Chapter 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 4.3Ownership and Sources of Capital Mutual Insurers Stock Insurers Lloyd’s of London

Chapter Outline 4.4Factors 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 4.5Insurer Operations, Reinsurance, and Insolvency Risk Diversification of Underwriting Risk Reinsurance Primary Function of Reinsurance Types of Reinsurance Asset Choice and Investment Risk 4.6Summary

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: –

Approach for Examining Insurer Capital Decisions –

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

Amount of Capital Held by Insurers

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

Assets Held by Property- Liability Insurers

Assets Held by Life-Health Insurers