RISK MANAGEMENT

Risk Management

Risk Management

Introduction

In recent years, the property-liability insurance industry has witnessed intense competition from alternative risk management techniques, such as large deductibles and retentions, risk retention groups, and captive insurance companies. Moreover, the next decade promises to bring additional competition from new players in the P/L insurance industry, including commercial banks and securities firms. In order to survive in this competitive new landscape, P/L insurers must manage total risk in a cost-efficient manner. This paper provides a rationale for P/L insurance risk management, and then describes four categories of risk management techniques utilized by insurers. Lastly, the paper closes with some general guidelines for cost-effective management of risk (Sandman, 2003).

Rationale for Property/Liability Risk Management

According to traditional financial theory, publicly owned corporations should be concerned only with undiversifiable, or systematic, risk; modern portfolio theory implies that corporate shareholders can eliminate unsystematic risk through portfolio diversification. More recent corporate risk management theories have suggested, however, that all corporations - public and private - must manage total risk, even after considering the benefits of individual diversification.

These newer theories emphasize the importance of internal cash flow as a source of financing, the implications of nonlinearity in the tax code , and the substantial costs of bankrupcy and financial distress. In addition, financial firms, including property/liability insurers, both stock and mutual, have three other unique reasons to manage total risk.

The first reason stems from the minimum regulatory solvency constraints that generally apply to these businesses. For many financial firms, franchise value, the opportunity to invest in positive-NPV contracts sometime in the future, comprises a significant portion of the firm's total value. If the firm's actual surplus falls below the minimum regulatory hurdle, the firm risks losing a substantial asset - its franchise value. Therefore, by limiting total firm risk to an acceptably low level, the firm protects this franchise value. Secondly, by managing its total risk, the financial firm secures a higher price for its products in the marketplace. This higher price results from the higher degree of security in the firm's promises.

This second rationale, however, may be less important in the U.S. property/liability industry, where policyholders are often protected by state guarantee funds. Nevertheless, recent research suggests that competitive P/L insurance premiums are negatively related to default probabilities, even in the presence of guarantee funds.

Insurance Capital As A Tool For Managing Risk

Conceptually, the simplest method for managing the firm's total risk is to raise enough capital to reduce the probability of default to an acceptably low level. Harrington, et al., emphasize three significant costs to a P/L insurer of raising and holding capital: double taxation, agency costs, and asymmetric information . As shown below, the importance of these costs has been overestimated in the current literature.

Double Taxation and Insurer Capital

P/L insurers largely overcome the problem of double taxation through two investment techniques: (1) offsetting taxable bond interest with insurance underwriting losses, thereby passing through the higher return on debt to the shareholder as a lower-taxed equity return3; and (2) ...