Insurance master

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.