Actuarial Risks: Operations and Markets

Pure risk is defined as a situation that involves a chance of loss without chance of gain. A good example of a pure risk is the chance that a fire will happen or it will not. Traditionally, pure risks have been considered insurable. In today's complex world, there are many risks that may fall into the category of pure risk- but are not insurable. Examples of these risks are acts of terrorism, pandemics or major catastrophic events. Insurers are struggling to deal with uncertainty in insurance markets in an increasingly risky world. Insurers rely on historical data to model risks and determine what premiums are needed to cover the risk of loss. Insurers are not able to model risks for many of today's pure risk scenarios because there is not sufficient data on which to base risk models or premiums. In some cases, insurers are not able to insure against pure risks because the premium costs are not reasonable. In some cases, corporations are choosing to self-insure against large risk scenarios. Today's insurance marketplace is faced with challenges in creating and maintaining sufficient capital through selling premiums. Insurance companies and reinsurance companies are integrating their risk strategies with financial markets to greatly increase equity capital and disperse risks across broad financial markets. Some of the instruments being used today are CAT bonds and sidecars which allow investors in equity markets to diversify their investment portfolios while infusing needed equity capital into insurance markets.

Keywords Cat Bond or Catastrophic Bond; Illiquidity; Indemnity; Industry Loss Warranties (ILWs); Insurance Linked Securities; Insurance Securitization; Law Of Large Numbers; Portfolio Insurance; Pure Risk; Pure-Risk Hedging; Reinsurance; Retrocession; Sidecar; Speculative Risk

Actuarial Science > Actuarial Risks: Operations & Markets

Overview

The best case scenario of a pure risk situation is that no threats to an asset occur. In other words, if a company insures its building against the danger of fire and no fire occurs, that is the best case scenario of insuring against the pure risk of fire. The insurance against a pure risk offers no option for a company to profit. "Pure risk is basically the risk to an organization resulting from physical, environmental or human threats to a business or part of that business. It might include such things as fire, flood, earthquake, accidents, injuries, industrial action, kidnapping, hostage taking, sabotage, plant failure, theft and fraud, just to name a few. As you might imagine, all of these scenarios are likely to result in major losses and require preventative action where necessary (or possible)" (Pure Risk Rating, 2004, Glossary).

The Use of Insurance

“Insurance works best for high-frequency, low-severity events, which are statistically independent and have probability distributions that are reasonably stationary over time” (Cummins, 2006, p.337). Insurers are in the business of assuming risk for individuals and businesses. In order for insurers to remain financially solvent and insure sufficient capital to pay claims, the insurers must apply what is known as the law of large numbers. In essence, insurers diversify their risk by pooling large numbers of policies together and relying on statistical models to insure that payouts are less than premiums collected from policy holders. Statistical modeling also allows insurers to predict losses using historical data that samples loss distributions. Insurers rely on multi-year data to project losses and estimate premiums based on the models. Historical data allows insurers to predict future losses and raise needed capital through premiums based on those projections. When heavy losses occur in a short period of time, insurers have difficulty estimating premiums and capital needs. Insurance companies do much better at insuring high frequency and lower impact events that can be modeled and quantified.

Statistical models currently predict that a major catastrophe is likely to happen in coming decades. A high severity event resulting in greater than $100 billion of losses in a high population state such as California or Florida could swamp the traditional insurance and reinsurance market. While such an event has the potential to adversely impact an insurer's capital reserves, financial markets could easily absorb such losses and have little noticeable impact on investors. "Securitization extends the scope of diversification from insurance and reinsurance markets to the entire securities market" (Cummins, 2006). The diversification of insurance to financial markets is seen most obviously in the rise in popularity of CAT bonds and Sidecars which will be discussed later in this essay.

The current market in the insurance industry can be termed as a hard market. "Hard markets are triggered by capital depletions" (Cummins, 2006). From a historical perspective, the early 1980s saw a depletion of capital which resulted from a high number of commercial liability claims, coupled with a drop in interest rates. A similar market impact was experienced from 1990- 2001 and was the result of Hurricane Andrew, the California earthquake in Northbridge and the 2001 terrorist attacks in New York and Washington. While the events in these two scenarios are different, the resulting impact on insurance markets was remarkably similar (Cummins, 2006).

Prior to 1986, the number of catastrophic events occurring in a year was fewer than 150. Since 1993, the number has increase to more than 270 a year. The most costly of these disasters have disproportionately occurred in recent decades. Hurricane Katrina, the mostly costly natural disaster ever, had projected losses of $40-60 billion- compared with the World Trade Center attacks at $40 billion and Hurricane Andrew at $22 billion (Cummins, 2006).

Applications

The New Sources of Risk

Today there are new sources of risk including: Terrorism, pandemics and increasing major chance of catastrophe. Catastrophes happen more often and they are more expensive than ever. Many companies that operate in global markets rely on supply chains that may be compromised by unforeseen events. Acts of terrorism target business with the hopes of disrupting business enterprise on a wide scale. The threat of terrorism poses many risks to corporations and markets — many of which have little experience upon which to model potential risks. Because many of the threats facing businesses today are new and their potential impact is not well known, much new risk is not insurable. For example, there is no insurance available to protect a company against the loss of employees due to a pandemic. The best that traditional insurers can offer is worker compensation insurance that might cover part of the loss associated with a large-scale pandemic.

Insuring Against Pure Risk

At the same time that companies find that there is no insurance available to insure against some risks, insurers are also cutting capacity (of available insurance) and raising rates. The following example illustrates the challenges that face companies in adequately insuring against pure risks. Florida's Memorial Healthcare system was faced with the following scenarios in 2005 and 2006. The bullets represent: $ coverage, $ deducible and $ cost of premiums paid (Millman, 2007).

In 2005:

• $1.2 billion in coverage
• $60 million deductible
• $4.5 million in premiums

In 2006:

• $100 million in coverage
• $100 million deductible
• $12.5 million in premiums

To summarize, in 2006, Memorial healthcare was only able to secure 10% of its previous year's coverage, but that 10% cost three times the previous year's premiums. The result was that Memorial Healthcare opted to go without insurance coverage in 2006 because the insurance was no longer affordable. This "hard market" scenario is forcing companies to re-evaluate their risk management strategies, but some see a silver lining. In the case of Memorial Healthcare, the hospital decided to pool its risks with several other hospitals rather than have the traditional insurance industry handle the risk. This approach allows participants in similar industries to assess likely risks and focus on insuring against the most likely. This option offers specificity of risk coverage that might not be available from traditional insurers.

Self Insurance

The upside of corporations opting out of the tradition insurance market is that shareholders in public companies stand to do better from an investment standpoint. Because publicly-traded companies already trade their stocks in equity markets, they are well positioned to absorb potential risks. "Corporations can take on risks that individuals have a harder time managing" (Millman, 2007). Self insurance is not a new concept; most business and individuals accept some responsibility for self-insurance. The risk that businesses and individuals are willing to self-insure is typically defined as the premium's deductible. The term "retention" is the industry term for what the client is willing to pay out of pocket. The retention amount represents the maximum out of pocket "loss" that an individual or entity can incur that will not result in financial hardship (Okumura, 2007).

In the "text book" sense, an entity usually insures against large losses and self insures against small ones. From a statistical standpoint, small losses usually occur from common events and happen frequently and independently; so, the law of large numbers is applicable. Companies usually get their money's worth from insuring against small loses; insurers settle claims without dispute, pay on claims and even offer guidance about how to avoid future claims. In the case of oil giant British Petroleum (BP) the company has decided to buy insurance coverage for small events and self-insure for high impact risk events. The following points illustrate why this strategy is attractive to BP:

• Equity in capital structure is a successful risk management technique.
• BP can self-insure using its equity cushion.
• BP has significant diversity in its operations, in-depth industry knowledge and the willingness to hedge against potential risks.

Challenges

Today, one of the biggest challenges for insurers offering affordable coverage is that there's "no depth of actuarial records" for modeling catastrophic risk. The insurance industry must then rely on statistical modeling rather than actual historical records. In some cases, statistical models have proven wrong. For example, the models used in projecting losses for the 2004-2005 Atlantic Hurricane seasons grossly underestimated the cost of labor and building materials that would be needed for reconstruction.

BP has many physical assets that it insures; these assets include: Drilling facilities, refineries and pipelines. There are pure risks associated with oil spills and fires which can cripple the company's core business and sometimes cost lives. BP has its roots in the traditional manufacturing and production sector of the economy and therefore has a need to insure its physical assets. Today's economy has moved from a mostly industrial-based and manufacturing economy to one that generates knowledge. The impact that the new economy has posed to insurers is well illustrated in the following passage (Chase, 2002):

Insuring Intangible Assets

Patents, trade secrets and customer relationships are considered intangible assets; these assets often have a high monetary value associated with them. Unlike a company's tangible assets such as buildings, machines, and physical inventory, intangible assets are difficult to assess in terms of their dollar value. In some companies, intangible assets are the lion's share of the value of an organization and as such, the risk to these assets can be very high. Traditional insurance policies can be thought of as a promise to pay money to a policy holder when a defined, insured, event takes place. If a fire destroys a company's warehouse, insurance covers the cost of the building and its contents and allows the company to re-build if desirable.

Difficulties

It is difficult to find agreement on the definition of an intangible asset, and therefore one may not be surprised that it is equally difficult to assess appropriate risk. How does one determine the financial loss of a trade secret that is lost? The "replacement value" of intellectual property is difficult if not impossible to determine. In many cases, insurance covers the cost of defending a challenge to a particular piece of intellectual property (IP)-rather than assessing an actual value. Ideally, insurance companies would treat intangible assets such as IP in exactly the same way as any other form of property. A policy would protect the commercial value of IP just the way it would protect a factory (Chase, 2002).

Banks have had similar difficulty in valuing intangible assets. A company's tangible assets are typically the collateral used in borrowing and securing credit. Not surprisingly, a company with mostly intangible assets well may have difficulty borrowing against its intangible assets to fund growth and expansion. The answer in all of this may be an insurance policy that is modeled like business interruption insurance. Rather than placing a value on the vale of an IP asset, the value could be calculated as the impact of the loss of profit if the asset is compromised.

Yamaha Corporation of America is one company that has struggled with the issue of protecting its intangible assets. Yamaha has business interruption insurance that covers the loss of profits due to an interruption, but the policy doesn't cover future losses that might result from the same event. Yamaha conducted a survey of its customers to see how many customers the company might lose as a result of a business interruption. The survey revealed that there was a potential to lose some important customer relationships and there is not traditional means of insuring against this type of loss. Toyota Motors is also concerned with protecting its relationships with vendors and customers in the event of a catastrophic event. Toyota and Yamaha are acutely aware that "business continuity relies on continuity of suppliers"(Millman, 2007) and these relationships have great value-even if the value is intangible.

Insurance Securitization

Insurance markets will need to adapt to the changing scope and needs of today's markets. Even as companies seek to mitigate risk and use intrinsic value to self-insure, there is clearly a need for insurance markets to respond to the changing marketplace. One of the solutions that insurance and reinsurance companies are leveraging is in the area of insurance securitization.

The "rationale for the increasing interest in securitization is easy to comprehend. Insurance markets operate most efficiently when individual losses due to a certain peril are random, easily measurable, and uncorrelated among exposure units. In such cases, losses can be spread efficiently across a large number of policyholders while the risk of failure for primary insurers is minimized. Insurance markets, however, have difficulty dealing with catastrophic or 'uninsurable' risks which have a low probability of occurrence and a high severity of losses" (Carayannopoulos, Kovacs & Leadbetter, 2003).

Issues

Catastrophic Risk Transfer

Catastrophic events are defined by some as pure risks, while others contend that many catastrophic events are generally not insurable. While it is possible for an individual to insure his or her home against fire or flood, the issue of wide spread (geographically dispersed) catastrophe has added a new dimension to what is now defined as a pure risk. While individual policy holders may be able to collect on a single claim or even a relatively small number of claims, a wide reaching fire that resulted in high numbers and dollars of claims, could cripple an insurer. Such was the case in 1992 when Hurricane Andrew struck Florida. The devastation caused by Hurricane Andrew resulted in the collapse of 60 insurance firms (Tourne, 2007) and re-focused attention on the vulnerability of insurance providers to remain solvent in the face of wide reaching catastrophic events.

Insurance securitization has emerged as a new tool to help mitigate the risk of insuring catastrophic and other types of pure risks in an increasingly risky world. Insurance companies are assessing their risk management programs from a "total financial risk management approach" (Carayannopoulos, Kovacs & Leadbetter, 2003) where insurers linking bundles of insurance risk to securities. The "securitization of insurance risk transfers underwriting risks to the capital markets through the creation and issuance of financial securities" (Carayannopoulos, Kovacs & Leadbetter, 2003).

Insurance is the main form of risk transfer and securitizing risk is one way that catastrophic and other risk is being transferred. The Alternative Risk Transfer Market is similar in some ways to tradition reinsurance, but instead of transferring the risk to other insurance companies, investors who buy the securities are taking on the risk. The linking of insurance and securities are referred to as, risk linked securities or insurance linked notes (or securities) (Catastrophic Risk Transfer, n.d.).

Key Drivers behind the Expansion of Insurance Linked Securities

Several factors have combined in recent years to cause insurers and reinsurers to look more seriously at alternative sources of risk capacity ( Bradley & Pickup, 2007):

• New sources of capital were needed by loss-affected insurers after the 2004-2005 hurricane seasons. Insurer's needed to re-stock balance sheets as rates hardened.
• Recalibration of catastrophic models resulted in the need for increased capital. Models predicted a greater frequency of severe climatic events and therefore more capital requirements were needed.
• Increasing insurance rates due to increased claims and retrocessions (re-insurance companies selling risk to other re-insurers).
• Demand from investors for new opportunities to diversify portfolios and gain higher returns.
• More risk-based regulation placed upon insurers through accounting and rating agency scrutiny. Insurers are looking for ways of transferring risks because traditional insurance solutions are no longer feasible.
• Regulators and rating agencies view transfer of risk out of insurance industry and increased collateral in a more favorable way.

One popular mechanism for transferring insurance risks from insurers to investors is with the issuance of catastrophic bonds which are often referred to as CAT bonds. CAT bonds are one type of insurance linked security (ILS). The CAT bond market made its debut in the 1990s and grew in response to the huge losses the resulted from Hurricane Andrew (Tourne, 2007) and the Northbridge CA earthquake.

CAT Bonds

CAT bonds are issued from a trust that is created called a special purpose reinsurance vehicle (SPRV). Premiums from the "insurance company and the proceeds from investors are pooled into a special purpose vehicle (SPV), usually operating in a tax-friendly environment, which serves as a fully collateralized (no credit risk) source of recovery for the insurer" (Carayannopoulos, Kovacs & Leadbetter, 2003).

Investors benefit from buying CAT bonds in a couple of ways. CAT bonds are a popular way for many investors to diversify their portfolios and CAT bonds pay a higher rate than other bonds because they are generally a riskier. CAT bonds are only sold to institutional investors and the market is growing quickly. "Catastrophe bond issues grew to almost two billion dollars in value in 2005, prior to Hurricane Katrina ravaging the US Gulf coast, but today the market for such instruments is worth almost five billion dollars" (Tourne, 2007, ¶4).

"Cat bonds also offer insurers and reinsurers a way to spread their risks against a sudden liquidity crunch in the wake of vast storm, some of which rack up billions of dollars in property damage" (Tourne, 2007, ¶8). The downside of CAT bonds includes high yields paid to investors if no claims are made and the bonds also incur high administrative costs (Catastrophic Risk Transfer, n.d.).

CAT funds are not very liquid and investors stand to forgo the interest and/or principal payments that are typically associated with bonds. If a catastrophic event happens, investors may have to defer payments or even skip getting payments altogether-depending upon the terms of the CAT bond. The lack of liquidity with CAT funds (typical bond maturity may be 20 years) has spawned another option for insurance linked security (ILS) which offers investors a high rate of return on their investment and a relatively liquid investment vehicle; this vehicle is known as a sidecar.

Sidecars

Sidecars have become popular with insurers as a way to underwrite more business without pumping up their balance sheets. These "limited purpose companies share the risks of certain policies with the underwriter in exchange for a portion of the premiums" (Moyer, 2006, ¶3). The investors stand to make double-digit returns, or lose everything.

Sidecars are set up by reinsurance companies with funds from outside investors; the commitment from investors is typically two to three years. Hedge funds are fueling a new frenzy of investment in the property catastrophe reinsurance industry (Moyer, 2006) and sidecars are one of the most popular investment opportunities. Like CAT bonds, investment proceeds are put in a trust that pays interest and profits if claims are not paid out. "These investors have poured $3 billion into sidecars since late last year, in expectation that recent price increases in reinsurance, or cover for insurers, will generate returns as high as 30 percent. The vehicles are attractive to investors looking to get into the reinsurance business without any underwriting experience" (Zuill, 2006).

Sidecars are designed to last two or three years and then self-liquidate or renew, depending on market conditions. If premiums stay high, many of the sidecars will likely renew. If they fall, or if industry losses are so steep that they trigger losses in the sidecars, they will lose some of their luster as investment opportunities. Sidecars dangle the potential for returns that are far higher than those of catastrophe bonds, which typically have returns around 10% and also attract investments from hedge funds and private equity firms (Moyer, 2006).

Hedge funds and private equity investors are happy to speculate in the insurance investment space, but the risks to investors are high. "The severe 2005 hurricane season wiped out a $650 million sidecar, Olympus Re, arranged in 2001 by White Mountain Insurance Group" (Moyer, 2006). Some players have already lost big money (Zuill, 2006), but many are willing to play the odds. With relatively benign hurricane seasons like 2007, the returns on sidecar investments could be 20-30%.

Terms & Concepts

Cat Bond or Catastrophic Bond: A high-yield, insurance-backed bond including provisions for delaying interest and/or principal payments in the event of major loss due to disasters such as earthquakes.

Illiquidity: Refers to a state of not being readily converted into cash.

Indemnity: Refers to the actual covering of insurance losses.

Insurance Linked Securities (ILS): See cat bond.

Industry Loss Warranties (ILWs): See cat bond.

Law of Large Numbers: A theorem that if a larger number of exposures are considered, the predicted losses will more closely equal the true probability of loss. The statistical expectation of loss determines permium rates and is founded on this principle.

Insurance Securitization: The allocation of underwriting risks to the capital markets through creating and issuing financial securities.

Pure Risk: Refers to a situation where the only options are loss or no loss and there is no chance of gain. These risks are insurable. For example, your house can either burn (loss), or it can not (no loss).

Speculative Risk: A risk where it is unknown whether the final outcome will be a gain or a loss, such as gambling. These types of risks usually cannot be insured.

Pure-risk Hedging: A strategy used by investors when they are uncertain about the future movements of the market. A perfect hedge is one that reduces the potential risk to zero (not including the cost of the hedge). For example, investors of sidecars are betting that the hurricane season will be light and few claims will be paid.

Portfolio Insurance: An insurance strategy involving hedging a stock portfolio against market risk through selling stock index futures short or purchasing stock index put options.

Reinsurance: Reinsurance refers to when an insurance company buys coverage from a second insurance company for risk that the original company is already insuring. This policy reduces vulnerability by spreading possible losses among more companies.

Retrocession: Retrocession refers to the practice of reinsurance companies buying reinsurance for themselves from other reinsurance companies, known as retrocessionaires. When a reinsurance company does this they are called the retrocedent.

Sidecar: These limited purpose companies share the risks of certain insurance policies with the underwriter in return for a fraction of the premiums.

Bibliography

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Cummins, J. (2006). Should the government provide insurance for catastrophes? Review, 88, 337-379. Retrieved November 13, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=21583370&site=ehost-live

Friedman, S. (2004). Risk managers clam up when media call. National Underwriter / Property & Casualty Risk & Benefits Management, 108, 21-22. Retrieved November 8, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=12925742&site=ehost-live

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Millman, G. (2007). Managing catastrophic risk. Financial Executive, 23, 28-32. Retrieved November 8, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23592487&site=ehost-live

Moyer, L. (2006). Hedge funds' sidecars. Forbes.com. Retrieved November 13, 2007, from http://www.forbes.com/business/2006/07/26/hedge-funds-sidecars-cx%5flm%5f0726hedge.html

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Okumura, K. (2007). Alternative risk-management strategies. Advisor Today, 102, 26-28. Retrieved November 8, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=26502423&site=ehost-live

Pimbley, J. M. (2012). Bond Insurers. Journal Of Applied Finance , 22, 36-43. Retrieved November 20, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=76363343&site=ehost-live

Powers, M. (2006). Pure vs. speculative risk: False choice; sham marriage. Journal of Risk Finance. Retrieved November 9, 2007, from http://astro.temple.edu/~powersmr/vol7no4.pdf

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Tourne, I. (2007). Catastrophe bonds a market answer to hail or high water. Agence France-Presse. Retrieved November 13, 2007, from http://www.terradaily.com/reports/Catastrophe%5fBonds%5fA%5fMarket%5fAnswer%5fTo%5fHail%5fOr%5fHigh%5fWater%5f999.html

Zuill, L. (2006). Insurance sidecar investors on white-knuckle ride. Reuters.com. Retrieved November 13, 2007, from http://today.reuters.com/news/articlebusiness.aspx?type=bankingFinancial&storyID=nN11454695&pageNumber=0&imageid=&cap=&sz=13&WTModLoc=BizArt-C1-ArticlePage3

Suggested Reading

Coglianese, C., & Marchant, G. (2004). Shifting sands: The limits of science in setting risk standards. University of Pennsylvania Law Review, 152, 1255-1360. Retrieved November 8, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=13041444&site=ehost-live

Friedman, S. (2004). Risk managers clam up when media call. National Underwriter / Property & Casualty Risk & Benefits Management, 108, 21-22. Retrieved November 8, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=12925742&site=ehost-live

Never the twain shall meet? (2007). Reactions, 27, 74-78. Retrieved November 13, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=24693828&site=ehost-live