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Capital Allocation and the Price of Insurance Discussion. 11 July 2007. Financial Services. Andrew Rear Berlin. CONFIDENTIAL | www.oliverwyman.com. Review of paper: M & A activity of insurers increases diversification benefits and decreases the prices charged by the merged entity.

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Capital allocation and the price of insurance discussion

Capital Allocation and the Price of InsuranceDiscussion

11 July 2007

Financial Services

Andrew RearBerlin

CONFIDENTIAL | www.oliverwyman.com


Review of paper: M & A activity of insurers increases diversification benefits and decreases the prices charged by the merged entity

  • Core of the work presented by Jeungbo Shim is an empirical analysis of capital allocation and prices charged by insurers following M&A activity

  • In the M & A transactions under consideration, economic capital requirements (in terms of capital-to-liability ratios) have been reduced

    • Bigger portfolio, hence more diversification benefits

    • Confirmed by outside-in-analysis of respective insurers

  • Following M&A activity, insurers have decreased their prices

    • Due to lower capital requirements when accounting for higher diversification benefit

    • Work establishes empirical link of business units’ change in prices and their change in capital requirement (using a marginal capital allocation approach) following M&A activity

Diversification matters and is reflected in pricing


The results of the work are in line with industry practice and trends
The results of the work are in line with industry practice and trends

Accounting for diversification in determining required capital . . .

. . . and using required economic capital in pricing decisions

  • Many insurers capture diversification benefits in their internal capital models

  • Solvency II will also account for diversification benefits

  • New S&P capital model also adjusts for diversification effects

  • Many insurers have developed risk-adjusted pricing frameworks

    • Economic return is compared to economic capital requirements

    • Often based on economic capital requirements after diversification benefits

  • MCEV also accounts for required economic capital, in particular for unhedgeable risks


The business question how far should this go
The business question: How far should this go? and trends

Is diversification always good?

How far should you reduce pricing

  • Reduced capital requirements are a competitive advantage…

  • … but there are two pitfalls:

    • Expertise

    • Investor surprises

  • Pricing is the mechanism through which competitive advantage is demonstrated…

  • … but does rational pricing behaviour prompt an apparently irrational pricing cycle?


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