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

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

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

Costs of Pooling
Arrangements
 Pooling arrangements reduce risk, but they involve costs:
–

Function of Insurance
Companies
– Insurers are intermediaries that lower the cost of pooling arrangements by
– Insurers also provide services needed by businesses
–

More on Insurance
Distribution
 Marketing in Insurance
–

Fixed Premiums Versus
Assessments
 Why do insurers charge fixed premiums (as opposed to having ex post assessments)?
–

Implications of Fixed
Premiums
– Revenues may not match costs

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

Definition of Insurer Capital
 Definitions:
– Capital = Assets - Policyholder Liabilities
– Surplus is another name for capital

Example to Illustrate the Role
 Example: of Insurer Capital
– Insurer initially has assets of $1million & no liabilities
 Surplus = $1 million
– It sells 10,000 one-year policies


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

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?
$10m $12m
Claim cost

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

Example to Illustrate the Role of Insurer Capital
– What if the correlation in losses increased?

Most Common Forms of
Insurer Ownership
 Two main types of ownership
– Mutuals
– Stock Companies

Lloyd’s of London
– Marketplace where insurance business is transacted
– Owners are called “names”

Factors Affecting Insurer
Capital Decisions
 How much capital should an insurer hold?
–
 Our objective:
–

Approach for Examining Insurer
Capital Decisions
–

Benefits of Capital
 Additional capital lowers the probability of insolvency
 Why is this a good thing for owners?

Costs of Insurer Capital
 What is the cost of adding capital?

Costs of Insurer Capital
– Differences between investment in an insurer and a mutual fund
 Insurer has liabilities

Cost of Insurer Capital
– Differences between investment in an insurer and a mutual fund (continued)

– Thus, investors will demand higher before-tax returns to invest in an insurer

Cost of Insurer Capital
– The costs of raising capital also limits the amount of capital that insurers hold

Amount of Capital Held by Insurers
$2,500
$2,303.0
$2,165.3
$2,000
Assets
Liabilities
Capital
$1,500
$1,000
$500
$802.3
$546.8
$255.5
$-
Property-Liability Life-Health
$137.7

Diversification of Underwriting
Risk
 Insolvency risk depends on variability of claim costs
 Variability can be reduced by

Reinsurance
 Reinsurance is insurance for insurers
 Primary roles of reinsurance

Types of Reinsurance
 Types of policies
– proportional (pro-rata)
– excess
– treaty
– facultative

Asset Choices and Insolvency
Risk
 Insolvency risk also depends on


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%

Assets Held by Life-Health
Insurers
Life-Health Insurers
Common & Preferred
Stocks
4%
U.S. & Foreign Govt.
Bonds
10%
Cash &
Short-term
4%
Municipal Bonds
12%
Corporate Bonds
55%
Mortgages & Real
Estate
15%