David F. Babbel

Financial Risk Management by Insurers: An Analysis of the Process

On-site visits to financial service firms were conducted to review and evaluate their risk management systems. In the insurance sector, this evaluation covered prominent life/health and property-liability insurers, both in the United States and abroad. The information obtained covered both the philosophy and the practice of financial risk management. This article outlines the results of this investigation. It reports the state of risk management techniques in the industry. It reports the standard of practice and evaluates how and why it is conducted in the particular way chosen. In addition, critiques are offered where appropriate. We discuss the problems which the industry finds most difficult to address, shortcomings of the current methodology used to analyze risk, and the elements that are missing in the current procedures of risk management.

The Relation Between Capital Structure, Interest Rate Sensitivity, and Market Value in the Property-Liability Insurance Industry

The choice of financial structure is appropriately viewed as a complex, multidimensional decision by insurer management. Specific attention is given to traditional theories regarding capital structure, including the tradeoff between the tax benefits and increasing probability of incurring the cost of financial distress associated with leverage, and the tradeoff between protecting franchise or charter value and expropriating value through increasing exposure to interest rate risk. Within this framework, the relation between leverage, interest rate sensitivity and firm value is investigated in the property-liability insurance industry. Equity value, as gauged by Tobins q, is determined to be related to an insurers choice of financial structure. It is shown that the market value of equity at first grows but then later declines as leverage increases. Interest rate risk has the opposite effect. Equity value first declines with interest rate risk, but then rises at high levels of interest rate risk. These results are consistent with the prediction that financial institutions will expend scarce resources to control risk in order to protect franchise value and may indeed be signaling the existence of these valuable intangibles via these actions.

Inflation, Indexation, and Life Insurance Sales in Brazil

Insurance industries in a growing number of countries are experimenting with indexed life insurance policies, in an effort to mitigate the value erosion produced by inflation. The present study focuses on life insurance in Brazil, before and after the advent of indexation. During both periods, rate regulations in that country have made life insurance more expensive when inflation is anticipated. The method of indexing did not correct his problem. Therefore, insurance sales are expected to decline in inflationary periods. Empirical evidence from Brazil reinforces this expectation, resulting in regulatory and indexing implications. Inflations impact upon life insurance contracts and sales has been of increasing concern to both consumers and the insurance industry. Insurance industries in a growing number of countries are experimenting with indexed life insurance policies, whose nominal values are linked to some price index. These steps are taken in an effort to mitigate the value erosion engendered by inflation. It has been shown elsewhere [5, 7] that anticipated inflation coupled with constraining regulations can lead to higher perceived real costs of life insurance, even when policies are index-linked. Accordingly, life insurance sales can be expected to decline in inflationary periods. The purpose of this paper is to provide a systematic treatment of the influence of inflation on rational life insurance purchases, and to investigate empirically life insurance consumer response in Brazil to inflation and the advent of indexed policies. This paper is divided into three sections. In Section I, a theoretical model is developed to examine rational life insurance purchases under inflation. The construction and crucial assumptions of the model were inspired by and derive support from the economic environment and institutions that have characterized Brazil during recent decades. The first section concludes with some theoretical propositions that are subjected to empirical analysis in Section II.

Extracting Probabilistic Information from the Prices of Interest Rate Options: Tests of Distributional Assumptions

Return distributions in general and interest rates in particular have been observed to exhibit skewness and kurtosis that cannot be explained by the (log)normal distribution. Using g-and-h distribution we derived a closed-form option pricing formula for pricing European options. We measured its performance using interest rate cap data and compared it with the option prices based on the lognormal, Burr-3, Weibull, and GB2 distributions. We observed that the g-and-h distribution exhibited a high degree of accuracy in pricing options, much better than those other distributions in extracting probabilistic information from the option market.

The Liability maze : the impact of liability law on safety and innovation

With an ever-increasing number of liability lawsuits, are corporations electing to play it safe rather than risk the uncertainties accompanying innovation? In The Liability Maze experts address the issues surrounding safety and innovation and present the most detailed and comprehensive study to date on the actual impact of U.S. liability law. In recent decades it has been widely assumed that liability laws promote safety by significantly raising the price companies must pay for negligence, product defects and accidents. More recently, others have suggested that the broad and unpredictable sweep of these laws actually deters innovation. The risks of lawsuits are so great that corporations are showing more caution in product innovation than ever before. The contributors focus on five sectors of the economy where the liability system appears to have had the greatest effects, positive or negative: the private aircraft, automobile, chemical, and pharmaceutical industries, and the medical profession. They suggest that in many sectors liability law has hampered innovation. In others it has stimulated safety improvements, although perhaps not so much as vigilant safety regulations.

Fair Value of Liabilities: The Financial Economics Perspective

Abstract In this paper we present the fundamental approaches of financial economics to valuation. Three methods are demonstrated by which financial economists account for risk. We illustrate how these methods relate to one another and how they can be applied in the valuation of risky corporate bonds, guaranteed investment contracts (GICs) with and without interest rate contingencies, and whole life insurance. Next, we discuss how these models treat orthogonal risks, such as the kind often covered by insurance contracts. Demand side and supply side diversification are treated, and liquidity risk is then considered. We conclude with a summary of the benefits of decomposition and transparency.

The Effect of Transaction Size on Off-the-Run Treasury Prices

This paper examines intra-day trading data from the inter-dealer broker market for U.S. Treasury securities and measures the degree of price pressure in the off-the-run Treasury market. As is well known, securities that would appear to be very close substitutes, i.e., on-the-run and off-the-run Treasury bonds, behave as if there is some degree of market segmentation. This is the first systematic study of the off-the-run Treasury note and bond market focused entirely on a price pressure effect using intra-day data. The paper analyzes price pressure through matched pairs of securities that differ only in liquidity.

Scenario Analysis in the Measurement of Operational Risk Capital: A Change of Measure Approach

At large financial institutions, operational risk is gaining the same importance as market and credit risk in the capital calculation. Although scenario analysis is an important tool for financial risk measurement, its use in the measurement of operational risk capital has been arbitrary and often inaccurate. We propose a method that combines scenario analysis with historical loss data. Using the Change of Measure approach, we evaluate the impact of each scenario on the total estimate of operational risk capital. The method can be used in stress-testing, what-if assessment for scenario analysis, and Loss Given Default estimates used in credit evaluations.

An Analysis of the Financial Risk Management Process Used By Life Insurers

The past decade has seen a dramatic rise in the number of insolvent life insurers. The ostensible causes of these insolvencies were myriad. Some of the insolvencies were precipitated by rapidly rising or declining interest rates. Others resulted from losses on assets such as junk bonds, commercial mortgages, CMOs, real estate, and derivatives. Mispricing of insurance policies hurt still others. The “churning” of policies by unscrupulous sales agents, insolvencies among the reinsurers backing the policies issued, noncompliance with insurance regulation, and malfeasance on the part of officers and directors of the insurance companies affected some as well. But despite the numerous and disparate apparent causes of these insolvencies, the underlying factor in all of them was the same: inadequate risk-management practices. In response to this, insurers almost universally have embarked upon an upgrading of their financial risk management and control systems to reduce their exposure to risk and better manage the amount they accept. In short, the industry has turned to financial risk-management techniques as a way to improve performance.

Scenario Analysis in the Measurement of Operational Risk Capital: A Change of Measure Approach: Scenario Analysis in the Measurement of Operational Risk Capital

At large financial institutions, operational risk is gaining the same importance as market and credit risk in the capital calculation. Although scenario analysis is an important tool for financial risk measurement, its use in the measurement of operational risk capital has been arbitrary and often inaccurate. We propose a method that combines scenario analysis with historical loss data. Using the Change of Measure approach, we evaluate the impact of each scenario on the total estimate of operational risk capital. The method can be used in stress�?testing, what�?if assessment for scenario analysis, and Loss Given Default estimates used in credit evaluations.