Chapter Outline 4.1CONTRACTING COSTS OF RISK POOLING ARRANGEMENTS Types of Contracting Costs Ex Ante...

Chapter OutlineChapter Outline

4.1CONTRACTING COSTS OF RISK POOLING ARRANGEMENTS

Types of Contracting Costs

Ex Ante Premium Payments vs. Ex Post Assessments

4.2Insurer Insolvency Risk and the Role of Capital

4.3 Ownership and Sources of CapitalMutual InsurersStock InsurersLloyd’s of London

Chapter OutlineChapter Outline

4.4 Factors Affecting Insurer Capital DecisionsBenefits of Increasing Capital

Higher Premium RevenueProtect the Value of ‘Specific Assets’ (Franchise

Value)Costs of Increasing Capital

Correlation of Insurer Liabilities with Investors’ Other Assets

Double Taxation on Investment ReturnsAgency CostsIssuance and Under-pricing Costs

Summary and Relationship to Business Risk Management Amount of Capital Held by Insurers

Chapter OutlineChapter Outline

4.5 Insurer Operations, Reinsurance, and Insolvency Risk

Diversification of Underwriting RiskReinsurance

Primary Function of ReinsuranceTypes of Reinsurance

Asset Choice and Investment Risk

4.6 Summary

Costs of Pooling Costs of Pooling ArrangementsArrangements

Pooling arrangements reduce risk, but they involve costs:

–

Function of Insurance Function of Insurance CompaniesCompanies

– Insurers are intermediaries that lower the cost of pooling arrangements by

– Insurers also provide services needed by businesses

–

More on Insurance More on Insurance DistributionDistribution

Marketing in Insurance

–

Fixed Premiums Versus Fixed Premiums Versus AssessmentsAssessments

Why do insurers charge fixed premiums (as opposed to having ex post assessments)?

–

Implications of Fixed Implications of Fixed PremiumsPremiums

– Revenues may not match costs

Insolvency Risk and the Role Insolvency Risk and the Role of Capitalof Capital

– Insolvency risk is reduced by insurer capital

– Capital provides a cushion

– Greater capital reduces the likelihood of insolvency, all else equal

Definition of Insurer CapitalDefinition of Insurer Capital Definitions:

– Capital = Assets - Policyholder Liabilities

– Surplus is another name for capital

Example to Illustrate the Role Example to Illustrate the Role of Insurer Capitalof Insurer CapitalExample:

– Insurer initially has assets of $1million & no liabilities

Surplus = $1 million

– It sells 10,000 one-year policies

Example to Illustrate the Role Example to Illustrate the Role of Insurer Capitalof Insurer Capital

– Assume premiums = $11 m, all paid at beginning of the year

– Surplus (Capital) at beginning of year = $2 million

Example to Illustrate the Role of Example to Illustrate the Role of Insurer CapitalInsurer Capital

– Although expected claim cost = $10 million, actual claim costs are uncertain

– Assume total claim cost distribution is as follows. What is the probability of insolvency?

Claim cost

$10m $12m

Example to Illustrate the Role Example to Illustrate the Role of Insurer Capitalof Insurer Capital

Main Points:

– Capital reduces Probability of Insolvency– Capital acts as a cushion

– More capital ==> lower probability of insolvency

Example to Illustrate the Role Example to Illustrate the Role of Insurer Capitalof Insurer Capital

– What if the correlation in losses increased?

Most Common Forms of Most Common Forms of Insurer OwnershipInsurer Ownership

Two main types of ownership

– Mutuals

– Stock Companies

Lloyd’s of LondonLloyd’s of London

– Marketplace where insurance business is transacted

– Owners are called “names”

Factors Affecting Insurer Factors Affecting Insurer Capital DecisionsCapital Decisions

How much capital should an insurer hold?

–

Our objective:

–

Approach for Examining Insurer Approach for Examining Insurer Capital DecisionsCapital Decisions

–

Benefits of CapitalBenefits of CapitalAdditional capital lowers the probability of

insolvency

Why is this a good thing for owners?

Costs of Insurer CapitalCosts of Insurer CapitalWhat is the cost of adding capital?

Costs of Insurer CapitalCosts of Insurer Capital

– Differences between investment in an insurer and a mutual fund

Insurer has liabilities

Cost of Insurer CapitalCost of Insurer Capital

– Differences between investment in an insurer and a mutual fund (continued)

– Thus, investors will demand higher before-tax returns to invest in an insurer

Cost of Insurer CapitalCost of Insurer Capital

– The costs of raising capital also limits the amount of capital that insurers hold

Amount of Capital Held by InsurersAmount of Capital Held by Insurers

$802.3

$2,303.0

$546.8

$2,165.3

$255.5$137.7

$-

$500

$1,000

$1,500

$2,000

$2,500

Property-Liability Life-Health

Bill

ion

s o

f $

Assets

Liabilities

Capital

Diversification of Underwriting Diversification of Underwriting RiskRisk

Insolvency risk depends on variability of claim costs

Variability can be reduced by

ReinsuranceReinsuranceReinsurance is insurance for insurers

Primary roles of reinsurance

Types of ReinsuranceTypes of ReinsuranceTypes of policies

– proportional (pro-rata)– excess

– treaty– facultative

Asset Choices and Insolvency Asset Choices and Insolvency RiskRisk

Insolvency risk also depends on

Assets Held by Property-Assets Held by Property-Liability InsurersLiability Insurers

Property-Liability Insurers

Municipal Bonds33%

Corporate Bonds19%

U.S. & Foreign Govt. Bonds18%

Cash & Short-term

7%

Mortgages & Real Estate

2%

Common & Preferred Stocks21%

Assets Held by Life-Health Assets Held by Life-Health InsurersInsurers

Life-Health Insurers

Corporate Bonds55%

Municipal Bonds12%

U.S. & Foreign Govt. Bonds10%

Cash & Short-term

4%

Common & Preferred Stocks

4%

Mortgages & Real Estate15%