Risk management for insurance companies

The insurance industry knows that it needs an explicit set of guidelines to govern risk in the sector, and it knows it is going to get them.

These regulations are likely to change the shape of global insurance. Insurance firms know that the cause of risk-based regulation, the insurance industry’s version of Basel II if you will, is a good one. What’s not yet clear is the effect that this will have.

The Solvency II risk-based capital regime proposed by the EU is forcing Europe’s insurers to consider what the effect of a stricter regime will be and how they can improve their existing risk management policies. For example, the second largest insurance company in the world, Allianz, has already centralised a group-wide risk framework. It has also borrowed from the banking industry to create a risk measurement tool for evaluating internal risk capital – because such models have been lacking from outside.

In the UK, the Financial Services Authority looked closely at the insurance industry and decided the regulatory structure was outdated and needed changing – and wasn’t prepared to wait for Solvency II to take root (expected to happen in 2006). But while the FSA’s proposals, due to kick in this year, deal with risk-based capital, they fail to address important issues such as operational risk.

In the US, life insurers are facing a fundamental rethink about how they manage their liquidity. They have traditionally relied on reinsurance as a method of risk transfer, but recent regulation has dissuaded life insurance companies from holding low capital reserves, and they are turning their attention to the securitisation market instead.

Of course, many insurance companies are by their nature among the largest managers of assets in the world. But the traditional approach to managing these funds has been conservative, and to date few if any major insurance firms outside the US will admit to hedge fund investments playing any kind of significant role in their overall portfolio. It looks like that situation has to change as insurers reassess their asset/liability management programmes and focus on how and where to generate higher returns on a long-term basis. But don’t expect a sudden rush – European insurers in particular have limited exposure, with a 3% allocation to hedge funds considered to be on the high side.