Although equity markets suffered dramatic losses, what really sets 2008 apart is that so many different markets fell at the same time.  This failure of diversification has affected the entire financial services market - from individuals invested in risky assets, through to the very largest global insurance groups who have seen significant erosion and volatility in their risk capital.

Despite the apparent rarity of such extreme events, past experience suggests that the loss of diversification under the impact of a large global shock should not have been a surprise.  Firms and regulators must now recognise this economic reality and the impact it will have on product design, individual advice and the associated capital costs.

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The market turmoil of 2008 has highlighted the need for firms to better understand, communicate and advise on the risks inherent in financial products. 

It is essential to be able to show to customers (and regulators) that the products and advice delivered are appropriate to savers' objectives, both at point-of-sale and throughout the life of a product.

Barrie & Hibbert have established a framework that consistently measures product and fund risk against customers’ objectives, allowing comparison of a diverse range of products, stress testing of the main risk drivers and effective communication with customers.

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The provision of investment guarantees to retail investors has been increasing over the last few years with the growth of variable annuities.  The expansion in the provision of these guarantees has led to the introduction of hedging programmes to manage the risks.  The extreme volatility of the last year has tested the effectiveness of hedging actions and it seems likely that many providers of guarantees will have experienced significant losses.

Our research has shown how VA hedging can be enhanced by more rigorous analysis of the non-hedged risks, better understanding of model risk and better estimates of exposures to credit risk.

As a consequence of last year's market turmoil providers will have to:

• upgrade their methods and models to significantly improve the measurement and management of VA market risks, and
• consider changes to guarantee product design and pricing.

Given the attraction to consumers of products with guarantees in volatile markets, the stakes remain high.

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During 2008, it sometimes seemed as if a “perfect storm” extreme stress scenario from a boardroom strategy presentation was unfolding before our eyes.

Although this has placed strains on capital adequacy levels and profit margins, it has also reinforced an important lesson that tail events, however unlikely, can happen.

As a result the global insurance industry is now considering revising its methodologies for market-based assessments of capital. 

Find out more about Barrie & Hibbert's current views on this issue.

Credit spreads can be split into estimates of expected default losses, a credit risk premium relating to uncertainty in those losses and a liquidity premium. Barrie & Hibbert economic research de-composes the recent significant movements in credit spreads into these underlying components.

This can be of interest to long-term liability writers such as annuity businesses, who are generally buy-and-hold investors, and can therefore earn the liquidity premium 'for free'. Armed with liquidity premium estimates, they are better able to price and value their business and, under some regulatory regimes, calculate their statutory reserves.

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