Insurance Flashcards
simplest form of insurance is
mutual insurance
mutual insurance
• When a member of a group is unlucky, gets helped out by the
other members
• Works in small long-term groups: hunter-gatherers, small
villages, early trade unions
• Small groups know each others risk profile
• Small groups can monitor each other’s behaviour
• And punish excessively risky behaviour
• Over the long-term, you know the gains and losses will
wash out
Modern insurance companies lose out on… but gain…
Lose out on a lot of informational advantages of small
groups
• But gain economies of scale, tailored products and easier
to transact.
Underinsurance
Caps on coverage
• Insurance will only pay off up to a maximum
amount
• e.g., in the US you had health insurance with
”life-time caps”.
• Coverage being denied
• Some customers may find it impossible to
find insurance at any price.
• Lack of insurance markets for bad decisions
Explanations for underinsurance
- Credit constraints
- Moral obligations/interest group
politics - Non-diversifiable risk
- Adverse Selection
- Moral Hazard
Credit constraints
People who simply cannot afford insurance, and
hence must bear the risk.
• Can be solved through either subsidies, or the
state providing insurance for free.
• Low income as limited liability:
• low-income/high-risk drivers may not see the
need to get insurance given that would never be
able to pay the full cost of any damage caused
anyway.
Moral obligations
Most of the civilized world sees healthcare as a
right: people will not be refused care, are not
asked for proof of insurance/income before
necessary treatment is started
• Thus can be a reason to underinsure.
• Same with for example flood insurance: in the
case of a bad flood the government usually pays
out anyway
• Regulatory solution: compulsory insurance if
you live in a flood prone area.
• Instead of moral obligation may also be lobbying
power
Non-diversifiable risk
• Insurance usually works with the “Law of large
numbers”: some lose, some don’t, insurance
company can predict the average number of
claimants.
• But for some risks, if they come to pass everybody
loses, so these events are difficult/ impossible to insure
• Global warming for example:
Moral hazard
When you are insured you may start taking more risk, resulting in more claims, higher rates and in the end making insurance unattractive for everybody but the biggest risk-takers
Adverse selection
• The highest quality customers (lowest risk) are
least likely to buy insurance, selecting themselves
out of the market.
• This makes the remaining pool more risky on
average, driving up prices.
• Higher prices drive out more high quality/low
risk customers, again increasing the average
riskiness of the pool, etc, etc.
• Similar death spiral, but now from the
customer side.
• Solution: compulsory insurance.
• Alternatively, insurers can design different
policies that separates different risk types
How does insurance work
- Risk pooling
- Risk spreading
- Risk transfer
Risk pooling
• When outcomes are independent, any single
outcome cannot be predicted, but the average
number of outcomes can.
• Example: coin flip. E(H) = 0.5n / n, Var(H) = p(1−p)/n
• Pooling many independent risks allows to
insurance company to treat the aggregate outcome
as almost certain.
• The insurance company uses the premia of the
lucky to pay for the unlucky.
• Using the law of large numbers can estimate the
necessary premium quite precisely.
Risk spreading
• Not all risks are independent: earthquakes, floods,
epidemics
• When risks hare highly correlated, makes it hard to
predict and hard to insure
• Many catastrophes are explicitly not covered by
insurance (”act of god”)
• But government can ’force’ insurance/solidarity.
• Taking a little of money from everybody has a
lower welfare impact then letting a few people bear
the full brunt.
• This is not a Pareto improvement! (some people
made worse off!) And hence cannot be
implemented with a market solution.
• Many of these insurance policies are implicit
• It is simply assumed that the government will help
victims of flooding, terrorist attacks, etc
• Sometimes government tries to force ex ante insurance
(e.g. compulsory flood insurance), but difficult to be
consistent when the disaster strikes.
Risk transfer
• Transfer risk from those less willing to bare it to those
more willing to bare it
• Assuming declining absolute risk aversion, a
• (p = 0.5, −$1000; p = 0.5, +$1000) bet is more
onerous on a poor individual than a rich individual.
• Thus the poor individual is willing to pay more to get
rid of the risk than the rich individual demands to
accept the risk.
• Also works with more risk averse/less risk averse in
general
Since also the low-risk types would prefer full
insurance (as long as they are risk averse) it can be
beneficial to make insurance
compulsory
If there are relatively few high-risk types, what equilibrium may have higher utility?
pooling
equilibrium may have higher utility than signaling
equilibrium.
• Advantage from full coverage may outweigh
the cost of cross-subsidization
Compulsory insurance often has to go hand in hand
with
subsidies (as otherwise not everybody would be
able to afford the insurance)
Another regulatory reason for compulsory insurance is
3rd party damages
• E.g., car insurance
• When you cause damage to another car, cost may
well exceed your ability to pay, especially when cash
and/or credit constrained
• This introduces limited liability issues
• Most countries have compulsory car insurance.
Problems with compulsory insurance
provides a captive market
• Makes it even more important that the market
is well-regulated and competitive
• Plus: not everybody can afford the insurance! So may
require a system of subsidies.
In the case of government issued insurance,
disbursements are typically funded by
taxation or other levies
private insurance schemes support their
liabilities (=future claims) by
holding investment
funds
In an insurance company the customers buy an insurance policy, but
it is the shareholders that
hold ownership of the assets, under limited
liability
• Moreover, shareholder equity is typically small
compared to total assets under management,
providing a kind of leverage effect.
What can cause excessive risk taking
Shareholder equity is typically small
compared to total assets under management,
providing a kind of leverage effect.
This can induce managers to take excessive
risks with the assets under management
• Especially when the company is already in
financial trouble
• ”Gamble for resurrection”
• Therefore there is quite strict regulation to ensure
the solvency and long-term ability to pay out
policies of insurance companies
Solvency requirements
• Assets must be sufficient to offset liabilities
• Surplus is carefully monitored by the national
regulators (DNB)
• Minimum capital requirement depend on the riskiness of
their investments and insurance operations
• Modern Risk Based Capital (RBC) standards
Risk Based Capital (RBC) standards depend on
- Underwriting risk
- Asset risk
- Interest rate risk
- Business risk
Typically, when a company falls below a certain capital
ratio, they must
file a report with the regulator outlining
corrective actions (reduce risk, raise capital)
• When RBC falls even further, the regulator must
investigate the insurer, and the insurer must file an
action plan.
• Falling even further the regulator is authorized to take
control of the the insurer
• And when the RBC get dangerously low the regulator is
required to take the insurer under control.
Static solvency
the ability to pay off all obligation
under a liquidation scenario.
dynamic solvency
the ability to pay off all
obligations assuming continuance of institution
In the EU - Solvency II Directive
Defines the Solvency Capital Requirement (SCR) as the
amount of capital needed to ensure that the insurance
company is able to meet its obligations over the next
twelve months with 99.5% certainty
• Formulas updated to better take into account the
asset risk not just the underwriting risk
• Allows insurers to invest in financial instruments
they were previously barred from, provided they
can show they “know what they’re doing”
In the EU - Solvency II Directive
When a firm falls below SCR
a ’supervisory ladder’
kicks in with the level of supervisory intervention
progressively intensifying.
• The Minimum Capital Requirement (MCR) is set to 85%
certainty that the firm is able to meet its obligations
(between 25% and 45% of SCR). Below this the national
regulator has to intervene, take control and liquidate the
firm – or can merge the firm’s operation with another
firm
Solvency II Directive (2009)
Three pillars
Pillar 1: Risk quantification
Pillar 2: Risk management
Pillar 3: Transparency
Solvency II Directive 2009 Pillar 1
- > Sets out valuation standard for liabilities to policyholders and the capital requirements corresponding to the risk
- > Insurers will need enough capital to have 99.5% confidence they could cope with losses over a year
-> Standardizes the formula used to calculate their capital reserves across all risk types ->
Solvency Capital Requirement (SCR) & Minimal Capital Requirement (MCR)
Solvency II Directive 2009 Pillar 1
Solvency Capital Requirement (SCR)
The amount of capital required to be held by insurers
- > can be calculated with approved internal models or standard models
- > regulators would get involved if it falls below that level
Solvency II Directive 2009 Pillar 1
Minimal Capital Requirement (MCR)
The absolute minimum amount of capital insurers have to hold before they are considered insolvent for regulatory purposes
Solvency II Directive 2009 Pillar 2
Insurers are required to prepare Own Risk & Solvency Assessment (ORSA) - an internal process to assess its risk and solvency positions under normal and severe stress scenarios
-> covers analysis of all reasonably foreseeable material risks that could affect an insurers’ ability to meet its policyholder obligation -> underwriting, credit, market, operational, liquidity risk and so on
Solvency II Directive 2009 Pillar 3
Firms are required to produce 2 reports:
1. Solvency and Financial Condition Report (SFCR): both quantitive and qualitative elements and has to be made public each year
2.Regulatory Supervisory Report (RSR): includes all quantitative templates and a defined set of qualitative reports. It is submitted to the regulator but not disclosed publicly
Most countries have conduct of business regulation in
place dealing with the following:
- Formation of insurance companies
- Licensing of agents and brokers
- Insurance rates
- Sales and claims practices
- Formation of insurance companies +
2. Licensing of agents and brokers
• Includes minimum capital and surplus
requirements
• Permission on one country and licensed in your
home domicile provision of insurance services is
then allowed in any other EU country.
• Called ”passporting”
Rate regulation
Often insurance companies (especially in the US) are
not allowed to set any rate they please:
• Prior approval laws
• File-and-use laws
• Flex rating laws (mix of prior approval and fileand-use)
• State mandated rate
• [Open competition]
Policy forms
• Regulators often have to pre-approve policy forms
to ensure they are not:
• Misleading
• Deceptive
• Unfair
• Or can instruct insurers to change forms after the
fact.
Sales practices and consumer protection
• Insurance salesmen and brokers often have to be licensed
• To prevent misrepresentation, twisting and rebating
• Twisting: pressuring someone in dropping an existing
policy in exchange for a new policy that provides little
economic benefit
• Rebating: giving premium reductions not stated in the
policy
In NL: WHC 2008
