Chapter Outline
4.1 CONTRACTING COSTS OF RISK POOLING ARRANGEMENTS
Types of Contracting Costs
Ex Ante Premium Payments vs. Ex Post Assessments
4.2 Insurer Insolvency Risk and the Role of Capital
4.3 Ownership and Sources of Capital
Mutual Insurers
Stock Insurers
Lloyd’s of London
H&N, Ch. 4
T4.1
Chapter Outline
4.4 Factors 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
H&N, Ch. 4
T4.2
Chapter Outline
4.5 Insurer Operations, Reinsurance, and Insolvency Risk
Diversification of Underwriting Risk
Reinsurance
Primary Function of Reinsurance
Types of Reinsurance
Asset Choice and Investment Risk
4.6 Summary
H&N, Ch. 4
T4.3
Costs of Pooling Arrangements

Pooling arrangements reduce risk, but they
involve costs:
• Adding Participants
• marketing
• underwriting
• Verifying Losses
• Collecting Assessments
H&N, Ch. 4
T4.4
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)
H&N, Ch. 4
T4.5
More on Insurance Distribution

Marketing in Insurance
•
•
•
•
•
H&N, Ch. 4
Exclusive agents
Independent agents
Brokers
Direct marketing
Internet
T4.6
Fixed Premiums Versus Assessments

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
H&N, Ch. 4
T4.7
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)
H&N, Ch. 4
T4.8
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
H&N, Ch. 4
T4.9
Definition of Insurer Capital

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
H&N, Ch. 4
T4.10
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
• 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
H&N, Ch. 4
T4.11
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%
H&N, Ch. 4
T4.12
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
H&N, Ch. 4
$12m
T4.13
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
H&N, Ch. 4
T4.14
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
H&N, Ch. 4
T4.15
Most Common Forms of Insurer Ownership

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
H&N, Ch. 4
T4.16
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
H&N, Ch. 4
T4.17
Factors Affecting Insurer Capital Decisions

How much capital should an insurer hold?
• Difficult question for insurers
• Difficult question for regulators
• Regulatory factors in Chapter 5

Our objective:
• Identify factors that influence insurers choice in an
unregulated environment
H&N, Ch. 4
T4.18
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?
H&N, Ch. 4
T4.19
Benefits of Capital

Additional capital lowers the probability of
insolvency

Why is this a good thing for owners?
• Improves the terms of contracts
• especially with commercial policyholders
• Protects insurer’s franchise value
H&N, Ch. 4
T4.20
Costs of Insurer Capital

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?
H&N, Ch. 4
T4.21
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
H&N, Ch. 4
T4.22
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
H&N, Ch. 4
T4.23
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
H&N, Ch. 4
T4.24
Amount of Capital Held by Insurers
$2,500
$2,303.0
$2,165.3
Assets
$2,000
Liabilities
Billions of $
Capital
$1,500
$1,000
$802.3
$546.8
$500
$255.5
$137.7
$Property-Liability
H&N, Ch. 4
Life-Health
T4.25
Diversification of Underwriting Risk

Insolvency risk depends on variability of claim
costs

Variability can be reduced by
• diversifying across geographical areas
• diversifying across lines of business
H&N, Ch. 4
T4.26
Reinsurance

Reinsurance is insurance for insurers

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
H&N, Ch. 4
T4.27
Types of Reinsurance

Types of policies
• proportional (pro-rata)
• excess
• treaty
• facultative
H&N, Ch. 4
T4.28
Asset Choices and Insolvency Risk

Insolvency risk also depends on
• risk of assets
• correlation of assets and liabilities
H&N, Ch. 4
T4.29
Assets Held by Property-Liability Insurers
Property-Liability Insurers
Cash &
Short-term
7%
Mortgages & Real
Estate
2%
U.S. & Foreign Govt.
Bonds
18%
Municipal Bonds
33%
Corporate Bonds
19%
Common & Preferred
Stocks
21%
H&N, Ch. 4
T4.30
Assets Held by Life-Health Insurers
Life-Health Insurers
Cash &
Common & Preferred
Short-term
Stocks
4%
4%
U.S. & Foreign Govt.
Bonds
10%
Municipal Bonds
12%
Corporate Bonds
55%
Mortgages & Real
Estate
15%
H&N, Ch. 4
T4.31