Non-Life Insurance Companies. Risk Objectives

Thursday, 12 May 2011 17:19

Written by Administrator

The second broad insurance category is the non-life (casualty) sector, which includes but is not limited to health, property, liability, marine, surety, and workers' compensation insurance. For purposes of considering investment policy, these non-life companies are really quite similar even though the products they sell are rather diverse.

Non-Life Insurance Companies. Risk Objectives

The investment policies of a non-life company differ significantly from those of a life insurance company, however, because the liabilities, risk factors, and tax considerations for non-life companies are distinctly different from those for life companies. For example:

Non-life liability durations tend to be shorter, and claim processing and payments periods are longer, than for life companies.
Some (but not all) non-life liabilities are exposed to inflation risk, although liabilities are not directly exposed to interest rate risk as those of life insurance companies.
In general, a life insurance company's liabilities are relatively certain in value but uncertain in timing, while a non-life insurance company's liabilities are relatively uncertain in both value and timing, with the result that non-life insurance companies are exposed to more volatility in their operating results.

As detailed in this section, the investment policies and practices of non-life insurance companies in the United States are evolving, with changes brought on by both operating considerations and new tax laws. In fact, tax planning has dominated the investment policy of non-life companies for decades, reflecting the cyclical characteristics of this segment of the insurance industry. For reasons described in the following pages, asset/liability management is receiving increased attention.

A unique aspect of the casualty insurance industry is what is often described as the ''long tail'' that characterizes the industry's claims reporting, processing, and payment structure.26 Whereas life insurance is heavily oriented toward products sold to or for individuals, commercial customers account for a very large portion of the total casualty insurance market. The long tail nature of many types of liability (both individual and commercial) and casualty insurance claims arises from the fact that months and years may pass between the date of the occurrence and reporting ofthe claim and the actual payment ofa settlement to a policyholder. Many casualty industry claims are the subject of lawsuits to determine settlement amounts. Furthermore, some of these claims require expert evaluation to determine the extent of the damages—for example, a fire in a major manufacturing plant or damage to an oceangoing vessel. Thus, the liability structure of a casualty insurance company is very much a function of the products that it sells and the claims reporting and settlement process for those types of products ( insurance mathematics ).

From an asset/liability management perspective, most casualty insurance companies traditionally have been classified as having relatively short-term liabilities, even though the spectrum of casualty insurance policies covers a wide range of liability durations. One of the primary factors that limits the duration of a non-life company's assets is the so-called underwriting (profitability) cycle, generally averaging three to five years. These cycles typically result from adverse claims experience and/or periods of extremely competitive pricing. They often coincide with general business cycles and, in the low part of the cycle, frequently require companies to liquidate investments to supplement cash flow shortfalls.

Estimating the duration of a casualty insurance company's liabilities introduces a different set of issues than with life insurance liabilities. Using multiscenario and multifactor models, casualty actuaries attempt to capture (1) the underwriting cycle, (2) the liability durations by product line, and (3) any unique cash outflow characteristics. For non-life companies, business cycles and not interest rate cycles, per se, determine a company's need for liquidity through appropriate durations and maturities of assets.

Risk Objectives

Like life insurance companies, casualty insurance companies have a quasi-fiduciary role; thus, the ability to meet policyholders' claims is a dominant consideration influencing investment policy. The risks insured by casualty companies, however, are less predictable. In fact, for companies exposed to catastrophic events—such as hurricanes, tornadoes, and explosions—the potential for loss may be significantly greater. Furthermore, casualty policies frequently provide replacement cost or current cost coverage; thus inflation adds to the degree of risk. In setting risk objectives, casualty companies must consider both cash-flow characteristics and the common stock-to-surplus ratio.

Cash-flow characteristics
. Not surprisingly, cash flows from casualty insurance operations can be quite erratic. Unlike life insurance companies, which historically have been able to project cash flows and make forward commitments, casualty companies must be prepared to meet operating cash gaps with investment income or maturing securities. Therefore, for the portion of the investment portfolio relating to policyholder reserves, casualty companies have low tolerance for loss of principal or diminishing investment income. Investment maturities and investment income must be predictable in order to directly offset the unpredictability of operating trends.

Interestingly, no regulations require casualty insurance companies to maintain an asset valuation reserve, although risk-based capital requirements have been established in the United States. Regulators and rating agencies closely monitor the ratio of a casualty insurance company's premium income to its total surplus. Generally, this ratio is maintained between 2-to-1 and 3-to-1.

Common stock-to-surplus ratio
. Inflation worldwide has further reduced investment risk tolerance among many casualty insurers. In fact, volatile stock market conditions in the 1970s persuaded many casualty companies to reduce the percentage of surplus invested in common stock. Until then, it was not uncommon for a casualty insurance company to hold common stock investments equal to or greater than its total surplus. Regulators in the United States forced several major companies to liquidate large portions of their common stock holdings near the end of the 1974 bear market because of significant erosion of surplus. This liquidation impaired these companies' ability to increase volume and, in some cases, their ability to provide sufficient financial stability for existing volume of business.

Essentially, the regulators gave such companies the option of reducing common stock holdings or of temporarily ceasing or curtailing the issuance of new policies. Needless to say, this experience reduced casualty companies' risk tolerance for the portion of the investment portfolio related to surplus. Unlike the life insurance industry, the casualty industry has almost no absolute limits imposed by regulation (in the United States, some states do limit commons stocks as a percentage of surplus). However, many casualty companies have adopted self-imposed limitations restricting common stocks at market value to some significant but limited portion (frequently one half to three quarters) of total surplus. During the bull market of the 1990s, many companies modified those self-imposed limits. Nevertheless, the attention paid to stock market risk exposure has prevented a repeat of the mid-1970s experience.