Insurance risk · RiskAtoms Academy

By the end you will be able to

1Explain underwriting (premium) risk and reserve risk, and tell them apart.
2Explain mortality and longevity risk, and why they partly offset.
3Explain why catastrophe risk breaks pooling, and how reinsurance limits it.
4Trace a bad insurance year through to an insurer's solvency ratio.

Why it matters

An insurer sells its product before it knows what it costs. The bill arrives later, sometimes decades later, and sometimes all at once. Insurance risk is the chance that the bill is bigger than the price.

Core explanation

When the bill is bigger than the price

L1.2.03: Insurers: life and non-life showed how insurers work: premiums first, reserves for what is owed, claims later, and pooling to make the total predictable. Insurance risk is everything that can make the claims differ from what was assumed. It is the risk insurers are paid to take, so the aim is not to avoid it but to price it, spread it and cap it. It splits into five main types.

Five insurance risks: guess the danger, then reveal

Mortality and longevity pull against each other. If people live longer, an annuity book pays out for more years, but a term life book pays fewer death claims. A life insurer with both has a partial natural hedge. It is only partial, because the two books cover different people, ages and amounts.

Not market risk, but close to it. Life promises are long, so their value also depends on interest rates (L2.2.02: Market risk). Most firms keep that under market risk and keep “insurance risk” for what the policyholders do: claim, die, live, cancel.

Sort itWhich insurance risk?

To win market share, the insurer prices next year's home insurance below what claims are likely to cost.
Car repair costs jump with inflation, so claims from last year's accidents cost more than reserved.
An earthquake damages thousands of insured buildings in one city.
A severe flu season raises deaths among people with life cover.
A new heart treatment adds two years to the life expectancy of the insurer's pensioners.
Decades after the policies were written, claims for illness from asbestos keep arriving.

On Example Group's balance sheets, insurance risk sits in Example Insurance SE's insurance contract liabilities: €44,000m for life and €10,000m for non-life.

ExploreExample Group: where the risks sit

Pick a risk type to light up the lines that carry it. Pick a line to see why.

Example Bank plc

£ billions · assets carrying insurance risk: £0bn (0%)

Assets

Liabilities

Example Insurance SE

€ millions · assets carrying insurance risk: €0m (0%)

Assets

Liabilities

Insurance risk

The risk that claims and benefits on insurance policies cost more, or come sooner, than priced and reserved for.

Where this goes next

M3.7: Insurance risk covers underwriting and reserve risk, catastrophe models, mortality, longevity and reinsurance in depth. The Solvency II capital charges are calculated in M4.6: Solvency II and insurance regulation, and IFRS 17's risk adjustment in M4.8: Insurance accounting: IFRS 17 (overview).

Try it

Example Insurance SE earns €8,000m of net premiums at a combined ratio of 95%, an underwriting profit of €400m. Its Solvency II own funds are €9,300m against a Solvency Capital Requirement of €5,000m: a solvency ratio of 186% (L1.8.06: Capital, equity and leverage). Of its life liabilities, assume €20,000m are annuities and pensions in payment. Give it a bad year, one risk at a time. Notice how the reinsurance flattens the catastrophe slider in the middle of its range.

Try itGive Example Insurance SE a bad year

Reinsurance calculator →

Underwriting: loss ratio on new business rises by0 pts

Reserves: claims reserves turn out too low by0%

Catastrophe: gross loss from one storm€0m

Longevity: annuity reserves rise by0.0%

Reinsurance pays catastrophe losses above €500m, up to €1,500m. Losses are before tax; the capital requirement is held fixed.

Own funds after€9,300m

Solvency ratio (own funds ÷ SCR)186%

Above 100%: the insurer still covers its Solvency Capital Requirement. How often does a storm this size come? Try the catastrophe return period calculator.

Worked example

A storm year at Example Insurance SE

A severe winter storm hits northern Europe. At the same time, claims inflation reveals that reserves were too low, the year's pricing proves thin, and a new mortality study shows pensioners living longer. Work out each hit before you reveal it. Amounts in €m, before tax.

From four insurance risks to the solvency ratio

Step 1 of 5

1
Underwriting
The loss ratio on the year's business comes in 3 points above plan: 3% × €8,000m = €240m.

Risk	Hit, €m	Share of the total
Underwriting	240	11%
Reserves	500	23%
Catastrophe (net)	1,000	47%
Longevity	400	19%
Total	2,140	100%

Regulatory lens

Solvency II sets capital for insurance risk in its underwriting modules: non-life (premium and reserve, lapse, catastrophe), life (mortality, longevity, disability, lapse, expense, revision, catastrophe) and health. Each is calibrated so the insurer could survive a 1-in-200-year bad year.
IFRS 17 adds a risk adjustment to insurance liabilities: the compensation the insurer requires for bearing non-financial risk, which is insurance risk in all but name.
Elsewhere: US insurers hold risk-based capital set by the NAIC formulas, and the IAIS has developed an Insurance Capital Standard for internationally active insurance groups.

The calculations are in M4.6: Solvency II and insurance regulation and M4.8: Insurance accounting: IFRS 17 (overview).

Sparks

SparkThe hurricane that made catastrophe models

Hurricane Andrew struck south Florida in August 1992. Insured losses far exceeded what many insurers had expected, and several became insolvent. Afterwards the industry turned to computer catastrophe models, which simulate thousands of possible storms, rather than relying on past claims alone.

SparkAsbestos and the long tail

Liability policies written in the mid-20th century went on producing asbestos claims for decades. The losses helped bring Lloyd's of London close to collapse in the early 1990s; in 1996 its old liabilities were moved into a new reinsurer, Equitas, so the market could carry on. Reserve risk can take a generation to show itself.

Key takeaways

Insurance risk: claims or benefits differ from what was priced and reserved for.
Underwriting (premium) risk is about business still to be written; reserve risk about events already happened.
Catastrophe risk breaks pooling because one event causes many claims; reinsurance caps it, up to a limit.
Mortality risk hurts life cover, longevity risk hurts annuities; they partly offset.
Losses from insurance risk come straight out of own funds and the solvency ratio.

Reaction

Check what stuck

Glossary

Insurance risk: The risk that claims and benefits on insurance policies cost more, or come sooner, than was priced and reserved for.
Underwriting (premium) risk: Premium risk: the risk that premiums for business written in the coming year will not cover its claims and costs.
Reserve risk: The risk that claims reserves set aside for events that have already happened turn out to be too low.
Catastrophe risk: The risk of a single event, such as a hurricane, earthquake or pandemic, causing many claims at once.
Mortality risk: The risk that more insured people die, or die sooner, than assumed. It hurts life cover.
Longevity risk: The risk that people live longer than assumed. It hurts annuities and pensions.
Lapse risk: The risk that policyholders cancel or stop paying more or less often than assumed.
Long-tail business: How long it takes for claims to be reported and settled. Liability business is long-tail.
Excess-of-loss reinsurance: Excess-of-loss reinsurance: the reinsurer pays losses above a set amount (the retention), up to a limit.
SCR: Solvency Capital Requirement: the capital Solvency II requires, enough to survive a 1-in-200-year bad year.

Deep Dives & Origins

Deep Dives

Swiss Re Institute, sigma reports on natural catastrophes (published each year). Beginner.
Hull, Risk Management and Financial Institutions (Wiley), the chapter on insurance companies and pension plans. Intermediate.
Grossi and Kunreuther (eds), Catastrophe Modeling: A New Approach to Managing Risk (Springer, 2005). Advanced.

Origins

Directive 2009/138/EC (Solvency II), Article 105 on the underwriting risk modules.
Commission Delegated Regulation (EU) 2015/35, the articles on life, non-life and health underwriting risk.
IASB, IFRS 17 Insurance Contracts, 2017, on the risk adjustment for non-financial risk.
IAIS, Insurance Core Principles and the Insurance Capital Standard.

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