Finance 432 Managing Financial Risk for Insurers Professor Stephen D’Arcy, FCAS

Course Website ~s-darcy/Fin432/2007/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

Examples and Applications Savings and loan industry Life insurance industry Recent financial disasters

The Savings & Loans Business - The Good Years S&L assets mostly long term maturity mortgages S&L liabilities usually short term savings deposits Pre-1980s, upward sloping yield curve is formula for success –Earn 6%, Pay 3%

The Savings & Loans Business - The Bad Years Was the S&L position a bomb waiting to detonate? 1980s - the yield curve inverts –Still earn 6%, but pay 12%

Insurers’ exposure in the 1980s Life insurers allowed policyholder loans Loan rates had a ceiling fixed by the contract at issue –Prior to 1980s, the ceiling exceeded rates available on earning assets Disintermediation –Money flowed out of life insurers into short term instruments such as money market funds

Responses to financial volatility Derivative products –Forwards and futures –Swaps –Options Application of risk management concepts to a firm’s balance sheet Finance 432 and seminars in financial risk management

Recent Disasters Long Term Capital Management Telecommunications industry Enron Amaranth

Next time... A survey of financial topics Actuaries in finance Finance vs. insurance