Risk Management of Lancashire Group

Course Title Financial Risk Management

Submitted to Sir. Syed Abbas

Submitted by Annum Javaid Khokhar Muhammad Kamran

MBA 2K9 June 13, 2011

SCOPE
The scope of this project is to analyze the risks of a General/ non-life insurance company listed anywhere except Pakistan. For the conduct of this research Lancashire Holdings Limited listed on London Stock Exchange is selected.

EXECUTIVE SUMMARY
Lancashire is a general insurance company founded in 2005. It has underwriting operations in Bermuda and London, and a marketing operation in Dubai. Its main focus is on property, energy, marine and aviation insurance. Lancashire during his past five years of operations has earned positive total investment return in 18 out of 20 quarters. Being a general insurance company proper risk management is very critical for the companys profitability. This report will highlight the different risks faced by Lancashire and the strategies used to mange those risks. How the use of certain derivatives can hedge some of the company risks is also discussed.

TABLE OF CONTENTS
Introduction ................................................................................................................................ 1 1. 2. Life insurance................................................................................................................... 1 General insurance ............................................................................................................. 1

Types of General Insurance ..................................................................................................... 1 Process for getting the insurance.............................................................................................. 2 Insurance Claims Process ........................................................................................................ 2 Company Introduction ................................................................................................................ 3 Lancashire Holdings Limited ................................................................................................... 3 Group Operating Structure ...................................................................................................... 3 Business Lines......................................................................................................................... 4 Lancashires Business Model .................................................................................................. 4 Disclosure of Company Risks and There Management Strategies................................................ 5 1. 2. 3. 4. 5. 6. 7. 8. Insurance risk ................................................................................................................... 5 Investment risk ................................................................................................................. 6 Debt risk .......................................................................................................................... 7 Currency risk .................................................................................................................... 7 Liquidity risk.................................................................................................................... 8 Credit risk ........................................................................................................................ 8 Operational risk ................................................................................................................ 9 Strategic risk .................................................................................................................... 9

Managing Risk with Financial Instruments ............................................................................... 11 Hedging Foreign Currency Risk ............................................................................................ 11 Forward contracts .............................................................................................................. 11 Option Contracts ................................................................................................................ 12 Hedging Interest Rate Risk .................................................................................................... 12 US market:......................................................................................................................... 13 European market: ............................................................................................................... 13 Appendix References

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INTRODUCTION
Insurance is defined as the impartial transfer of the risk of a loss, from one entity (policyholder) to another (insurer), in exchange for payment (premium). Insurance is broadly classified into following two areas.

1. LIFE INSURANCE
In life insurance a specific sum of money is designated to a beneficiary upon the death of the insured person. Depending on the contract, other events such as terminal illness or critical illness may also trigger payment.

2. GENERAL INSURANCE
General insurance typically means anything other than life insurance coverage. It is called property and casualty insurance in the U.S. and Non-Life Insurance in Continental Europe. It involves insuring the risks associated with automobiles, business related, natural incidents, commercial and residential properties, fire and marine etc. In most countries, both life and non-life insurance providers are subject to different regulations and different tax and accounting rules. The main reason for the distinction is that life insurance is very long-term in nature and can cover risks over many decades. By contrast, non-life insurance cover usually covers a shorter period, such as one year.

TYPES OF GENERAL INSURANCE

1. Standard lines: When companies use pattern or "cookie-cutter" policies without variation from one person to other. 2. Excess lines: Typically insure risks not covered by the standard lines market. They are broadly referred as being all insurance placed with non-admitted insurers. These companies have more flexibility and can react faster than standard insurance companies.

PROCESS FOR GETTING THE INSURANCE

INSURANCE CLAIMS PROCESS

COMPANY INTRODUCTION
LANCASHIRE HOLDINGS LIMITED
The company founded on 2005, focus on short-tail, specialty property insurance. It has underwriting operations in Bermuda and London, and a marketing operation in Dubai. Lancashire is headquartered in Bermuda. Its main focus is on property, energy, marine and aviation insurance. 85% of its business is primary insurance rather than re-insurance. Lancashire during his past five years of operations has earned positive total investment return in 18 out of 20 quarters. At the end of year 2010 Lancashire reported net income of $329 million with assets of worth $2,6274 millions and ROE of 23%.

GROUP OPERATING STRUCTURE

BUSINESS LINES
Lancashire business lines includes the following.

LANCASHIRE S BUSINESS MODEL

Lancashire makes money in two ways: 1. through underwriting, the process by which insurers select the risks to insure and decide how much in premiums to charge for accepting those risks 2. by investing the premiums they collect from insureds. Profit = earned premium + investment income - incurred loss - underwriting expenses

RATINGS
Lancashire has received investment grade ratings from the 3 major rating agencies namely Standard & Poors Rating Services, Moodys Investor Service and A. M. Best. The detailed credit quality description is depicted in the figure.

DISCLOSURE OF COMPANY RISKS AND THERE MANAGEMENT STRATEGIES

The Group is exposed to risks from several sources. These include market risk, liquidity risk, credit risk, operational risk and strategic risk. Market risk: The Market risk of Lancashire incorporates the following risks. y y y y Insurance risk Investment risk Debt risk Currency risk

1. INSURANCE RISK
This risk arises from the factors mentioned below, y The advent or continuation of a soft market, which may result in a stabilization or decline in premium rates and/or terms and conditions for certain lines, or across all lines. y The actions and reactions of key competitors, which may directly result in volatility in premium volumes and rates, fee levels and other input costs. y Market events which may cause a limit in the availability of cover, including unusual inflation in rates, causing political intervention or national remedies. MANAGEMENT OF INSURANCE RISK These areas are managed by Lancashire in following ways, y y y y Reviews and amends underwriting plans and budgets as necessary. Reduces exposure to market sectors where conditions have reached unattractive levels. Purchases appropriate, cost effective reinsurance cover to mitigate exposure. Closely monitors changes in rates and terms and conditions.

2. INVESTMENT RISK
It is the uncertainty that the actual return on an investment will be lower than the investor's expectations. The Groups net asset value is directly impacted by movements in the value of investments held. There are three types of investment portfolios held by the company. Core portfolio, which has duration matched to the duration of the insurance liabilities within an agreed range. The core portfolio is invested in fixed income securities and cash and cash equivalents. The primary objectives of this portion of assets are capital preservation and providing liquidity to meet insurance and other near term obligations. Assets in excess of those required to be held in the core portfolio, are typically held in the core plus or surplus portfolios. The assets in the core plus and surplus portfolios are not matched to specific insurance liabilities and invested in fixed income securities, cash and cash equivalents and derivative instruments. In general, the duration of the surplus portfolio may be slightly longer than the core or core plus portfolio, while maintaining a focus on high quality assets. MANAGEMENT OF INVESTMENT RISK Company is managing this risk by setting parameters on permissible assets, duration ranges, credit quality and maturity and compliance with guidelines is monitored on a monthly basis. If certain asset classes are anticipated to produce a higher return within managements risk tolerance or if the risk profile is expected to move outside of tolerance levels, adjustments may be made to reduce the risks in the portfolio. The sensitivity of the Groups fixed income and derivative investment portfolio to interest rate movements is detailed in Appendix. The duration of the core portfolio is matched to the modeled duration of the insurance reserves, within a permitted range. The permitted duration ranges for the core and core plus portfolios are 0 4 years and 1 5 years respectively. The overall duration for fixed income and managed cash and cash equivalents is 2.2 years.

3. DEBT RISK
Debt risk deals with uncertainty in terms of coupon payments against the loan held by a company. On 15 December 2005 the Group issued, $97.0 million and 24.0 million in aggregate principal amount of subordinated loan. The loan notes bear interest at a floating rate that is re-set on a quarterly basis, plus a fixed margin of 3.70%. MANAGEMENT OF DEBT RISK The Group is subject to debt risk on the coupon payments of the long-term debt, which was mitigated by entering into interest rate swap contracts as follows: Subordinated loan notes $97.0 m Subordinated loan notes 24.0 m Maturity date 15-Dec-35 15-Jun-35 Prepayment date 15-Mar-11 15-Mar-11 Interest hedged 50% 50%

These swaps have expired on 15 March 2011. In certain circumstances the subordinated loan notes could have been prepaid and the price penalty for prepayment has reduced to zero by 15 March 2011.

4. CURRENCY RISK
The Group underwrites from two locations, Bermuda and London, although risks are assumed on a worldwide basis. The functional currency, in which operations are conducted, is U.S. dollars. The Group is exposed to currency risk to the extent its assets are denominated in different currencies to its liabilities. Exchange gains and losses can impact income. MANAGEMENT OF CURRENCY RISK The Group hedges non-U.S. dollar liabilities primarily with non-U.S. dollar assets. The Groups main foreign currency exposure relates to its insurance obligations, cash holdings, premiums receivable, dividends payable and the 24.0 million subordinated loan. Lancashires assets and liabilities are in different currencies are presented in appendix.

5. LIQUIDITY RISK
Liquidity risk is the risk that cash may not be available to pay obligations when they are due without incurring an unreasonable cost. The Groups main exposures to liquidity risk are with respect to its insurance and investment activities. Exposures in relation to insurance activities are as follows: y Large catastrophic events, or multiple medium-sized events in quick succession, resulting in a requirement to pay a large amount of claims within a relatively short time-frame. y Failure of insureds or reinsurers to meet their contractual obligations with respect to the payment of premiums or claims in a timely manner. Exposures in relation to investment activities are as follows: y Adverse market movements and/or a duration mismatch to obligations, resulting in investments being disposed of at a significant realized loss; and y An inability to liquidate investments due to market conditions.

MANAGEMENT OF LIQUIDITY RISK The Group manages its liquidity risks via its investment strategy to hold high quality, highly liquid securities, sufficient to meet its insurance liabilities and other near term liquidity requirements. The creation of the core portfolio with its subset of guidelines ensures funds are readily available to meet potential insurance liabilities in an extreme event plus other near term liquidity requirements. The Group monitors market changes and outlooks and re-allocates assets as deemed necessary.

6. CREDIT RISK
Credit risk is the risk that counter-party may fail to pay, or repay, a debt or obligation. The Group is exposed to credit risk on its y y fixed income investment portfolio derivative instruments

y y

inwards premiums receivable from insured and cedants and, on any amounts recoverable from reinsurers.

MANAGEMENT OF CREDIT RISK For managing credit risk Lancashire use the following tactics y y Invest in instruments of high credit quality issuers Keeping securities rated below BBB/Baa3 no more than 5% of equity, with the exception of U.S. government and agency securities y Use of exchange traded instruments with established clearing houses and margin requirements y Credit risk on inwards premiums receivable from insureds and cedants is managed by conducting business with reputable broking organizations and by employing.

7. OPERATIONAL RISK
Operational risk is the risk of loss resulting from inadequate or failed internal processes or systems. MANAGEMENT OF OPERATIONAL RISK In order to manage operational risks, the Group has implemented a robust governance framework. The Groups internal audit function provides independent feedback with regard to the accuracy and completeness of key risks and controls, and independently verifies the effective operation of these through substantive testing..

8. STRATEGIC RISK There are following three types of strategic risks faced by Lancashire.

BUSINESS PLAN RISKS The Group addresses the risks associated with the planning and execution of the business plan through a combination of the following. y y y y An iterative annual planning process with cross departmental involvement. Approval of the annual business plan by the Board of Directors. Regular monitoring of actual versus planned results. Periodic review and re-forecasting as market conditions change.

CAPITAL MANAGEMENT RISK Risks associated with the effectiveness of the Groups capital management is mitigated as follows: Regular monitoring of current regulatory and rating agency capital requirements. Maintaining contact with vendors, regulators and rating agencies in order to stay abreast of upcoming developments. The Group reviews the level and composition of capital on an ongoing basis with a view to: Maintaining sufficient capital for underwriting opportunities and to meet obligations to policyholders. Maximizing the return to shareholders within pre-determined risk tolerances. Meeting internal and regulatory capital requirements. RETENTION RISKS Risks associated with succession planning, staff retention and key man risks are mitigated through a combination of resource planning processes and controls, including: The identification of key personnel with appropriate succession plans. Documented recruitment procedures, position descriptions and employment contracts. Resource monitoring and the provision of appropriate compensation and training schemes.

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MANAGING RISK WITH FINANCIAL INSTRUMENTS

Lancashire use difference governance mechanisms accompanied with continuous monitoring and controlling for managing its risk. Being an insurance company, changes in external variables can impact its bottom line by affecting subcomponents of its business model which is:Profit = earned premium + investment income - incurred loss - underwriting expenses Financial instruments particularly derivatives can be used to protect Lancashire from unfavorable changes in market variables. The Groups investment guidelines also permit the investment managers to utilize exchange-traded derivative instruments and forward OTC instruments.

HEDGING FOREIGN CURRENCY RISK

Lancashire business has been continuously growing around the globe since its inception from year 2005. This has resulted in Cashflows other than its functional currency which is US Dollars. This is a major reason for Lancashires foreign exchange risk. There are a number of tools available to hedge the foreign exchange exposure. We will concentrate on the use of derivative instruments. Year 2010 foreign currency receivables and payables are mentioned in Table1. These trends are assumed to be continued in 2011 and derivates are planed accordingly. FORWARD CONTRACTS The table below shows the covered position using one year forward rates to buy and sell. These rates have been obtained from FX Street Foreign Exchange Services as of 10th June 20111. Bid 6.48019 0.6969 11.8686 Ask 6.4825 0.6975 11.8697

USD/Chi Rmb USD/EUR USD/MEX$

FX Street one year forward rates, [Available from http://www.fxstreet.com/rates-charts]

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OPTION CONTRACTS Forward contracts can provide a perfect hedge to match foreign exposure requirements; however it restrained Lancashire to gain from favorable conditions. To overcome this, currency options contracts can be used. It is assumed that the notational amounts will be the same as the previous year 2010. Calculating net notional amounts and option types:Notion l R iv bl ( ) Notion l bl ( ) Net ount ( ) Option T pe t ll ll

The table below shows the number of options contracts that will be needed to hedge net receivables and payables for the coming year using PHLX currency option specifications2. The exercise style of PHLX options are European.
China N t ti Spot P L N . Cover l ri i l change rate i r i l rr rr hange ntract si e ti n contracts required option contracts Chi . 62,500 311 ,437,500 . 0,000 781 7,810,000 . 00000 59 5,9,00,000 Europe Mexico

HEDGING INTEREST RATE RISK

The financial statement of the group shows that the group has a debt of $97m and 34m (Financial Statements 2010). Interest rate risk on debt can be hedged by taking short positions in bond futures contract in their respective markets.

Nasdaq PHLX, [Available from http://www.nasdaqtrader.com/Micro.aspx?id=phlxwcoproductspecs]

 # &

 # # 
.

Chi s i i i P s r

- . - .

! ! 

% 

% $# 

" ' " !   

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US MARKET: The debt for US markets is $97million (Annual Report 20101). The size per contract is 100,000 US dollars for the CME swaps rate futures with settlement price of 96.32. Hence the number of contracts to be shorted is 970.

EUROPEAN MARKET: The amount of debt outstanding is 24million (Annual Report 2010). The size of one Euro-Bund future contract is 100,000 and it is for 8.5 to 10.5 years with last quoted settlement price is 108.61 (Eurex). For hedging the number of contracts to be shorted is 24.

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APPENDIX

The sensitivity of the Groups fixed income and derivative investment portfolio to linear movements in interest rates. Immediate shift in yield (basis points) 100 75 50 25 -25 -50 -75 -100 $m -52.5 -39.4 -26.3 -13.1 11.9 23.8 35.7 47.6 % -3.1 -2.3 -1.5 -0.8 0.7 1.4 2.1 2.8

Assets in liabilities denominated in other currencies. Assets ($ m) otal assets as at 31 December 2010 U.S.$ 2,155.20 Sterling 286.7 Euro 138.9 ther 46.6 otal 2,627.40

Liabilities ($ m) otal liabilities as at 31 December 2010

U.S.$ 864

Sterling 292.2

Euro 147.4

ther 36.9

otal 1,340.50

REFERENCES

Lancashire holding group corporate website http://www.lancashiregroup.com/

Lancashire annual report 2010 http://www.lancashiregroup.com/lre_group/investor_relations/results_presentations/repor ts/2010/2011-03-15/2011-03-15.pdf

Lancashire in estors presentations http://www.lancashiregroup.com/lre_group/investor_relations/results_presentations/prese ntations/

FX Street one year forward rates http://www.fxstreet.com/rates-charts

Nasdaq PHLX http://www.nasdaqtrader.com/Micro.aspx?id=phlxwcoproductspecs

Chicago Mercantile Exchange, Interest ate Swap http://www.cmegroup.com/trading/interest-rates/swaps/cbot-10-year-interest-rateswap_contract_specifications.html

Eurex, Euro-Bund Futures (FGBL) Version 18

ct 2010

http://www.eurexchange.com/trading/products/I T/FIX/FGBL_en.html