D.02.Feldblum IRR

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D.02.Feldblum IRR
2012-05-09 17:01:15
IRR NPV Surplus

Pricing Insurance Policies: Internal Rate of Return Model
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  1. Disadv of fixed profit margin pricing model
    • lack of theoretical justification of fixed margin
    • high int rates imply margin could be too low
    • incr competitiveness imply periods of reduced profits
  2. 2 points of view to look at insurance
    • financial mkt: exp return influenced by shareholders
    • product mkt: premium affected by supply / demand
    • interrelated: high demand = better return, inadequate rate = pull reserves
  3. IRR Model
    • IRR = rate which sets NPVof CF = 0
    • as long as IRR > opportunity cost, accept project
    • CF inversed: need surplus contrib at inception, then payout
    • assumptions: amt of S req; timing of commitment; of release
  4. NPV vs IRR differ when
    • unusual CF: rare unless simplify CF
    • mutually excl: rare (1) if IRR > COC use profits to grow (2) usually set IRR = COC
    • NPV preferable: does not make assumption that CF reinv @ IRR
  5. Practical criticisms of IRR
    • if 0 < IRR < COC or inv yield < IRR < COC, cpy is unprofitable but appears to make money for regulators
    • insr more likely to run into that situation: C isn't fixed
  6. Insurance risks
    • asset risk: depreciation
    • pricing risk: L + E > expected
    • reserving risk: insufficient
    • A-L risk: chg in int rate has different impact
    • cat risk
    • reins risk: recoverables
    • cr risk: agents & ph premium receivables
  7. Surplus vs policy form
    • claims made: no pure IBNR -> less surplus
    • service contracts: no ins risk
    • retro: share risk -> S need btwn prosp & service
    • some models make no dist: overstate retro, understate XS
    • other allocate in prop to ins risk: understate retro, XS, large ded (volatility)
  8. Manufacturer fixed assets vs Insurer surplus
    • manuf can objectively measure assets
    • manuf can divide assets into products (similar to LOBs)
    • amt of surplus heavily dependent on past profits