Financial Markets, Securities, and Risk Management Concepts
Financial Market Assets
Other assets exchanged on the financial market include:
Commodities
Tangible or non-tangible goods such as crude oil, gold, coal, aluminum, copper, wheat, electricity, broadcasting rights, and digital commodities.
Securitization
A process by which non-tradable assets or financial products, such as mortgages, car loans, and credit cards, are aggregated to build a tradable security.
Mortgage-Backed Securities (MBS)
Securities whose cash flows depend on a pool of residential or commercial mortgages. There are special types of bonds based on the principal or interest payments of the underlying loans. Life insurers and pension plans invest in MBS to manage interest rate risk.
Collateralized Debt Obligations (CDOs)
Securitization has led to complex structured products such as CDOs. In CDOs, low-quality (subprime) mortgages and MBS were repackaged into other securities. The collapse of the housing market in the U.S. in 2007–2009 and the financial crisis that followed have confirmed the difficulty of assessing the risk of these complex securities.
Bonds and Interest Rates
A bond is a type of loan issued by an entity, such as a corporation or a government.
Term Structure of Interest Rates
The relationship between the maturity of a loan and the annual interest rate underlying that loan, usually represented by a yield curve.
Spot Rates (rT)
The T-year spot rate is the annual interest rate agreed upon today, at time 0, for a loan or an investment starting immediately, whose capital and interest are paid only at maturity, at time T.
Forward Rates (fT1,T2)
An annual interest rate agreed upon today, at time 0, for a loan or an investment starting some time in the future, say at time T1, and whose capital and interest are paid at a later maturity time, say at time T2 > T1.
Stock Indices
Stock indices represent the value of an artificial portfolio of stocks chosen to represent a sector, an overall market, or a subset of the entire spectrum of stocks available. They are maintained by financial information companies or large institutional investors.
Risk Management and Investment Strategies
Risk Management, Hedging, and ALM
Gain (loss) from a derivative position is used to offset loss (gain) from a risk exposure or actuarial liability.
Investment and Speculation
Gain (loss) from a derivative position is used to increase profits, at the risk of suffering significant losses.
Characteristics of Univariate Financial Series
Typical characteristics for univariate series include:
- Non-i.i.d. Returns Across Time: Time series data of returns, in particular daily return series, are in general not independent and identically distributed (i.i.d.).
- Non-Constant Volatility: The volatility of return processes is not constant with respect to time.
- High Auto-Correlation: The absolute or squared returns are highly autocorrelated.
- Non-Normal, Fat-Tailed Distribution of Returns: The distribution of financial market returns is leptokurtic. The occurrence of extreme events is more likely compared to the normal distribution.
Characteristics of Multivariate Financial Series
Typical characteristics for multivariate series (from a portfolio viewpoint) include:
- Strong Contemporaneous Correlations: The absolute value of cross-correlations between return series is less pronounced, and the contemporaneous correlations are in general the strongest.
- High Auto-Correlation: In contrast, the absolute or squared returns do show high cross-correlations. This empirical finding is similar to the univariate case.
- Non-Constant Contemporaneous Correlations: The contemporaneous correlations are not constant over time.
- High Correlation in Extreme Values: Extreme observations in one return series are often accompanied by extremes in the other return series.
Implications of Financial Return Observations
- Analytic models which assume i.i.d. processes for the losses are not adequate during all market episodes.
- Analytic models that are based on the normal distribution will fall short in predicting the frequency of extreme events (losses).
What is Insurance?
Insurance is an instrument designed to protect against a potential financial loss. It is a risk transfer mechanism whereby an individual or an organization pays a premium to another entity to protect against a loss due to the occurrence of an adverse event. Insurance includes typical insurance policies (life, homeowner’s), pension plans, and other social security systems.
Core Analytics Functions in the Insurance Industry
Pricing
Computing the cost of insurance protection (or of a specific pension plan design), designing policies and protections that are best for the customer (or employee) and the company (or pension plan sponsor), and participating in the price determination.
Valuation
Given the current market conditions (interest rates, returns on financial markets) and a set of assumptions, computing the current value of actuarial liabilities, i.e., of contractual obligations. Valuation is useful to determine the amount of money to reserve, an actuarial function known as reserves, and to determine capital requirements.
Investments
Designing investment strategies and finding financial assets to mitigate the risks related to the organization’s actuarial obligations. This is not as common for property and casualty (P&C) insurance companies.
Risk Management Approaches
Risk management approaches differ according to the type of risks:
Diversifiable Risk
Diversify over additional (independent) individuals or geographically over additional countries and continents.
Systematic Risk
Hedging and Replication
Trade in the financial markets to reproduce the behavior of cash flows of liabilities. This approach is generally costly but carries very small insolvency risk. This is also known as replication or hedging.
Investment Strategy and Speculation
Manage a balanced portfolio of financial securities with the objective of increasing returns, thus lowering the time value of money. However, it comes with the risk that investments are insufficient to meet obligations. Portfolio managers focus on reducing this latter risk while trying to maximize returns.