Chapter Overview

1. Chapter Overview • Insurer Ownership • Mutual • Stock • Lloyds • Insolvency risk and Capital • Insolvency risk and insurer operation Ins301 Ch5

2. Two Main Types 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 Ins301 Ch5

3. 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 Ins301 Ch5

4. Insolvency Risk and the Role of Capital • Insolvency risk is reduced by insurer capital Ins301 Ch5

5. 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 Ins301 Ch5

6. Illustrating the Role of Insurer Capital • Example: • Insurer initially has assets of $1million & no liabilities • Surplus = $1 million • It sells 10,000 one-year policies at beginning of the year • expected claim cost = $1,000 per policy • claims paid at end of year • ignore non-claim costs and the time value of money • Liabilities at beginning of year = $10 million Ins301 Ch5

7. Illustrating the Role of Insurer Capital • Assume premiums = $11 m, all paid at beginning of the year • Then assets at beginning of year = $12 million • Surplus (Capital) at beginning of year = $2 million • surplus/assets = 2/12 = 16.7% • surplus/liabilities = 2/10 = 20.0% Ins301 Ch5

8. 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 Ins301 Ch5

9. Costs of Insurer Capital • Opportunity cost • If claim cots are negatively correlated with the value of investors’ other assets, investors will require additional compensation • Double taxation of investment returns • Agency costs • Issuance and underpricing costs Ins301 Ch5

10. Amount of Capital Held by Insurers Ins301 Ch5

11. Insolvency Risk and Insurer Operations • Diversification of underwriting risk • Reinsurance • Asset choice and investment risk Ins301 Ch5

12. Diversification of Underwriting Risk • diversifying across geographical areas • diversifying across lines of business Ins301 Ch5

13. Reinsurance • Reinsurance is the purchase of insurance by an insurer • 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 Ins301 Ch5

14. Types of Reinsurance • Types of policies • proportional (pro-rata) • excess • treaty • facultative Ins301 Ch5

15. Largest Reinsurers in 2000 Ins301 Ch5

16. Asset Choices and Insolvency Risk • Insolvency risk also depends on • risk of assets • correlation of assets and liabilities Ins301 Ch5

17. Assets Held by Property-Liability Insurers Ins301 Ch5

18. Assets Held by Life-Health Insurers Ins301 Ch5