Feldblum - Pricing Insurance Policies: The Internal Rate of Return Flashcards
What are the three simuli for more accurate pricing models?
- Didn’t consider time value of money 2. Didn’t respond to the changes in the competitive market environment to capture current return expectations of, for instance, investors. 3. Used sales as a rate base, which doesn’t take into account the equity provided from the investors.
What are the important differences between the manufacturer’s fixed assets and the insurer’s surplus?
The fixed assets needed for production can be objectively measured, for the firm as a whole and often for each product line which it produces. The surplus needed by an insurer, and its allocation to lines of business and time periods, is a theoretical construct.
What are the implications of the difference between (i) insurance pricing and (ii) the use of internal rate of return models in other industries?
- Required surplus is a theoretical construct. Even if the industry as a whole has an appropriate surplus level, individual firms may be over or under-capitalized. 2. The relationship between the product market and the capital market is strong for the industry as a whole but weak for any individual firm.
How do we determine how much surplus must be committed up front?
At the company level, the initial surplus required is not always clear. Regulatory capital requirements only set the minimum levels and actual company surplus at any point in time is highly volatile. => it is common to rely on industry wide surplus levels (e.g. industry premium to surplus ratios). This assumes that the industry overall must be in equilibrium and operate with adequate capital level.
How do we determine when surplus can be released?
It is assumed surplus can be released in proportion to paid loss, earned premium, or some combination of the two. e.g. surplus is committed in proportion to written premium, and then released when all the of premium is earned. Better still is to try to capture relative risk and release surplus as the risk dissipates.
How can surplus be allocated to lines of business?
Surplus is often allocated in proportion to premiums or reserves, or more commonly a combination of the two. As more surplus is allocated for a longer periods of time, the IRR declines.
What are the pitfalls of IRR analysis?
- IRR rule vs. NPV rule identical in many cases. But not always the case, especially when there are constrains on total resources, where two projects are mutually exclusive, or when CFs show multiple sign reversals. 2. Constrains - IRR gives no sense of scale, NPV is measured in dollars and so the scale is obvious. 3. Sign reversal: IRR can be difficult to use when there are multiple sign reversal. 4. Mutually exclusive contracts: Can be misleading to focus solely on IRR, but this shouldn’t be a major concern: 1). evaluate one of the projects as baseline, then view each of the other options as having incremental cash flows 2). part of the problem is IRR analysis assumes the fund collected today can be reinvested at the IRR rather than cost of capital. But it’s not an issue for insurance application. 5. Presentation of Results It isn’t always clear how an IRR lower than cost of capital impacts the company. NPV will be a negative number -> clear indication that rates are inadequate.
Many insurance pricing models focus solely on the underwriting cash flows and ignore the equity commitments of the investors. Describe why this is a problem and identify the characteristics of insurance companies that makes the investor’s perspective important.
Not ensuring that rates include an adequate provision for returns to equity investors, makes it impossible to ensure that enough capital can be attracted to the industry to satisfy society’s demand for insurance. And the reason the equity flows are important is that in the insurance industry the capital committed by investors is primarily invested in marketable securities. The subjects investors to double taxation of the investment income, which is something that could be easily avoided if investors simply invests their capital directly in the same marketable securities. This imposes an additional cost that must be considered in the rates.
What are the two aspects of insurance operations that reflect the equity holders’ perspective incorporated in IRR pricing model?
- when an insurer writes a policy, part of the premium is used to pay acquisition, underwriting and administrative expenses. The remaining premiums are invested in financial securities, such as bonds and stocks, to support the UEP reserve and loss reserve.
- Insurance companies “commite surplus” to support their insurance writings: that is to assure that the company has sufficient capital to support unexpected losses.
Briefly describe the two points of view one can examine insurance transactions
(1) Insurer-policyholder
(2) Equity provider - Insurer
(1) Insurer <-> Policyholder: policyholder pays premium to purchase an insurance contract, which obligates the insurer to compensate the policyholder for incurred losses. These transactions occur in the product market, and prices are influenced by the supply and demand.
(2) Equity Provider <-> Insurer: shareholders invest funds in an insurance company. The investment provides a return, whether of capital accumulation or dividends. These transactions happen in financial market, and the expected returns are influenced by the risks of insurance operations.
One may examine insurance transactions from two points of view: insurer-policyholder and equity provider-insurer. Briefly explain how these two view points are interrelated.
The supply of insurance serivices in the product market depends on the costs that insurers pay to obtain capital, as well as the returns achievable by investors on alternative uses of capital. The expected returns in the financial market, which are influenced by the risks of insurance operations, depend on customers’ demand for insurance services.
