The Journal of Risk Finance

Michael Mainelli

2012 The Journal of Risk Finance

doi: 10.1108/15265941211254426

Purpose – The purpose of this editorial is to examine fiat currencies and common tenders (trade‐based money) from a risk perspective. The editorial encourages risk managers to consider the distributive benefits of a multiplicity of currencies and urges them to examine common tenders both old, such as the Swiss WIR, and novel, such as capacity exchange monies, as risk management tools. Design/methodology/approach – The editorial is based on research conducted for the City of London Corporation in 2011 into capacity, trade and credit which examined new architectures for commerce and money. Findings – The editorial links Freiwirtschaft movement ideas with some characteristics of common tenders. Further, it considers whether some simple regulatory approaches might make such common tenders more useful. Originality/value – Of note, the author suggests that a modern alternative to government regulation might be an audited ISO accreditation standard for “good currency” or “good common tender”.

Hato Schmeiser; Caroline Siegel; Joël Wagner

2012 The Journal of Risk Finance

doi: 10.1108/15265941211254435

Purpose – The purpose of this paper is to study the risk of misspecifying solvency models for insurance companies. Design/methodology/approach – Based on a basic solvency model, the authors examine the sensitivity of different risk measures with respect to model misspecification. An analysis considers the effects of introducing stochastic jumps and linear, as well as non‐linear dependencies into the basic setting on the solvency capital requirements, shortfall probability and expected policyholder deficit. Additionally, the authors take a regulatory view and consider the degree to which the deviations in risk measures, due to the different model specifications, can be diminished by means of requiring interim financial reports. Findings – The simulation results suggest that the sensitivity of solvency capital as a risk measure – as it is in regulatory practice – underestimates the actual misspecification risk that policyholders are exposed to. It is also found that semi‐annual mandatory interim reports can already reduce the model uncertainty faced by a regulator, significantly. This has important implications for the design of risk‐based capital standards and the implementation of internal solvency models. Originality/value – The results from the Monte Carlo simulation show that changes in the specification of a solvency model have a much greater impact on shortfall probabilities and expected policyholder deficits than they have on capital requirements. The shortfall risk measures react much more sensitively to small changes in the model assumptions, than the capital requirements. This leads us to the conclusion that regulators should not solely rely on capital requirements to monitor the solvency situation of an insurer, but should additionally consider shortfall risk measures. More precisely, an analysis of model risk focusing on the sensitivity of capital requirements will typically underestimate the relevant risk of model misspecification from a policyholder's perspective. Finally, the simulation results suggest that mandatory interim reports on the solvency and financial situation of an insurance company are a powerful tool in order to reduce the model uncertainty faced by regulators.

Mariarosaria Coppola; Valeria D'Amato

2012 The Journal of Risk Finance

doi: 10.1108/15265941211254444

Purpose – The determination of the capital requirements represents the first Pillar of Solvency II. The main purpose of the new solvency regulation is to obtain more realistic modelling and assessment of the different risks insurance companies are exposed to in a balance‐sheet perspective. In this context, the Solvency Capital Requirement (SCR) standard calculation is based on a modular approach, where the overall risk is split into several modules and submodules. In Solvency II, standard formula longevity risk is explicitly considered. The purpose of this paper is to look at the backtesting approach for measuring the consistency of SCR calculations for life insurance policies. Design/methodology/approach – A multiperiod approach is suggested for correctly calculating the SCR in a risk management perspective, in the sense that the amount of capital necessary to meet company future obligations year by year until the contract will be in force has to be assessed. The backtesting approach for measuring the consistency of SCR calculations for life insurance policies represents the main contribution of the research. In fact this kind of model performance is generally specified in the VaR validation analysis. In this paper, this approach is considered for testing the ex post performance of SCR calculation methodology. Findings – The backtesting framework is able to measure, from time to time, if the insurer has allocated more or less capital to support his in‐force business, with adverse effects on free reserves and profitability or solvency. Practical implications – The paper shows that the forecasting performance is an important aspect to assess the effectiveness of the model, a poor performance corresponding to a biased allocation of capital. Originality/value – The backtesting approach for measuring the consistency of SCR calculations for life insurance policies represents the main contribution of the research. In fact this kind of model performance is generally specified in the VaR validation analysis. Recently, Dowd et al. have proposed it for verifying the goodness of mortality models and now, in this paper, this approach is considered for testing the ex post performance of SCR calculation methodology.

Dorothea Diers; Martin Eling; Christian Kraus; Andreas Reuß

2012 The Journal of Risk Finance

doi: 10.1108/15265941211254453

Purpose – The purpose of this paper is to transfer the concept of market‐consistent embedded value (MCEV) from life to non‐life insurance. This is an important undertaking since differences in management techniques between life and non‐life insurance make management at the group level very difficult. The purpose of this paper is to offer a solution to this problem. Design/methodology/approach – After explaining MCEV, the authors derive differences between life and non‐life insurance and develop a MCEV model for non‐life business. The model framework is applied to a German non‐life insurance company to illustrate its usefulness in different applications. Findings – The authors show an MCEV calculation based on empirical data and set up an economic balance sheet. The value implications of varying loss ratios, cancellation rates, and costs within a sensitivity analysis are analyzed. The usefulness of the model is illustrated within a value‐added analysis. The authors also embed the MCEV concept in a simplified model for an insurance group, to derive group MCEV and outline differences between local GAAP, IFRS and MCEV. Practical implications – The analysis provides new and relevant information to the stakeholders of an insurance company. The model provides information comparable to that provided by embedded value models currently used in the life insurance industry and fills a gap in the literature. The authors reveal significant valuation difference between MCEV and IFRS and argue that there is a need for a consistent MCEV approach at the insurance‐group level. Originality/value – The paper presents a new valuation technique for non‐life insurance that is easy to use, simple to interpret, and directly comparable to life insurance. Despite the growing policy interest in embedded value, not much academic attention has been given to this methodology. The authors hope that this work will encourage further discussion on this topic in academia and practice.

Soon‐Yau Foong; Razak Idris

2012 The Journal of Risk Finance

doi: 10.1108/15265941211254462

Purpose – The purpose of this paper is to examine the effect of leverage on the financial performance of general insurance companies in Malaysia, and investigate whether the leverage‐performance relationship is a function of or contingent on the extent of product diversification. Design/methodology/approach – The sample consisted of the entire population of authorized general insurance companies operating during the period from 2006 to 2009 in Malaysia. A total of 94 observations were analysed. All the data used were sourced from the Malaysian Central Bank's (BNM) database. Findings – It is found that leverage is negatively associated with firm performance. However, there is a significant interaction effect between leverage and product diversity on firm performance. The finding indicates that leverage could be beneficial or detrimental to the financial performance of general insurance firms, contingent on the extent of product diversity of the firm. Research limitations/implications – As the scope of study is limited to the general insurance industry and the sample size is small, the findings of the study must be interpreted with caution and the results may not be generalizable to the life insurance sector or other industry. Originality/value – Findings of prior empirical studies on leverage‐performance relationship and effect of insurance product diversification are rather mixed and inconclusive. Based on analysis of a single insurance (general) sector that is highly regulated, the paper provides empirical evidence that the benefits of product diversification strategy are contingent on level of the firm's leverage. The paper hence, enhances understanding and contributes to the existing literature on impact of leverage, product diversification on performance of the highly regulated general insurance firms in a developing country.

Khalid Al‐Amri; Said Gattoufi; Saeed Al‐Muharrami

2012 The Journal of Risk Finance

doi: 10.1108/15265941211254471

Purpose – The purpose of this paper is to analyze the performances of the insurance sector in Gulf Cooperation Council (GCC) countries and carry out a comparative analysis for its different units. Design/methodology/approach – The authors analyse the technical efficiency of insurances in the GCC countries using DEA methodology and Malmquist Productivity Index (MPI) to decompose the change in the efficiency into an intrinsic component reflecting the individual change in technical efficiency and a second component reflecting the impact of the change in the market technology on the individual technical efficiencies of insurance companies. Findings – The study considers 39 insurance firms in the region, with a panel data covering the period 2005‐2007. The authors found that the insurance industry in the GCC is moderately efficient and there is large room for improvement. Originality/value – In these very special market conditions, a deep analysis of the overall efficiency of the sector is needed and an assessment of its performance – to the authors' best knowledge so far non‐existent – becomes a must to provide insights about the realities and the future trends of the sector. This research uses DEA and MPI to assess the efficiency of the insurance sector in the GCC region and analyses its variation over the period 2005 to 2007.

Zaneta Chapman; Thomas Getzen

2012 The Journal of Risk Finance

doi: 10.1108/15265941211254480

Purpose – The purpose of this paper is to examine the risks caused by “hazardously immoral” contracts which force external parties to bear significant losses without their consent. Design/methodology/approach – The expectation of substantial future losses raises the question of how investors can become profitable by entering into such risky contracts. The authors investigate the use of such contracts, which obscure the expected cost of failure by not only concentrating risks but ultimately not taking routine charges for predictable, albeit uncertain, future losses. In their investigation, the authors look at a risk concentration strategy and discuss expected profits (losses) under conditions of limited and unlimited liability. Findings – It is found that companies are more likely to minimize losses and maximize profits if they can obtain credit at a low enough interest rate and externalize the majority of the risk. Risks are more likely to be externalized when government and/or international agencies bail out the offending organizations to limit total damages and stabilize the economy. Originality/value – The main contribution of the paper is to show that a risk concentration strategy can be used to make the overall probability of winning arbitrarily large, even when individual trials have less than a 50 percent chance of obtaining positive profits. The corollary lesson is that credit is valuable, and having substantial credit obtainable at low rates is so valuable that significant gains are probable despite negative expected profits.