Finance 432 Financial Risk Management of Insurance Enterprises Professor Stephen D’Arcy, FCAS

Course Website ~s-darcy/Fin432/2005/index.html

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What You Need to Be in this Course Familiarity with insurance terminology Fin 230 or 232 Understanding of investment instruments Fin 300 Strong math skills Calculus through Math 245 Statistics through Math 308 Linear algebra - Math 315 or 383 Spreadsheet competence

Why study financial risk management? Deal with financial market volatility Protect balance sheet from exposure to financial risk Understand derivative instruments and other risk management products Avoid misuse of derivatives –Accounting scandals –Excessive exposure to risk –Misleading financial analysts’ reports

Why the increased volatility? Foreign Exchange –Breakdown of Bretton Woods (early 1970s) Interest rates –New Fed policy (late 1970s) Commodity prices –OPEC shock (1970s)

Short-Term Interest

Long-Term Interest

Inflation

Impact of increased volatility on firms Transaction exposure –Underlying price change –FX: translation exposure Economic or competitive exposure –Changes in quantity

Examples: Transaction or Economic Exposures? A U.S. pension fund invests in yen- denominated bonds A U.S. P/C insurer issues policies in Australia A life insurer credits its policyholders’ cash values at a fixed rate of 5%

Answers: Transaction or Economic Exposures? Pension fund: Transaction exposure to fluctuating income/asset value P/C insurer: Transaction exposure, but also economic exposure since policy is more expensive as $AUD declines Life insurer: Economic exposure since it affects how policy will sell/lapse