Extract from. Études et Dossiers No th Insurance and Finance Seminar of The Geneva Association December 2012 London.

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1 International Association for the Study of Insurance Economics Études et Dossiers Extract from Études et Dossiers No th Insurance and Finance Seminar of The Geneva Association December 2012 London March 2013 Working Paper Series of The Geneva Association Association Internationale pour l'etude de l'economie de l'assurance Geneva Route de Malagnou 53, CH-1208 Geneva Tel: Fax: Basel Sternengasse 17, CH-4051 Basel Tel: Fax:

The Geneva Association Association Internationale pour l'etude de l'economie de l'assurance Geneva Route de Malagnou 53,

2 The Geneva Association Working Paper Series Études et Dossiers appear at irregular intervals about times per year. Distribution is limited. The Études et Dossiers are the working paper series of The Geneva Association. These documents present intermediary or final results of conference proceedings, special reports and research done by The Geneva Association. Where they contain work in progress or summaries of conference presentations, the material must not be cited without the express consent of the author in question. The opinions expressed in Geneva Association newsletters and publications are the responsibility of the authors. We therefore disclaim all liability and responsibility arising from such materials by any third parties. This document is free to download from The Geneva Association website, please visit:. Layout & Distribution: Alessandra Platania The Geneva Association Association Internationale pour l'etude de l'economie de l'assurance

These documents present intermediary or final results of conference proceedings, special reports and research done by The Geneva Association.

3 Insurers as Investors: Derivatives and Risk Management Clifford W. Smith I want to offer a simple framework for analyzing risks and derivatives I will focus on three risks Price Risk Default Risk Systemic Risk 12-1

4 Understanding these Risks is Important for At Least Four Reasons Insurers use of derivatives to manage their risks The value of an insurer s asset portfolio depends on the derivatives positions of the firms whose claims they purchase Some insurers are derivatives market makers The industry is regulated, in part, by its perceived risks To start, consider a firm with a core business exposure to a price if firm value falls by enough, it becomes insolvent ΔV Δp Core business exposure 12-2

insurers are derivatives market makers The industry is regulated, in part, by its perceived risks To start, consider a

5 If the firm uses derivatives to hedge, the likelihood of insolvency is reduced Derivatives Position Net Exposure Core business exposure Famous (Or Infamous) Quotes about Derivatives Derivatives are the moving vans of risk they shift risk from place to place by substituting one type of risk for another. Richard Breeden Former SEC Chair Derivatives are financial weapons of mass destruction. Warren Buffett 12-3

moving vans of risk they shift risk from place to place by substituting one type of risk for another.

6 Versus Default With most corporate claims, insolvency and default are closely tied For example, if a firm is insolvent, it will default on its obligations with respect to its debt obligations But with many derivatives, the firm may either owe funds or be entitled to receive funds. Derivative is out of the money ΔV Derivative Position Δp Default 12-4

debt obligations But with many derivatives, the firm may either owe funds or be

7 Derivative Used As A Hedge ΔV Δp Default Derivative used to speculate Doubling Up the core business exposure ΔV Δp Default 12-5

8 Systemic risk is often envisioned as a domino effect default on one derivatives contract spreads to other contracts and markets If derivatives are to cause such a domino effect, it is critical to understand the correlations among derivative defaults There are strong economic incentives for derivative defaults to have correlations Dealers have incentives to assess default risks; in practice, derivative customers tend to be strong credits Firms using derivatives to hedge are not likely to become insolvent when their derivatives are in the money Thus derivative defaults are significantly more idiosyncratic than defaults on loans 12-6

have correlations Dealers have incentives to assess default risks; in practice, derivative customers tend to be strong credits Firms using derivatives to hedge

Extract from. Études et Dossiers No. 295. Annual Liability Regimes Conference A European Perspective on Global Developments

Extract from. Études et Dossiers No. 295. Annual Liability Regimes Conference A European Perspective on Global Developments International Association for the Study of Insurance Economics Études et Dossiers Extract from Études et Dossiers No. 295 Annual Liability Regimes Conference A an Perspective on Global Developments 27