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- If insurance is available at the same price to people facing widely
- varying risks, then those with the greatest risks are more likely to buy
- insurance. This adverse selection works to the detriment of insurers.
- Unchecked, it would make underwriting unprofitable.
- Insurers protect themselves from adverse selection by attempting to
- measure risk and either charging more from the higher risks, or by
- refusing to cover them at all. For example, motor insurers charge higher
- premiums for cars and drivers that are statistically more likely to be
- involved in accidents. Medical insurers usually exclude pre-existing
- conditions (i.e. any illness that pre-dates the start of cover) from
- their cover in order to deter people from buying cover after a problem
- has been diagnosed.
- In part, the problem of adverse selection is dealt with by the insurers'
- attempts to measure risk, which is anyway necessary to setting
- premiums. However, this still leaves insurers with a significantly
- problem in any circumstances where the insured may have more information
- than they do. This is why, unlike other contracts, insurance contacts
- are agreed uberrimae fides
- (in utmost good faith). This means that a persons (which includes
- organisations as well as people) taking out insurance are required to
- inform the insurer of all relevant information, not just what they are
- directly asked for.
- In some countries there are restrictions on what information insurers
- can gather, which can affect their ability to limit adverse selection.
- In the UK, life insurers cannot require applicants for cover below a
- threshold level to take genetic tests, even though it is fairly easy for
- people to have tests performed and conceal the results.
Adverse selection has similarities to moral hazard. Both change risks to insurers as a result of customer behaviour.
Annual premium equivalent
- It is common (in the UK) to use annual premium equivalent (APE) to allow
- comparisons of the amount of new business (policies written during the
- period) gained in a period by insurance companies with different
- proportions of single premium and regular premium business.
- It is clearly not possible to compare the total amounts of premiums as
- single premium policies bring in more money up front than equivalent
- regular premium policies.
- Annual premium equivalent is the total amount of regular premiums from
- new business + 10% of the total amount of single premiums on business
- written during the year.
PVNBP is a more sophisticated alternative that is part of the European Embedded Value standards.
- An annuity, in financial theory, is a series of equal fixed payments
- made at regular intervals that terminates at some point. A similar
- stream of payments that does not terminate is called a perpetuity.
- An annuity is also a financial produce, usually purchased from a life
- insurance company, that pays a regular income until the death of the
- purchaser in return for a lump sum. The insurance company needs to use
- the lump sum and the income they get from investing it to meet the
- annuity payments. As the length of any person's life is uncertain the
- insurance company bears a risk.
- A life assurance
- policy can be thought of as the opposite of an annuity. With a life
- assurance policy, the insurance company makes a loss when each insured
- person dies within the term of the policy as it has to make a payment.
- With an annuity, the insurance company makes a gain when each insured
- person dies.The opposing natures of annuities and life insurance means that the annuities an insurance company sells hedge
- certain risks to its life policy payouts and vice-versa. For example,
- if the death rate rises then the insurance company will have to pay out
- more on life policies but less on annuities.
Assurance is insurance against events that will inevitably occur.
The common example of assurance is life assurance.
- There is no real difference between assurance and insurance, although
- the long term over which life assurance is taken complicates all the actuarial calculations linked to it.
- Bancassurance is the selling of insurance and banking products through
- the same channel, most commonly through bank branches selling insurance.
- The sales synergies available have been sufficient to be used to justify mergers and acquisitions.
- Some of the sales synergies come through the extensive customer base
- that banks have. Some come from opportunities to sell insurance together
- with some banking products. For example, banks generally insist on life
- insurance for mortgage borrowers. Although borrowers are not obliged to
- buy insurance from the lender, many do (despite it often being very
- over-priced) as it is an easy option.
Credit cards and personal loans create opportunities for banks to sell protection insurance (another high margin business) and the knowledge a bank has of its customers' finances creates opportunities to sell other products.
- Bancassurance has become significant. Banks are now a major distribution
- channel for insurers, and insurance sales a significant source of
- profits for banks. The latter partly being because banks can often sell
- insurance at better prices (i.e., higher premiums) than many other
- channels, and they have low costs as they use the infrastructure
- (branches and systems) that they use for banking.
- What has not happened to any great extent, at least in Britain, is the
- merger of banks and insurers to form integrated bancassurance companies.
- Catastrophe bonds (cat bonds) are a form of insurance securitisation.
- They are an alternative to insurance that transfers risk to investors
- rather than insurers. They are legally not insurance, which has some
- important consequences.
- The most important of these differences are that they are not uberrimae fides and that they can be bought by any investor (not just a insurer). See credit default swaps for a more detailed discussion of the differences between insurance and non-insurance contracts.
- Catastrophe bonds may be issued by an insurer to spread risk, in order
- to protect their own balance sheets in the event of large scale payouts
- such as those caused by natural disasters. They therefore also reassure
- policy holders.
- They may also be issued an entity that requires insurance against a
- single large risk. In this case they can be regarded as a form of
- insurance disintermediation. A good example of was FIFA's issue of $260m worth of catastrophe bonds against cancellation of the 2002 football world cup.
- Catastrophe bonds are usually issued by an SPV.
- The SPV will keep bondholders' money and pay them interest. It will
- also usually receive a premium from the insured. In the event of the
- "catastrophe" occurring the bondholders lose their money and it is used
- to pay the insured.
- In return for a low risk of losing all their money cat bond holders get a
- better yield and an otherwise reasonably safe investment. The risk is
- also usually an easily diversifiable one.
Claims equalisation reserve
- The claims equalisation reserve is a balance sheet
- item showing funds an insurance company has (nominally) set aside in
- order to smooth fluctuations in the cost of claims. The claims
- equalisation reserve is not required and is used at a company's
It produces more consistent revenues, but it is obviously something that lends itself to abuse.
- There is a certain irony in there being a recognised balance sheet item
- that allows insurance companies to use a (limited) form of profit
- smoothing — something that accounting standards are designed to make as
- difficult as possible in any other industry. There is, of course, a
- reason for this: the availability of actuarial estimates of the "normal" level of claims provides a sounder basis for smoothing.
- The claims ratios is claims payable as a percentage of premium income. This is the equivalent of gross profit margin
- for an insurance business. An insurer's investment income is also part
- of its core business so the comparison with gross profit is not exact.
- The loss ratio is similar, but is sometimes defined subtly different as claims paid (rather than payable).
- The claims ratio can be combined with the expense ratio to produce the combined ratio.
In general (non-life) insurance, the combined ratio is claims and operating expenses as a percentage of premium income.
- If it is less than 100% the company is making an operating profit
- on investment underwriting. A company may still make a profit despite a
- combined ratio of over a 100% as insurance companies normally have
- substantial investment income.
It is may include or exclude amounts reimbursed by reinsurers. It is important to be clear which of these variants is being used in any instance.
The combined ratio combines two types of costs: claims and operational expenses. It can be decomposed into two ratios, the claims ratio and the expense ratio to give a more detailed breakdown.
- The embedded value of a life insurance business is an estimate of the
- value of both its net assets and the income stream expected from
- policies already in force.
E = PV + NAV
- where E is the embedded value,
- PV is the present value of future cash flows on policies already in force and
- NAV is the company's NAV with investments valued at market value.
- The future profits do not include the value of policies that
- the company will sell in the future, only those already sold. Policies
- that the company can expect to sell in the future are an important
- component of the difference between the embedded value and the actual
- value of the business to investors.
European embedded value
- European Embedded Value (EEV) is a standardised calculation of embedded value and related numbers that is being adopted by European insurance companies to make their results more meaningfully comparable.
- The EEV principles provide consistent definitions, actuarial assumptions and disclosure requirements for EEV.
- Although EEV provides a tighter set of rules and more consistency
- between companies, it still leaves a number of important decisions (such
- as risk premiums to be used) to individual companies. Given the complex
- nature of insurance accounts, investors should not expect this to mean
- that comparisons are now easy.
- A key part of EEV is a uniform method of comparing new business premiums: PVNBP.
A general insurer's expense ratio is its operating expenses as a percentage of its premium income.
It is analogous to the overhead cost ratio but in the context (and suited to the very particular requirements) of insurance.
It, together with the claims ratio, is part of the decomposition of the combined ratio.
Free asset ratio
A solvency measure used by British life insurance companies, the free asset ratio is:
(available assets - required minimum margin of solvency) ÷admissible assets
- The exact definition varies and the numbers disclosed by different
- companies as headline free asset ratios may not be comparable. For
- example, some companies include future profits. The ratio will also
- depend on the assumptions made in valuing liabilities.
In general, the higher the ratio, the more surplus capital a company has available.
A person or organisation who has insurance cover may be be more prepared to take risks than someone who does not.
- For example, someone whose car is insured against theft may be more
- careless about reducing the chances of theft than they would have been
- without such insurance.
- This is partly why insurance companies require excesses (the amount of a
- claim paid by the person covered) on most claims, and reduce premiums
- quite sharply as excesses rise. It is also why insurers are very careful
- about the valuation of what they insure and why they are not legally
- required to pay more than the real value of what they cover, even if it
- has been insured for more.
- Moral hazard can also occur outside insurance, although it is less of a
- concern. Banks and financial institutions often have implicit state
- guarantees (not formal or legally binding guarantees, but a general
- expectation that they are too big/important to fail). This creates an
- incentive for the management and shareholders to take bigger risks as
- they will benefit from gambles that work, but the state will pay for
- those that do not. This is similar to the agency conflict between shareholders and debt holders.
New business margin
- New business margin in a profit measure used by insurers. The
- measurement of new business (the equivalent of sales when calculating profit margins in other industries) is less straightforward than similar numbers in other industries. It is common practice to use the present value of net new business (PVNBP), and in the EU this would be the EEV measure.
- Given this:
- new business margin = profit on new business ÷ PVNBP
- The profit number used also needs to be calculated on a basis
- consistent with the PVNBP denominator. For example, if PVNBP is an EEV
- number, then the profit number should be the EEV profit on those sales.
- As with most of the important insurance numbers, new business margin is sensitive to actuarial assumptions.
Outstanding claims reserve
- The outstanding claims reserve is the provision made in the balance sheet
- of an insurance company for all claims that have been made and for
- which the insurer is liable, but which had not been settled at the
- balance sheet date.
- Premium earned is the amount of premiums earned by the risk covered by an insurer during a period. Premium written
- is the amount customers are required to pay for policies written during
- the year. The two differ because of the timing of premium payments.
For example if:
- An insurance policy that runs from the 1st July 2005 to the 30th June 2006.
- The premium is £1,000.
- The insurance company has a December year end.
- Then, as the policy runs for six months of this year and six months of
- next, half the risk is taken in the current year and half next year.
- Therefore the premium earned is £500 for 2005 and £500 for 2006.
However as the cover is agreed during 2005, the gross premium written is £1,000 for 2005.
- The revenues an insurance company receives as premiums paid by customers
- is its premium income. This excludes other revenue streams, most
- importantly investment income.
The most important definitions of premium income are premium earned and premium written.
- The amount of premiums customers are required to pay for insurance
- policies written during the year. This contrasts with premium earned
- which is the amount of premiums that a company has earned by providing
- insurance against various risks during the year.
It may be measured gross (before deduction of reinsurance costs) or net (after reinsurance costs). It is a measure of sales.
Present value of new business premiums (PVNBP) is a measure of sales that forms part of the European Embedded Value accounting principles that have been adopted in order to provide uniform measures for all European insurers.
PVNBP is, like annual premium equivalent (APE), a way in which the values of single and regular premium new business sold during a financial period can be combined to give a single sales number. It is:
value of single premiums + present value of regular premium streams
There are two major differences between PVNBP and APE:
- PVNBP adjusts regular premiums to make them comparable with single premiums, APE does the opposite.
- APE uses a simple adjustment factor, PVNBP uses a more sophisticated discounted value.
- The first of these is not of great importance. The APE way of doing
- things gives a number that is more like the sales number of a trading
- company and that therefore may be more intuitive.
- In using a DCF PVNBP is more
- correct, but it introduces more uncertainties and more room for
- manipulation because it requires choosing an appropriate discount rate.
- Regulatory capture is what happens when regulated industries
- are able to gain influence over their regulator, so that regulation that
- ostensibly serves the public interest actually supports the interest of
- the industry concerned.
- Some economists argue that regulatory capture is inevitable, most
- that it is a significant risk. It occurs because those who are regulated
- have a high stake in influencing regulation to favour them, whereas
- those the benefits of regulation are more diffusely spread: consider a
- typical regulated industries, such as most utilities, where a small
- number of large firms are regulated to benefit a large number of
- consumers. Each firm's profits are heavily influenced by regulation, so
- they will each put a lot of effort into influencing the regulator,
- whereas few individual consumers will have a sufficiently large stake to
- expend much effort.
- Another advantage that the regulated industry has over consumers, and
- often over the regulator, is expert knowledge of the industry. This
- allows the industry to marshal the facts and arguments needed to
- influence the regulator, far more easily than consumers, and often more
- easily than regulators.
- Conflicts of interest among individuals who run the regulator may
- also lead to regulatory capture. It is not uncommon for people to move
- between working for the regulator and working for the industry: for
- example working for a financial regulator and then in a compliance role in a bank.
- Regulated industries may also be able to lobby legislators to
- restrict the level or form of regulation, or the duties and aims of the
- regulator. Even where there is no industry regulator as such, most
- industries are affected by a variety of regulation that they can
- influence. Once again, focus, funding, expert knowledge, and conflicts
- of interests enable this.
- Regulation may even evolve so as to make things worse for consumers
- by reducing competition. Minimum capital requirements, licenses to
- operate, and similar restrictions increase barriers to entry.
- From and investor's point of view increased barriers to entry will
- increase profits, but be aware that this may all ready be reflected in
- the price. It is most useful for value investors looking for a safe source of profits — what Warren Buffet calls a moat.
- Regulator capture may be reversed if failure become apparent, or
- consumers become active enough: banking after the global financial
- crisis is a good example of this.
- Reinsurance is simply insurance for insurers. It allows them to pass on
- risks that they cannot, or do not wish, to absorb themselves.
- Insurance companies typically insure some (but not all) of the risks
- that they are exposed to with specialist reinsurers. The insurer can
- then recover a part of the claims they pay out from the reinsurer. This
- reduces the risk of the failure of the insurer in the event of a
- catastrophic event, such as a natural disaster, that may produce a very
- high level of claims.
Reinsurance companies are usually very large, well funded and have a wide spread of operations.
Risk measures such as solvency margin are adjusted for the level of reinsurance cover.
There are two types basic types of reinsurance arrangement, facultative reinsurance and treaty reinsurance.
- This is the arrangement of separate reinsurance for each risk that the
- insurer underwrites. This is normally part of an on-going arrangement
- and the insurer continually offers policies to the reinsurer, and the
- reinsurer decides whether to accept each or not individually. Obviously
- this requires a lot of work and is now generally regarded as too
- expensive in human resources to be practical.
- Treaty reinsurance is arranged for a block an insurer's underwritten
- policies. The reinsurer reinsurers a whole large chunk of the insurer's
- business. This means that the reinsurer does not need to scrutinise each
- policy individually and the insurer does not have the added workload of
- providing the reinsurer details of each and every risk it underwrites.
Reinsurance may be agreed on a pro rata basis or a stop loss basis:
- Pro rata basis: the reinsurer gets a fixed proportion of
- the premium on the risks covered, and in return pays out a fixed
- proportion of the claims made.
- Stop loss basis: the insurer will absorb losses up to a limit (the
- retention), and reinsurer will absorb almost all losses above that
Reinsurnace may also cover only individual risks of above a certain size or losses above a specified excess.
Major reinsurers include Swiss Re, Munich Re, General Re, and (collectively) Lloyds syndicates.
Lloyd's of London
Lloyd's is an insurance market. It provides a framework in which buyers of insurance can be matched with sellers. It is not an insurance company;
Lloyd's is particularly popular for risks that are hard to place elsewhere.
As with any market it has its brokers, and there are many insurance brokers that bring business to Lloyd's.
On the other side are investors who underwrite risks through Lloyd's syndicates that are run by managing agents.
- Each syndicate is, in essence, an insurance company. The syndicates pay
- claims, not Lloyd’s itself. This is why Lloyd's can be described as a
- market: its function is to match the syndicates with their clients.
Reinsurance retention ratio
The reinsurance retention ratio is:
net premium written ÷gross premium written
It is a rough measure of how much of the risk is being carried by an insurer rather than being passed to reinsurers.
Single premium vs regular premium
- Single premium insurance policies are those on which the customer pays a
- single one-off payment. The insurer gets an up front payment for
- covering a continuing risk over a period of time. This contrasts with
- regular premiums which give the insurers an income stream in return for
- covering the risk. General insurance is paid with regular premiums but
- single premiums are not uncommon in life assurance.
Annual premium equivalent or PVNBP can be used to measure insurers' new business using a single number that combines regular and single premium business.
- The solvency margin is a minimum excess on an insurer's assets over its
- liabilities set by regulators. It can be regarded as similar to capital adequacy requirements for banks. It is essentially a minimum level of the solvency ratio, but regulators usually use a slightly more complex calculation. The current EU requirement is the greatest of:
- 18% of premium written up to €50m plus 16% of premiums above €50m.
- 26% of claims up to €35m plus 23% of claims above €35m.
- Some other adjustments are also made. Premiums for high risk classes of
- business are increased for the purpose of this calculation, an
- adjustment is made for reinsurance, etc.
- This requirement is being replaced by "Solvency II". This is a
- development that is very similar to the Basel II capital adequacy
- requirements for banks, as it will mean a move to more complex risk
The free asset ratio is net assets adjusted for the solvency margin.
- The solvency ratio of an insurance company is the size of its capital
- relative to premium written. The solvency ratio is (most often) defined
net assets ÷ net premium written
- The solvency ratio is a measure of the risk an insurer faces of claims
- that it cannot absorb. The amount of premium written is a better measure
- than the total amount insured because the level of premiums is linked
- to the likelihood of claims.
- It is a basic measure of how financially sound an insurer is, but this
- simple calculation that does not take into account the types of business
- the company does.
- Technical reserves are the amounts insurance companies set aside from
- profits to cover claims. Technical reserves include the unearned premium
- reserve and the outstanding claims reserve. The latter is the amount of premium written but not earned.
- Any reinsurance receivables will be deducted from the technical
- reserves, as will deferred acquisition costs (the acquisition or
- marketing costs relating to policies which have not expired by the year
Technical reserves may also include the unexpired risk reserve and the claims equalisation reserve if such reserves have been created.
Uberrimae fides means “utmost good faith&rdquot; in Latin. Insurance is agreed uberrimae fides.
- Buyers of insurance do not only need to answer the questions that the
- insurer asks honestly. They must also disclose certain facts unasked.
- These are those that may cause a "reasonable insurer" not to underwrite the risk, or to underwrite it on different terms. Failure to do this can invalidate insurance.
- The reason insurance contracts are agreed uberrimae fides is that it helps to reduce adverse selection. If insurance contracts were agreed caveat emptor
- (buyer beware) like most other contracts, then the slightest omission
- from insurance proposal documents would attract significant numbers of
- people who could exploit the loophole.
- The contrast of uberrimae fides with caveat emptor
- is legally correct, in that contract law in itself imposes no duties on
- either party to act fairly. However there are often other protections in
- place - particularly for consumers. Most transactions are covered by
- laws (such as the Sale of Goods Act), regulators and implied terms of
An underwriter is someone who takes a financial risk (relieving another party of it) in return for a fee.
The most familiar underwriters are insurance companies, whose entire business is the underwriting of a wide range of risk.
- Some new issues, most importantly IPOs,
- of securities are underwritten, usually by investment banks. The
- underwriter agrees to buy any securities that unwanted by the market. If
- the offer is not as successful as expected the underwriter may make a
- The underwriter does not usually take as large a risk as may appear. New
- issues, especially large ones, are priced low enough to make it likely
- that the issue will be fully subscribed. This is why stags usually make a gain on IPOs.
The underwriter of an issue of a security may be a single investment bank or, especially in the case of a large IPO, a syndicate of banks.
- Underwriting is very lucrative, and there has been a long running
- controversy over whether this is an indication that investment banks are
- colluding on pricing.
Unearned premium reserve
The unearned premium reserve is an item that appears on insurers balance sheets. It shows the total amount of premiums written but not yet earned. The unexpired risk reserve is very similar to the unearned premium reserve.
Unexpired risk reserve
- If an insurer considers its unearned premium reserve
- to be too small, then it may create an unexpired risk reserve in
- addition to it. The unearned premium reserve is required, unexpired risk
- reserves are created at companies' discretion