Financial Risk Management of Insurance Enterprises Measuring a Firm’s Exposure to Financial Price Risk

Overview w What is a risk profile? w How do we measure risk exposure? w What information sources are available to measure risk exposure? w What internal measures are used? w What market-based measures are used?

Key to analyzing risk exposure: Correlation Analysis w Do cash flows fluctuate with some underlying financial variable? Do inflows decrease as interest increases? Do outflows increase as the exchange rate decreases? w Does the firm’s stock price change as key variables change?

Correlation Review w Definition: degree of the relationship between variables  If ρ = 0, no correlation (independence)  If ρ = 1, there is perfect correlation w In EXCEL, use CORREL function

Correlation Review (cont.)

Risk Profile w Graphical summary of relationship between two variables w Example: As interest rates increase, S&L value decreases

Risk Profile (Cont.) w NOTE: For S&Ls, this risk profile is apparent from the balance sheet The balance sheet lists long-term vs. short-term assets and liabilities w Economic exposures require more work Example: Construction company will be affected by higher interest rates w Enter correlation analysis

Gap Analysis w Gap analysis is frequently used in banking as a crude measure of interest rate exposure w For a given maturity, the gap is defined as the value of assets with that maturity less the liabilities of the same length If a floating-rate note resets quarterly, it is put in the 3-month gap w If gap>0, firm benefits from increase in interest (Why?)

Sources of Information for Financial Risk Exposure w Financial Statements (Note: Beware of accounting tricks) Balance sheet - including notes Income statement - including notes Statement of changes in financial position Letter to shareholders w Internally generated reports w Stock price movements

Balance Sheet w Liquidity risk Compare short-term assets vs. liabilities Indicates ability to survive short-term shocks Look at industry average for accounting ratios w Leverage Review outstanding debt vs. equity Indicates cushion for longer maturity shocks w Foreign assets/liabilities reveals FX exposure

Balance sheet (cont.) w Interest rate exposure Review outstanding interest-bearing assets or liabilities Are they floating or fixed rate? w Footnotes can illustrate exposures Explain questionable accounts Detail contingent exposures

Income Statement w How well is firm handling debt payments? w Is there any foreign income or expense? w Can we determine any historical relationships? May need more frequent reports than annually

Other Announcements w Can explain good/poor performance and the reason for it w Can give hints on future w Examples: Letters to shareholders Press releases

Internal Measures w Use detailed cash inflow/outflow reports to perform regressions against: Interest rates Exchange rates Commodity or equity prices w Monte Carlo Simulation Model financial results (need assumptions) w Can be entire firm or a line of business

External Measures w Based on market price of stock Why does State Farm not use this approach? w Measure correlation of stock price with key financial variables R t = a + b i F it R t is stock return; b i is sensitivity measure to factor i; F it is level of factor i w Duration measures change in value for a given change in the interest rate

In the first four lectures, we have constructed a foundation... w Why risk management is essential in a volatile financial world w Why actuaries can play a key role in managing risk, but that they must learn the language of finance w Why insurers can do a lot more to improve their risk management systems w How to begin to analyze a firm’s exposure to financial risk

Next... w We will build the second level of our pyramid and fill our toolbox with: A review of cash flow valuation (Next time) A description of financial instruments used in financial risk management A description of the approaches used to hedge financial risk Use our tools to cap the pyramid You are here