared to equity capital concentrated in insurances) -> transfer from insurance to capital markets
  • Reliable scientific models and measurements for meteorological and seismic events
  • Modern pricing approaches compatible with financial theory
  • Attractive security format for fixed income investors
  • Minimal credit risk since cat bonds are fully collateralized transactions

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS) - Cat Bonds

Illustrate the typical cat bond structure graphically and explain it

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  1. SPV gains cat risk exposure via reinsurance contract/cat swap with sponsor
  2. SPV issues a bond
  3. SPV uses investor money to purchase highly-rated collateral (MMF in T-Bills)
    • Trigger-Event: Sponsor is repaid from collateral , investors use all/part of their principal
    • If nothing happens, investors get their whole principal plus MMF +Scat back

Tenor is usually around three years and cat bonds can feature a variety of trigger types

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS) - Cat Bonds

What risks are cat bond investors mainly exposed to?

  • Property Catastrophe Risk (almost "pure play")!!!
  • Liquidity Risk (however, there's a fairly active secondary market nowadays)
  • Credit Risk (minimized due to tight collateral provisions, very secure!)
  • Interest Rate Risk (minimized due to floating rate coupons)

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS) - Cat Bonds

List and explain the four trigger types

Indemnity

  • Bond pays if ACTUAL INSURANCE LOSSES suffered by the sponsor exceed a threshold
  • Like traditional reinsurance: perfect hedge against catastrophe (not basic!) risk!

Industry Loss

  • Industry-wide losses are aggregated into an index by providers
  • They are modified with index weights for geographical locations to match exposure

Modeled Loss

  • Model insurance portfolio and modeling software
  • If disaster occurs, losses are modeled based on corresponding physical parameters (model shows how damatic losses are and if money is paid out)

Parametric (pure and index)

  • Pure parametric: based on values of physical parameters such as wind speed
  • Parametric index: weighted and aggregated data from different weather stations

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS) - Cat Bonds

  • List the four factors affecting the trigger choice
  • Give a graphical overview
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Transparency for investors

  • Asymmetric information: sponsors have better portfolio information than investors
  • Moral Hazard: underwriting standards and claim-settlement practices may be relaxed

Basic risk for sponsor

  • Possibility that sponsor is not perfectly indemnified for his losses
  • So, if basic risk is high, cat bond is NOT A GOOD HEDGE to the sponsor

Settlement time (!)

  • Time needed to determine payout after event has occured

Accounting and regulatory acceptance

  • Trigger determines if the cat bond receives a quasi-reinsurance status for sponsor

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS) - Cat Bonds

What are the two payout types of cat bonds?

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Proportional payout and binary payout ("all or nothing")

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS)

Catastrophe Risk Modeling:

  • Describe the critical role of catastrophe modeling firms
  • Describe main output of the catastrophe modeling proess
  • List the four major components of risk modeling

Critical Role:

  • Provide a comprehensive probabilistic risk analysis because of a lack of historical data, natural science expertise, and exposure information
  • Firms: e.g. RMS, AIR worldwide, EQECAT

Main Output

  • Probability distribution of insurance losses
  • Crucial input for selection of the trigger thresholds and the pricing of the cat bond

Four major components:

  • Hazard module (only sufficient alone if you have parametric trigger)
  • Inventory module (database of properties in the area)
  • Damage module (material, age, size etc.)
  • Financial module

3.3) Risk Management Techniques - Risk Financing

Alternative Risk Transfer - Insurance-Linked Securities (ILS)

Probability Density Function of insured losses:

  • Map the modeled insurance losses into losses on a cat bond
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s.picture

4) Guest Lecture SwissRe

What is reinsurance?

Reinsurance is a catalyst for economic growth

Insured Risks -> Primary Insurance -> Reinsurance -> Retrocession & Capital Markets

Insured risks: very uncertain about their individual risk
Primary Insurance: as much market and pricing power as possible, diversification irrelevant
Reinsurance: replication of theoretical diversified portfolio (risk profiles become much more predictable)

4) Guest Lecture SwissRe

What are the three functions of reinsurance are the corresponding prerequisits?

Functions:

  1. Risk Transfer (diversify risks on global basis) - mobility of capital & premiums
  2. Capital Market (invest premium income) - ability to invest in real economy
  3. Information (put price tag on risks) - market- and risk-based pricing

4) Guest Lecture SwissRe

List three ways of diversification for reinsurers

  • geographical (culture, society...)
  • lines of business (life, car, mortality...)
  • number of independent risks

The better the diversification, the less capital is needed to meet claims

4) Guest Lecture SwissRe

What are the three components of risk management of a reinsurer?

  • Underwriting (assessment, pricing, capacity allocation and assuming risk)
  • Capital Management (adequate for 100 and 200 year events)
  • Asset Management (assets need to be there when claims are made)

4) Guest Lecture SwissRe

What are the four major drivers behind increasing demand for insurance in emerging markets?

  • Economic growth
  • Urbanization trends and infrastructure growth (>50% world population lives in urban areas now)
  • Natural catastrophe protection gap
  • Large mortality protection gap

4) Guest Lecture SwissRe

What are the implications of urbanization for insurance?

  • Economic
  • Social
  • Infrastructure
  • Environment

Economic

  •  Higher income and wealth drives demand for motor, home and savings products

Social

  • Longevity and reduced inter-generational support will create opportunities for old-age health and pension products 

Infrastructure

  • New opportunity for commercial insurance during the 
    construction phase of infrastructure projects

Environment

  • Many large cities located in areas exposed to multi-natural disasters to create higher demand for nat cat re/insurance

 

 

4) Guest Lecture SwissRe

  • Show what the Disaster Risk Financing Gap is
  • Show what the Mortality Protection Gap is

 

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s. picture

4) Guest Lecture SwissRe

What are the six main challenges to (insurance) markets because of the changing environment?

  • Regulatory environment
  • Financial markets, sovereign debt
  • mature markets, high growth markets
  • low interest rates, inflation, price pressure
  • Weak growth
  • Changing risk landscape

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