Chapter Outline 4.1 CONTRACTING COSTS OF RISK POOLING ARRANGEMENTS Types of Contracting Costs Ex Ante Premium Payments vs. Ex Post Assessments 4.2 Insurer Insolvency Risk and the Role of Capital 4.3 Ownership and Sources of Capital Mutual Insurers Stock Insurers Lloyd’s of London
Chapter Outline 4.4 Factors Affecting Insurer Capital Decisions Benefits of Increasing Capital Higher Premium Revenue Protect the Value of ‘Specific Assets’ (Franchise Value) Costs of Increasing Capital Correlation of Insurer Liabilities with Investors’ Other Assets Double Taxation on Investment Returns Agency Costs Issuance and Under-pricing Costs Summary and Relationship to Business Risk Management Amount of Capital Held by Insurers
Chapter Outline 4.5 Insurer Operations, Reinsurance, and Insolvency Risk Diversification of Underwriting Risk Reinsurance Primary Function of Reinsurance Types of Reinsurance Asset Choice and Investment Risk 4.6 Summary
Costs of Pooling Arrangements • Pooling arrangements reduce risk, but they involve costs:
Function of Insurance Companies • Insurers are intermediaries that lower the cost of pooling arrangements by • Insurers also provide services needed by businesses
More on Insurance Distribution • Marketing in Insurance
Fixed Premiums Versus Assessments • Why do insurers charge fixed premiums (as opposed to having ex post assessments)?
Implications of Fixed Premiums • Revenues may not match costs
Insolvency Risk and the Role of 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 Capital • Definitions: • Capital = Assets - Policyholder Liabilities • Surplus is another name for capital
Example to Illustrate the Role of Insurer Capital • Example: • Insurer initially has assets of $1million & no liabilities • Surplus = $1 million • It sells 10,000 one-year policies
Example to Illustrate the Role of 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 Insurer 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 of 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 of Insurer Capital • What if the correlation in losses increased?
Most Common Forms of Insurer Ownership • Two main types of ownership • Mutuals • Stock Companies
Lloyd’s of London • Marketplace where insurance business is transacted • Owners are called “names”
Factors Affecting Insurer Capital Decisions • How much capital should an insurer hold? • Our objective:
Benefits of Capital • Additional capital lowers the probability of insolvency • Why is this a good thing for owners?
Costs of Insurer Capital • What is the cost of adding capital?
Costs of Insurer Capital • Differences between investment in an insurer and a mutual fund • Insurer has liabilities
Cost 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 Capital • The costs of raising capital also limits the amount of capital that insurers hold
Diversification of Underwriting Risk • Insolvency risk depends on variability of claim costs • Variability can be reduced by
Reinsurance • Reinsurance is insurance for insurers • Primary roles of reinsurance
Types of Reinsurance • Types of policies • proportional (pro-rata) • excess • treaty • facultative
Asset Choices and Insolvency Risk • Insolvency risk also depends on