Tail-risk events are extreme events such as flood, storms and market crashes which can erode an insurer's capital and profitability.Tail-risks are found at the extreme left end of bell curves. Insurers would want to minimize fat tail risks without losing out on right tail growth potentials.
Two separate companies can have exact loss exceeding amounts but with difference tail expectations. Portfolio changes can be made to influence the shape of the tail reducing solvency risk in extreme scenarios.Below is an example of a bell curve with a fat tail.
The collapse of Lehman Brothers is an example of tail risk due its leverage and liquidity issues. Banks relied on VAR models to manage credit and market exposures with 2 flawed assumptions being market is efficient and losses are normally distributed. More will be covered on VAR in subsequent posts.
MANAGING TAIL-RISK AT A COST
General Insurers employ a re-insurance strategy to reduce the impact of insurance tail events. life insurers use options and derivatives to hedge investment embedded return guarantees.
As its not feasible to hedge every security, Insurers should consider a risk factor approach to identify and hedge the main drivers of risk.
For example a typical insurance company is investing 85% of its assets in fixed income with remainder allocated to equities and real estate. Assuming the fixed income portion are mainly invested in government bonds and has matched its its liabilities, the risk driver would come from equity and credit spread risks from the bonds reason being equities are much volatile than fixed income.
Lastly, Solvency II regulations specifically recommended hedging for capital management and explicitly identified instruments such as swaps, swap options, credit derivatives and puts but there are still some level of basis risk as perfect hedges are unavailable or not economically sound.
