Insurance master

Banking associations

admin — Mon, 29 Mar 2010 13:44:17 +0000

Some banking associations act to coordinate default data collection and dissemination between their members. This data is usually not available publicly. In the US, however, data from home lender associations is available on housing loans broken down by geographic location and type of property.

CREDIT RISK AND FORWARD CONTRACTS

admin — Fri, 26 Jun 2009 21:17:54 +0000

To illustrate how credit risk affects a forward contract, consider the currency forward contract example we just finished in the previous posts. It concerns a contract that expires in 180 days in which the long will pay a forward rate of $0.6008 for each Swiss franc to be received at expiration. Assume that the contract covers 10 million Swiss francs. Let us look at the problem from the point of view of the holder of the long position and the credit risk faced by this party.
Assume it is the contract expiration day and the spot rate for Swiss francs is $0.62.
The long is due to receive 10 million Swiss francs and pay $0.6008 per Swiss franc, or $6,008,000 in total. Now suppose that perhaps because of bankruptcy or insolvency, the short cannot come up with the $6,200,000 that it would take to purchase the Swiss francs on the open market at the prevailing spot rate.27 In order to obtain the Swiss francs, the long would have to buy them in the open market. Doing so would incur an additional cost of $6,200,000 – $6,008,000 = $192,000, which can be viewed as the credit risk at the point of expiration when the spot rate is $0.62. Not surprisingly, this amount is also the market value of the contract at this point.
This risk is an immediate risk faced at expiration. Prior to expiration, the long faces a potential risk that the short will default. If the long wanted to gauge the potential exposure, he would calculate the current market value. In the example we used in which the long is now 40 days into the life of the contract, the market value to the long is $0.0499 per Swiss franc. Hence, the long’s exposure would be 10,000,000($0.0499) = $499,000. Although no payments are due at this point, $499,000 is the market value of the claim on the payment at expiration. Using an estimate of the probability that the short would default, the long can gauge the expected credit loss from the transaction by multiplying that probability by $499,000.
The market value of a forward contract reflects the current value of the claim at expiration, given existing market conditions. If the Swiss franc rises significantly, the market value will increase along with it, thereby exposing the long to the potential for even greater losses. Many participants in derivatives markets estimate this potential loss by running simulations that attempt to reflect the potential market value of the contract along with the probability of the counterparty defaulting.
We have viewed credit risk from the viewpoint of the long, but what about the short’s perspective? In the case in which we went to expiration and the short owed the long the greater amount, the short faces no credit risk. In the case prior to expiration in which the contract’s market value was positive, the value of the future claim was greater to the long than to the short. Hence, the short still did not face any credit risk.
The short would face credit risk, however, if circumstances were such that the value of the transaction were negative to the long, which would make the value to the short positive.

PRICING AND VALUATION OF FORWARD CONTRACTS

admin — Thu, 25 Jun 2009 21:17:12 +0000

Before getting into the actual mechanics of pricing and valuation, the astute reader might wonder whether we are being a bit redundant. Are pricing and valuation not the same thing? An equity analyst often finds that a stock is priced at more or less than its fair market value and uses this conclusion as the basis for a buy or sell recommendation. In an efficient market, the price of a stock would always equal its value or the price would quickly converge to the value. Thus, for all practical purposes, pricing and valuation would be the same thing. In general, when we speak of the value and price of an asset, we are referring to what that asset is worth and what it sells for. With respect to certain derivatives, however, value and price take on slightly different meanings.
So let us begin by defining value: Value is what you can sell something for or what you must pay to acquire something. This applies to stocks, bonds, derivatives, and used cars.’”
Accordingly, valuation is the process of determining the value of an asset or service. Pricing is a related but different concept; let us explore what we mean by pricing a forward contract. A forward contract price is the fixed price or rate at which the transaction scheduled to occur at expiration will take place. This price is agreed to on the contract initiation date and is commonly called the forward price or forward rate. Pricing means to determine the forward price or forward rate. Valuation, however, means to determine the amount of money that one would need to pay or would expect to receive to engage in the transaction. Alternatively, if one already held a position, valuation would mean to determine the amount of money one would either have to pay or expect to receive in order to get out of the position. Let us look at a generic example.

Risk retention: self-insurance

admin — Wed, 24 Jun 2009 20:42:13 +0000

This is an alternative where a large corporation such as IBM, Exxon, BMW can retain a large risk because of the size and strength of its balance sheets. Another choice would allow companies to forget insurance and incorporate other hedging instruments themselves. The rationale is that the total savings on insurance premiums for the company are more than the will cut costs so that operational efﬁciency in the insurance companies diminishes, so that client satisfaction falls and business leaves.
This means that there will be more regulations from Basel II as the insurance business overlaps with that of pure banking. The insurance industry needs to be innovative.
substitute hedging costs of the portfolio. The hedging instruments would match or exceed the total insured losses for an adequate substitution. Banks may adopt self-insurance (SIR) retained part for only a portion or threshold level of the potential operational risk hazard. The rest that they feel unable to handle would be covered by the captives.
Yet, the matter can be different where the big losses surround the downside risk.
The view of long-term value theorists is that such sudden losses or short-term volatility offer too much potential for damage to the portfolio. Once the company’s long-term earnings are discounted for short-term losses, the calculus still comes out in credit territory. But, such huge drops in stock prices in 2000–2 remain highly worrying to fund managers. The comparison and substitution of increasing insurance premiums after September 11th 2001 against other forms of loss cover will still continue.
The usual insurance practice is pooling, transferring to institutions with more capital, or transferring to those who know the risk better. We have seen that a loss database, plus the associated actuarial skills, puts the insurers way ahead of the banks when it comes to analysing risk. Backed up with easy access to large sums of capital for insuring potentially huge disasters, these loss risk managers could be on to a winning business.
There can be no bigger or more well-known capital or knowledge base for risk transfer than Lloyds, London. The capital for covering losses and claims is derived from a large reserve base built up over a long time, as in the three centuries of the company.
The ramiﬁcations of September 11th for reinsurance are that people will buy and pay more insurance premiums. The insurers will buy more reinsurance, but both insurers and reinsurers will restrict their risk offer and coverage. Supply shrunk, demand rose – insurance prices have already risen substantially.
What is needed is an industrial shift from pure insurance to risk protection services. Outsourcing tail event risks is a good business practice, but a better procedure is to work in partnership with risk experts to manage these risks. Business continuity planning is the typical part of active risk management, rather than simplistic outsourcing. Mitigating risks by pooling within the same insurance group is called “spray and pray”.
The risks are that:
1. The insurance companies will not have enough capital reserves to pay the insurance liabilities of their clients’ claims.
2. The insurance companies will expand their policy small-print so that their clients ﬁnd that certain conditions nullify, or reduce, their insurance coverage.
3. Operational weaknesses within the structure of the insurance companies continue so that client satisfaction diminishes.
The insurance industry should learn and expand skills. Instead of designating risks bought or eliminated from policies as being “uninsurable”, we should train ourselves to be active risk managers beforehand. The unintended result so far is a host of uncovered risks; risks that could be avoided are pooled. This produces a lack of risk awareness and risk mismanagement. We must move forward.

Insurance: a short description (2)

admin — Wed, 24 Jun 2009 20:41:45 +0000

With the increasing use of derivatives and the impending deadlines of Basel II, we should see more variety in the types of insurance policies to cover foreseeable loss events. Insurance provides a safety net for sustaining losses where the costs in a single period would be too punitive. If the risk is deemed too large to handle singly by the company and collectively by shareholders, the risk must be transferred out and dispersed among a wider pool.
Insurance is the latest but one line of defence against risk, after capital reserves and before beneﬁting from bankruptcy law. It does not protect against risk but just smoothens the risk over time, transforming risks into costs. Pooling by transferring to institutions with more capital; or transferring to those who know the risk better.
Insurance results in a transfer of insurable risk into a tail credit risk and a host of legal risks. For these reasons of legal friction and contractual costs, insurance ends up a very incomplete market. A lot of risks are not covered at any price other than at excessive levels because of the paucity of up-to-date market information and the risk-aversion of many companies. If ﬁnancial markets were as incomplete as insurance, a considerable number of arbitrages between market segments would not be possible, and trading would be minimal.
The effects of large impact disasters, certainly after the emergence of terrorist waves post 9/11, and the collapse of stock-market prices are causes for concern. The major worries for the insurance industry are that they:
will not be able to pay the insurance liabilities of clients’ claims
will reduce their cover by expanding exclusion clauses, so that clients will ﬁnd self-insurance protection more attractive
When we are unsure of a speciﬁc type of risk, e.g. with complex damage or liability risk, a convenient get-out is to pass it to the insurer. You can protect yourself better against investment or corporate failure – for a premium. Thus, a popular policy was the D&O insurance – the Director and Ofﬁcer cover. A company could cover the performance of its key staff, as well as protect against shareholder lawsuits through purchasing this policy. Unfortunately, with the rise in company scandals and accounts restatements post-AEW, this D&O cover has become more expensive. So, General Electric found its D&O policy quadrupling within one year.
Market players should familiarise themselves with the idea that buying insurance not solve all their risk problems. Furthermore, investors and company chiefs should acquaint themselves with the basic techniques of risk maps and loss databases to provide advance warning of potential corporate damage. Funnily enough, the insurers are the ones who are most likely to have understood the beneﬁts of a loss database and created one, years before the banks and managed funds.
Do the groundwork – you need to be:
Assessing areas of risk weakness or corporate vulnerability.
Assessing cost-beneﬁts of buying in risk management expertise or cover.
Assessing areas of non-coverage for corporate cover.
Read the small-print beforehand in great detail, there are obvious advantages to be gained. Corporations and individuals have become used to retaining risk that would have been insured. Insurers trap the cost of losses over time, charging their expenses for the risk burden. Insurance provides a safety-net for sustaining losses where the costs in a single period would be too punitive. The normal view was that a corporation takes a diversiﬁed portfolio of investments plus their associated risks. The increasingly common perspective will be to view enterprise risk management (ERM) status of the client.
This means that clients will be assessed upon the value and quality of their portfolio, plus to what degree they have the tools, techniques and business processes to manage risk. This is analogous to the Basel II view of operational risk. The insurer would work progressively with the client to develop strategies, implement them tactically and monitor business performance. A hands-off “just post us the premium cheque” will be less commonplace. More detailed inspection will take place before policies are signed.
If the risk is deemed too large to handle singly, the risk is farmed out or dispersed. The directors and shareholders will tend to shun investments where the insurance premiums eat too much of the associated proﬁts. The idea of ceasing to buy insurance is not new, the investor can take on the total potential loss.

Insurance: a short description (1)

admin — Wed, 24 Jun 2009 20:41:04 +0000

Insurance is looking at the other side, assuming that there is a signiﬁcant chance that external risk events will strike or that the corporate leadership will be anything but sound. There are residual risks that are difﬁcult to calculate, or know about for sure if they never happened to you. These are particularly true in operational risk. Part of this ignorance or uncertainty is because companies have not created, or cannot gain access to, the relevant knowledge base. The investment risk of ﬁxed capital assets can be insured on the institutional market, such as houses or industrial plant equipment. There are risks of speciﬁc catastrophic events to insure against, e.g. ﬁre, ﬂood or storms.
Marsh McClellan insurance company sees systemic risk as that which affects the whole enterprise. It takes the deﬁnition:
Enterprise risk management: the process of systematically and comprehensively identifying critical risks, quantifying their impacts, and implementing integrated risk management strategies to maximize enterprise value.
This is investment risk management in the banking sense.
Insurance has a choice of risk strategies (sometimes more than banking):
Accept it, ﬁnance the risk burden.
Transfer it, e.g. insurance.
Mitigation, damage-limitation exercises.
Leave business completely (bankruptcy).
Insurers and bankers come from different parts of the risk spectrum. Different types of risk expertise are found on both sides of the insurance–banking border. Banks handled risk pooling, for credit risk, as well as risk ﬁnancing. Banks’ access to capital markets gave them better access to capital than insurers. Banks took credit risk in lending operations as their normal bread-and-butter, and worked under market risk as an intermediary, e.g. a broker. Insurers worked in direct acceptance and management of risk. They engaged in risk pooling – taking unrelated risks so that the average losses are regular. Otherwise, they could choose risk absorption where they could afford to take the risks because of stronger ﬁnancial backing, or risk ﬁnancing to maintain liquidity to pay for the risk events. Insurers have the structural tools to provide risk management support:
captives
risk funding
risk transfer
risk ﬁnancing.
Insurance business was traditionally about transferring risk. It created value in pooling risk, therefore lowering upper-band risk limits to any single party. It could also pool different types of risks under diversiﬁcation to obtain heterogeneity of the risk portfolio, thus lowering risk impact of any one single risk. It would transfer risks to the people who have deeper knowledge about these speciﬁc risks and/or who could afford to insure them. The captives act as specialist intermediaries between banks that are worried by operational risk and want insurance cover for it, and the international reinsurance and retrocession market.
Insurers can advise about management of certain risks, and ﬁnancial markets being used to transfer risks. The justiﬁcation for insurance is, thus, the right specialist information with adequate ﬁnancial backing. Note the Lloyds’ Names scandal, which dealt in specialised risk and reinsured it within the same group of companies. The wrong information and skills, with localisation of risk burden, cropped up again in the Investment Fund “Splits” ﬁasco. Specialist knowledge over what the insurance policy does not cover, how much it costs, alternative forms of protection are basic business starting points. Sometimes, this start line is ignored for businesses that think they are covered. At the most basic level, the evaluated expectation of risk should be more than the insurance premium paid, i.e.
Risk expectation = Sum of all (risk event × damage)
Risk damage expectation > insurance premium paid
This test will generally give a negative result, where the premiums plus the costs of transfer are greater than the damage. Therefore, the insurance company proﬁts. Such a calculation would give a satisfactory result only if the client had an asymmetry of information and knew better than the insurance company his a priori probability of suffering damage. The 1980s’ Lloyds’ errors in home appliance insurance came about because the insurance companies miscalculated that there was a lower risk of electric gadgets going wrong. The resultant malfunctions and claims cost Lloyds’ insurers more than average losses.

Index options

admin — Sat, 20 Jun 2009 18:21:20 +0000

Stock market indices are well known, not only in the investment community but also among many individuals who are not even directly investing in the market. Because a stock index is just an artificial portfolio of stocks, it is reasonable to expect that one could create an option on a stock index. Indeed, we have already covered forward and futures contracts on stock indices; options are no more difficult in structure.
For example, consider options on the S&P 500 Index, which trade on the Chicago Board Options Exchange and have a designated index contract multiplier of 250. On 13 June of a given year, the S&P 500 closed at 1241.60. A call option with an exercise price of $1,250 expiring on 20 July was selling for $28. The option is European style and settles in cash. The underlying, the S&P 500, is treated as though it were a share of stock worth $1,241.60, which can be bought, using the call option, for $1,250 on 20 July. At expiration, if the option is in-the-money, the buyer exercises it and the writer pays the buyer the $250 contract multiplier times the difference between the index value at expiration and $1,250.
In the United States, there are also options on the Dow Jones Industrial Average, the Nasdaq, and various other indices. There are nearly always options on the best-known stock indices in most countries.

Stock options

admin — Sat, 13 Jun 2009 18:19:14 +0000

Options on individual stocks, also called equity options, are among the most popular. Exchange-listed options are available on most widely traded stocks and an option on any stock can potentially be created on the over-the-counter market. We have already given examples of stock options in an earlier post; we now move on to index options.

EXCHANCE- LISTED OPTIONS MARKETS

admin — Sat, 06 Jun 2009 18:17:53 +0000

As briefly noted above, the Chicago Board Options Exchange was formed in 1973. Created as an extension of the Chicago Board of Trade, it became the first organization to offer a market for standardized options. In the United States, standardized options also trade on the Amex-Nasdaq, the Philadelphia Stock Exchange, and the Pacific Stock ~xchange.~
On a worldwide basis, standardized options are widely traded on such exchanges as LIFFE (the London International Financial Futures and Options Exchange) in London, Eurex in Frankfurt, and most other foreign exchanges. Note, perhaps surprisingly, that the leading options exchange is in Korea. As described in posts on futures, the exchange fixes all terms of standardized instruments except the price. Thus, the exchange establishes the expiration dates and exercise prices as well as the minimum price quotation unit. The exchange also determines whether the option is European or American, whether the exercise is cash settlement or delivery of the underlying, and the contract size. In the United States, an option contract on an individual stock covers 100 shares of stock. Terminology such as “one option” is often used to refer to one option contract, which is really a set of options on 100 shares of stock. Index option sizes are stated in terms of a multiplier, indicating that the contract covers a hypothetical number of shares, as though the index were an individual stock. Similar specifications apply for options on other types of underlyings.
The exchange generally allows trading in exercise prices that surround the current stock price. As the stock price moves, options with exercise prices around the new stock price are usually added. The majority of trading occurs in options that are close to being at-the-money. Options that are far in-the-money or far out-of-the-money, called deep-in-the-money and deep-out-of-the-money options, are usually not very actively traded and are often not even listed for trading.
Most exchange-listed options have fairly short-term expirations, usually the current month, the next month, and perhaps one or two other months. Most of the trading takes place for the two shortest expirations. Some exchanges list options with expirations of several years, which have come to be called LEAPS, for long-term equity anticipatory securities. These options are fairly actively purchased, but most investors tend to buy and hold them and do not trade them as often as they do the shorter-term options.
The exchanges also determine on which companies they will list options for trading. Although specific requirements do exist, generally the exchange will list the options of any company for which it feels the options would be actively traded. The company has no voice in the matter. Options of a company can be listed on more than one exchange in a given country.
In earlier posts, we described the manner in which futures are traded. The procedure is very similar for exchange-listed options. Some exchanges have pit trading, whereby parties meet in the pit and arrange a transaction. Some exchanges use electronic trading, in which transactions are conducted through computers. In either case, the transactions are guaranteed by the clearinghouse. In the United States, the clearinghouse is an independent company called the Options Clearing Corporation or OCC. The OCC guarantees to the buyer that the clearinghouse will step in and fulfill the obligation if the seller reneges at exercise.
When the buyer purchases the option, the premium, which one might think would go to the seller, instead goes to the clearinghouse, which maintains it in a margin account. In addition, the seller must post some margin money, which is based on a formula that reflects whether the seller has a position that hedges the risk and whether the option is in- or out-of-the-money. If the price moves against the seller, the clearinghouse will force the seller to put up additional margin money. Although defaults are rare, the clearinghouse has always been successful in paying when the seller defaults. Thus, exchange-listed options are effectively free of credit risk.
Because of the standardization of option terms and participants’ general acceptance of these terms, exchange-listed options can be bought and sold at any time prior to expiration. Thus, a party who buys or sells an option can re-enter the market before the option expires and offset the position with a sale or a purchase of the identical option. From the clearinghouse’s perspective, the positions cancel.
As in futures markets, traders on the options exchange are generally either market makers or brokers. Some slight technical distinctions exist between different types of market makers in different options markets, but the differences are minor and do not concern us here. Like futures traders, option market makers attempt to profit by scalping (holding positions very short term) to earn the bid-ask spread and sometimes holding positions longer, perhaps closing them overnight or leaving them open for days or more.
When an option expires, the holder decides whether or not to exercise it. When the option is expiring, there are no further gains to waiting, so in-the-money options are always exercised, assuming they are in-the-money by more than the transaction cost of buying or selling the underlying or arranging a cash settlement when exercising. Using our example of the SUNW options, if at expiration the stock is at 16, the calls with an exercise price of 15 would be exercised. Most exchange-listed stock options call for actual delivery of the stock. Thus, the seller delivers the stock and the buyer pays the seller, through the clearinghouse, $15 per share. If the exchange specifies that the contract is cash settled, the seller simply pays the buyer $1. For puts requiring delivery, the buyer tenders the stock and receives the exercise price from the seller. If the option is out-of-the-money, it simply expires unexercised and is removed from the books. If the put is cash settled, the writer pays the buyer the equivalent cash amount.
Some nonstandardized exchange-traded options exist in the United States. In an attempt to compete with the over-the-counter options market, some exchanges permit some options to be individually customized and traded on the exchange, thereby benefiting from the advantages of the clearinghouse’s credit guarantee. These options are primarily available only in large sizes and tend to be traded only by large institutional investors. Like futures markets, exchange-listed options markets are typically regulated at the federal level. In the United States, federal regulation of options markets is the responsibil- ity of the Securities and Exchange Commission; similar regulatory structures exist in other countries.

Over-the-counter option markets

admin — Sun, 31 May 2009 18:16:58 +0000

In the United States, customized over-the-counter options markets were in existence in the early part of the 20th century and lasted well into the 1970s. An organization called the Put and Call Brokers and Dealers Association consisted of a group of firms that served as brokers and dealers. As brokers, they attempted to match buyers of options with sellers, thereby earning a commission. As dealers, they offered to take either side of the option transaction, usually laying off (hedging) the risk in another transaction. Most of these transactions were retail, meaning that the general public were their customers.
The creation of the Chicago Board Options Exchange was a revolutionary event, but it effectively killed the Put and Call Brokers and Dealers Association. Subsequently, the increasing use of swaps facilitated a rebirth of the customized over-the-counter options market. Currency options, a natural extension to currency swaps, were in much demand. Later, interest rate options emerged as a natural outgrowth of interest rate swaps. Soon bond, equity, and index options were trading in a vibrant over-the-counter market. In contrast to the previous over-the-counter options market, however, the current one emerged as a largely wholesale market. Transactions are usually made with institutions and corporations and are rarely conducted directly with individuals. This market is much like the forward market described in earlier posts, with dealers offering to take either the long or short position in options and hedging that risk with transactions in other options or derivatives. There are no guarantees that the seller will perform; hence, the buyer faces credit risk. As such, option buyers must scrutinize sellers’ credit risk and may require some risk reduction measures, such as collateral.
As previously noted, customized options have all of their terms-such as price, exercise price, time to expiration, identification of the underlying, settlement or delivery terms, size of the contract, and so on–determined by the two parties.
Like forward markets, over-the-counter options markets are essentially unregulated. In most countries, participating firms, such as banks and securities firms, are regulated by the appropriate authorities but there is usually no particular regulatory body for the over- the-counter options markets. In some countries, however, there are regulatory bodies for these markets.