Why Can Financial Firms Charge for Diversifiable Risk? Ian Moran, Andrew Smith, David Walczak 10 April 2003

© Deloitte & Touche. Presentation Overview Determinants of Insurance Premiums in 5 logical steps Pricing and accounting why recognition criteria are different profit and loss on inception Conclusions

© Deloitte & Touche. Premium Factors liability risk

© Deloitte & Touche. Step 1: Pure Modigliani and Miller Fair premium = PV of liabilities discount rate reflects liability risk systematic (non-diversifiable) risk only The following are irrelevant: expected return on investments insurer cost of equity or debt capital allocated

© Deloitte & Touche. Step 2: Myers – Cohn and Extensions Additional frictional costs cost of investing tax on profits agency costs Capital allocation now matters premium include loading for cost of allocated capital

© Deloitte & Touche. Step 3: Franchise Allocation This year actual Next year target market capitalisation equity Franchise value market capitalisation dividend target total return 12% target franchise growth 3% implied 30% target ROE

© Deloitte & Touche. Step 4: Cost of Impairment statutory net assets at year end shareholder value franchise value at risk default option

© Deloitte & Touche. Step 5: Capital Optimisation default option franchise value at risk optimal capitalisation capital costs too high based on Hancock, Huber & Koch, 2001

© Deloitte & Touche. Premium Factors: Reminder liability risk

© Deloitte & Touche. Conclusions Frictional costs drive a wedge between the prices we see in capital markets and prices of insurance cover. Therefore, any search for a universal pricing framework that replicates both markets is a fruitless endeavour Accounting practice necessarily decomposes the value of a firm into equity, e, recognised by accounting standards, and an additional franchise value f representing intangible elements outside the scope of accounting standards. It is common pricing practice to add a “margin for profit”. We rationalise this as the shareholders’ required return on the franchise value f. Rational product pricing takes account of the impact of a new contract both on the equity and the franchise value of a business. Accounting, by definition, reflects only the change in equity.

© Deloitte & Touche. Conclusions (ctd) Any part of the premium corresponding to the change in franchise value will emerge as a profit or loss on inception. In the past, various devices were used to smooth out the profit on inception. These included the invention of fictional assets (deferred acquisition costs) and fictional liabilities (market value margins). These devices corrupt the accounting definitions of assets and liabilities, and therefore represent a cure (inconsistent recognition) that is worse than the disease (income volatility). This is not to deny the importance of risk loadings in setting premiums, which should allow for effects both on accounting equity and non- accounting effects on franchise value.

Why Can Financial Firms Charge for Diversifiable Risk? Ian Moran, Andrew Smith, David Walczak 10 April 2003