Insurance and finance risk modeling

See also: Introduction to risk analysis, Distributions in ModelRisk, Aggregate distributions introduction, Discounted cashflow modeling

We introduce some techniques that have been developed in insurance and finance risk modelling. Even if insurance and finance are not your fields you might still find some interesting ideas in here.

Insurance and finance analysts have placed a lot of emphasis on finding numerical solutions to stochastic problems - something that is highly desirable because it gives more immediate and accurate answers than Monte Carlo simulation. We show some modelling techniques to give you a flavour of what can be done. Notice that the insurance and finance domains frequently share common principles in modeling.

We cover the following topics:

• Operational risk modeling

• Credit risk

• Credit ratings and Markov Chain models

• Two measures of risk: Value at Risk (Var) and Expected Shortfall (ES)

• Term life insurance

• Accident insurance

• Modeling a correlated insurance portfolio

• Modeling extremes

• Discounted cashflow modeling - in this topic many of the general risk analysis topics covered come together.

Two other types of risk are noteworthy but not covered in separate topics: market risk and liquidity risk. So we'll touch upon them only briefly.

Market risk

Market risk concerns equity, interest rate, currency and commodity risks. The returns or values of a portfolio of assets are subject to individual level uncertainty but are also subject to various correlations at two levels: specific risks apply to a small number of assets that are subject to a common acute drive" and systematic risks apply more generally to a market sector (e.g. the price of natural gas affects methanol producers) or the market as a whole (e.g. exchange rate).

Correctly recognizing the effects of market risk allows an investor to manage its portfolio of assets by mixing negatively correlated assets to offset specific risks (e.g. invest in both a methanol and an oil company) and systematic risks (invest in assets in different countries). The quality of market risk analysis is highly dependent on accurate modelling of correlation. Copulas are particularly helpful in this regard because they offer considerable flexibility in representing and fitting the structure of any correlation.

Liquidity risk

Liquidity risk concerns a party who is an owner, or is considering becoming an owner, of an asset, and is unable to trade the asset at its proper value (or at all) because nobody in the market is interested. Liquidity risk arises when the party needs to raise cash at short notice, so it is intimately linked to the cash position of the party. The problem mostly concerns emerging or low-volume markets when the assets are stocks, etc. When the asset is an entire company and there are few potential buyers, the buyer may take advantage of the urgency to sell.

Read on: Operational risk modeling