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Home > Financial Risk Management Best Practice > How Should Insurers Optimally Manage Market Risk?

Financial Risk Management Best Practice

How Should Insurers Optimally Manage Market Risk?

by Patrick O. J. Kelliher

This Chapter Covers

  • What market risk is.

  • Market risk in different companies and countries.

  • Market risk governance and policy.

  • How market risk is identified.

  • Modeling and measuring market risk.

  • Appetite for market risk.

  • Monitoring market risk.

  • Management of market risk.


Market risk is a key risk for most life insurers, many of whom need to manage guarantees on volatile portfolios of assets. For general insurers, the importance of market risk varies depending on the tail of the business, but investment income is a key driver of profitability and market risk encompasses variations in this income. The author’s experience is of the life insurance market in the United Kingdom, where there is a bias in coverage toward this market, but it is hoped that the points made are applicable to other insurers.

What is Market Risk?

Any framework for market risk should start from clear definitions of market risks as part of a comprehensive risk universe. There is no definitive classification of market risk per se—each company will use one that suits its needs, but the market risk classification should be suitably granular to address the many different types of risks. It should also identify areas of overlap with other risks, not least as there may be separate accountabilities for these within a firm. The actuarial profession in the United Kingdom has published a paper on risk classification (Kelliher et al., 2011), together with a spreadsheet of detailed risk categories, which may be of use in this regard.1 This defines market risk as “the risk that as a result of market movements, a firm may be exposed to fluctuations in the value of its assets, the amount of its liabilities, or the income from its assets,” and then identifies 11 high-level categories and nearly 100 subcategories of market risk.

Market Risk in Different Companies and Countries

There are wide divergences between the market risk exposures of insurers in different countries. In the United Kingdom, life insurers have exposure to guarantees which are in effect under “with-profits” policies, where part of the assets is invested in equities, effectively giving rise to an exotic put option position. Unit-linked funds offered by life insurers are a key investment vehicle for pensions. These generally contain no guarantees, with market risk borne by the policyholder, but the life insurer is exposed to fluctuations in fund-related fees. Until recently, pension funds have had to be converted into an annuity for life, and UK life insurers have substantial liabilities to this type of business, typically backed by corporate bonds to avail themselves of the liquidity premium on these (there being little need for liquidity as the annuities cannot be encashed), but this gives rise to exposure to movements in credit spreads.

By contrast, in the United States, with-profits or participatory business has evolved differently than in the United Kingdom, in part because of guaranteed surrender value requirements imposed by US regulators. Market risk exposure relates more to corporate bonds than to equities. Mutual funds rather than insurer unit-linked funds are the key vehicle for pension saving. Life insurer unit-linked offerings typically come as “variable annuities” with guarantees which are dynamically hedged. Conversion to an annuity for life is not mandatory, so this business is not as important as it is in the United Kingdom.

If we were to look at life insurance markets in the European Union and elsewhere, we would find further diversity—what is notable about market risk in life insurance is its heterogeneity between different countries.

There are further differences in the case of general insurers, which typically have a more short-term investment outlook, although certain long-tail lines of business may have a similar time-frame of investment to that of life insurers. Typically, assets held will be mainly cash and bonds, reflecting the nature of the liabilities, but some general insurers invest in equities and other risky assets to boost investment returns and profits. Indeed, one of the most famous equity investors, Warren Buffet’s Berkshire Hathaway, is primarily a property and casualty insurer.

As well as market risks relating to policy liabilities, insurers may be exposed to market risk in respect of staff pension schemes. The accounting and regulatory capital treatment of staff pension schemes may vary, but the economic risk posed by such schemes should be captured in the market risk framework. Similarly, there is an economic value associated with the value in-force (VIF) of future fund-related charges, and while this may not be reflected in accounts or regulatory capital, the market risk framework should capture fluctuations in VIF due to market risks.

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Further reading


  • Ferguson, Adam. When Money Dies: The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany. New York: Public Affairs, 2010.
  • Galbraith, John Kenneth. The Great Crash 1929. New York: Houghton Mifflin, 2009. A classic account of financial disaster.
  • Hull, John C. Options, Futures, and Other Derivatives. 8th ed. Upper Saddle River, NJ: Prentice Hall, 2011. Seminal textbook covering derivatives and the risks associated with these.
  • Reinhart, Carmen M., and Kenneth S. Rogoff. This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press, 2011. Excellent coverage of financial crises, putting these into their historical and geographical perspective.
  • Sweeting, Paul. Financial Enterprise Risk Management. Cambridge, UK: Cambridge University Press, 2011. Textbook on market risk and wider financial risk management, giving a sound grounding in quantitative techniques for modeling these.
  • Taleb, Nassim Nicholas. Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets. New York: Random House, 2005. An interesting read with some profound insights into financial market behavior.


  • Besar, D., P. Booth, K. K. Chan, A. K. L. Milne, and J. Pickles. “Systemic risk in financial services.” Institute and Faulty of Actuaries, November 27, 2009. Online at: Paper on systemic risks and how market and other risks may be amplified.
  • Derivatives Working Party of the Institute and Faculty of Actuaries. “Credit derivatives.” Institute and Faculty of Actuaries, January 26, 2006. Online at:
  • Eason, Scott, William Diffey, Ross Evans, Paul Fulcher, and Tim Wilkins. “Does your hedge do what it says on the tin? Hedging strategies for insurers: Effectiveness in recent conditions and regulatory treatment.” Staple Inn Actuarial Society, April 13, 2010. Online at:
  • Frankland, Ralph, Andrew D. Smith, Timothy Wilkins, Elliot Varnell, Andy Holtham, Enrico Biffis, Seth Eshun, and David Dullaway. “Modelling extreme market events.” Institute and Faculty of Actuaries, October 22, 2008. Online at: Paper by the UK actuarial profession’s benchmarking stochastic models working party, with particularly good coverage of equity market falls.
  • Kelliher, P. O. J., D. Wilmot, J. Vij, and P. J. M. Klumpes. “A common risk classification system for the actuarial profession.” Institute and Faculty of Actuaries, October 31, 2011. Online at:; accompanying spreadsheet:
  • Lazzari, Shaun, Celine Wong, and Peter Mason. “Dimension reduction techniques and forecasting interest rates.” Staple Inn Actuarial Society, July 17, 2012. Online at: Includes useful coverage of the PCA technique widely used in modeling yield curves.
  • Maher, J., J. Corrigan, A. Bentley, and W. Diffey. “An executive’s handbook for understanding and risk managing unit linked guarantees.” Institute and Faculty of Actuaries, October 20, 2010. Online:

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