Academic journal article Journal of Risk and Insurance

On the Risk of Insurance Liabilities: Debunking Some Common Pitfalls

Academic journal article Journal of Risk and Insurance

On the Risk of Insurance Liabilities: Debunking Some Common Pitfalls

Article excerpt

INTRODUCTION

The savings and loan debacle - the soaring number of insolvencies of financial institutions - was a traumatic event for the United States. During the "roaring eighties," a lot of changes affected the U.S. financial landscape. The rising interest rates in the early 1980s led to a significant flow of consumer dollars into mutual funds. The competition for the savings dollar became very fierce among financial institutions. This pressure, combined with regulatory mistakes (see White, 1991), had a perverse consequence on many financial institutions. They reached for riskier assets offering higher yields and operated with less capital per dollar of assets. In that respect, the example of life insurance companies is very informative. Life insurers were forced to redesign their product lines and to migrate toward interest rate sensitive products (see Wright, 1991). This new environment induced life insurance company investment officers to mismatch assets and liabilities and to lower quality standards by assuming higher credit risks. The result was, as we know now, disastrous. In 1987, 19 companies went bankrupt; in 1989, a worrisome 40; in 1991, a new record of 58 insolvent insurance companies. Canada went through the same kind of turmoil. In 1992, only a year after CompCorp, an industry-financed guarantee corporation, the insurance company Les Cooperants failed. It was followed by the collapse of Sovereign Life in 1993. In 1994, Confederation Life went into receivership.

Europe has not been spared by these costly events, either. Although less publicity has been given to the distresses of the major European insurance companies, concern is growing among European regulators and consumers. According to a July 17, 1993 article in The Economist, insurance companies in the United Kingdom have started to cut bonuses on "with profits" policies. Most Scandinavian companies have been severely downgraded.

The objective of this article is to contribute to a better understanding of the driving forces of a life insurance company. More specifically, the issues of the interest rate elasticity and duration of insurance liabilities and equity are addressed. As noted above, these issues deserve a careful rethinking given the recent trends that have affected the insurance landscape. A correct assessment of these risk measures is critical as they constitute the primary ingredients of any sound asset-liability management approach. In addition, the effort toward a more detailed and more accurate risk picture of life insurance operations enables one to debunk some pitfalls that are commonly encountered in the insurance industry.

In the next section, we debunk three common pitfalls: inversion of the insurance production cycle, risk taking on the liability side of the balance sheet, and long maturity of life insurance liabilities. Then we introduce the model and its main assumptions, based on a contingent claims methodology. In this continuous time valuation framework, interest rate risk and default risk are taken into account. Subsequently, we derive the market values of equity and liabilities of the life insurance company. Two sections examine the duration of insurance liabilities and some implications for equity immunization. A conclusion summarizes the main findings and suggests further avenues of research.

DEBUNKING SOME COMMON PITFALLS

Most life insurers claim that their industry carries distinguishing features that make it quite unique. In particular, they often reject comparison with the banking industry by arguing that banks and life insurance companies are significantly different animals. To support their claim, life insurers usually put forward three basic arguments. These arguments, as the story goes, are sufficient motives for their industry to deserve a specific asset-liability management treatment.

The first argument, which is also shared by property-liability insurers, underlines the fact that the insurance production process is inverted: output prices (insurance premiums) must be established before input prices and costs (claims) are known. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.