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Characteristics of an Insurable Risk

1) Large number of similar objects
2) Losses are accidental/unintentional
3) Losses can be determined/measured
4) Losses should not be catastrophic
5) Large Loss Principle
6) Insurable Interest

Insurance companies (or insurers) prefer their risks to have thesix characteristics of Insurable risks. Can you think ofany insurable risk that lacks any one of thecharacteristics? You can name the risk, loss exposure orperil and explain what characteristics this lacks.

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Keith Leannon
Keith LeannonLv2
28 Sep 2019
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Short Story
Insurance

Let’s now look at Berkshire’s various businesses, starting with our most important sector, insurance. The property/casualty (“P/C”) branch of that industry has been the engine that has propelled our growth since 1967, the year we acquired National Indemnity and its sister company, National Fire & Marine, for $8.6 million. Today, National Indemnity is the largest property/casualty company in the world as measured by net worth.

One reason we were attracted to the P/C business was its financial characteristics: P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as claims arising from exposure to asbestos, payments can stretch over many decades. This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume.

We recently wrote a huge policy that increased float to more than $100 billion. Beyond that one-time boost, float at GEICO and several of our specialized operations is almost certain to grow at a good clip. National Indemnity’s reinsurance division, however, is party to a number of large run-off contracts whose float is certain to drift downward.

We may in time experience a decline in float. If so, the decline will be very gradual – at the outside no more than 3% in any year. The nature of our insurance contracts is such that we can never be subject to immediate or near-term demands for sums that are of significance to our cash resources. This structure is by design and is a key component in the unequaled financial strength of our insurance companies. It will never be compromised.

If our premiums exceed the total of our expenses and eventual losses, our insurance operation registers an underwriting profit that adds to the investment income the float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it.

Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous indeed that it sometimes causes the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Competitive dynamics almost guarantee that the insurance industry, despite the float income all its companies enjoy, will continue its dismal record of earning subnormal returns on tangible net worth as compared to other American businesses.

Question:
Describe what Buffett means by “float” and “underwriting profit” in his overview of Berkshire’s insurance business.

Hi guys could someone help me and explain in detail the two fundamental principles of investments – the risk/return tradeoff and diversification. Also, describe how asset allocation and the correlation of various securities within asset classes impact the riskiness of an investor’s portfolio.

I found an answer but it seems to me very long and not sure about it so can you help me out guys

ANS:

Risk /Return Tradeoff

Risk, return and liquidity are three dimensions of investment decision. Risk/Return trade off considers two dimension ie risk and return. As risk of an investment increases , its expected return will decrease. Risk is measured by volatility of return which can be statistically obtained by standard deviation of return. Higher the standard deviation, higher will be volatility of return and higher the risk

Risk can be also measured as a relative risk compared to the market. This is measured by stock beta with reference to a market index. Higher the beta, higher the value of stock Beta, higher will be the risk .

Investors seeking higher return will need to take higher risks.

Treasury bonds are almost risk free assets. This has the lowest rate of return. Stocks have higher risk , hence have higher expected return. High beta stocks will have higher risk and higher returns.

An investor should understand his risk taking ability and will have to make a trade off between risk and return depending on his risk apetite.

Diversification:

There is a saying, do not put all your eggs in one basket. The reason is that it has higher risk if all eggs are in one basket. If the eggs are distributed in different basket, risk of loss decreases.

Same principle is applied in investment. Diversification reduces risk.

If one invests in different classes of assets like bonds, stock, commodities and properties –his risk is likely to reduce. Reduction in return in one asset is likely to be compensated by return in other asset.

Within one class of asset also, there should be diversification to reduce risk.

For example one stock “A “may have expected return of 10% and standard deviation of 5%.This risk can be reduced by diversification in number of assets and the ratio of Risk/return can be decreased.

If we diversify and instead of investing 100% in stock A, we invest 60% in “A” and 40% in another stock “B” having expected return15% and standard deviation of 8%.assume the correlation between the two assets are 0.5

Portfolio return=wa*Ra+wb*Rb

Wa=Weight of asset A=0.6

Wb=Weight of asset B=0.4

Ra=Return of A=10%

Rb=Return of B=15%

Sa=Standard deviation of A=5%

Sb=Standard deviation of B=8%

Corr(a,b)=Correlation of A & B=0.2

Portfolio return=0.6*10+0.4*15=12%

Portfolio Variance=(wa^2)*(Sa^2)+(wb^2)*(Sb^2)+2wa*wb*Cov(a,b)

Cov(a,b)=Corr(a,b)*Sa*Sb=0.1*5*8=4

Portfolio Variance=(0.6^2)*(5^2)+(0.4^2)*(8^2)+2*0.6*0.8*4=23.08

Portfolio standard deviation=Square root of Variance=(23.08^0.5)=4.8%

The diversification has increased return and reduced risk

Stock A was giving 10% return with 5% standard deviation. With diversification of portfolio we have 12% return and 4.8% standard deviation. Risk return ratio is decreased.

It may be noted that, higher the correlation between assets in the portfolio, higher will be risk in terms of standard deviation. Hence it is better to diversify with uncorrelated assets.

Diversification reduces unsystematic risk,but it cannot reduce systematic risk of overall market or economy

I NEED HELP WITH A RESPONSE TO THE POSTBELOW.

How do bonds provide financing to corporations for theircapital projects? Issuing bonds is the easiest mosteffective way to raise money to do the things needed to allow thecompany to grow without taking a loan from the bank with higherinterest rates. A investor basically loans the company the money inexchange for interest payments. Companies are more willing to issuea bond and pay a lower interest rate.

What are the key differences between using bonds tofinance capital projects and using stock for that purpose?The key difference is that with bonds companies can continue toissue all the bonds that they want just as long as they haveinvestors who are willing to invest the money for a certaininterest rate. When a company does this it does not have any impacton ownership and the way the company is operated or the sharesdistributed. With stocks you have to put up shares of the company,which will mean that the company brings in less money because ofthe sharing of the revenue with the stockholders of thecompany.

References

Smith, L. (2018, December 21). Why Companies Issue Bonds.Retrieved January 14, 2019, fromhttps://www.investopedia.com/articles/investing/062813/why-companies-issue-bonds.asp

The value of a bond is dependent primarily on twofactors. Name and explain these factors. The value of abond is dependent on the value of its cash flow in terms of thepresent value of the coupon payments and the present value of thepar value. The coupon changes according to the current interestrate. When the interest rate falls lower than the coupon rate thenthe value of the bond payment rises. The length of paymentsremaining before maturity is also a factor as it represents agreater or lesser portion of the value. The current value of a bondis always measured against the going interest rate, whichdetermines what will be paid out.

Compare and contrast the differences between stocks andbonds. The characteristics of bonds is that the valuerises and falls depending on interest rates, interest payment aretax deductible by the corporation, equity is not lost throughissuance, unpaid debt is a liability, can be issued at any time forany reason and the creditors have not voting powers. Thecharacteristics of stocks is that the value rises and fallsdepending on the value that the stock trades are at, dividends arenot tax deductible, loss of stock value creates no liability, canonly be issued one time, equity owners can control the company withvoting powers and stock issuance is based on transfer ofequity.

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