T4.1 H&N, Ch. 4 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

T4.2 H&N, Ch. 4 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

T4.3 H&N, Ch. 4 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

T4.4 H&N, Ch. 4 Costs of Pooling Arrangements l Pooling arrangements reduce risk, but they involve costs: Adding Participants marketing underwriting Verifying Losses Collecting Assessments

T4.5 H&N, Ch. 4 Function of Insurance Companies Insurers are intermediaries that lower the cost of pooling arrangements by reducing the number of contracts employing people with expertise in marketing, underwriting, and claims processing Insurers also provide services needed by businesses loss control claims processing (third party administrators)

T4.6 H&N, Ch. 4 More on Insurance Distribution l Marketing in Insurance Exclusive agents Independent agents Brokers Direct marketing Internet

T4.7 H&N, Ch. 4 Fixed Premiums Versus Assessments l Why do insurers charge fixed premiums (as opposed to having ex post assessments)? Cost of collecting assessments With assessments, there might be a delay in payments to those who have claims Assessments impose greater uncertainty to policyholders than fixed premiums

T4.8 H&N, Ch. 4 Implications of Fixed Premiums Revenues may not match costs Someone must be the residual claimant i.e., someone must bear unexpectedly high losses and receive profits when losses are lower than expected Insurers can fail (become insolvent)

T4.9 H&N, Ch. 4 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

T4.10 H&N, Ch. 4 Definition of Insurer Capital l Definitions: Capital = Assets - Policyholder Liabilities Economic values not accounting values Assets = market value of securities, etc. Liabilities = present value of expected payments on policies already sold Surplus is another name for capital

T4.11 H&N, Ch. 4 Example to Illustrate the Role of Insurer Capital l Example: Insurer initially has assets of $1million & no liabilities Surplus = $1 million It sells 10,000 one-year policies expected claim cost = $1,000 per policy claims paid at end of year ignore non-claim costs and the time value of money Liabilities = $10 million

T4.12 H&N, Ch. 4 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 surplus/assets = 2/12 = 16.7% surplus/liabilities = 2/10 = 20.0%

T4.13 H&N, Ch. 4 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

T4.14 H&N, Ch. 4 Example to Illustrate the Role of Insurer Capital l Main Points: Capital reduces Probability of Insolvency Capital acts as a cushion More capital ==> lower probability of insolvency

T4.15 H&N, Ch. 4 Example to Illustrate the Role of Insurer Capital What if the correlation in losses increased? Distribution of claim costs would have greater variance Holding capital constant, probability of insolvency would increase with the correlation in losses Holding probability of insolvency constant, amount of capital needed increases with the correlation in losses

T4.16 H&N, Ch. 4 Most Common Forms of Insurer Ownership l Two main types of ownership Mutuals Policyholders are the residual claimants Policyholders usually have limited liability; they cannot be assessed Cannot raise capital by issuing equity Stock Companies Investors are the residual claimants Investors have limited liability

T4.17 H&N, Ch. 4 Lloyd’s of London Marketplace where insurance business is transacted most business is commercial insurance, reinsurance, and automobile insurance Owners are called “names” Names contribute capital to syndicates Individual names have unlimited liability Corporate names have limited liability

T4.18 H&N, Ch. 4 Factors Affecting Insurer Capital Decisions l How much capital should an insurer hold? Difficult question for insurers Difficult question for regulators Regulatory factors in Chapter 5 l Our objective: Identify factors that influence insurers choice in an unregulated environment

T4.19 H&N, Ch. 4 Approach for Examining Insurer Capital Decisions Perspective of an owner Assume the insurer has some level of capital, Identify the benefits of adding additional capital Identify the costs of adding additional capital?

T4.20 H&N, Ch. 4 Benefits of Capital l Additional capital lowers the probability of insolvency l Why is this a good thing for owners? Improves the terms of contracts especially with commercial policyholders Protects insurer’s franchise value

T4.21 H&N, Ch. 4 Costs of Insurer Capital l What is the cost of adding capital? There is an opportunity cost - owners cannot invest elsewhere. If investment in insurer has disadvantages compared with alternatives, then investors require additional compensation What are the differences between giving funds to an insurer versus putting them in a mutual fund?

T4.22 H&N, Ch. 4 Costs of Insurer Capital Differences between investment in an insurer and a mutual fund Insurer has liabilities can lead to lower returns but also can lead to higher returns If liabilities are not correlated with investor’s other assets, then the net effect is zero

T4.23 H&N, Ch. 4 Cost of Insurer Capital Differences between investment in an insurer and a mutual fund (continued) Insurer’s investment returns are taxed twice Insurer might have greater agency costs Thus, investors will demand higher before-tax returns to invest in an insurer

T4.24 H&N, Ch. 4 Cost of Insurer Capital The costs of raising capital also limits the amount of capital that insurers hold Cost of raising capital issuance costs underpricing costs

T4.25 H&N, Ch. 4 Amount of Capital Held by Insurers

T4.26 H&N, Ch. 4 Diversification of Underwriting Risk l Insolvency risk depends on variability of claim costs l Variability can be reduced by diversifying across geographical areas diversifying across lines of business

T4.27 H&N, Ch. 4 Reinsurance l Reinsurance is insurance for insurers l Primary roles of reinsurance Reduce variance in claim costs by diversification reducing exposure to very high claims Reduce amount of capital needed to achieve a given probability of insolvency

T4.28 H&N, Ch. 4 Types of Reinsurance l Types of policies proportional (pro-rata) excess treaty facultative

T4.29 H&N, Ch. 4 Asset Choices and Insolvency Risk l Insolvency risk also depends on risk of assets correlation of assets and liabilities

T4.30 H&N, Ch. 4 Assets Held by Property-Liability Insurers

T4.31 H&N, Ch. 4 Assets Held by Life-Health Insurers