the U.K. Market
Abstract
Insurers’ risk-taking behaviour has stimulated researchers’ attention because it concerns the financial interest of policyholders and insurers. This risk-taking is also a paramount concern of regulators because they must enhance insurers’ performance and stabilise the financial system. Insurers face specific risks arising from their business and investment strategies. This chapter explores the relationship between risk-related activities (risk-taking and risk management) and firm performance in the UK market from 1996 to 2013.
To examine the issues, both cost and profit efficiencies are used to present the firm’s performance. The ordinary least squares (OLS) fixed effects model and the dynamic panel model are adopted to examine the impacts of two risk-taking strategies (i.e. underwriting and investment strategies) on insurers’ performances. At the same time, the impacts of two risk management techniques—capital holding and using reinsurance—are further considered and embedded with the risk-taking strategies.
The overall findings confirm that underwriting and investment strategies are fundamental factors affecting insurers’ performance from both cost and profit perspectives. Analysing the impacts of interaction between underwriting and investment strategies on the insurer performance reveals that short-term investment volatility takes the dominant role in lowering cost performance. However, the benefit of diversification can overcome short-term investment volatility and enhance insurers’ abilities to generate profit. Thus, interactions between risk-taking and risk management significantly affect insurers’ performance.
Section 2.1 Introduction
The primary task of running a business is carefully evaluating an insurer’s performance and disclosing the driving forces behind changes in performance because insurers who perform well can easily fulfil stakeholder expectations and maintain firm solvency (Cummins, Rubio-Misas and Vencappa, 2017; Eling and Jia, 2018). Among all performance measurements, efficiency analysis can present a more accurate and unbiased indication of an insurer’s ability and performance in a pool (Baluch, Mutenga and Parsons, 2011). Lin, Wen and Yang (2011) also state that cost-efficiency significantly reflects whether risk management could improve firm performance.
To effectively perform insurers’ functions, enhance soundness and maintain a competitive position in the market, the firms’ initial focus should be to identify and understand the risks they face. Risks to which insurers are exposed can be classified in many ways, and different international organisations have provided various guidelines to clarify risks across different business lines. For instance, the Casualty Actuarial Society (2000) categorised risks for property-casualty insurers, into four divisions: obligation risk, mismanagement risk, asset risk and interest rate risk. The Financial Services Authority (2001) also set six dimensions of risks across UK insurers: market risk, operational risk, group risk, credit risk, liquidity risk and insurance risk. It was only recently that the Solvency II (2009 Directive) unified these various guidelines and categorised risk factors into the ‘life risk model’ and the ‘non-life risk model’. The five catalogues in the life risk model are persistency risk, mortality risk, longevity risk, expenses risk and morbidity risk;
and the four catalogues in the non-life risk model are operating risk, market risk, underwriting risk and default risk. All factors in the non-life risk model also influence those in the life risk model.1
Traditionally, underwriting risk is a priority factor to consider in the spectrum of enterprise risks, as underwriting is the insurer’s primary activity (Baranoff and Sager, 2011). Underwriting allows an insurer to remove risks from the policyholder in exchange for a premium. Stronger underwriting ability would potentially improve the insurer’s performance (i.e. gaining underwriting profit) and maintain its competitiveness (i.e.
1 More details about the Solvency II framework can be found from Directive 2009/138/EC on the European Insurance and Occupational Pensions Authority (EIOPA) website: https://eiopa.europa.eu/regulation-supervision/insurance/solvency-ii.
gaining market share). Unfavourable underwriting results may cause a high probability of financial distress (Browne and Hoyt, 1995). Underwriting risks arise when the sum of claims and expenses deviate from the received premium level due to accidents, errors and unexpected changes in circumstances, thus leading to uncertainty of underwriting profit or even underwriting losses. Thus, from the view of the technical process, Jakov and Žaja (2014) suggest that underwriting risks could be split into pricing risk, reserve risk, reinsurance risk and occurrence risk.
Product risks can also be treated as a branch of underwriting risks. For example, health insurance is riskier than the annuity contract in the life sector (Baranoff and Sager, 2002);
homeowner and general liability insurance are more easily affected by external factors (e.g. underwriting cycle) than auto liability insurance in the non-life sector (Ren and Schmit, 2006); and insurers with diversified businesses can be more cost-effective than those with monoline businesses (Berger et al., 2000). Sharpe and Stadnik (2007) demonstrate that the mix of an insurer’s businesses influence the firm’s financial soundness. Therefore, production plans or business strategies are essential in an insurer’s underwriting and also play a vital role in a firm’s operation (see Baranoff and Sager (2002); Hardwick and Adams (2002); Hu and Yu (2015)). For example, Berger and Humphrey (1997) state that a bank’s profit inefficiency due to suboptimal production plans is much higher than its cost inefficiency; this is also true for insurance firms. A profit-inefficient insurer may write too many risky contracts or use inappropriate discount rates when pricing, thereby incurring excessive risk for both debtholders and shareholders in exchange for less effort needed to monitor policyholders’ risk profiles (cost reduced).
This leads the current research to focus on the insurer’s performance from two different perspectives: cost and profit.
In addition to underwriting risks, according to Baranoff and Sager (2002), Lin, Wen and Yang (2011) and Zou et al. (2012), another type of risk that must be considered with underwriting risk is investment risk (asset risk). As there is a time gap between receiving premiums and paying off claims, apart from setting up regulatory reserves, insurers also invest most of the collected premiums into various assets to generate investment returns, which can fulfil stakeholders’ expectations.1 Hammond, Melander and Shilling (1976)
1 For example, the investment return can be used to pay interests to debtholders and dividends to shareholders or can be treated as internal capital for future business expansions. There are even some
state that return on investments is important because insurer’s underwriting results are often negative. Insurers not only generate excess returns through investment but also bear a higher level of risk from market volatility, resulting in more uncertain underwriting capacity and firm performance. Therefore, even if a firm has profited from its underwriting activities, it is still unable to meet all its obligations due to poor performance from investments, which results in higher insolvency risk. The insurer aims to manage and control its insolvency risk at the enterprise level, and, thus, it must make a trade-off among different risks. For example, under the asset-liability matching strategy, the insurer adjusts its investment strategy based on the nature of its underwriting strategy. Insurers with a highly volatile business may prefer investments with a high degree of liquidity and a low degree of volatility. Zou et al. (2012) demonstrate that it is difficult and costly to modify underwriting strategies, since such adjustment exerts an adverse effect on the long-term customer relationships.1 From this perspective, investment strategies follow basic underwriting.
On the other hand, the insurer can also modify its underwriting strategy according to investment strategy, if the investment is costly and difficult to adjust at the time of market downturn. Thus, as stated by Hammond, Melander and Shilling (1976) nd Hammond and Shilling (1978), there should be interconnections between an insurer’s underwriting risks and investment risks. Therefore, managing these two risks is the primary concern of the insurer’s operations.
To improve customer protection, fulfil future liabilities and prevent unexpected losses, regulators and policymakers set up a series of appropriate policies or standards, which impose capital requirements based on insurers’ risk appetites and disclosing firms’ risk profile so that they may be assessed by the public. For an insurance company, the primary objective is to correctly specify types of risk taken from its operations and to use risk management techniques, such as reinsurance, to enhance performance and stability.
From regulatory perspectives, the primary objective of supervision is to strengthen the insurer’s soundness and maintain adequate capital levels for the firm’s number of
products closely linked to investment activities, such as unit-link products, in which bonuses are paid to policyholders at maturity.
1 Such as scaling down the liability amount by underwriting less business or changing underwriting criteria, which would reduce firm attractiveness.
obligations. Underwriting and investment activities automatically affect a firm’s liability obligations and lead to a change in required capital. For example, Zanjani (2002) demonstrates that insurer’s with more businesses exposed to natural disasters had more capital holding than others. Insurers hold financial capital to provide a future source of payments to policyholders when clients need to be paid if claims (benefits) are higher than expected and/or if investment returns are lower than predicted (Cummins and Nini, 2002). Brockett et al. (2004b, 2005) and Kasman and Turgutlu (2011) also mention that holding equity capital could be a buffer against unexpected future losses to fulfil insurance obligations. Thus, the higher an insurer’s capital amount, the safer the policyholders’ compensations (Brockett et al., 2005). However, holding capital could be expensive because of the regulatory cost, agency cost and tax payments (Cummins and Grace, 1994). Still, insurers may face debt overhang problems if they hold too little equity capital because debtholders and policyholders are usually merged in the insurance industry, and this may further reduce a firm’s ability to attract new customers; it may even start to lose current business as it faces more insolvency risk (Cheng and Weiss, 2012a).
External factors can also influence the use of capital. For example, regulatory pressure plays a crucial role in determining whether equity capital should be held or should be used to make a different investment (Kasman and Turgutlu, 2011).
Apart from regulatory capital building, an efficient internal risk management system can also help insurers enhance safety for policyholders after quantitatively and qualitatively identifying the risks in its business activities—but also by allowing insurers to accept other (or more) risks to achieve higher profitability. Froot, Scharfstein and Stein (1993) also note that risk management techniques could enhance insurers’ market values.
Cummins et al. (2009) further point out that risk management decisions could be regarded as the consequences of external factors and that they provide insurers with an objective function to reduce their total costs. Smith and Stulz (1985) specify that risk management helps a company to reduce: 1) bankruptcy and distress costs, 2) financing costs, and 3) expected payments to stakeholders. They further suggest that using financial derivatives could manage investment risks to reduce costs, and this is confirmed by Clark and Siems (2002), Lieu, Yeh and Chiu (2005) and Rivas, Ozuna and Policastro (2006), who find that utilising derivatives can improve bank performance. Cummins, Phillips and Smith (2001) also suggest that insurers could use derivatives to hedge market risk. Lin, Wen and Yang
(2011) propose a study of using financial derivatives1 and reinsurance to manage insurer’s risk, as they believe that derivatives could be used to manage investment risk and that insurers use reinsurance to reduce underwriting risk. Froot and O’Connell (2008) further suggest that insurers are likely to use reinsurance when facing more non-standardised and difficult to assess risk exposures. Chen, Hamwi and Hudson (2001) argue that an insurer with solvency problems might like to use more reinsurance because raising financial capital would be too expensive. Thus, reinsurance not only mitigates policyholders’
concerns about insurers’ insolvency but also enables insurers to effectively manage cash flow volatility (e.g., pre-tax income volatility), maintain future underwriting capacity and enhance firms’ ability to bear risk (Doherty and Tinic, 1981; Cole and McCullough, 2006;
Shiu, 2011). Moreover, Liu, Shiu and Liu (2016) note that reinsurance could also reduce the liquidity problem arising from asset-liability mismatch due to the nature of general insurance.
This chapter mainly contributes to ongoing studies on revealing the determinants of insurer’s efficiency (Lin, Wen and Yang, 2011; Biener, Eling and Wirfs, 2016; Bikker, 2016; Eling and Schaper, 2017). The purpose of this chapter is to exam the extent to which risk-taking behaviours (underwriting risk and investment risk) influence insurer performance, while simultaneously considering insurers’ risk management activities, which are represented by usage capital and reinsurance. The expected results will be useful for policyholders, regulators and insurers to enhance understanding of the driving forces behind the insurers’ performance in the UK market from the risk-related perspective.
Then, several contributions can be made to the literature. Firstly, this study investigates the impact of both risk-taking behaviours and risk management activities on the insurers’
performance, but most of the extant studies only focus from one perspective (Lin, Wen and Yang, 2011; Biener, Eling and Wirfs, 2016). Secondly, it is the first study to consider the interaction effects between insurers’ risk-taking behaviours and risk management activities. It is worth to determine such impacts, because of the fact that insurers’ risk-taking behaviours and risk management activities are often jointly considered. Third, this chapter responds to measurement issues and employs product risk, diversification
1 Due to lack of data, it is not possible to test derivatives-related activities in this study; therefore, it will focus only on using reinsurance as a strategy to mitigate underwriting risk.
strategy and pricing risk as underwriting risk measures. This provides more detailed information on insurers’ underwriting strategies. Fourth, it is vital to consider the impact on both cost and profit efficiencies, as two efficiencies capture different information.
Moreover, the results confirm that both risk-taking and risk management strategies have significant impacts on insurer performance. Some impacts are consistent in both cost and profit models; others may have varied impacts across different models. In particular, by considering the interplay between risk-taking and risk-management (or between business strategies and financial decisions), the results confirm interacting effects that significantly contribute to insurer performance. This finding can help insurers devise appropriate strategies combining both business and operational activities at the aggregated level to improve performance. Regulators can also use the findings to establish regulations or standards related to insurers’ business and operational activities.
The rest of this chapter is structured as follows. Section 2.2 develops this study’s hypotheses based on the empirical literature, and Section 2.3 briefly discusses the methodology and interprets the data and variables used. Empirical results are presented in Section 2.4, and Section 2.5 concludes the chapter.