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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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