1.  Economic Foundations of Insurance Pricing UNSW Actuarial Research Symposium 14 November 2003 mark.e.johnston@au.pwc.com

2. PricewaterhouseCoopers Introduction The economic foundations of insurance pricing are being debated actively at present –Regulators and insurance companies are seeking a sound economic basis to guide pricing decisions Myers and Cohn (1981) applied the Capital Asset Pricing Model (CAPM) to an insurance firm Many insurance professionals are uncomfortable with the conclusions of the Myers-Cohn approach, as it implies premiums should be set at levels below those considered viable

3. PricewaterhouseCoopers Outline of this presentation We have re-visited the foundations of insurance pricing, using modern economic valuation methods (SDF approach) –Conclusions intuitive to insurance practitioners, within a rigorous economic framework In this presentation, we: –review the Myers-Cohn approach –review economic valuation methods –outline the approach we have taken –summarise our key conceptual findings, and –illustrate how our approach might be applied to guide the setting of insurance premiums

4. PricewaterhouseCoopers Summary of our conclusions (1) Policyholders will, in aggregate, place a different value on a portfolio of insurance policies than shareholders will This value difference – the insurance surplus – gives rise to a range of premiums that policyholders and shareholders will be happy with – the feasible range of premiums Our approach, in contrast to CAPM-based approaches, allows the relationship between capital strength and premium to be determined, leading to the determination of the set of feasible combinations of these factors - the feasible region

5. PricewaterhouseCoopers Summary of our conclusions (2) The feasible region exists due to consumers’ assumed aversion to the insured risks, and the fact that these risks cannot be offset by traded securities – capital market incompleteness Consequently, “fair” premiums cannot be determined with reference to capital markets alone – pricing information from consumer insurance markets must be considered also

6. PricewaterhouseCoopers What did Myers and Cohn do ? 1.Discussed premiums with reference to the values of the components of the insurer’s balance sheet 2.Proposed a “fair premium principle”: The premium that makes entering into the insurance contract NPV-zero for shareholders 3.Employed CAPM to calculate the values of the components of the insurer’s balance sheet

7.  Economic Valuation – a brief refresher

8. PricewaterhouseCoopers Basic terminology and notation An asset is defined by the payoff (x) it provides to its owner The payoff typically: –occurs in the future –is uncertain (a random variable) The price or value (V) of an asset is the amount of cash we would pay today for the right to the asset’s risky future payoff e.g. The call option, with payoff distribution shown here, has a value of $0.09

9. PricewaterhouseCoopers Asset Pricing 101 (single time-period) Old way: “Risk-adjusted discount rate” New way: “Stochastic discount factor” Cash flow info required Expected payoff E(x) Payoff distribution x Discount factor Deterministic – but different for each asset: 1 / (1 + r j ) Stochastic – but prices all assets of interest: m Pricing formulaV = E(x) / (1 + r j )V = E(m x)

10. PricewaterhouseCoopers The risk premium is a covariance – with consumption Economic derivation says… Definition of covariance says… u’ – marginal utility; c* - optimal consumption; R f – gross risk-free return

11. PricewaterhouseCoopers A nested set of equilibrium models ModelAssumptionsDiscount factor Stochastic discount factor Expected utility, smooth utility function u m = A u’(c*) c* = agent’s optimal consumption Buhlmann’s model (1980) Exponential utility, closed market m = A exp(- c), c = total consumption Wang’s specialisation of Buhlmann’s model (2003) Total consumption normal, normal copula with assets m x = A x exp(- x h -1 (x)) x = h(z), z unit normal, x =  z, = (E(R c ) – R f ) /  (R c ) Capital Asset Pricing Model (1965-ish) Asset payoffs normalm = A x exp(- x (x-  x )/  x )

12.  The Insurance Surplus

13. PricewaterhouseCoopers The shareholders’ perspective Insurance companies take risk from policyholders for a fee, and offer the aggregate risk to shareholders –Any risk premium shareholders place on this aggregate risk will be based on its contribution to the variance of their entire asset portfolio (as a proxy for their consumption)

14. PricewaterhouseCoopers Consumers are willing to pay a risk premium for insurance Some aspects of individuals’ behaviour are not explained by economic valuation models: –We observe individuals holding concentrations of wealth in particular assets, like the family home –They also have exposure to concentrations of liability, such as obligations when injury is caused to another person while driving This gives rise to risks that can’t be offset in the securities market –There can in no practical sense be traded securities that replicate the payoff of a particular individual’s house burning down, for example; Accordingly, individuals will be willing to pay a risk premium for instruments that mitigate such risks – such as insurance

15. PricewaterhouseCoopers The insurance surplus To understand the impact of the different valuation perspectives of policyholders and shareholders, we introduce the notion of the insurance surplus –This is defined as the difference between the sum of the values placed by consumers upon a portfolio of insurance policies, and the market value of this portfolio It is clear that in practice there must be a positive surplus at the raw liability level – that’s where the expenses and taxes are paid from –Without a surplus, the insurance industry would not exist The existence of a positive surplus implies the existence of a range of premiums that consumers and shareholders will be happy with

16. PricewaterhouseCoopers The feasible range of premiums Myers and Cohn defined the “fair premium” to be the premium that makes entering into an insurance contract an NPV-zero proposition for shareholders –They claimed that setting premiums any higher than this would involve a wealth transfer from policyholders to shareholders –This is not the case – both shareholders and policyholders can (and must) have their expected utility improved through entering into an insurance contract (a win-win situation) We introduce the notion of the feasible range of insurance premiums –This range is defined as the set of premiums that make entering into the insurance contract NPV-positive for both shareholders and policyholders

17. PricewaterhouseCoopers Position in the feasible range is determined by competition In a “typical” or “realistic” un-regulated insurance market, we would expect premiums to be set in the interior of the feasible range, as there are barriers to entry, such as licensing, capital requirements, systems and skills, and the scale necessary to achieve diversification If a regulator has aims other than price minimisation (e.g. stability, accessibility), prices above the lower end will need to be allowed Low Premium High Premium NPV S = 0 NPV P > 0 NPV S > 0 NPV P = 0 NPV S > 0 NPV P > 0 Perfect Competition MonopolyTypical Market ?

18. PricewaterhouseCoopers Insurance surplus, mathematically... Consumer k faces a set of payoffs X k, employs a discount factor m k All consumers can trade a set of assets X (the securities market) –there exists a market discount factor m –each m k agrees with m on X –m k may be decomposed as m k = m + m k  Consumer k’s insurance policy has a payoff w k Insurance surplus is:  =  k E(m k w k ) – E(m  k w k ) Can show that  =  k cov(m k, w k  ) (if R f traded) So insurance surplus will be positive if: –The securities market is incomplete (w k  != 0), and –Consumers are averse to the non-traded part of their insured risk (cov(m k, w k  ) > 0)

19.  Implications for a corporate insurance firm

20. PricewaterhouseCoopers A simple limited-liability insurance firm Cash InCash Out Shareholders’ FundsQExpensesX0X0 PremiumPInvestmentsA0A0 Cash InCash Out InvestmentsA T = (P + Q - X 0 ) * R f Claims paidL T = min(C T, A T ) TaxesG T = … Equity cash flowA T – L T – G T Time 0 Time T The firm will take on a portfolio of policies to be resolved at time T –The underlying uncertainty is the total amount claimed, denoted C T –We’ll assume an insurance surplus would exist if claims were guaranteed to be paid

21. PricewaterhouseCoopers Market value of the claim portfolio (unlimited liability) Discount factor (m) indicates how much weight the market places on each loss outcome Payout distribution (  ( C T )) describes what we could lose Value = C 0 = E(m C T ) =  m(c) c  (c) dc The discount factor shown here places greater weighting on high payouts than low payouts, which makes the liability value bigger

22. PricewaterhouseCoopers We can value the liabilities as derivatives on the claims The payout is capped by the level of asset backing: L T = min(C T, A T ) e.g. NPV from shareholders’ point of view (ignoring tax) is: NPV S (P, Q)=  m(c) max(0, A T (P,Q) –c)  (c) dc – Q...and then calculate the NPV’s for stakeholders, as functions of the initial funds contributed:

23. PricewaterhouseCoopers We can determine the impact of variation in asset backing… Both premiums and shareholders’ funds provide asset backing: Insurance surplus is larger when asset backing is higher

24. PricewaterhouseCoopers …and expenses and taxes Expenses eat away initial funding, and require a certain minimum feasible level of asset backing Taxes eat away profits, and force a certain maximum feasible level of asset backing

25. PricewaterhouseCoopers Putting it all together gives the structure of the feasible region Taxes and expenses diminish the surplus, and can wipe it out –the surplus is wiped out by tax if the firm is too strongly capitalised Policyholders require a certain strength of asset backing before they will pay for insurance

26. PricewaterhouseCoopers Relationship with the Myers- Cohn approach The Myers-Cohn principle yields the lowest premium in the feasible region, for each level of shareholders’ funds Myers-Cohn / CAPM calculation method only applies under assumptions of unlimited liability and normally-distributed portfolio payoff –in which case it would produce the diagonal dashed line

27. PricewaterhouseCoopers Next step: attempt to calibrate the model to observed prices For example, assume: Log-normal claims with Coeff. of var. 24%, expenses 17%, tax 25% “zero-beta” liability Power-law discount factor …and suppose we observe these combinations of sufficiency and premium: (99.9%, 1.48), (99.5%, 1.43), (98.0%, 1.41) Then we can infer the “minimal” aggregate discount factor that the policyholders are using

28. PricewaterhouseCoopers Summary We have argued that policyholders will, in aggregate, place a different value on a portfolio of insurance policies than shareholders will This value difference – the insurance surplus – gives rise to a range of premiums that policyholders and shareholders will be happy with We have examined how this surplus is affected by the structure of a corporate insurance firm –Our model has produced insights into the workings of such firms, showing endogenously, for example, that asset backing should be high, but not too high “Fair” premiums cannot be determined with reference to capital markets alone – pricing information from consumer insurance markets must be considered also The author would like to thank Tim Jenkins for many helpful discussions during the development of this paper, Tony Coleman for suggesting the area of research and providing helpful references, and Insurance Australia Group for sponsoring this research.