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Saturday, August 14, 2010

The Fate of Insurance Industry

In the last few years, the insurance industry has been exposed, world-wide, to large losses and disruptions, ranging from the payments that had to be made following the attacks of 9/11/01, to the costs of asbestos claims, the collapse of high-tech segments of financial markets, and government investigations of industry practices. Such events, however, do not seem to be the main cause of insurance firms' bankruptcy and at this time, and investments are pouring in that industry in anticipation of high returns of a “hard market” following these events. Yet, the recent failures of Kemper, Reliance and Trenwick, among others, illustrate the reality of the exposure of insurance firms to a spectrum of business failure scenarios.

In this paper, we present a Global Financial Analysis (GFA) framework, i.e., a dynamic stochastic model that goes beyond the scope of the existing Dynamic Financial Analysis model, and is designed to understand better the nature and the relative importance of the different threats in the commercial insurance industry. The approach is to combine the choice of strategies of the firm with a dynamic description of external events in a simplified model and simulation of the balance sheet of an insurance company. The principal output of the quantitative part of the model is the probability distribution of the time to failure of the firm, i.e., the time at which it may become insolvent.

We identify four external factors as key dynamic input to this balance sheet model in the GFA framework:

• the economic variables that affect the return on investment (inflation, stock market, interest rates, etc.)

• the underwriting cycles and their successions of soft and hard markets;

• the occurrences of big losses due to large catastrophes or large long-tail claims;

• emerging social issues and changes in laws, legal interpretations or regulations.

Based on this model, we estimate the probability of insolvency of an insurance firm given a present state and for a specified time horizon, and we determine the effects of external factors on that risk.

We chose to model firm of substantial size ($500M initial surplus) that provides personal and commercial property and liability products. The simulation results show that for our illustrative example and given our assumptions about its strategy, the failure risk of that firm is about 5% chance of insolvency within a 10-year time horizon. The simulation also enables us to undertake “experiments”. By replacing the underwriting cycle by a progressive growth (instead of a succession of growths and declines), we found that the firm failure risk decreases significantly. This finding suggests that the business cycles play an important role in insurers' insolvency.

Indeed, the fate of an insurance firm depends in large part on its strategy, which we divide into a choice of product portfolio, a pricing policy in hard and soft markets, a reinsurance policy, and an investment policy. Therefore, in addition to estimating the risk of insolvency, we seek to identify strategies that an insurance firm can adopt to improve its robustness, given what is on its horizon. In particular, we found that one determining factor of the failure risk was the product portfolio offered by the firm. Further analysis reveals that, with an appropriate investment strategy; the failure risk of insurance firms that offer risky products can be significantly decreased.

The penguin shines across the loving hydrogen.

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Saturday, January 3, 2009

Banking and Finance in Slowdown Situation

With banks crumbling globally, the fact that the Indian banks - 80 % of which are state-owned - are shackled be archaic rules, function as an oligrachy, serves only 40% of the population, and lose billions from forced political patronage seems like petty misdemeanour.

New Delhi's response to crisis is well documented. But it does nothing. India alone among the major economies has done nothing meaningful to combat slowdown. So the Reserve Bank of India’s Promised review of banking in 2009 is unlikely bring the Changes the sector desperately needs … Further privatization, greater consolidation and more competition (Domestic & Foreign).

India has no long term debt market and this hinders business from building scale. As a result, economic activity is eons away from reaching its full potential and crating the 50 millions jobs over the next decade to employ the growing population.

The prospects of scoring India’s development in such circumstances appear bleak. But ironically, securing India’s growth will be easier. The distortion in the system afford opportunity for great profit. Connected individuals in regulated industries such as real estate, telecom, mining & power, have grabbed national assets at throw away prices and are making generous margins, swelling the GDP.

Need for an “International Financial Architecture” :

On October 2008 French President Nicolas Sarkozy said the world could not manage 21st century crisis with the 20th century institutions. In Russia Vladimir Putin called for “Changing the Architecture of International Finances” in September. There has been calls for putting the International Monetary Fund (IMF) in change and strengthening its mandate.

Another solution called for giving financial Stability Forum (FSF) – a forum of supervisors and central banks set up in 1999 – greater power. So despite all the sentiments about including market seeking a solution, the developed economies are going to continue to influence international monetary and economic relationship in future.

Very unlikely, our lake of real power in international organizations such as IMF, is well known; the FSF(Financial Stability Forum) membership comprises mostly European Countries, the US, Japan, and the UK, even Singapore and Hong Kong but not India & China.

So India and China and other emerging markets will have to seek their own responses to the financial crisis. Sadly these economies comprised of half of the world’s population and much of these will be the effects of what the developed economies decide. We were not the part of the problem in the first place and we are unlikely to be the part of the solution. Only we have to tolerate/shoulder the crisis.

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