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Home > Insurance Markets Viewpoints > Toward a Deeper Understanding of Risk in the Insurance Sector

Insurance Markets Viewpoints

Toward a Deeper Understanding of Risk in the Insurance Sector

by Alex McNeil

Introduction

Alex McNeil is the Maxwell professor of mathematics at Heriot-Watt University, Edinburgh. He was formerly assistant professor at ETH Zurich. Professor McNeil has a BSc from Imperial College, London, and a PhD in mathematical statistics from Cambridge University. He has published papers in leading statistics, econometrics, finance, and insurance mathematics journals and is a regular speaker at international risk management conferences. He is joint author of the book Quantitative Risk Management: Concepts, Techniques and Tools (2005). Professor McNeil is the director of the Scottish Financial Risk Academy, which aims to provide financial service companies with an efficient, streamlined framework for exploring complex issues of risk and related topics, in partnership with academia.

In 2010 you were instrumental in the setting up of the Scottish Financial Risk Academy, a forum for academics with expertise in risk management, to work with the finance sector to enhance the understanding of various forms of financial risk. How has that progressed?

In September 2011 the Scottish Financial Risk Academy held its third biannual colloquium, where we had speakers from academia, industry, and regulatory bodies. The focus of the colloquium was Solvency II, the new regulatory standard for the insurance industry. The implementation date for Solvency II is 2013, and institutions across the sector are currently involved in trying to understand both how Solvency II will affect them specifically, and in looking at a number of outstanding issues with Solvency II that have yet to be resolved. What came out of the colloquium was a clear sense that there are still one or two ongoing challenges with Solvency II. We looked at the outstanding technical issues and how they might be best addressed.

In particular there are a lot of questions about MCV, or market-consistent valuation. There are well-known concerns from the regulator on the procyclical effects of marking to current value, where you mark up the value of your liabilities when interest rates are low and mark down the value of your assets in falling markets. The net effect of this when you have a situation such as we saw in October 2011, when falling markets were accompanied by continuing ultra-low interest rate regimes, is of course to make the solvency position of any institution look considerably worse than it might turn out to be. The risk is that the view provided by marking-to-market may prompt dramatic interventions on issues that may well not require action. One result could be that a regulator could end up calling for capital ratios to be enhanced at exactly the time when this would hurt firms the most.

Does the fact that the life sector, for example, writes extremely long-term contracts pose particular challenges?

One of the characteristics of the insurance industry is that organizations have long-term liabilities going into the future, and how they value these liabilities can have a really material impact on views of the solvency of those organizations. No one is arguing that the industry should move away from MCV, but it is recognized that certain kinds of liability are very hard to replicate or hedge, particularly when the maturity date for the liability could be like 30 to 40 years in the future. It is clear that mathematical techniques have a very important contribution to make here.

Another debate in the industry is how to account for liquidity in the valuation of liabilities. There is still some debate as to whether liabilities can in fact be valued in a way that respects the fact that insurance companies will back their liabilities with the cheapest assets possible. They can pursue buy-and-hold strategies with less liquid assets, such as off-the-run securities rather than on-the-run, and they can use the asset cash flows to cover liability outgoings. Because these assets are cheaper for them to obtain, they want to have this taken into account in the valuation of long-dated liabilities. So the question arises as to what value to place on liquidity as an end in itself. There is a tremendous amount of literature on the theme of liquidity premiums.

In essence, the liquidity premium is the difference between the prices of a liquid and an illiquid asset, assuming both to be equivalent. The more liquid asset is easier to deal in and has correspondingly lower dealing costs. It follows from this is that liquid assets trade at a premium over more illiquid assets, and that premium, arguably, needs to be taken into account when matching assets against future liabilities. This is just one complexity among many when computing the solvency position of an insurance company.

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