Banana skins, risk and youArticle added by Mike Boot on April 14, 2009
Mike Boot

Mike Boot

Joined: July 31, 2008

Did you know that the risks affecting insurance companies are sometimes not that different from the ones impacting your clients? A survey of the risks facing companies, titled "Insurance Banana Skins 2009," provides insights into risks for every financial advisor. This February 2009 study by the Centre for the Study of Financial Innovation in association with PricewaterhouseCoopers (PwC) was administered globally, and included more than 400 responses from nearly 40 countries. Although 74 percent of the responses were from Europe, the top concerns were strikingly similar across geographical regions, including North America. The full report is available at

This is the second edition of the survey, and there are significant changes from the previous year's findings. In keeping with the volatility following the financial crisis, the risks that now lead the list include: 1) investment performance, 2) equity markets, and 3) capital availability. None of these were selected in the top 10 risks in 2007.

The previous survey showed the top concerns as 1) overregulation, 2) natural catastrophe and 3) management quality. It is not surprising that the top three risks now all relate to the financial crisis and the impact of the strength and profitability of the insurance industry. Many insurers have recently identified substantial losses, often due to deferred acquisition costs (DAC) write-downs, as well as write-downs in insurers' asset portfolios.

The full list of the top 10 risks in the current survey are as follows:
    1. Investment performance -- The insurance industry's ability to earn an adequate return to meet its guarantees.

    2. Equity markets -- This issue is more severely felt in Europe than in North America due to the amount of equity held. This is reduced in the United States due to current risk-based capital formulas; however, anyone holding stock -- either as an individual investor or insurance corporation -- is feeling the impact of the stock market decline.

    3. Capital availability -- This raises the big question as to what extent new capital will be attracted to the insurance sector.

    4. Macro-economic trends -- It is interesting that in this measure, North Americans are taking a gloomier perspective than most Europeans.

    5. Too much regulation -- This response is particularly interesting in light of the renewed call for an optional federal charter to oversee insurance in the United States.

    6. Risk management technique -- Some question whether risk management was effective. Most observers do not believe that risk management processes failed, but that these were not properly implemented with sound procedures.

    7. Reinsurance security -- It is very important for direct writing insurance companies to have the availability of reinsurers to lay off certain insurance risks.

    8. Complex instruments -- Complex products -- particularly derivatives -- contributed to the financial crisis.

    9. Actuarial assumptions -- The actuarial calculations that underlie the insurance pricing are being tested. Most folks understood that there was some tail risk for the one-in-every-hundred-years event, but few people truly understood the impact that the extreme event could cause. This does not mean that actuarial models are not reliable for pricing information, but that multiple extreme tail scenarios must be carefully analyzed.

    10. Long tail liabilities -- Oftentimes, insurance involves long-term guarantees, and it is very difficult to analyze the various items that will have an impact over an extended time frame, such as 50 years. People buying insurance in their 20s will want to make sure that they receive the insurance protection they purchased throughout their entire lifetime.
So what does this mean to you, as a financial advisor?
    1. Be prepared to answer questions from clients about the solvency of any recommended company. It's important to note that the insurance industry is taking action during this critical time. Although the industry has lost large amounts of capital and surplus, it is important to stress that there are only a couple of isolated cases where the state regulator has had to take over the operations of insurers due to looming insolvency. Insurers know that consumer confidence is low in all financial service companies, and they are beginning to identify particular actions to address the lack of confidence.

    2. Understand that everyone is very sensitive to investment performance. Just as corporate risk managers have made large changes in their key risk items in the past two years, investors face the same issue. Potential investors will focus more acutely than ever before on investment performance. Be sure to remind your clients to keep looking at the long-term picture, as performance in the very short term will be volatile. Recently, the Dow Jones had a 497-point one-day climb; so does that mean that we are now well on the way to a full and very rapid recovery? It is unlikely that any long-term trend will be rapid, so remind your clients to be careful about chasing something that is hot for one day.

    3. Note that complex instruments were identified and a temporary return to the basics has occurred. Explain product features and risks clearly so that customers fully understand and become more comfortable making a purchase. This trend can be seen in the area of life insurance, where there has been a temporary shift away from variable life and universal life products to term insurance. Customers do understand that they need protection, so they continue to buy that product. In fact, U.S. life insurers received one percent more requests for individual coverage in February 2009 than they received in February 2008, largely driven by term insurance applications. The MIB Group Inc. bases that figure on an analysis of North American life insurers' use of MIB databases to check individually underwritten life applications.

    4. In light of actuarial assumptions being listed as the ninth risk, it is now very critical to understand the impact of extreme events. Just as actuaries are now looking at the worst case scenarios in a new light, consider doing the same for your customers as you help them consider the risk of worst case scenarios, such as premature death or outliving all of their assets. It is also important that you convey the large risk that any client takes by not having health insurance coverage. The events of 2008 have taught us lessons about the dangers of looking at the averages and ignoring the extreme event scenarios.
Just as insurance companies are taking actions on the banana skins that can lead them to disaster, it is equally important that you take these same actions with your clients so they do not fall into their own personal financial crisis or ignore key risks in today's economic environment.
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