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Capital Allocation and the Price of Insurance Discussion

Capital Allocation and the Price of Insurance Discussion. 11 July 2007. Financial Services. Andrew Rear Berlin. CONFIDENTIAL | www.oliverwyman.com. Review of paper: M & A activity of insurers increases diversification benefits and decreases the prices charged by the merged entity.

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Capital Allocation and the Price of Insurance Discussion

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  1. Capital Allocation and the Price of InsuranceDiscussion 11 July 2007 Financial Services Andrew RearBerlin CONFIDENTIAL | www.oliverwyman.com

  2. Review of paper: M & A activity of insurers increases diversification benefits and decreases the prices charged by the merged entity • Core of the work presented by Jeungbo Shim is an empirical analysis of capital allocation and prices charged by insurers following M&A activity • In the M & A transactions under consideration, economic capital requirements (in terms of capital-to-liability ratios) have been reduced • Bigger portfolio, hence more diversification benefits • Confirmed by outside-in-analysis of respective insurers • Following M&A activity, insurers have decreased their prices • Due to lower capital requirements when accounting for higher diversification benefit • Work establishes empirical link of business units’ change in prices and their change in capital requirement (using a marginal capital allocation approach) following M&A activity Diversification matters and is reflected in pricing

  3. The results of the work are in line with industry practice and trends Accounting for diversification in determining required capital . . . . . . and using required economic capital in pricing decisions • Many insurers capture diversification benefits in their internal capital models • Solvency II will also account for diversification benefits • New S&P capital model also adjusts for diversification effects • Many insurers have developed risk-adjusted pricing frameworks • Economic return is compared to economic capital requirements • Often based on economic capital requirements after diversification benefits • MCEV also accounts for required economic capital, in particular for unhedgeable risks

  4. The business question: How far should this go? Is diversification always good? How far should you reduce pricing • Reduced capital requirements are a competitive advantage… • … but there are two pitfalls: • Expertise • Investor surprises • Pricing is the mechanism through which competitive advantage is demonstrated… • … but does rational pricing behaviour prompt an apparently irrational pricing cycle?

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