Risk Sharing in Insurance and Asset Markets

Market risk can be defined as the volatility in market price assets. There is the involvement of exposure to movements in the market level of financial variables. The insurance market is one of the financial institutions that face a lot of risks. When financial variables such as stock prices, interest, or commodity prices change, they come with increased risks and other market factors that may affect production. Risk is inevitable in any investment process. But it is in the way these risks are handled that makes the difference. Success comes when the involved parties have a clear understanding of the situation and can find the best approach to mitigating potential risks.

Risk sharing is one way of ensuring every party in an agreement receives marginal benefits. It is not about how much they get, but how much each party in a contract contributes. In financial markets, intermediaries are there to provide costly enforcement for most trades when people share the risk; hence, they form a crucial aspect of the organization in financial markets. It is vital to assess the degree of risk-sharing that can be achieved through financial markets when enforcement follows the threat of exclusion from future trading. Costly enforcement intermediaries are there to ensure risk-sharing happens in the most convenient manner for both parties involved.

One way of understanding risk sharing is through the study of Lindahl-equilibrium, where people put their investment in asset portfolios and relax their borrowing limits simultaneously by offering fees to an intermediary body that handles the cost of enforcement. It can be shown that financial markets always allow for optimal risk-sharing incomplete markets, and they prevent default in equilibrium when there is competitive, costly enforcement from intermediaries. 

Equilibrium' costly investments change into both agent-specific borrowing limits and price schedules that include separate default premium.

In today's economies, risk-sharing has become far too common, mainly through trades in financial assets. In many of these trades, there is the involvement of ex-post transfers between involved parties, and they have to be enforced because a party under obligation to make transfer has the incentive to default. Many institutions have been put up to assess the issue of default, give out penalty guidelines to these defaults, and carry out the penalties. One good example is the bankruptcy procedure, where specific sets of rules have to be followed for both parties' benefit. Its application through courts and its enforcement through public policy ensure every party involved gets what they deserve. Another great example is in enforcement and financial intermediaries like rating and collection agencies, clearinghouses, and settlement banks.

Because these intermediaries give out costly enforcement for most transactions on financial markets, they are a critical aspect of organizations in these markets. As an economic student, there are many situations you will meet that deals with risk and risk-sharing among different parties. Understanding the role of intermediaries in any degree of risk-sharing through financial markets, specifically for this unit, the insurance industry is one way to get ahead of the situation.

What is market risk?

Before looking at risk-sharing and related processes, it is important to first define what market risk is and why it is crucial in the economy. Market risk is closely related to the volatility of the market price of assets, and it involves exposure to movements in the level of financial values. Market risk also takes into account the exposure of options to movements in the hidden asset prices. In other words, the risk goes in buying stock exchange prices, interest rates, exchange rates, or commodity prices. And that is not all; market risk touches exposure to other unanticipated movements in the financial variables or the shifts in the actual or implied volatility of asset prices options.

Volatility affects the company's assets' real market value, which includes those needed to cover its liabilities. Every company that has assets and liabilities has to find a proper way of balancing them since they end up affecting the company's actual surplus. The volatility of market price for assets extends their effects into liabilities. This is why it becomes important to consider the assets and liabilities as well when looking at risk-sharing costs. There are at least of the possible ways involved in these effects. One way is that a change in asset yields affects the market value of liabilities via their effect on discount rates in cash flow if these liabilities. One must always consider these effects on liability. Most importantly, it is crucial to consider market risks from the look of both assets and liabilities. These two aspects each have important roles to play market development, particularly financial markets. The other effects come from a change in asset returns/yields, which affects the future cash flow of liabilities, where policyholders are entitled to some form of policy sharing, which may be related, for example, to actual or past returns on the assets. Based on this, we find three categories of the different types of 'interest' profit, which are;

1. Those involved in profit sharing based on objective indicators of capital markets' performance. For example, and indicator of the real interest rate that is discovered and made public.

2. Sharing of profit with the involvement of the company's actual performance, or performance-linked approach, more so, in connection to the company's investments. It is important to note that this type includes systems in which the management is entitled to 'declaring the bonus rate.'

3. Then there is a profit rate that is linked to the real performance of the assets that are 'locked-in' in at the discretion of the policyholder. In simple terms, the policyholder themselves are at least somehow responsible for how their premiums are invested. Also, note that the best instance of this category of profit-sharing in life insurance is profit sharing that is given with unit-linked or universal life products.

These three types of profit sharing may also come with specific types of guarantees to the insurer. For example, a bonus rate that will never be negative or a minimum maturity benefit. Based on these, we can say:

Market risks are a related aspect to the volatility between the market values of assets and liabilities within a certain period resulting from future changes in asset prices, yields, or returns. Considering this, alteration in liability cash flow because of effects on expected profit sharing should also be considered, and the free assets may be ignored.

Types of market risk

There are many types of market risk distinguished in the literature. Some examples include: Interest Rate Risk which follows exposure to losses from fluctuations in interest rates; Equity and Property Risk, which is the risk of exposure to losses due to fluctuations in the market values of equities and another asset; Currency Risk, that involves risk relative to changes in currency value, which cause a decline in the value of dominant assets in foreign currencies; Basis Risk, is the risk that feeds in instruments of different credit quality, liquidity, and maturity do not pull together, which exposes the company to variance in its market value independent of liability value; Reinvestment Risk, is the risk that benefits on the fund to be reinvested may fall below the expected levels. There is also Concentration Risk, which is the risk of increased exposure to losses that come from the concentration of investment in a geographical area or a different economic section. ALM Risk follows the idea of the risk that fluctuations in interest and inflation rates will have different effects on the values of the assets and liabilities. Another form of risk is the Off-Balance-Sheet Risk, which is involved with changes of contingent assets and liabilities, e.g., swaps, which under other circumstances, are not indicated on the balance sheet.

But there seems to be much more than has not yet been exploited in these categories. For instance, they do not take into consideration the minimum investment return guarantees. Also, some of the risk categories, like Interest Rate, Reinvestment, aid ALM Risk, have similar features and can be easily defined as one. As if that is not enough, some experts believe that most of these risks can be regarded as 'ALM Risks' or 'mismatch risk,' which is the risk related to the different sensitivity of assets and liabilities to shifts in the return on assets. This generally means risks relating to residual sensitivity of the surplus in these changes.

Measuring mismatch risks is only right if both the market value of assets and the market value of liabilities are measured adequately. We can derive the value of assets from listings in the different securities markets. The issue is a lack of real market value for insurance liabilities; their value can only be approximated. Based on these issues, it can be assumed that market risks fall into two main categories:

1. Risks from uncertainty concerning the composition of the replication asset portfolio, resulting in uncertainty of its value on the market,

2. Give the perceived replicating asset portfolio, the volatility of differences between the market value of the real asset portfolio, and the asset portfolio replication of the liabilities that result from changes in asset yields.

The difference between the two types of market risk can be proved through the aspect of time horizon. To some extent, we can consider category A risk as systematic, since they are caused by the scarcity of the replicating portfolio, or sometimes uncertainty about its composition. Also, replicating the asset portfolio may be missing.

Category B risks, on the other hand, can be diversified if we assume that it's possible to purchase replicating asset portfolio on the capital market, the real mismatch risk from the deviations between the market value of the specific portfolio and the value of the available assets deliberately selected by the management.

The benefits of risk-sharing

The funding structure of financial institutions is not something new. It has been heavily debated since the 2008-2009 crisis. On one side, there are advocates requesting a greater indebtedness of financial institutions that are harmful to the wider economy, without any good. Under this thought are the classic Modigliani-Miler logic and the leverage relating to distortion, as see through the proposal in the pecking-order and trade-off theories (such as the Admati and Hellwig 2013. 

The other group advocates for a more deposit-based funding structure, as seen in the modern process. They opine that relying solely on deposits is helpful for institutions due to the associated socially beneficial liquid-claim production, which makes the Modigliani-Miller model miss the market.

Even though these arguments focus most on banks, discussing them extends into insurance firms and other markets. Some discussions developed a unifying thought for the capital structure choice by insurance firms, which defines why people and firms chose equity, financial debt, or technical provisions. It is crucial to understand that insurer for the largest share of the financial sector as they hold close to 12% of a global financial asset. The worldwide market shares of 35 and for Europe and the US respectively are the most important markets for insurance services. In many previous cases, the financial theory has been used to the pricing of an insurance contract, (like in the case of Doherty and Garven, 1986), Kraus and Ross (1982), Cummins (1990) and Shimko (1992). These complete capital markets are not consistent with profitable insurance companies, which have substantial operating expenses.

Risk sharing in these institutions has been a major subject of discussion for many years. But we cannot deny its importance for insurers in terms of openness and international investment. There is a link between risk diversification, the intensity, and characteristics of international investment and institutions' quality in borrowing economies. We have already seen what risk-sharing is and why it is applicable to the market. It is clear that insurance institutions and markets require openness to carry out a profitable transaction. Risk sharing is necessary for proper transaction in any markets that involve money. Most importantly, studying the subject leads to more informed decision-making processes. The types of risks mentioned above are the basics of understanding this subject.

Author: James Hamilton