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Outline the main features of each category of insurance company and name the risks insurers are exposed to.

FRM® Part I · Financial Markets and Products · Insurance Companies and Pension Plans · FRM1.FM.2.a

The idea

Insurers fall into three broad groups. Life insurers pay on the death of the insured or, for annuities, pay while the annuitant lives, so their liabilities run for decades. Property-casualty insurers cover damage to property and legal liability, usually under one-year policies, although liability claims can take years to settle. Health insurers cover medical costs. Underwriting risk is the risk that claims exceed what premiums were priced for, through mortality, longevity or catastrophe losses. Reserve risk is the risk that provisions for claims already incurred prove too low. Investment risk comes from credit, market and interest rate moves and from asset-liability duration mismatch. Insurers also face liquidity risk, operational risk and credit risk on reinsurers. For the exam, match each line of business to its dominant risk: mortality for life cover, longevity for annuities, catastrophe and reserve risk for property-casualty.

A practice question

From the question bank, with the reason each wrong option is wrong.

A company sells policies that cover the policyholder's legal liability for injury caused to third parties and for damage to the policyholder's own buildings, mostly on one-year contracts. Which category of insurer does it belong to?

  1. Property-casualty insurer - correct
  2. Annuity providerWhy not: Annuity providers pay income to a living person; they do not cover liability or property damage.
  3. Reinsurer of mortality riskWhy not: A mortality reinsurer takes on death-benefit risk from other insurers, not direct liability and property cover.
  4. Life insurerWhy not: Life insurers pay on the death or survival of a person; liability and building cover is not life business.

Cover for property damage and legal liability is the definition of property-casualty insurance. Life insurance is tied to death or survival, and annuities pay income while the holder lives.

A harder one

Compared with the mortality experience of a large life insurer, why is a property-casualty insurer's claims experience generally harder to diversify?

  1. Property-casualty insurers face no investment risk, so all risk comes from claimsWhy not: Property-casualty insurers invest premiums and face investment risk like any insurer.
  2. Property-casualty claims depend only on policyholder age, which is hard to predictWhy not: Age is the key rating factor in life business; property claims depend on hazards, location and events.
  3. Property-casualty policies are written for decades, so claims are more spread out in timeWhy not: Property-casualty policies are typically one year; long contracts describe life business.
  4. A single hurricane or flood can generate many claims at once, so losses are correlated - correct

Mortality losses across many people are fairly independent, which lets them diversify. Catastrophe losses cluster, so one event can hit a large share of the book at once.

The hardest tier

A property-casualty insurer buys excess-of-loss reinsurance that caps its net losses from a single hurricane. Which risk does the insurer take on in exchange for the reduction in catastrophe underwriting risk?

  1. Moral hazard on the part of its own policyholders, who now take more careWhy not: Reinsurance does not change policyholder behaviour; moral hazard is not created by the cover.
  2. Counterparty credit risk, since the reinsurer may fail to pay after a large loss - correct
  3. Reserve risk, because reinsurance requires larger reserves for the retained claimsWhy not: Reinsurance does not enlarge reserve risk; ceding risk reduces net exposure, it does not add a new reserving risk.
  4. Longevity risk, because reinsured policyholders live longerWhy not: Longevity concerns survival of people and is unrelated to property catastrophe cover.

Ceding risk converts an underwriting exposure into an exposure to the reinsurer's creditworthiness, which matters most after a major catastrophe when many claims arrive together.

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