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Flashcards in Feldblum Deck (40)
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Problem with early/traditional pricing procedures


used fixed UW profit provisions that became less credible & useful with time


Reasons to seek more accurate pricing models (3)


1. TVoM - pricing model should reflect timing & magnitude of CFs
2. competition and expected returns - price depends on degree of competition in the market
3. rate base - traditional profit margins are ROS, but ROE is more appropriate


Different POV for insurance transactions (2)


1. insurer and policyholder (focus in traditional ratemaking)
2. equity provider and insurer (focus in IRR model)


Insurer and policyholder view of insurance transactions (market, transaction, prices, and profits)


transactions occur in the product market

PH pays premiums and insurer is obligated to indemnify losses

prices are influenced by supply & demand of insurance

profits are only related to premiums & losses


Equity provider and insurer view of insurance transactions (market, transaction, return, and profits)


transactions occur in the financial market

shareholders invest in insurer & receive a return on their investment

returns are driven by insurance risk

profits are related to assets/equity only and only consider premiums/losses/expenses to the extent they impact shareholder transactions


Relationship between different POV for insurance transactions (2)


1. supply of insurance depends on cost insurers pay to obtain capital & returns achievable by investors
2. expected returns in the financial market depend on insurance risk & consumer demand for insurance


Decision rule for the IRR model


accept opportunities where IRR > cost of capital


Internal rate of return (IRR)


IRR = rate of return needed to set PV(CFs) = 0

(alternatively to set PV(cash inflows) = PV(cash outflows))


Initial cash outflows at policy inception from equity-holder's viewpoint (2)


1. portion of premium is used to pay expenses (not invested)
2. surplus is committed


Surplus impacts on equity flows & IRR (2)


1. base/amount of surplus
2. timing of commitment


Timing of surplus commitment and tail length comparisons (2)


if surplus base is premium, no distinction b/w required surplus for long vs. short-tailed LOB

if surplus base is reserves, long-tailed LOB require more surplus compared to short-tailed LOB (b/c surplus is committed for a longer amount of time)


General relationship between surplus and IRR


increase in required surplus reduces IRR


Equity CFs at time 0 (5)


1. PH pays premium to insurer
2. insurer pays expenses
3. insurer posts reserves
4. insurer commits surplus
5. equity holders pay insurer to cover shortfall


Equity CFs after time 0 (5)


1. insurer collects investment income
2. insurer pays losses
3. insurer reduces reserves
4. insurer releases surplus
5. excess returns are returned to equity holders


Initial loss reserves


initial loss reserves = expected losses


Required surplus at time t


required surplus(t) = loss reserve(t) / (reserve / surplus)


Required assets at time t


required assets(t) = required surplus(t) + loss reserve(t)


Ending assets at time t


ending assets(t) = required assets(t)


Equity flow (EF) at time t from insurer's and equity holder's POV


EF(t) = required assets(t) + payments(t) - beginning assets(t)

from shareholder's POV = - EF(t) from insurer's POV


Base options for surplus allocations for IRR model (2)


1. premiums
2. reserves


Timing of surplus commitment and surplus allocation base (2)


1. premiums - surplus is committed at policy inception and released at expiration
2. reserves - surplus is committed when losses occur or when UPR established and released as losses are paid


Steady state reserves


reserves at any point in time in a steady state environment

SS reserves = WP * LR * average time from loss to payment


Risks surplus protects the insurer against (7)


1. asset risk
2. pricing risk
3. reserving risk
4. asset-liability mismatch risk
5. catastrophe risk
6. reinsurance risk
7. credit risk


Asset risk


risk that financial assets depreciate


Pricing risk


risk that losses and expenses > expected


Reserving risk


risk that reserves may not be enough to cover ultimate loss payments


Asset-liability mismatch risk


risk that changes in interest rates impact assets and liabilities differently


Catastrophe risk


risk that unforeseen losses depress insurer returns


Reinsurance risk


risk that reinsurance recoverables will not be collected


Credit risk


risk that agents will not remit premium balances or insureds will not remit retro premiums