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Chapter Overview. Insurer Ownership Mutual Stock Lloyds Insolvency risk and Capital Insolvency risk and insurer operation. Two Main Types of Insurer Ownership. Two main types of ownership Mutuals Policyholders are the residual claimants
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Chapter Overview • Insurer Ownership • Mutual • Stock • Lloyds • Insolvency risk and Capital • Insolvency risk and insurer operation Ins301 Ch5
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
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
Insolvency Risk and the Role of Capital • Insolvency risk is reduced by insurer capital Ins301 Ch5
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
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
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
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
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
Amount of Capital Held by Insurers Ins301 Ch5
Insolvency Risk and Insurer Operations • Diversification of underwriting risk • Reinsurance • Asset choice and investment risk Ins301 Ch5
Diversification of Underwriting Risk • diversifying across geographical areas • diversifying across lines of business Ins301 Ch5
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
Types of Reinsurance • Types of policies • proportional (pro-rata) • excess • treaty • facultative Ins301 Ch5
Largest Reinsurers in 2000 Ins301 Ch5
Asset Choices and Insolvency Risk • Insolvency risk also depends on • risk of assets • correlation of assets and liabilities Ins301 Ch5
Assets Held by Property-Liability Insurers Ins301 Ch5
Assets Held by Life-Health Insurers Ins301 Ch5