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This description mentions the two core categories that an insurance company is exposed to: underwriting risk arising from the issue of insurance policies, and investment risk arising from its investment portfolio of assets. In practice it is difficult to completely separate investment and underwriting risks, as in the case of long-term contracts. The objective of this paper is to look closely at investment risks and the ways of managing them. The first part of this paper is concerned with the investment risks an insurance company faces. The second part concentrates on management of the interest rate risk, which is the core risk to the investments. This paper considers the asset-liability management as the tool to manage interest rate risks. The asset side of the balance sheet consists mainly of financial assets in the form of government or corporate bonds, mortgages and shares, property all of which are subject to market risk and liquidity risk. Market risk includes unexpected changes in stock price or interest rates or foreign exchange rates. It constitutes the main threat to the asset side of the balance sheet. Bonds and other credit arrangements may be negatively affected by deterioration in the creditworthiness of a debtor. Liquidity risk is the risk that assets need to be liquidated at unfavourable conditions if cash is needed immediately to meet unexpected obligations to policyholders. The investment department of insurance companies often mitigate liquidity risk by appropriate asset liability management. Systematic risk is the risk of asset and liability value changes associated with systematic factors. It is sometimes referred to as market risk. As such, it can be hedged but cannot be diversified completely away. In fact, systematic risk can be thought of as undiversifiable risk. All investors assume this type of risk whenever assets owned or claims issued can change in value as a result of broad economic factors. Systematic risk comes in many different forms. For the insurance sector, however, three are of greatest concern: variations in the general level of interest rates, basis risk, and (especially for property-liability insurers) inflation. Because of the insurers' dependence on these systematic factors, most try to estimate the impact of these particular systematic risks on performance, attempt to hedge against them, and thus limit the sensitivity of their financial performance to variation in these undiversifiable factors. To do so, most will both track and manage each of the major systematic risks individually. The first of these is undoubtedly interest rate risk. Here, they measure and manage the firm's vulnerability to interest rate variation, even though they cannot do so perfectly. At the same time, insurers with large corporate bond, mortgage, and common stock holdings closely monitor their basis risk. Here the concern is that yields on instruments of varying credit quality, liquidity, and maturity do not move together, exposing the insurer to market value variation that is independent of fluctuating liability values. In this case, too, they try to manage, as well as limit, their exposure to it. Finally, to the extent that the frequency and severity of claims are influenced by inflation risk, expected losses will also be affected. This is particularly the case where insurance policies are written on a replacement cost basis. The inflation of concern can be general inflation--affecting repair costs, medical costs, and the like--or specific and localized inflation--like the quadrupling of certain building materials costs in southern Florida shortly after Hurricane Andrew. All three of these systematic risks will be recognized as sources of performance variation. The real risk associated with insurance company investments lies not in an overexposure to volatile assets, but in their sensitivity to changing interest-rate conditions. Specifically, these risks relate to the impact of a sustained low interest-rate environment or sudden and unexpected jumps in interest rates. Both scenarios could lead to asset-liability mismatches; the latter could create significant liquidity pressures for some insurers. To hedge against interest-rate risk, many insurers make extensive use of derivatives. While well-run derivatives programs are an appropriate means of managing risk, the events of 1998 have raised questions about systematic risk and illiquidity in this market. As financial markets become more integrated and international, the logic for seeking better yielding international investment opportunities becomes more compelling. Investing in a foreign security involves all the risks associated with investment in a domestic security but involves additional considerations and risks as well. The cash flows from international investments will be realised in a foreign currency. If the insurer expects claims in that currency, the investment will reduce the currency risk associated with policies whose claims are denominated in the foreign currency. If no such claims are expected, there is the possibility that exchange losses/gain could arise when investment cash flows are converted into domestic currency. Currency risk refers to uncertainty about the rate at which future foreign cash flows can be converted into the domestic currency. Currency risk can usually be hedged in the futures and options markets, although some believe that the transaction and maintenance costs may outweight the reduction in risk. Liquidity risk can best be described as the risk of a funding crisis. While some would include the need to plan for growth, the risk here is more correctly seen as the potential for a funding crisis. Such a situation would inevitably be associated with an unexpected event, such as a large claim or a write down of assets, a loss of confidence, or a legal crisis. Because insurers operate in markets where they may receive clustered claims due to natural catastrophes, or massive requests for policy withdrawals and surrenders due to changing interest rates, their liabilities can be said to be somewhat liquid. Their assets, however, are sometimes less liquid, particularly where they invest in private placements and real estate. Given this situation, it is important for an insurer to maintain sufficient liquidity to handle easily any demands for cash. Otherwise, an insurer that would be solvent without a sudden demand for cash may have to sell off illiquid assets at concessionary prices, leading to large losses, further demands for cash, and potential insolvency. Credit risk is the risk that a borrower will not perform in accordance with its obligations. Credit risk may arise from either an inability or an unwillingness on the part of the borrower to perform in the precommitted contracted manner. This can affect the investor holding the bond or lender of a loan contract, as well as other investors and lenders to the creditor. Therefore, the financial condition of the borrower, as well as the current value of any underlying collateral, are of considerable interest to an insurer who has invested in the bonds or participated in a direct loan. The real risk from credit is the deviation of portfolio performance from its expected value. Accordingly, credit risk is diversifiable but difficult to eliminate completely, as general default rates themselves exhibit much fluctuation. This is because a portion of the default risk may, in fact, result from the systematic risk outlined above. In addition, the idiosyncratic nature of some portion of these losses remains a problem for creditors in spite of the beneficial effect of diversification on total uncertainty. This is particularly true for insurers who take on highly illiquid assets. In such cases, the credit risk is not easily transferred, and accurate estimates of loss are difficult to estimate. There exist other investment risks like the movements in share price or reinvestment risk. It is worth mentioning that all these risks interrelated with each other. If interest rates go down and there is an urgent need to raise funds to finance liabilities due, then liquidity risk comes into play. Eventually, it is very important to manage interest rate risk because it is the core risk for investment business. The second part of this paper illustrates interest rate risk management technique known as asset-liability management. If an insurer does not coordinate its decisions on assets and liabilities, he might face a financial disaster. One of the best examples is the case of Nissan Mutual Life, a Japanese company with 1.2 million policyholders and assets of JPY 2 trillion. The company sold individual annuities paying guaranteed rates of 5 to 5 ½ percent without hedging these liabilities. Government bond yields dropped sharply, thus creating a large gap between the interest rates that Nissan Mutual had to pay on its annuities and the returns earned on its own investments. The company was to suspend its business. It was the first Japanese insurer to go bankrupt in five decades. Its losses totaled JPY 300 billion. (Sigma, No. 6/2000) ALM initially developed to manage interest rate risk, which became a major concern in the 1970s, when interest rates increased sharply and became far more volatile than in the past. As a result, some major insurers who had not managed their interest rate risk, have failed. The regulators demanded that insurers apply a basic analysis to the interest risk management. ALM became an important tool for managing product-specific as well as company-wide risks. Investment risk is determined by the risk that liabilities cannot be met. Therefore it is important to minimize investment risk by investing in assets which are appropriate for a given set of liabilities, i.e. choose investments to match as closely as possible the liabilities. The nature of the liabilities is the most important issue when making an investment decision. When liabilities are specified in the contract, e.g. non-profit portion of a life assurance fund, it may be possible to develop a clear investment policy designed to reduce risk. Liabilities, which are fixed in money terms, should be matched by fixed money assets, e.g. bonds. Price index -linked liabilities will be better matched by investment in the real asset classes. Sometimes it is not easy to define the liabilities precisely. For example, with-profit life fund policyholders are promised to be paid reasonable rate or return. According to past experience, policyholders may expect certain benefit payments. Thus, investment policy must take into account. When the most appropriate asset is selected, it is also important to ensure, that terms of assets and liabilities are matched. If an asset's life is shorter that of a liability's, then the proceeds have to be reinvested at unknown future rates of interests. On the liability's side, the short-term return from such assets as property or equity may e inappropriate if liabilities are of short-term nature. Another aspect of matching asset and liability is matching by currency, which is true if an insurance company holds an internationally diversified portfolio. The company will be exposed to currency risk. Insurers face risks that derive from the assets they hold, their liabilities, and the relationship between the two. ALM provides a framework for assessing and managing these risk exposures systematically and efficiently. There are significant differences in the way that life and non-life companies practice ALM. Life insurers generally focus on interest rate risk. Property-casualty insurers typically consider a wider range of risks, including underwriting risks. Their models look at the company as a whole instead of a particular insurance product as for life insurers. ALM techniques employed in the life and property/casualty industries vary in complexity. Cash flow testing involves creating different scenarios of different interest levels and test the viability of an insurance company. Cash flow matching is simply matching the liabilities with assets whose cash flows are identical. Immunization, or in another words protection against losses caused by a change in interest rates, is accomplished by structuring a portfolio so that the impact of a change in interest rates on the value of liabilities offsets the corresponding impact on assets value. Among the ALM techniques now in use is an approach known as dynamic financial analysis (DFA), which was developed in the property-casualty industry. DFA involves large-scale simulation of an entire company and enables to assess how it would fare under a range of scenarios and how its prospects would change in response to different strategic moves. The ALM is important risk management tool because it helps to control interest rate risk and prevents major blunders. In addition, it helps insurers steer decision-making and enhance the ability of decision-makers to view their business from several different perspectives. ALM also clarifies their risk landscape in ways that other models cannot. Risks are difficult to control. ALM provides a systematic means of evaluating, understanding, and reacting to the collective impact of insurer's asset-based and liability-based risks. ALM also represents the uncertainty inherent in future plans. It provides the tool to measure the distribution of key variables of particular concern to decision-makers. This enables managers to examine the likelihood of different developments, which cannot be addressed by conventional financial planning. Though ALM is an important tool, it lacks a uniform approach and is quite complex. ALM allows insurers to determine the overall risk exposures arising from different activities, but does not assess sources of risk. It only offers a framework for collecting information about risk exposures and assessing these exposures on a consistent basis. ALM can not help with risks that are not identified. As with any model, a practitioner should be aware of the model's strengths and weaknesses, because none of the models offer a perfect representation of reality. Historically, the insurance industry has depended on investment income to generate returns. Therefore it is very important for an insurance company to manage investment risks. Every insurer faces a different exposure to each of these risks, depending on its business mix. In all its activities, an insurer must decide how much business to originate, how much to finance, how much to reinsure, and how much to contract to agents. In so doing, it must weigh both the return and the risk embedded in its asset and liability portfolios. The uncertain nature of liabilities makes it more difficult for insurers to manage their risk exposure. This paper has examined the asset-liability management as the tool of interest risk management, which is the core risk for investment decisions. ALM can help insurers operate not only more soundly, but also more profitably. Although ALM tools have limitations, rating and regulatory agency interest in them suggest that their use will continue to spread. Technological progress in the capture and transfer of data has made increasingly sophisticated risk management systems available to insurers. In this environment, the practice of ALM will have more opportunities to flourish, though its rate of adoption is uncertain. It is very likely that ALM will play an increasing role in the insurance industry. This si due to several factors. On one side, these include the increasing complexity of insurance companies, the concerns of regulators and rating agencies. On the other side, progress in computer technology and the improvements of professional actuarial organizations support a trend towards more sophisticated modelling techniques Bibliography: Reference: Sigma Np 6/ 2000 Asset-Liability management for insurers Swissre From risk to capital: An insurance prospective Anonymous 1999 New Models for new times, Best's Review Santomero, Anthony M.; Babbel, David F, 1997 Financial risk management by insurers: An analysis of the process. Journal of Risk & Insurance, Vol. 64 Issue 2, pp 231-271 Anonymous, 2000 Balancing risks and rewards. Best's Review; Oldwick; Jan Coopers & Lybrand Consulting report , 1998 Insurers cotton to investment risk. Best's Review / Life-Health Insurance Edition, Jan98, Vol. 98 Issue 9, p14, 1/3p Word Count: 2543
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