The Design of Private Reinsurance Contracts

This article examines the effect of asymmetric information on the trading of underwriting risk between insurers and reinsurers and how it is mitigated in a context of long-term relationships. It begins by explaining how information problems affect the efficiency of the allocation of risk between insurers and reinsurers and how long-term implicit contracts allow the inclusion of new information in the pricing of reinsurance coverage. A key feature of these relationships is the reliance on loss-contingent rebates and commissions in the pricing of reinsurance coverage. We argue that when information is revealed only over time, long-term implicit contracts between insurers and reinsurers allow the inclusion of new information into reinsurance pricing. Because of this feature, the allocation of risk between insurers and reinsurers is more efficient. Specifically, such arrangements lead to more reinsurance coverage, higher insurer profits, and lower expected distress in the industry. Journal of Economic Literature Classification Numbers: G22, G13, L15, D81.     

The Economics of Insurance Intermediaries

This article analyzes the economic functions of independent insurance intermediaries (brokers and independent agents), focusing on the commercial property–casualty insurance market. The article investigates the functions performed by intermediaries, the competitiveness of the market, the compensation arrangements for intermediaries, and the process by which policies are placed with insurers. Insurance intermediaries are essentially market makers who match the insurance needs of policyholders with insurers who have the capability of meeting those needs. Intermediary compensation comprises premium‐based commissions, expressed as a percentage of the premium paid, and contingent commissions based on the profitability, persistency, and/or volume of the business placed with the insurer. Empirical evidence is provided that premium‐based and contingent commissions are passed on to policyholders in the premium. However, contingent commissions can enhance competitive bidding by aligning the insurer's and the intermediary's interests. This alignment of interests gives insurers more confidence in the selection of risks and thus helps to break the “winner's curse” and encourages insurers to bid more aggressively. Independent intermediaries also help markets operate more efficiently by reducing the information asymmetries between insurers and buyers that can cause adverse selection.     

On the Lack of Participating Policy Usage by Stock Insurance Companies

Stock insurers can reduce or eliminate agency conflicts between policyholders and stockholders by issuing participating insurance. Despite this benefit, most stock companies don't offer participating contracts. This study explains why. We study an equilibrium with both stock and mutual insurers in which stockholders set premiums to provide a fair expected return on their investment, and with a policyholder who chooses the insurance contract that maximizes her expected utility. We demonstrate that stockholders cannot profitably offer fully participating contracts, but can profitably offer partially participating insurance. However, when the policyholder participation fraction is high, the fair‐return premium is so large that the policyholder always prefers fully participating insurance from the mutual company. Policies with lower levels of policyholder participation are optimal for policyholders with relatively high risk aversion, though such policies are usually prohibited by insurance legislation. Thus, the reason stock insurers rarely issue participating contracts isn't because the potential benefits are small or unimportant. Rather, profitability or regulatory constraints simply prevent stock insurers from exercising those benefits in equilibrium.     

An Analysis of Contingent Commission Use by Property–Liability Insurers

The payment of contingent commissions in the property–liability insurance industry has long been commonplace, but recent events have made the practice highly controversial. Even prior to these events, wide variation existed among insurers in their use of contingent commissions. In this article, we examine the determinants of whether or not an insurer chooses to pay contingent commissions at all, as well as the determinants of the extent of their use for those insurers that pay them. We find a number of variables that have a significant relation to the use and extent of use of contingent commissions.     

Analysis of Participating Life Insurance Contracts: A Unification Approach

Fair pricing of embedded options in life insurance contracts is usually conducted by using risk‐neutral valuation. This pricing framework assumes a perfect hedging strategy, which insurance companies can hardly pursue in practice. In this article, we extend the risk‐neutral valuation concept with a risk measurement approach. We accomplish this by first calibrating contract parameters that lead to the same market value using risk‐neutral valuation. We then measure the resulting risk assuming that insurers do not follow perfect hedging strategies. As the relevant risk measure, we use lower partial moments, comparing shortfall probability, expected shortfall, and downside variance. We show that even when contracts have the same market value, the insurance company's risk can vary widely, a finding that allows us to identify key risk drivers for participating life insurance contracts.     

Corporate Hedging in the Insurance Industry

Abstract

In this paper we investigate the extent to which insurance companies utilize financial derivatives contracts in the management of risks The data set we employ allows us to observe the universe of individual insurer transactions for a class of contracts, namely, those normally thought of as off-balance-sheet (OBS) We provide information on the number of insurers using various types of derivatives contracts and the volume of transactions in terms of notional amounts and the number of counterparties. Life insurers are most active in interest rate and foreign exchange derivatives, while property/casualty insurers tend to be active in trading equity option and foreign exchange contracts Using a multivariate probtt analysis, we explore the factors that potentially influence the existence of OBS activities. We also investigate questions relating to whether certain subsets of OBS transactions (for example, exchange traded) are related to such things as interest rate risk measures, organizational form and other characteristics that may discriminate between desired risk/return profiles across a cross-section of insurers. We find evidence consistent with the use of derivatives by insurers to hedge risks posed by guaranteed investment contracts (GICs), coilater-alized mortgage obligations (CMOs), and other sources of financial risk     

Catastrophe Bonds and Reinsurance: The Competitive Effect of Information-Insensitive Triggers

We identify a new benefit of index or parametric triggers. Asymmetric information between reinsurers on an insurer's risk affects competition in the reinsurance market: reinsurers are subject to adverse selection, since only high-risk insurers may find it optimal to change reinsurers. The result is high reinsurance premiums and cross-subsidization of high-risk insurers by low-risk insurers. A contract with a parametric or index trigger (such as a catastrophe bond) is insensitive to information asymmetry and therefore alters the equilibrium in the reinsurance market. Provided that basis risk is not too high, the introduction of contracts with parametric or index triggers provides low-risk insurers with an alternative to reinsurance contracts, and therefore leads to less cross-subsidization in the reinsurance market.     

Participating Insurance Contracts and the Rothschild-Stiglitz Equilibrium Puzzle

We extend the Rothschild-Stiglitz (RS) insurance market model with adverse selection by allowing insurers to offer either non-participating or participating policies, that is, insurance contracts with policy dividends or supplementary calls for premium. It is shown that an equilibrium always exists in such a setting. Participating policies act as an implicit threat that dissuades deviant insurers who aim to attract low-risk individuals only. The model predicts that the mutual corporate form should be prevalent in insurance markets where second-best Pareto efficiency requires cross-subsidisation between risk types.     

Are health insurers in multiple lines of business less profitable? An examination of scope economies in health insurance

In markets where companies can offer multiple products or services, production costs may decline, and profitability may increase as business scope expands. Using a sample of health insurers from 2015 to 2018 with data reported in the annual NAIC Supplemental Health Care Exhibit, we test whether scope economies exist among health insurers. We evaluate the relationship between scope and four profitability metrics—the medical loss ratio, the expense ratio, the underwriting profit ratio, and a profit efficiency measure obtained using a data envelopment analysis technique. We test two competing hypotheses from prior literature on scope economies in insurance. The strategic focus hypothesis states performance is higher for insurers that specialize in one line of business. The conglomeration hypothesis states performance is higher for insurers that operate in multiple lines of business. Our results provide evidence in support of the strategic focus hypothesis among US health insurers.     

Cream Skimming: Innovations in Insurance Risk Classification and Adverse Selection

We demonstrate how innovations in insurance risk classification can lead to adverse selection, or cream skimming, against insurers that are slow to adopt such pricing innovations. Using a model in which insurers with insufficient pricing data cannot differentiate between low‐ and high‐risk policyholders and therefore charge both the same premium, we show how innovative insurers develop new risk classification data to identify overcharged low‐risk policyholders and attract them from rival insurers with reduced prices. Less innovative insurers thus insure a growing percentage of high‐risk customers, resulting in adverse selection attributable to their informational disadvantage. Next, we examine two cases in which “Big Data” innovations in risk classification led to concerns about cream skimming among U.S. auto insurers. First, we track the rapid adoption of credit‐based insurance scores as pricing variables in personal auto insurance markets. Second, we examine the growing popularity of usage‐based insurance programs like telematics, plans in which insurers use data on policyholders’ actual driving behavior to set prices that attract low‐risk customers. Issues associated with the execution of such pricing strategies are discussed. In both cases, we document how rival insurers quickly adopt successful innovations to reduce their exposure to adverse selection.     

On the Possibility of Profitable Self-Selection Contracts in Competitive Insurance Markets

Several studies extend the Rothschild–Stiglitz model of competitive insurance contracting with adverse selection by incorporating additional dimensions of private information and conclude that some insurers may earn positive profit in a separating, self-selection equilibrium, provided each insurer is restricted to making a single contract offer. The main result of this article is that these profitable configurations are not sustainable when individual insurers can offer multiple contracts. It is also shown that the ability to offer multiple contracts overturns equilibria that have applicants from different risk classes pooled as well as those where profits are dissipated by a fixed entry cost.     

Tail Risk Networks of Insurers Around the Globe: An Empirical Examination of Systemic Risk for G-SIIs vs Non-G-SIIs

In this article, we investigate systemic risk of 157 insurers around the globe. We construct tail risk networks among these insurers using a single-index model for quantile regressions with a variable selection technique. We develop a new network-based systemic risk indices, taking into account expected tail losses of insurers, direct and indirect contagion effects, and the time-varying strength of tail risk spillover. Our systemic risk indices successfully recognize global systemically important insurers (G-SIIs). We find that on average G-SIIs are more systemically relevant than non-G-SIIs, particularly during the recent U.S. financial crisis. We also find a small group of non-G-SIIs that are more important than G-SIIs. Our results have significant implications for systemic risk regulation.     

The Capital Structure of Firms Subject to Price Regulation: Evidence from the Insurance Industry

Automobile and workers' compensation insurance are relatively homogeneous products sold under varying regulatory systems among the states. This paper investigates how price regulation affects the capital structure decisions of profit-maximizing insurers who sell insurance in both competitive and/or regulated markets. Specifically, we test the hypothesis that insurers subject to price regulation will choose to hold less capital. In addition, we hypothesize insurers subject to more stringent regulatory pricing constraints will choose even higher degrees of leverage because the benefits of holding additional amounts of capital are suppressed. We conduct empirical tests using cross-sectional data on insurers and find evidence consistent with both hypotheses. These findings have important implications for insurance price and solvency regulation. Stricter price regulation increases the default risk (i.e., reduces the financial quality) of insurance contracts purchased by individuals and firms.     

Negotiating contract types and contract clauses in the German construction industry during the Third Reich

This article examines the determinants of contractual form and renegotiations in the German construction industry during the Third Reich. At the beginning of World War II, firms dealt with growing uncertainty by convincing procurement agencies either to use cost‐plus contracts or to include an additional risk premium in fixed‐price contracts. In the later years of the war, procurement agencies initiated renegotiations over contract clauses to reduce the extraordinary profits resulting from information rents and high‐risk premiums. This regulatory course undermined the credibility of the regulatory commitment, thereby weakening the incentives of the fixed‐price contracts still in use.     

Risk aversion,prudence, and compensation

In a standard principal-agent setting, we use a comparative approach to study the incentives provided by different types of compensation contracts, and their valuation by managers with utility function u who are risk averse (u″<0) and prudent (u″′>0). We show that concave contracts tend to provide more incentives to risk averse managers, while convex contracts tend to be more valued by prudent managers. This is because concave contracts concentrate incentives where the marginal utility of risk averse managers is highest, while convex contracts protect against downside risk. Thus, managerial prudence can contribute to explain the prevalence of stock-options in executive compensation. However, convex contracts are not optimal when the principal is sufficiently prudent relative to the manager.     

The Effects of Customer Satisfaction on Company Profitability: Evidence From the Property and Casualty Insurance Industry

Prior literature presents a positive link between customer satisfaction and firms’ financial outcomes, including greater revenue, profitability, and prices. However, few studies approach the topic of customer satisfaction in the insurance industry. Using a unique data set obtained from J.D. Power, we observe customer satisfaction among U.S. auto insurers and link their customer satisfaction rating to insurer profitability metrics. Our results support the notion that greater customer satisfaction leads to reduced expenses and increased profitability. A potential explanation is that more satisfied customers are more likely to remain with an insurance company and refer others to the insurer, reducing customer acquisition expenses.     

Risk,Capital, and Operating Efficiency: Evidence from Taiwan’s Life Insurance Market

ABSTRACT

In this article, we investigate the relationships among risk, capital, and operating efficiency for Taiwanese life insurance companies from 2004 to 2009 by using the two-stage least-square approach. We find a positive relation between inefficiency and product risk. At the same time, efficient insurers are seen as taking higher asset risk than inefficient insurers. A contrasting finding also shows that the relationship between capital and product risk is positive, while the relationship between capital and asset risk is negative. Moreover, we present a negative relationship between inefficiency and capital level, indicating that well-capitalized insurers operate more efficiently than poorly capitalized insurers.     

ARE PAIRS TRADING PROFITS ROBUST TO TRADING COSTS?

We examine the impact of trading costs on pairs trading profitability in the U.S. equity market, 1963 to 2009. After controlling for commissions, market impact, and short selling fees, pairs trading remains profitable, albeit at much more modest levels. Specifically, we document a risk‐adjusted return of about 30 basis points per month among portfolios of well‐matched pairs that are formed within refined industry groups. Pairs trading exhibits a lower risk and lower return profile than a short‐term reversal strategy that sorts stocks relative to their industry peers. Notably, both these types of contrarian investing are largely unprofitable after 2002.     

The interplay between risk adjustment and risk rating in voluntary health insurance

Many regulated health insurance markets include risk adjustment (aka risk equalization) to mitigate selection incentives for insurers. Empirical studies on the design and evaluation of risk-adjustment algorithms typically focus on mandatory health insurance schemes. This paper considers risk adjustment in the context of voluntary health insurance, as found in Chile, Ireland, and Australia. In addition to the challenge of mitigating selection by insurers, regulators of these voluntary schemes have to deal with selection by consumers in and out of the market. A strategy for mitigating selection by consumers is to apply some form of risk rating. Our paper shows how risk adjustment and risk rating interact: (1) risk rating reduces the need for risk adjustment and (2) risk adjustment reduces premium variation across rating factors, thereby increasing incentives for consumers to select in and out of the market.     

The Impact of the Secondary Market on Life Insurers' Surrender Profits

Life insurers often claim that the life settlement industry reduces their surrender profits and leads to an adverse shift in their portfolio of insured risks; that is, high risks remain in the portfolio instead of surrendering. In this article, we aim to quantify the effect of altered surrender behavior––subject to the health status of an insured––in a portfolio of life insurance contracts on the surrender profits of primary insurers. Our model includes mortality heterogeneity by applying a stochastic frailty factor to a mortality table. We additionally analyze the impact of the premium payment method by comparing results for annual and single premium payments.