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Risk-averse characteristic
has a curve on the graph. as money earned goes up, happiness per dollar earned decreases
risk neutral characteristics
45 degree line when graphed. Means that as wealth increases, happiness from every dollar stays the same
CAPM formula
Rf+(Rm-Rf)B
ratemaking
the process of setting a price for a unit of insurance
who does ratemaking
actuaries
underwriting
the process of selecting and pricing applicants for insurance
reasons to underwrite
to make a profit, protect against adverse selection, and provide equity among homeowners.
reinsurance
insurance for insurance companies
life insurance investments
tend to be long term because of the historical data
Property and Casualty Investments
tend to be short term because there is more uncertainty
balance sheet items
difference between assets and liabilites
property and casualty insurance liabilities
loss reserves- what insurance company expects to pay out on losses.
unearned premium reserves- premiums for which coverage has not been earned yet but has been collectedU
UPR importance
they need this to make sure they can pay off future claims. Earned premiums can be invested. Unearned premiums keep from investing elsewhere
property and casualty income statement
shows revenues and expenses
revenues on the property and casualty income statement
premiums and investment companies
ratemaking methods
judgement rating, class rating, and merit rating
judgement rating
each individual is evaluated and rate is decided by underwritercl
class rating
individuals with similar characteristics are pooled into same underwriting class and charged the same rate
merit rating
class rates adjusted upward or downward based on individual loss history.
timeline of regulatory development
State insurance commissions, paul v virginia, southeastern underwriters association case, mcCarran-Ferguson Act, Financial Modernization Act.
solvency
Insurance companies' ability to meet long-term financial obligations even with financial downturns.
importance of solvency
Solvency is important because it ensures claims are paid when needed, financial stability, market confidence, and regulatory compliance.
methods for regulating insurance
Legislation, courts, and state insurance departments
risk based capital
difference between total capital and risky capital. RBC of 125% or higher is good. RBC of 35% and below is bad. 250% is the average RBC.
why firms shouldn’t manage risk
risk is the only way to get return, in a perfect world this would work
why firms manage risk
tax motivation, paid vs incurred losses, reduce external financing costs, other RM services
quota share treaty (how much will each insurer pay out in losses for the claims)
take % of claim that correlates with insurers, no ceding commission change yet.
ex: How much wiill each company recieve in premiums. ceding commission is 5% of the premium
add ceding commission to primary insurer %, subtract from secondary insurer %. multiply premium and the new %.
excess of loss treaty
primary has limit on payment of claims, secondary pays the rest.
internal reinsurance
transferring liability from one group to another under the same structure. Can help with financial standing
external reinsurance
transferring liability from one structure to another
Guaranty Funds
pay for policyholders if their insurer goes default during the time they are active and have a claim. 3 reasons guarantee funds sometimes considered incomplete, shortcomings of these funds. Happens when insurance company becomes insolvent.
twisting
agent comes to client with new policy saying it is better. In real life it is usually the same but maybe more expensive. Illegal.
rebating
agent giving client part of the commission under the table to buy their policy. Illegal
Fed advantages
uniformity of laws, more competent regulators
Fed disadvantages
more local responsiveness, NAIC promotion, more innovation opportunity
State advantages
more local responsiveness, NAIC promotion, more innovation opportunity
State disadvantages
bad consumer protection, complaint pileup, availability of insurance
advantages of credit based insurance scores
high correlation between credit score and future claims
disadvantages of credit based insurance scores
discriminate against minorities, credit reports can be wrong, customer penalization during recessions.
Expected utility
(probability of outcome 1 X utility of outcome 1) + (probability of outcome 2 X utility of outcome 2)
Pure premium= fair premium= Expected loss=
probability X loss
variance=
(Probability1(Loss1)^2 + probability2(loss2)^2)- expected loss^2
Standard deviation (find variance first)=
square root of variance
expected utility= indifference point
square root of W-X. solve for X
Loading charge
premium - expected loss
Firm value
Expected cash flow that year/(1+discount rate)^time
CAPM
rf+(RM-RF)Bi
Expected after tax income with no insurance=
(pi X xi) OR (probability of no loss(1- corporate tax) X pre tax earnings) + probability of loss( pre tax- $ value from chance of loss)
Loss ratio
(Incurred Losses + Loss Adjustment Expenses)/ Premiums Earned
Expense ratio=
underwriting expenses/ premiums written. Want this to be low
Combined ratio =
loss ratio + expense ratio. Full story for underwriting profit
Investment income
net investment income/ earned premiums
Overall operating ratio =
combined ratio - investment income ratio
Determining if underwriting profit was made:
if combined ratio is greater than 1, there is no underwriting profit. If combined ratio is less than 1, there is underwriting profit.
Total profit:
if overall ratio is over 1, there is not total profit.
Policy holder surplus = equity =
total assets - total liabilities
