Insurance Portfolio Pricing
Insurance Portfolio Pricing: Insurance Demand, Supply, and Contracts.
1. Insurance Demand
Demand for insurance services can be broken into three types.
Risk transfer is the classic motivation for risk averse individuals to purchase insurance. The insured is exposed to a risk which they wish to avoid. Diversification allows them to do this by pooling their risk with other insureds.
Risk pooling is the magic ingredient of insurance; diversification through pooling is the closest to a free lunch that finance allows. Risk pooling for short-tailed, property-casualty lines is inter-insured, intratemporal. It shares losses in one period between a pool of risks.
Satisfying demand, a phrase from Kunreuther, Pauly and McMorrow (2013) : the insurance policy satisfies certain statutory, regulatory, or contractual requirements in order for the insured to carry out another desired activity. Financial responsibility laws for driving an automobile and employer liability laws are examples of statutory requirements.
A debt contract requiring insurance collateral protection is an example of a contractual requirement. Insurance purchased wholly or in part for satisfying requirements accounts for at least 60% of global property-casualty premium, according to Aon Benfield (2015).
Risk financing, the insured seeks to finance uncertain future contingencies in an efficient manner. Risk financing requirements are driven by accounting, regulation, and tax law. Under GAAP, an obligation cannot be expensed, and is not tax deductible, unless it is reasonably certain in timing and amount. A contingent future payment to settle a lawsuit may not meet these requirements and so may not be a deductible expense.
Entities use insurance-based risk financing to convert contingent, nondeductible liabilities into certain, deductible amounts.
Risk financing is typically performed for a single entity over time: it is intertemporal, intra-insured. Risk financing is used to fund reasonably certain losses in a cost efficient manner. Large deductible and retrospectively rated policies, self-insured retentions, and captives are used to satisfy risk financing demand.
Insurance that is purchased to meet a satisfying requirement generally needs to be issued by a regulated entity, especially if it is third-party, because judgment-proof buyers have no interest in the quality of insurance and simply purchase the cheapest allowable cover (Cummins, 1988). Insurers with on-balance sheet capital exist primarily to meet such demand.
2. Insurance Supply
Ins Co. collects premium from customers and supplies services in return. Insurance services include sales, marketing, risk surveys and loss control, customer billing and support, underwriting and pricing, claims adjusting, risk bearing, and investment management services.
These services are bundled in different ways. Managing a risk pool involves two critical functions. The first is controlling access to the pool through underwriting and pricing, and the second is ensuring the pool is solvent by funding risk-bearing assets through the sale of liabilities.
These two critical functions are the heart of an insurance company, and we abbreviate them Pool Co. and Capital Co. Underwriting assures pool members they are all treated fairly. To manage incentive conflicts Pool Co. and Capital Co. are usually one entity, Ins Co., which normally also bundles Claim Co. to adjust claims.
The market includes a wide variety of service combinations:
– Customer Co. functions are bundled in a direct writer, or handled by independent agents and brokers.
– Managing general underwriters can provide stand-alone Pool Co. services.
– Reinsurance and sidecar arrangements can provide stand-alone Capital Co. services.
– Third-party claims adjuster Claim Cos. are common, especially for large accounts.
– Independent Inv Cos. that provide asset management services for the pool’s assets are very common, particularly for smaller insurers.
3. Insurance Contracts
Insurance contracts must be written so that claims are clear and objective, easy to adjust, and discourage fraud. A contract is specified by delineating the circumstances under which it responds and the amount it pays. The amount is a random variable, a function of the underlying outcome.
A basic requirement of insurance is that it pays no more than the subject loss. The insured should never profit from an insurance claim.
Parametric insurance policies pay based on an explicit event outcome, defined by an objective physical description such as a hurricane intensity and landfall or earthquake magnitude and epicenter. Parametric insurance is easy to underwrite because it does not depend on the characteristics of the insured.
However, they are hard to design to ensure that the insured has a loss only when a claim is triggered — to prevent the insured from profiting from a claim. The insured is also exposed to basis risk: a mismatch between their subject loss and the insurance recovery.
For these reasons, the majority of insurance responds on a dual-trigger basis: an objective event occurs and it causes an economic loss to the insured. The indemnity payment is a function of an underlying subject loss amount suffered by the insured. Indemnity is a function of an implicit event. Policies apply an indemnity function to the subject loss that combines limits and sublimits, occurrence, aggregate deductibles, and so forth.
Insurance Portfolio Pricing Series: Insurance Pricing