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Flashcards in Feldblum Deck (42)
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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


Timing of risks surplus protects against


pricing and catastrophe risk occur during the policy period

all other risks continue until all losses are paid


Required surplus for occurrence vs. claims-made policies


claims-made policies eliminate almost all IBNR, so they require less surplus compared to occurrence policies


Required surplus for service contracts


no insurance risk because insurer handles claims but does not incur any loss liabilities, no surplus is required


Required surplus for retrospective rating


retrospective rating = mix b/w regular insurance policy & service contract with credit risk for the primary layer but significant insurance risk for losses > limits or premiums limited by max premium

requires more surplus than a service contract, but less surplus than an occurrence policy


Capital budgeting techniques (2) and comparison


1. IRR - determines the interest rate that sets PV(cash outflows) = PV(cash inflows), projects with IRR > cost of capital should be pursued
2. NPV - uses the cost of capital to discount all CFs to the same point in time, projects with NPV > 0 should be pursued

generally provide the same accept/reject decisions


Conditions when IRR and NPV might result in different accept/reject decisions (3)


1. budget constraints
2. mutually exclusive projects
3. unusual CFs


NPV and interest rates


often preferable to defer larger income streams when interest rates are low and take larger income streams early when interest rates are high


Major criticism of the IRR pricing model


assumes firms can reinvest funds at the IRR (which may not be reasonable)


Reasons that the criticism of the assumption that firms can reinvest funds at the IRR under the IRR model is not an issue according to Feldblum (2)


1. IRR is not used to price individual policies, so any revenue above the cost of capital can be used to write more business
2. when using IRR to select the UW profit provision, analysts select the rate s.t. IRR = cost of capital which eliminates differences b/w IRR and NPV analyses


Using the IRR pricing model to set the UW profit provision


select an UW profit provision that sets IRR = cost of capital


Beginning assets at time 0


beginning assets (0) = premium

(b/c expenses are already reflected in the payments)


Handling of audit premium in Feldblum's IRR method


offset to the payments (not in beginning assets)