Feldblum

Question 1

Problem with early/traditional pricing procedures

Feldblum

Answer 1

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

Question 2

Reasons to seek more accurate pricing models (3)

Feldblum

Answer 2

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

Question 3

Different POV for insurance transactions (2)

Feldblum

Answer 3

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

Question 4

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

(Feldblum)

Answer 4

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

Question 5

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

(Feldblum)

Answer 5

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

Question 6

Relationship between different POV for insurance transactions (2)

(Feldblum)

Answer 6

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

Question 7

Decision rule for the IRR model

Feldblum

Answer 7

accept opportunities where IRR > cost of capital

Question 8

Internal rate of return (IRR)

Feldblum

Answer 8

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

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

Question 9

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

(Feldblum)

Answer 9

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

Question 10

Surplus impacts on equity flows & IRR (2)

Feldblum

Answer 10

1. base/amount of surplus

2. timing of commitment

Question 11

Timing of surplus commitment and tail length comparisons (2)

(Feldblum)

Answer 11

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)

Question 12

General relationship between surplus and IRR

Feldblum

Answer 12

increase in required surplus reduces IRR

Question 13

Equity CFs at time 0 (5)

Feldblum

Answer 13

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

Question 14

Equity CFs after time 0 (5)

Feldblum

Answer 14

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

Question 15

Initial loss reserves

Feldblum

Answer 15

initial loss reserves = expected losses

Question 16

Required surplus at time t

Feldblum

Answer 16

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

Question 17

Required assets at time t

Feldblum

Answer 17

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

Question 18

Ending assets at time t

Feldblum

Answer 18

ending assets(t) = required assets(t)

Question 19

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

(Feldblum)

Answer 19

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

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

Question 20

Base options for surplus allocations for IRR model (2)

Feldblum

Answer 20

1. premiums

2. reserves

Question 21

Timing of surplus commitment and surplus allocation base (2)

Feldblum

Answer 21

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

Question 22

Steady state reserves

Feldblum

Answer 22

reserves at any point in time in a steady state environment

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

Question 23

Risks surplus protects the insurer against (7)

Feldblum

Answer 23

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

Question 24

Asset risk

Feldblum

Answer 24

risk that financial assets depreciate

Question 25

Pricing risk | Feldblum

Answer 25

risk that losses and expenses > expected

Question 26

Reserving risk | Feldblum

Answer 26

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

Question 27

Asset-liability mismatch risk | Feldblum

Answer 27

risk that changes in interest rates impact assets and liabilities differently

Question 28

Catastrophe risk | Feldblum

Answer 28

risk that unforeseen losses depress insurer returns

Question 29

Reinsurance risk | Feldblum

Answer 29

risk that reinsurance recoverables will not be collected

Question 30

Credit risk | Feldblum

Answer 30

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

Question 31

Timing of risks surplus protects against | Feldblum

Answer 31

pricing and catastrophe risk occur during the policy period all other risks continue until all losses are paid

Question 32

Required surplus for occurrence vs. claims-made policies | Feldblum

Answer 32

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

Question 33

Required surplus for service contracts | Feldblum

Answer 33

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

Question 34

Required surplus for retrospective rating | Feldblum

Answer 34

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

Question 35

Capital budgeting techniques (2) and comparison | Feldblum

Answer 35

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

Question 36

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

Answer 36

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

Question 37

NPV and interest rates | Feldblum

Answer 37

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

Question 38

Major criticism of the IRR pricing model | Feldblum

Answer 38

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

Question 39

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) (Feldblum)

Answer 39

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

Question 40

Using the IRR pricing model to set the UW profit provision | Feldblum

Answer 40

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

Question 41

Beginning assets at time 0 | Feldblum

Answer 41

beginning assets (0) = premium | b/c expenses are already reflected in the payments

Question 42

Handling of audit premium in Feldblum's IRR method | Feldblum

Answer 42

offset to the payments (not in beginning assets)