1. The term risk margin is commonly used in the observation that stating the loss reserve at nominal (rather than discounted) values provides an implicit risk margin. It is clear that the amount of the risk margin in this circumstance is the difference between undiscounted and discounted reserves.
RISK MARGIN APPLICATION
1. Self Insurance Trust fund tend not to have a capital or surplus account. Rather, it establishes a funding requirement such that the available funds correspond to the p” percentile of the aggregate loss distribution, where p is typically 75% or 90%. The risk margin is the recommended funding requirement less the expected present value of the reserves.
2. A company retiring from business may sell a portfolio of reserves to another company. In theory, the amount of the purchase price less the present value of the expected payments represents a risk margin. Unfortunately, this does not provide a good empirical source for risk margin data because most of these transactions involve other factors, such as tax considerations and stop loss agreements.
3. a risk margin represents the difference between the expected (discounted) value of the reserves and the certainty equivalent of the reserves, where certainty equivalent means the amount certain one would accept (or pay) now in exchange for a stream of payments in the future whose amount and timing is uncertain. A lump sum payment in exchange for a portfolio of reserves will represent a certainty equivalent, if no extraneous items (such as taxes, expenses, side agreements or default risk) are involved.
RISK MARGIN DEVELOPMENT
1. Some actuary methodology tend to be heavily judgemental relating margins to claims development, reinsurance recovery and interest rates.
2. Each margin is selected from a range (with options for selecting outside the range) based on a qualitative list of considerations. The claims development margin range could be O-15%, the reinsurance recovery at O-25% and the interest rate margin is a downward adjustment, (which can vary by line of business) to the interest rate used for discounting. The range is from 50 basis points to 200 basis points.
TYPE OF RISK MARGINS
1. Risk margin based on a certainty equivalent concept - Under this concept, a risk margin would be calculated such that, when added to a present-value reserve, it produces an estimate of the certainty equivalent value; that is, the amount of cash immediately payable to transfer the liability. This concept corresponds to loss portfolio transfers.
2. Risk margin based on a theory of ruin concept - Under this concept, a risk margin would be calculated such that the probability of insolvency or the expected cost of insolvency is reduced to an acceptable level. This concept corresponds to risk theoretic discussions of insurance enterprises.
3. A risk margin based on probability intervals - Under this concept, a probability, such as 75% or 90%, is specified. A risk margin is calculated such that the actual loss amount is less than or equal to the expected loss plus the risk margin in the specified proportion of times, These intervals are sometimes referred to as confidence intervals.’ This concept is commonly used in trust fund analyses.
The probability intervals are usually applied to undiscounted losses.
4. A risk margin intended to simply provide a relative measure of tisk - Fixed percentage of the aggregate loss variance might be proposed as a risk measure. This value would be higher for companies with more risk, thereby providing a relative measure. The absolute value of the measure, however, might not have a precise meaning.
PRICING AND RISKS MARGIN
1.A block of business is normally priced at a level intended to provide a sufficient profit after paying expected losses and expenses, Premium levels will be affected by many external events, but over long periods of time for the industry as a whole, it is reasonable to assume that the profit margins will be related to the amount of risk assumed by the company.
2. An insurance enterprise must be financially able to withstand actual loss payments in excess of expected payments, There are two ultimate sources of funds to provide for this contingency. They are Surplus from investors and Profit margin from insureds. The term capital is sometimes used to refer to the original amount of assets provided by the investors (or subsequent infusions) as distinct form retained earnings.
3. The profit margin, is generally considered to be the risk margin, and the other source, surplus, is not. When we turn to loss reserves, the situation is not as clear.
LOSS RESERVE AND RISK MARGIN
1.A loss reserve margin is an amount needed over and above the expected (discounted) reserves to reflect the inherent riskiness of the reserves.
2. The term “risk margin” in the context of loss reserves does not provide a distinction between the two ultimate sources of fund-the insured and the investor. Therefore loss reserve margin should be merely an earmarked surplus item which is equivalent to implying that the source of the amount is the investor.
RISKS MARGIN IN ACCOUNTING
1. In the property-casualty insurance industry, accounting conventions have generally dictated that loss reserves should be established on a nominal basis, that is, without any reduction for the time value of money. On other hand, life insurance has always formally incorporated the time value of money in its accounting. The length of time associated with life contracts has always been long enough that the simplicity arising from nominal reserves is far overshadowed by the material distortions which would result.
2. However the industry has changed in three significant ways:
(i) The property-casualty industry has migrated from a predominantly property (i.e., short-tail) to a predominantly casualty (longer tail) book of business
(ii) Individual lines of business have experienced a lengthening of the payment tail
(iii) Interest rates, while lower today than a decade ago, are still well above rates prevalent over the first half of this century.
3. An analysis of the accounting of a single policy, starting with a low-interest scenario on short-tail business, and gradually changing assumptions to a level consistent with today’s marketplace would yield the following:
(i) If very short-tail business is written in a low interest environment, the timing of profit recognition arising from accounting rules roughly mirrors the pattern that corresponds to economic reality.
(ii) If longer-tail business is written in a higher interest rate environment, accounting conventions significantly delay the recognition of profit. The accounting of a single policy implies that the business loses money in the year it is written, and profits are earned in subsequent years.
