Why Can Financial Firms
Charge for Diversifiable Risk?
Ian Moran, Andrew Smith, David Walczak
10 April 2003
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
110
premium
105
Impairment
Profit Margin
Tax + Agency
Systematic
Risk Free
100
95
90
10%
diversifiable
10% systematic
20%
diversifiable
© Deloitte & Touche.
liability risk
20% systematic
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
Franchise value
200
100
110
market capitalisation
market capitalisation
target total return 12%
20
dividend
206
target franchise growth 3%
equity
implied 30% target ROE
This year
actual
© Deloitte & Touche.
Next year
target
franchise value at risk
shareholder value
Step 4: Cost of Impairment
statutory net assets at year end
default option
© Deloitte & Touche.
Step 5: Capital Optimisation
based on Hancock, Huber & Koch, 2001
20
default option
franchise
18
capital costs
too high
16
optimal
capitalisation
14
franchise value
at risk
12
10
0
© Deloitte & Touche.
10
20
30
equity
40
50
Premium Factors: Reminder
110
premium
105
Impairment
Profit Margin
Tax + Agency
Systematic
Risk Free
100
95
90
10%
diversifiable
10% systematic
20%
diversifiable
© Deloitte & Touche.
liability risk
20% systematic
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 nonaccounting effects on franchise value.
© Deloitte & Touche.
Why Can Financial Firms
Charge for Diversifiable Risk?
Ian Moran, Andrew Smith, David Walczak
10 April 2003