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)