Chapter Outline 4.1CONTRACTING COSTS OF RISK POOLING ARRANGEMENTS Types of Contracting Costs Ex Ante...
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Transcript of Chapter Outline 4.1CONTRACTING COSTS OF RISK POOLING ARRANGEMENTS Types of Contracting Costs Ex Ante...
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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
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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
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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
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Costs of Pooling Costs of Pooling ArrangementsArrangements
Pooling arrangements reduce risk, but they involve costs:
–
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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
–
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More on Insurance More on Insurance DistributionDistribution
Marketing in Insurance
–
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Fixed Premiums Versus Fixed Premiums Versus AssessmentsAssessments
Why do insurers charge fixed premiums (as opposed to having ex post assessments)?
–
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Implications of Fixed Implications of Fixed PremiumsPremiums
– Revenues may not match costs
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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
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Definition of Insurer CapitalDefinition of Insurer Capital Definitions:
– Capital = Assets - Policyholder Liabilities
– Surplus is another name for capital
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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
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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
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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
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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
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Example to Illustrate the Role Example to Illustrate the Role of Insurer Capitalof Insurer Capital
– What if the correlation in losses increased?
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Most Common Forms of Most Common Forms of Insurer OwnershipInsurer Ownership
Two main types of ownership
– Mutuals
– Stock Companies
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Lloyd’s of LondonLloyd’s of London
– Marketplace where insurance business is transacted
– Owners are called “names”
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Factors Affecting Insurer Factors Affecting Insurer Capital DecisionsCapital Decisions
How much capital should an insurer hold?
–
Our objective:
–
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Approach for Examining Insurer Approach for Examining Insurer Capital DecisionsCapital Decisions
–
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Benefits of CapitalBenefits of CapitalAdditional capital lowers the probability of
insolvency
Why is this a good thing for owners?
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Costs of Insurer CapitalCosts of Insurer CapitalWhat is the cost of adding capital?
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Costs of Insurer CapitalCosts of Insurer Capital
– Differences between investment in an insurer and a mutual fund
Insurer has liabilities
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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
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Cost of Insurer CapitalCost of Insurer Capital
– The costs of raising capital also limits the amount of capital that insurers hold
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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
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Diversification of Underwriting Diversification of Underwriting RiskRisk
Insolvency risk depends on variability of claim costs
Variability can be reduced by
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ReinsuranceReinsuranceReinsurance is insurance for insurers
Primary roles of reinsurance
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Types of ReinsuranceTypes of ReinsuranceTypes of policies
– proportional (pro-rata)– excess
– treaty– facultative
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Asset Choices and Insolvency Asset Choices and Insolvency RiskRisk
Insolvency risk also depends on
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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%
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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%