What is the biggest risk for insurance?

The challenges of the past year have put pressure on all sectors, but for insurance, they are adding to an already complex landscape. The sector’s challenges all come with associated risks, often interconnected, demanding that boards and executive leadership need to continually assess if and where risk management sits on their agenda.

A quick review of some of the current complexities, particularly in the areas of general, life and health insurance, demonstrates the challenges at hand and ahead. This article considers these challenges, managing multiple interconnected complexities, the opportunity for insurers and questions for you to consider.

The rise in cybercrime risk is dominating concerns within the insurance industry, and it’s position as most urgent risk reflects serious concerns about both the ability of cyber criminals to attack insurers’ technology systems directly and the potential costs of underwriting attacks against policyholders.

In addition, it’s clear that the impact of climate change is a much nearer-term risk than previously perceived around the world, and in many cases the effects are already being felt. 

Thirdly, insurers have identified that regulatory risk is also a key concern particularly in light of the volume of regulatory change they are dealing with. 

Watch Karl Deutschle, Partner and Insurance Sector Leader, talk about the issues top of mind for insurers and how to mitigate these risks. 

All companies are subject to various risks:commercial, operational, legal, technical andfinancial risks. To protect from some of these risks and to cover their engagements, insurancecompanies set up provisions that they supplement to the liability of their balance sheet.

However, and contrarily to classical companies that disburse sums for the acquisition of raw material prior to being paid by the customer, insurance companies are subjected to a reversal of theproduction cycle that renders activity uncertain and that multiplies risks.

Within this scheme,policyholders are required to pay before benefiting later from possible service and whose amount may vary. In view of the number of engagements, their volume and the variability for each contract, the financial management of an insurance company required adapted financial tools and models.

Moreover, due to this reversed cycle of production, the benefits are provided more or less a long time after settlement of the premium. Insurers end up with a substantial amount of funds that they have to manage before providing their benefits..

In order to make sure that insurers can honor their engagements towards policyholders and contribute to corporate solvency, regulators have imposed strict rules on asset managers. Thesemeasures pertain to the evaluation ofengagements and to their coverage by means of secure assets.

Risks sustained by insurance companies

It is up to the appointed managers or actuaries to assess the financial situation of the company and the types of risks having the biggest impact on its operation.

Two major categories of risks are particularlyprejudicial to the solvency and the performance of insurance companies:

• Technical risks affect the liability of the balance sheet. They emanate from the very activity of the company and relate in particular to the frequency and severity of claims.
• Investment risks are the set of risks related to the insurer’s asset management.

While the basic approach designed to control the risk consists in, first, identifying the periodic flowsgenerated by the liabilities and second, finding most adapted investments to cover, amount by amount and date by date, management tools have gradually developed in order to take intoaccount the greatest number of factors.

To immunize against risks, insurers are today required to reduce the duration gap between balance sheet elements by selecting asset classes that are best adapted to market context and to interest rates in particular.

Insurance companies and technical risks

Technical risks relate in essence to the activity of the insurer. Premium and claims provisions areattributed to the balance sheet liability. Any insufficiency in these reserves due to premium calculation error or to misevaluation of outstanding claims may strain the company.

In this situation, insurers willstruggle to face their technical engagements. Main technical risks pertain to:

• Underpricing:, inherent to insurance operation, it is accounted for by the fact that rates are set before knowing the actual cost price of benefits. Underpricing may derive from a choice undertaken by the company in order to conquer or maintain market shares. It may also derive from involuntary methodological errors,
• Risk modification: Legal, economic and regulatoryevolutions, not anticipated the day of underwriting may modify the risk. This may be, for instance, the case of a new law for the amendment of the rules designed to compensate bodily prejudice in personal accident or motor insurance,
• Other risks inherent to insurance: Insurers may also be faced with an exceptional claim: badlyassessing risks awaiting payment or sustaining growth of general costs exceeding that of loadings.

Insurance companies and investment risks

They are about the set of risks related to the insurer’s asset management. They relate to:

• Credit risk: The credit risk or counterpart risk is when the debtor is unable to honor his initialobligation to refund the credit.

There are two kinds of counterparts depending on the quality of the defaulting party:

• Counterparty risk related to a defaultingeconomic operator, also called credit risk. It depends on the quality of the debts standing in the balance sheet assets of the insurer. The debts may, for instance, arise on the occasion of a pool in which a leading member may centralize payment from direct operations or from reinsurance contracts.
• Counterparty risk related to State defaulting or to that of its banking system. This risk is part of what is called systemic risk.

• Inflation risk: It is the risk sustained by the insurers when their inflation risk erodes performance rate of financial services or the revaluation rate of their savings contracts.
• Rate risks: it is a risk related to the variations ofinterest rates on bond markets that play out in two forms:

• Reinvestment risk (or declining rates) is the risk that performance rate assigned to future investments are below guaranteed rate related to insurance contracts. Reinvestment risk emerges when the life of assets (bonds) is below that of commitments. In case insurers are holding bonds having attained maturity, they are compelled to reinvest at unfavorable rate conditions.

Example of unfavourable investment in year 5. The asset value is lower than the value of the contract expiring in year 10.

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