Mildenhall Section 2 Flashcards
Basis Risk
Mismatch between insurer’s subject loss and insurance recovery
Insured should never profit from a claim
Demand for Insurance
Risk Control
Satisfying demand (e.g. mandatory)
Risk Financing
Return on Equity
Income/Equity
UW Margin * UW leverage + Invest Return * Invest leverage
Invest Return + Reserves/Equity (Inv Return + UW Inc/Reserves)
UW Margin
UW income/Premium
UW leverage
Premium/Equity
Investment Return
Invest Income/Assets
Investment Leverage
Assets/Equity
Why use risk-free rate in ratemaking
- Premium profit margins should not depend on investment portfolio (just risk-free rate and systematic UW risk)
- Policyholders don’t share investment risks, should pay same regardless of investment strategy
Why use expected market return in ratemaking
Added investment risk means higher prob of default for policyholders, so premium should reflect
IRR Model
From investors’ POV.
Undertake if IRR >= hurdle rate
Pro: doesn’t require discount rates for each cash flow
Con: requires hurdle rate to make a decision
DCF Model
undertake project if total discounted cash flows are positive
Special case: portfolio constant cost of capital (when no tax)
Market Imperfections
-Transaction costs (UW expenses)
-Frictional costs (agency costs, regulation, double taxation)
-Market frictions (bid-ask spreads)
Bernoulli Layer
Very thin loss layer, no partial losses
Completely described by prob of loss
Either pays $0 or $1
Myers-Cohn Fair Premium Condition
A premium is fair if when policy issued, resulting equity value =equity invested to support that policy
if prem inc equity = transfer wealth from policyholder to investor
if dec = transfer opposite
