Fair Rate of Return in Property-Liability Insurance
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Hence, even writing insurance at a negative under- writing profit will be advantageous! The rea- son for this is of course the delayed nature of claim payments which enables insurers to invest premiums and get return on invest- ments. In other words, from the time premi- ums are paid until payment occurs, time for capital investment opportunities pass.
There- fore, even an insurance line with a negative return will be profitable, if the investment income multiplied with the funds generating factor, k, exceeds the underwriting loss. Capital Asset Pricing Model Up to now, the insurance firm was described in isolation from other competitive insurers. To be able to determine the equilibrium return it is necessary to introduce an asset pricing model.
In a competitive mar- ket the underwriting return must be compared with other investments in the same risk cat- egory. See equation 3.
Through diversification the capital market can eliminate all so-called unsystematic risk and the risk which is not offset is called systematic risk or market risk. Since the in- vestors can eliminate the unsystematic risk through an efficient portfolio mixture, the important part is how an asset contributes to the market risk. The beta value,?
External impacts on the property-liability insurance cycle - Munich Personal RePEc Archive
According to the model the portfolio manager has to choose a suitable risk level. If the manager chooses a portfolio with? We see that the CAPM implies that investors will only be rewarded for bearing market risk and not for bearing unsystematic risk. The reason is that the unsystematic risk can be diversified away, but not the systematic market risk. Insurance Capital Asset Pricing Model Using the equilibrium risk-return relation implied by the CAPM, we can get important knowledge about the operation of insurance markets.
John David Cummins
Several authors have applied the original CAPM for insurance purposes e. In contrast to statistical insurance models, the insurance CAPM pays attention to the finan- cial nature of an insurance contract and it identifies the specific types of risk that deter- mines the price relationships that will hold in equilibrium. See equa- tion 4. Equation 4 is the so-called insurance CAPM. Premiums are paid in advance and the funds generating coefficient k indicate the average time between policy issue and claims pay- ment. The first part of equation 4 , — k rf, represents the interest credit to the policy- holders for the premium lending.
- J. David Cummins (Author of Fair Rate of Return in Property-Liability Insurance).
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As the in- surer can invest the policyholder funds, the premium price must be corrected. The factor — k rf reduces required premium profits and the policyholders receive an implicit interest payment in parity of the risk free return over k periods. The second component of the un- derwriting return is the insurer compensation for bearing risk. The risk compensation con- sists of underwriting beta? U multiplied with the market risk premium rm — rf.
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In the same manner as the investors in the original CAPM only get compensation for the system- atic risk, also the insurers only will be reward- ed for bearing systematic risk4. Let us consider this feature of the insurance CAPM little further. If underwriting profits are positively correlated with the market return,?
On the contrary, if? Underwriting pro- fits can take negative values, since the insurer can invest the premium funds at an interest rate at least as good as the risk free return. And the policyholder is implicitly refunded in par- ity with the risk free interest rate for lending to the insurer. It is most likely, that profit margins will decrease in a competitive insu- rance market! We can now state a fundamental proposi- tion about insurance contracts issued in a competitive market: 4 Here a tax-free world is considered.
By adding taxes to the model, the equilibrium premiums will increase, see further Fairley In equilibrium, the insurance underwriting profit margins are a linear function of the riskless rate of interest and the systematic risk of underwriting. Haley, Joseph D. Hall, S. Harrington, Scott E.
Litan and C. Winston, eds. Jenkins, G. MacKinnon, James G. McGee, R. Myers, Stuart C. David Cummins and Scott E. Harrington, eds. Pindyck, Robert S. Stewart Barbara D. Randall ed. Winter, Ralph A. Login Create Account. External impacts on the property-liability insurance cycle.
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All papers reproduced by permission. Reproduction and distribution subject to the approval of the copyright owners. View Item. Julie Hotchkiss. Chatfield, C.