Feldblum Flashcards
Problem with early/traditional pricing procedures
Feldblum
used fixed UW profit provisions that became less credible & useful with time
Reasons to seek more accurate pricing models (3)
Feldblum
- TVoM - pricing model should reflect timing & magnitude of CFs
- competition and expected returns - price depends on degree of competition in the market
- rate base - traditional profit margins are ROS, but ROE is more appropriate
Different POV for insurance transactions (2)
Feldblum
- insurer and policyholder (focus in traditional ratemaking)
- equity provider and insurer (focus in IRR model)
Insurer and policyholder view of insurance transactions (market, transaction, prices, and profits)
(Feldblum)
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)
(Feldblum)
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)
(Feldblum)
- supply of insurance depends on cost insurers pay to obtain capital & returns achievable by investors
- expected returns in the financial market depend on insurance risk & consumer demand for insurance
Decision rule for the IRR model
Feldblum
accept opportunities where IRR > cost of capital
Internal rate of return (IRR)
Feldblum
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)
(Feldblum)
- portion of premium is used to pay expenses (not invested)
- surplus is committed
Surplus impacts on equity flows & IRR (2)
Feldblum
- base/amount of surplus
2. timing of commitment
Timing of surplus commitment and tail length comparisons (2)
(Feldblum)
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
Feldblum
increase in required surplus reduces IRR
Equity CFs at time 0 (5)
Feldblum
- PH pays premium to insurer
- insurer pays expenses
- insurer posts reserves
- insurer commits surplus
- equity holders pay insurer to cover shortfall
Equity CFs after time 0 (5)
Feldblum
- insurer collects investment income
- insurer pays losses
- insurer reduces reserves
- insurer releases surplus
- excess returns are returned to equity holders
Initial loss reserves
Feldblum
initial loss reserves = expected losses
Required surplus at time t
Feldblum
required surplus(t) = loss reserve(t) / (reserve / surplus)
Required assets at time t
Feldblum
required assets(t) = required surplus(t) + loss reserve(t)
Ending assets at time t
Feldblum
ending assets(t) = required assets(t)
Equity flow (EF) at time t from insurer’s and equity holder’s POV
(Feldblum)
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)
Feldblum
- premiums
2. reserves
Timing of surplus commitment and surplus allocation base (2)
Feldblum
- premiums - surplus is committed at policy inception and released at expiration
- reserves - surplus is committed when losses occur or when UPR established and released as losses are paid
Steady state reserves
Feldblum
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)
Feldblum
- asset risk
- pricing risk
- reserving risk
- asset-liability mismatch risk
- catastrophe risk
- reinsurance risk
- credit risk
Asset risk
Feldblum
risk that financial assets depreciate
Pricing risk
Feldblum
risk that losses and expenses > expected
Reserving risk
Feldblum
risk that reserves may not be enough to cover ultimate loss payments
Asset-liability mismatch risk
Feldblum
risk that changes in interest rates impact assets and liabilities differently
Catastrophe risk
Feldblum
risk that unforeseen losses depress insurer returns
Reinsurance risk
Feldblum
risk that reinsurance recoverables will not be collected
Credit risk
Feldblum
risk that agents will not remit premium balances or insureds will not remit retro premiums
Timing of risks surplus protects against
Feldblum
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
Feldblum
claims-made policies eliminate almost all IBNR, so they require less surplus compared to occurrence policies
Required surplus for service contracts
Feldblum
no insurance risk because insurer handles claims but does not incur any loss liabilities, no surplus is required
Required surplus for retrospective rating
Feldblum
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
Feldblum
- IRR - determines the interest rate that sets PV(cash outflows) = PV(cash inflows), projects with IRR > cost of capital should be pursued
- 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)
(Feldblum)
- budget constraints
- mutually exclusive projects
- unusual CFs
NPV and interest rates
Feldblum
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
Feldblum
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)
(Feldblum)
- IRR is not used to price individual policies, so any revenue above the cost of capital can be used to write more business
- 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
Feldblum
select an UW profit provision that sets IRR = cost of capital
Beginning assets at time 0
Feldblum
beginning assets (0) = premium
b/c expenses are already reflected in the payments
Handling of audit premium in Feldblum’s IRR method
Feldblum
offset to the payments (not in beginning assets)
