Iowa Bankers Association Continuing Education 2008: In-Class Seminar

1. Iowa Bankers Association Continuing Education 2008: In-Class Seminar • Instructor: Mark L. Power • University Professor • Principal Financial Group Finance Professor • Department of Finance • Iowa State University • (mpower@iastate.edu) • 6 Continuing Education Credits: 4 Basic CECs and 2 Ethic CECs

2. Iowa Bankers Association Continuing Education 2008: In-Class Seminar • Topic I: Ethical Issues and The Mitigation of Risk Induced Information Asymmetries: A Qualitative and Quantitative Analysis. • Part A: A qualitative approach • Part B: Financial analysis • Topic II: The Condition of Health Care in the United States • Part A: Health Care Systems in Developed Countries • Part B: Systemic Health Care Goals and Reform Proposals • Findings of Iowa Commision on Affordable Health Care • Topic III: An Analysis of State of the Bond Insurance Market during the Sub-Prime Lending Crisis in the United States.

3. Topic I: Ethical Issues and The Mitigation of Risk Induced Information Asymmetries • Topic Objectives: • Review business ethics: concepts & theory • Discuss the concept of ethics as it pertains to the procurement of insurance • Simulate insurance market ethical dilemmas • Understand the importance of transparent information exchange to the insurance device • Show economic consequences of information asymmetry

4. Insurance Ethics Insurance Ethics is the study of how personal and corporate “morality” influence the behavior of the participants in the process for procurement of insurance.

5. Ethics Models and Insurance Markets • Self Interest/ Egoism • If it furthers my interest it is right! • Stakeholder Management • Capital Market Stakeholders • Shareholders, suppliers of capital, banks • Highest return • Product Market Stakeholders • Customers, suppliers, host communities, unions • Lowest price and full coverage • Organizational Stakeholders • Employees, managers, non-managers • High total compensation and job security

6. Ethical Problems in Insurance Markets Ethical problems tend to occur when three factors come together: • Pressure • Perceived opportunity • A way to rationalize the act as appropriate

7. Ethics in Insurance Focus Areas: • Insurance markets • Insurance regulation • Insurance intermediaries • Insurance agent compensation • Insurance buyers: individual and corporate Example of ethical dilemmas in insurance due to Interaction of: • Pressure • Perceived opportunity • Behavior rationalization

8. Topic I: Qualitative and Financial Implications of Information Asymmetry in Insurance Markets • Our focus: • Qualitative analysis of information disclosure • Impact of information disclosure (lack of disclosure) on market participants • Ethical dilemmas created when information is needed to make financial decisions

9. Dynamic Insurance Market: A Simulation Approach • Market participants: • Insurance companies (underwriters) • Prospective insureds • Capital providers • Regulators • Type of insurance: incentive to procure is very high – auto liability (mandatory or homeowners coverage (lender required)

10. Insurance Market Simulation • Groups are formed and facts provided for: • Handouts: • Insurance companies (underwriters) • Prospective insureds • Capital providers • Regulators (market observers)

11. Insurance Market SimulationBased on Eckles and Halek (2007), RMIR, V.10,1,93-105. • How the market works: • Multiple rounds of buying and selling • Each insurer can accept or reject, but only sell a maximum of two policies during each round • Insureds are not required to buy insurance, but have only one buying opportunity • Insurers must raise capital after each round of buying and selling • Regulators observe and make corrections to the market, ex post • Insurance company profit is equal to the price of the policy sold minus the risk appropriate ex post policyholder loss • In later rounds, assumptions will be relaxed and actual losses will be randomly determined

12. Market Simulation InformationBased on Eckles and Halek (2007), RMIR, V.10,1,93-105. • Insurer Revenue and Expense Forecasts:

13. Insurance Market SimulationBased on Eckles and Halek (2007), RMIR, V.10,1,93-105. • Forecasted Net Profit

14. Insurance Market SimulationBased on Eckles and Halek (2007), RMIR, V.10,1,93-105. • Return on Capital

15. Insurance Market SimulationBased on Eckles and Halek (2007), RMIR, V.10,1,93-105. • Prospective policyholder information: • All prospective insured have the same level of wealth (W), which equals $20,000 • All prospective insured have the same level utility function where: U(W) = √W • Each risk type faces the same potential loss of $10,000. • Probability of loss is unique: where the probability of loss for high, medium, and low risks is 0.12, 0.10, and 0.08 respectively.

16. Insurance Market SimulationBased on Eckles and Halek (2007), RMIR, V.10,1,93-105. • Prospective policyholder information:

17. Insurance Market SimulationBased on Eckles and Halek (2007), RMIR, V.10,1,93-105. • Capital Provider information: Invest in mutual fund like account where expected return is 9% or provide capital to the insurance market where the expected % return is as follows:

18. Topic I: Part A – Financial Implications of Information Asymmetry in Insurance Determinants of Fair Premiums 4 Determinants • Expected Claim Costs • Administrative Costs • Investment Income • Fair Profit Loading • Examine each factor separately • Assume independent and identical exposures

19. Expected Claim Costs • The premium that just covers expected claim costs is called the pure premium • Example: • Large number of homogeneous buyers, i.e. each has the same loss distribution: Possible LossProbability $0 0.95 $10,000 0.05 • Pure Premium = $500

20. Premium Must Cover Expected Claim Costs • To cover claim costs, on average, premiums must equal $500. • if premium = $480, the insurer will lose money, on average • if premium = $640, the insurer will make profits, on average (competition would prevent this) Conclusion: • Fair Premium must cover expected claim costs

21. Investment Income • Key Point: • Fair premium is reduced to reflect investment income on premiums • Equivalently, • Fair Premium = Present Value of Expected Costs

22. Example to Illustrate Effect of Investment Income • Assume • no administrative costs • one year policies, premium received at beginning • certain claim costs = $100 paid according to table below Fair Premium

23. Effect of Investment Income Varies Across Lines of Business

24. Administrative Expenses • Fair Premium must cover administrative costs, such as • marketing • underwriting • loss adjustment • premium taxes • underwriting income taxes • etc.

25. Expense Loadings as a Percentage of Premium

26. Effect of Uncertainty: Profit Loading • Uncertainty ==> claim costs could exceed premiums • insolvency is possible • We know that Insurers hold capital to reduce the likelihood of insolvency • Capital providers ultimately bear the risk associated with insurance operations (insolvency risk) • Capital providers require compensation for risk

27. Conclusion • Fair Premium = PV of Expected Claim Costs + PV of Expected Administrative Costs + Fair Profit Loading • Note fair premiums depend on • Expected losses • Unpredictability of losses

28. Numerical Example: Insurer Perspective $100,000 with prob. 0.02 Loss = $20,000 with prob. 0.08 0 with prob. 0.90 Find Fair Premium if • policy provides full coverage • underwriting costs = 20% of pure premium • claims are paid at end of year • interest rate = 8% • claim processing costs = $5,000 • fair profit = 5% of pure premium

29. Numerical Example: Insurer Perspective • Solution: • pure premium = $3,600 • PV of expected claims = $3600/1.08 • underwriting costs + fair profit = (0.20 + 0.05) x $3,600 = $900 • expected claim processing costs = $5,000 x 0.10 = $500 • PV of expected claim processing costs = 500/1.08 • Fair premium = 900 + 4,100/1.08 = 900 + 3,796 = $4,696

30. Implications of Heterogeneous Buyers • What if there are two groups of buyers? • No longer identical exposures, adverse selection becomes a problem, and parameter uncertainty exists, underwriting may become necessary • One Group (Preferred Risk) Possible LossProbability $0 0.95 $10,000 0.05 • Another Group (Substandard Risk) Possible LossProbability $0 0.90 $10,000 0.10

31. Implications of Heterogeneous Buyers • Assume initially that • Equal number of each type • Losses are Independent • Full Insurance is mandatory • Costless to distinguish among risks

32. Implications of Heterogeneous Buyers • Initial Scenario: • Equal Treatment Insurance Company is only insurer • Premium for everyone = $750 • Does Equal Treatment cover its costs? • _____, the SS Risks pay less than their expected cost, but the P Risks pay more

33. Implications of Heterogeneous Buyers • New Scenario: allow competition • Competition from Selective Insurance Company • If Selective assumes Equal Treatment will continue to charge $750, how does Selective set price to maximize profits, • Premium to Preferreds = • Premium to Sub standards = • Profitable?

34. Implications of Heterogeneous Buyers • What happens to Equal Treatment? • It would experience adverse selection • Thus, Equal Treatment will have to classify or lose money

35. Implications of Heterogeneous Buyers Key Points: Profit Maximization + ==> Risk Classification Competition Lack of Classification + ==> Adverse Selection Competition

36. Implications of Heterogeneous Buyers • What if full insurance is not mandatory? • Recall, Initial Scenario: • Equal Treatment is only insurer • Equal Treatment charges $750 to everyone • What do Preferred Risks do? • may purchase less insurance from Equal Treatment, • S Risks still buy full insurance from Equal Treatment  Equal Treatment experiences adverse selection

37. Remember Pricing Example 1 $100,000 with prob. 0.02 Loss = $20,000 with prob. 0.08 0 with prob. 0.90 Find Fair Premium if • policy provides full coverage • underwriting costs = 20% of pure premium • claims are paid at end of year • interest rate = 8% • claim processing costs = $5,000 • fair profit = 5% of pure premium

38. Pricing Example 1 • Solution: • pure premium = $3,600 • PV of expected claims = $3600/1.08 • underwriting costs + fair profit = (0.20 + 0.05) x $3,600 = $900 • expected claim processing costs = $5,000 x 0.10 = $500 • PV of expected claim processing costs = 500/1.08 • Fair premium = 900 + 4,100/1.08 = 900 + 3,796 = $4,696

39. Pricing Example 2 – Insurer requires a Deductible (actual discrete probability distribution) $100,000 with prob. 0.02 Loss = $20,000 with prob. 0.08 0 with prob. 0.90 (Insurer Perspective of distribution) $80,000 with prob. 0.02 Loss = $0 with prob. 0.98 Find Fair Premium if • policy has a $20,000 deductible • underwriting costs = 20% of pure premium • claims are paid at end of year • interest rate = 8% • claim processing costs = $5,000 • fair profit = 5% of pure premium

40. Pricing Example 2 • Solution: • pure premium = 0.02 x $80,000 = $1,600 • PV of expected claims = $1600/1.08 • underwriting costs + fair profit = (0.20 + 0.05) x $1,600 = $400 • expected claim processing costs = 0.02 x $5,000 = $100 • PV of expected claim processing costs =$100/1.08 • Fair premium = $400 + $1,700/1.08 = $400 + $1574 = $1,974

41. Comparison of the Two Examples • Note difference in loading on the two policies Full coverage Deductible Premium $4,696 $1,974 Expected claim cost $3,600 $1,600 Dollar loading $1,096 $374 Percentage loading 30.4% 23.4% (relative to exp. claim cost) Difference is due to the deductible policy eliminating small predictable claims and the high processing costs on that claim type Also allows the Preferred Risks to identify themselves because they would be more likely to buy partial insurance

42. Implications of Heterogeneous Buyers Key Points: Profit Maximization + ==> Risk Classification* Risk Management Alternatives to Insurance *(assume marginal benefit > marginal cost of underwriting) Lack of Classification + ==> Adverse Selection Risk Management Alternatives to Insurance

43. Insurance Market SimulationBased on Eckles and Halek (2007), RMIR, V.10,1,93-105. • Round One Observations: • Insurance companies (underwriters) • Prospective insureds • Capital providers • Regulators

44. Insurance Market SimulationBased on Eckles and Halek (2007), RMIR, V.10,1,93-105. • Round Two Observations: • Insurance companies (underwriters) • Prospective insureds • Capital providers • Regulators

45. Insurance Market SimulationBased on Eckles and Halek (2007), RMIR, V.10,1,93-105. • Round Three Observations: • Insurance companies (underwriters) • Prospective insureds • Capital providers • Regulators

46. Insurance Market SimulationBased on Eckles and Halek (2007), RMIR, V.10,1,93-105. • What did we learn?

47. Comments • It is in the best interest of all parties in the insurance mechanism to have a full and good faith disclosure of information and as much transparency in the process as possible with out undue regulatory intervention and control. • Yours?

48. Topic II: The Condition of Health Care in the United States • Topic objectives: • Part A: Determine objectives and understand the Health Care System (HCS) • Part B: Become familiar with HCS reform proposals • Part C: Summarize the findings of the Iowa Legislative Commission on Affordable Health Care Plans

49. Part A: Determine objectives and understand the Health Care System • All health care systems must have the following components in common: • Delivery • Financing • Consumption