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Chapter 8

Chapter 8 BU353.docx

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Heather Graham

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BU353 Chapter 8 – Insurance Companies: Financial Structure and Legal Environment Week 4 Insurer Capital -With a typical insurance policy, the policyholder pas a fixed premium to the insurer and the insurer promises to pay losses or benefits as provided under the terms of the policy -Economic capital – the difference between the market value of assets and the market value of liabilities -The market value of assets reflects the market value of the insurer’s stocks, bonds, real estate, cash and the like -The market value of liabilities equals the present value of the payments the insurer has promised to make in the future for policies already sold Ownership Structures and Sources of Capital -Two broad approaches to insurance company ownership: -Make the policyholders the owners -Make investors the owner Mutual and Reciprocal Insurers -Mutual insurer – incorporated insurance companies that usually charge fixed, advance premiums to policyholders -Because policyholders usually cannot be assessed to pay unexpectedly high claim costs, their liability for the insurer’s claim costs is limited to what they originally paid in premiums -Reciprocal – managed by an entity known as an attorney in fact, which is in essence a management company Stock Insurers -Stock insurers – incorporated insurance companies that are owned by investors who have purchased -In this way it accumulates the assets (capital) that is needed as a cushion for future liabilities -A stock insurer issues shares of stock -Thereafter, capital is accumulated through retained earnings and through additional stock or bond issues -Stockholders have the right to any profits that the insurer earns -Stock insurers sometimes pay dividends to policyholders although the amount of dividends paid by stock insurers is typically lower than that paid by mutual insurers Lloyd’s of London -It is an organization that provides a location and a set of rules and procedures under which insurance business is transacted -Conducts commercial insurance, reinsurance, and auto insurance -Names – the insurance organizations that conduct business through Lloyd’s of London -When joining Lloyd’s and each year thereafter, a name decides which syndicates to participate in and the extent of participation Factors Affecting Insurer Capital Decisions -An important decision facing all insurers is how much capital to hold, given underwriting and investment decisions -It is assumed that all claim costs will be paid at the end of the year Benefits of Increasing Capital -The additional capital obtained will decrease the likelihood that claim costs will exceed assets at the end of the year -The more money raised from issuing stock, the more money a company will have to pay claim costs at year-end -The more stock that a company issues, the greater the likelihood that policyholders will receive BU353 Chapter 8 – Insurance Companies: Financial Structure and Legal Environment Week 4 what they are promised -Consumers of insurance, especially commercial customers, generally are willing to pay higher premiums to insurers that have a lower probability of insolvency -When assets have greater value to one firm than to other firms, the assets are said to be specific assets -An insurer could lose its franchise value if it were to experience financial distress due to unexpectedly high claim costs or a reduction in the value of its investment portfolio Costs of Increasing Capital -One difference between a mutual fund investment and an investment in an insurer is that the mutual fund investor does not face the possibility that part of his or her investment could be used to pay unexpectedly high insurance claims costs -An investment in insurers creates the possibility that the return from investing in an insurer will be higher than the return on the mutual fund investment, because insurance claim costs could be lower than expected -Investors will require additional compensation to invest in insurers because of the correlation of its stock return with their other assets -Uncertain claim costs increase the expected return required by investors in an insurer, compared to an investment in a mutual fund with the same assets, if claim costs are negatively correlated with the value of investors’ other assets -Agency cost – the reduction in firm value due to managers not acting in the stockholders’ interest -Any costs incurred in monitoring and motivating managers to act in the stockholders’ interest are additional agency costs -If agency costs are greater for an insurance company than for a mutual fund company, then investors will view agency costs as a disadvantage of investing in the insurance company -With agency costs, the insurer must sell insurance at prices above expected claim costs and admin costs in order to give investors a return which, net of agency costs, is equal to the return investors can receive by investing in a mutual fund -Insurers may also limit the amount of capital that they raise through equity issues because of equity issuance and underpricing costs -Whenever a firm issues new stock, it faces the possibility that the price received for the new shares will be less than the true value of the shares -Before purchasing the new stock, these investors will ask themselves: Why do the better- informed managers want to sell additional shares? Regulation -In order to be licensed, all insurers in Canada have been required to meet minimum capital requirements to establish and continue operations in a jurisdiction Capital Holdings by Insurers -The amount of capital actually held by insurers varies across companies and across lines of business -The capital-to-asset ratio varies considerably across individual insurers, depending on product mix, assets, and reinsurance -The principle liabilities are: -The loss reserve, which equals the liability for claims that have occurred but have not yet been paid -The unearned premium reserve which equals liability for premiums that have been paid but not yet earned by insurers because the entire coverage period has not elapsed -Variability of claim costs generally is lower for life and health insurance than for property-liability insurance, with life insurance generally having the lowest variability in claim costs BU353 Chapter 8 – Insurance Companies: Financial Structure and Legal Environment Week 4 Asset Choice and Investment Risk -The asset choices made by insurers also have a major effect on insurer risk and the need to hold capital -Insurer investment decisions need to balance higher expected returns from holding riskier investments against the increased investment risk and need for capital -Insurer investment decisions also are strongly influenced by the tax treatment of investment returns and by solvency regulations -As a group, insurers invest heavily in medium- to long-term fixed income securities, such as government bonds, corporate bonds, and mortgages -Asset choices by insurers also affect their vulnerability to interest rate risk -Insurers often do not fully hedge interest rate risk because hedging involves transaction costs and can reduce expected yields Insurance Company Risk Management -The manager in which an insurance company operates significantly impacts the risk it faces and the corresponding amount of capital it needs Diversification of Underwriting Risk -The standard deviation also decreases as the correlation between claim costs across participants declines -Insurers generally can reduce underwriting risk – the risk that average claim costs will differ from the amount expected when policies are sold – by selling large numbers of policies across different types of insurance coverage in different areas -Lower underwriting risk reduces the amount of capital needed for a given level of insolvency risk -Many insurers routinely reduce underwriting risk by selling policies in different geographic regions -Geographic diversification reduces the correlation in claim costs that arises across policies from factors such as catastrophes and other weather-related claims -Insurers also reduce underwriting risk by selling multiple types of policies -Risk reduction through
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