Actuarial risks

Insurance risks

Insurance risks are the risks bonded to leading an insurance business. The most important insurance risks are underwriting risks.

• Mortality risk - the risk that more policyholders die than expected (when death is the insured event). The risk may materialise e.g. due to incorrect assumptions used in the model.
• Longevity risk - the risk that policyholders live longer than expected (e.g. in case of annuities). The risk may materialise due to rapid medical enhancements.
• Morbidity risk - the risk that more policyholders get sick than expected.
• Lapses (surrenders) risk - the risk that more/fewer people surrender from the policy than expected. Early in the duration, the company is usually exposed to the withdrawal, whereas later on lapses could be supported. The rate of lapses might depend if there are any surrender changes.
• Expenses risk - the risk that expenses are higher than expected. Expenses are often split into regular expenses and one-offs. Additionally, the risk of expenses should allow for expense inflation.
• (Policyholders) concentration risk - the risk of policyholders being concentrated e.g. in one geographical area.
• Catastrophe risk - the risk of e.g. natural disasters or military conflicts.

To limit insurance risks, the company should perform actuarial experience study. An experience study is a comparison of expected versus actual realisations.

Market risks

Market risks are the economic risks that impact mostly assets but also liabilities of the insurance company.

• Investment return risk - the risk of investment return being lower (in some cases higher) than assumed. This risk could be further split into e.g. equity return, equity volatility, commercial property return, residential property return, etc. Investment return risk can be limitied by purchasing derivatives. However, purchasing derivatives increases counterparty default risk.
• Interest rates risk - the risk of the interest rates curve being different than expected. This risk is especially onerous for long-term policies. Under the Solvency II regime, insurance companies are required to use risk-free interest rates published by EIOPA (possibly allowing for Matching Adjustment or Volatility Adjustment).
• Inflation risk - the risk of inflation being higher (in some cases lower) than expected. The company may protect itself from inflation by linking premium to an inflation index.
• Credit risk - the risk of the increase of bond spreads. Credit risk may be further split into corporate and sovereign credit risks. If credit spreads increase, the value of bonds falls.
• Counterparty default risk - the risk of the counterparty defaulting, e.g. the company which bonds we own, reinsurer, etc. The probability of default is reflected by the credit rating of the bond. The worse rate, the higher probability of default. The risk, however, allows achieving a higher investment return. Blue-chip companies offer stability but this results in low investment returns.
• Currency risk - the risk of foreign currency getting weaker against local currency (e.g. EUR). To limit the currency risk, the company can purchase forward exchange rate agreements.
• (Assets) concentration risk - the risk of investing all assets in one type of investment which may crash, e.g. investing in only London properties whereas the London property bubble may burst. To limit the risk, the company can invest in equities from different sectors.
• Property risk - the risk of commercial property or residential property losing on value.

Operational risks

Operational risks stem from inadequate or failed internal processes, people and systems, or external events.

• Model risk - the risk that the actuarial model produces incorrect results. For example, the model can simplify the reality too much or the assumptions may not reflect reality.
• Reputational risk - the risk that the reputation of the company will be damaged. A good reputation requires a good communication with policyholders. The reputational risk may materialize if the product does not meet the policyholder's expectations.
• Regulatory risk - the risk that the company will not be compliant with the required regulations. Also, the risk that govermental or regulatory change will impact the business.
• Liquidity risks - the risk that company is not able to meet its obligations at time due to lack of liquid assets.