Pricing for Multiline Insurer: Frictional Costs,Insolvency, and Asset Allocation

This article examines multiline insurance pricing based on the contingent claim approach in a limited liability and frictional costs environment. Capital allocation is based on the value of the default option, which satisfies the realistic assumption that each distinct line undertakes a pro rata share of deficit caused by insurer insolvency. Premium levels, available assets, and default risk interact with each other and reach equilibrium at the fair premium. The assets available to pay for liabilities are not predetermined or given; instead, the premium income and investment income jointly influence the available assets. The results show that equity allocation does not influence the overall fair premium. For a given expected loss, the premium-to-expected-loss ratio for firms offering multiple lines is higher than that for firms only offering a single line, due to the reduced risk achieved through diversification. Premium-to-expected-loss ratio and equity-to-expected-loss ratio vary across lines. Lines having a higher possibility or claim amount not being paid in full exhibit lower premium-to-expected-loss ratio and higher equity-to-expected-loss ratio. Positive correlation among lines of business results in lower premium-to-expected-loss ratio than when independent losses are assumed. Positive correlation between investment return and losses reduces the insolvency risk and leads to a higher premium-to-expected-loss ratio.     

Capital Allocation in Financial Firms

This paper develops a theory of capital allocation in financial intermediaries where the cost of "risk capital" is a critical consideration. The implication for capital budgeting is that financial firms should use a modified NPV rule in which projects are valued by calculating the NPV of cash flows using marketdetermined discount rates and then subtracting a deadweight cost of capital that reflects the project's marginal contribution to firm-wide risk.
By taking account of deadweight costs—mainly monitoring and moral hazard costs associated with having too little equity capital as well as "free cash flow" agency costs and higher taxes associated with having too much—the capital allocation model predicts that financial firms will diversify across businesses with similar deadweight costs. Such diversification reduces the cost of risk capital for the individual businesses, thereby creating more profitable investment opportunities at the margin and enabling the businesses to operate on a larger scale. The authors note that their model has similarities to but also important differences from the standard applications of RAROC models.     

Performance Management in Insurance Firms by Using Transfer Pricing

In this article, we analyze the asset and liability management and market risk systems of insurance companies. We discuss that the current system is not goal congruent and does not satisfy necessary conditions for effective control. It follows that managers are unable to run their business effectively. We develop a transfer pricing system that allows the clear separation of underwriting and investment activities, both on the risk and return aspects. It creates the appropriate incentive schemes. We illustrate this system with an example indicating the differences in incentives between the traditional embedded value measures and the proposed funds transfer pricing system.     

美国保险业资金运用

由于持续地面临不确定的市场风险,保险业普遍寻求将自有资金尽可能多地投向收益率较高的投资工具。在发达国家中,美国寿险公司的资产分配方案比较典型,债券,尤其是公司债券,占保险公司资产总额的比例较高。     

Allocation of Capital in the Insurance Industry

ABSTRACT: This article discusses and critiques the methods that have been proposed for allocating capital in financial institutions, with an emphasis on applications in the insurance industry. The author discusses the rationale for allocating capital by line of business and explains how capital allocation can be used to maximize firm value. The implications for capital allocation of regulatory risk-based capital and the capital asset pricing model are discussed. The advantages and disadvantages of using value-at-risk and insolvency put option criteria in capital allocation are analyzed. Finally, recently proposed methods of marginal capital allocation are evaluated. One conclusion is that using the insolvency put option is superior to value-at-risk for allocating capital but that both methods fail to account for diversification across lines in the multi-line firm. The primary conclusion is that marginal capital allocation methodologies based on option-pricing models that recognize the effects of diversification are the best approach for allocating capital in the financial industry.     

Information Production and Capital Allocation: Decentralized versus Hierarchical Firms

This paper asks how well different organizational structures perform in terms of generating information about investment projects and allocating capital to these projects. A decentralized approach—with small, single–manager firms—is most likely to be attractive when information about projects is "soft" and cannot be credibly transmitted. In contrast, large hierarchies perform better when information can be costlessly "hardened" and passed along inside the firm. The model can be used to think about the consequences of consolidation in the banking industry, particularly the documented tendency for mergers to lead to declines in small–business lending.     

多元化公司内部资本市场配置效率——国外相关研究述评与启示

内部资本市场理论是理解多元化公司内部资金配置最重要的理论之一,本文介绍了多元化公司内部资本市场理论的研究进展,分别围绕内部资本市场的配置效率、测度方法以及内部资本市场与多元化公司价值的实证检验等几个方面,对国外已有的文献进行回顾与梳理,并阐述了内部资本市场理论对我国经济改革与发展具有的重要现实意义。     

Capital Structure, Agency Problems, and Deposit Insurance in Banking Firms

This paper applies and synthesizes various theories of corporate finance, including capital structure, agency insurance, and regulation, to the case of banking firms and the deposite insurance system. It is argued that a value-maximizing bank would reach its optimal capital structure by minimizing the agency costs of incentive conflicts among stockholders, managers, uninsured depositors, and the deposit insurance agency. Although a regulatory imposed capital requirment may reduce the agency costs inherent in the insurance contact, it cannot produce a universal capital structure that is optimal for all insured banks. The observed capital structure patterns also suggest that banks actively seek an optimal capital structure.     

Capital Allocation for Insurance Companies—What Good IS IT?

In their 2001 Journal of Risk and Insurance article, Stewart C. Myers and James A. Read Jr. propose to use a specific capital allocation method for pricing insurance contracts. We show that in their model framework no capital allocation to lines of business is needed for pricing insurance contracts. In the case of having to cover frictional costs, the suggested allocation method may even lead to inappropriate insurance prices. Beside the purpose of pricing insurance contracts, capital allocation methods proposed in the literature and used in insurance practice are typically intended to help derive capital budgeting decisions in insurance companies, such as expanding or contracting lines of business. We also show that net present value analyses provide better capital budgeting decisions than capital allocation in general.     

The Impact of Introducing Insurance Guaranty Schemes on Pricing and Capital Structure

The introduction of an insurance guaranty scheme can have significant influence on the pricing and capital structures in a competitive market. The aim of this article is to study this effect on competitive equity–premium combinations while considering a framework with policyholders and equity holders where guaranty fund charges are volume‐based, as levied in existing schemes. Several settings with regard to the origin of the fund contributions are assessed and the immediate effects on the incentives of the policyholders and equity holders are analyzed through a one‐period contingent claim approach. One result is that introducing a guaranty scheme in a market with competitive conditions entails a shift of equity capital towards minimum solvency requirements. Hence, adverse incentives may arise with regard to the overall security level of the industry.     

Capital Requirements for Securities Firms

Regulatory authorities set capital requirements to cover the position risk of securities firms and to protect against losses arising from fluctuations in the value of their holdings. The requirements may be set using the comprehensive approach required by the U.S. Securities and Exchange Commission, the building-block approach required by the European Community, or the portfolio approach required by the United Kingdom. We compare these three alternatives using a large sample of U.K. equity trading books. The portfolio approach systematically specifies larger requirements for riskier books, and vice versa. It is more efficient than the building-block approach, and far more efficient than the comprehensive approach.     

Solvency, Capital Allocation, and Fair Rate of Return in Insurance

In this article, we consider the links between solvency, capital allocation, and fair rate of return in insurance. A method to allocate capital in insurance to lines of business is developed based on an economic definition of solvency and the market value of the insurer balance sheet. Solvency, and its financial impact, is determined by the value of the insolvency exchange option. The allocation of capital is determined using a complete markets’ arbitrage‐free model and, as a result, has desirable properties, such as the allocated capital “adds up” and is consistent with the economic value of the balance sheet assets and liabilities. A single‐period discrete‐state model example is used to illustrate the results. The impact of adding lines of business is briefly considered.     

Venture Capital and Capital Allocation

I show that venture capitalists' motivation to build reputation can have beneficial effects in the primary market, mitigating information frictions and helping firms go public. Because uninformed reputation‐motivated venture capitalists want to appear informed, they are biased against backing firms—by not backing firms, they avoid taking low‐value firms to market, which would ultimately reveal their lack of information. In equilibrium, reputation‐motivated venture capitalists back relatively few bad firms, creating a certification effect that mitigates information frictions. However, they also back relatively few good firms, and thus, reputation motivation decreases welfare when good firms are abundant or profitable.     

Optimal Capital Utilization by Financial Firms: Evidence from the Property-Liability Insurance Industry

Capitalization levels in the property-liability insurance industry have increased dramatically in recent years—the capital-to-assets ratio rose from 25% in 1989 to 35% by 1999. This paper investigates the use of capital by insurers to provide evidence on whether the capital increase represents a legitimate response to changing market conditions or a true inefficiency that leads to performance penalties for insurers. We estimate best practice technical, cost, and revenue frontiers for a sample of insurers over the period 1993–1998, using data envelopment analysis, a non-parametric technique. The results indicate that most insurers significantly over-utilized equity capital during the sample period. Regression analysis provides evidence that capital over-utilization primarily represents an inefficiency for which insurers incur significant revenue penalties.     

资本约束下保险公司最优大类资产配置模型研究

中国第二代偿付能力监管制度体系(以下简称“偿二代”)执行以后,投资风险直接体现在资本要求上,资本充足率成为保险公司投资决策的重要约束。在此背景下,保险公司有必要建立整体经济资本预算框架,通过提高各类资产的边际资本回报率,提升公司股东价值。本文通过理论研究证明资本约束下保险公司最优大类资产配置的路径首先是进行负债风险匹配资产的管理,其次才是追求盈余资产收益最大化,同时,本文创新性提出了三阶段的数值求解方法,填补了国内文献以及保险公司实践中难以前置化资本约束得到大类资产配置数值解的研究空白。     

External and Internal Pricing in Multidivisional Firms

Multidivisional firms frequently rely on external market prices in order to value internal transactions across profit centers. This paper examines market‐based transfer pricing when an upstream division has monopoly power in selling a proprietary component both to a downstream division within the same firm and to external customers. When internal transfers are valued at the prevailing market price, the resulting transactions are distorted by double marginalization. The imposition of intracompany discounts will always improve overall firm profits provided the supplying division is capacity constrained. Under certain conditions it is then possible to design discount rules so that the resulting prices and sales quantities are efficient from the corporate perspective. In contrast, the impact of intracompany discounts remains ambiguous when the capacity of the selling division is essentially unlimited. It is then generally impossible to achieve fully efficient outcomes by means of market‐based transfer pricing unless the external market for the component is sufficiently large relative to the internal market.     

Resource Allocation Auctions within Firms

There is growing interest in the use of markets within firms. Proponents have noted that markets are a simple and efficient mechanism for allocating resources in economies in which information is dispersed. In contrast to the use of markets in the broader economy, the efficiency of an internal market is determined in large part by the endogenous contractual incentives provided to the participating, privately informed agents. In this paper, we study the optimal design of managerial incentives when resources are allocated by an internal auction market, as well as the efficiency of the resulting resource allocations. We show that the internal auction market can achieve first‐best resource allocations and decisions, but only at an excessive cost in compensation payments. We then identify conditions under which the internal auction market and associated optimal incentive contracts achieve the benchmark second‐best outcome as determined using a direct revelation mechanism. The advantage of the auction is that it is easier to implement than the direct revelation mechanism. When the internal auction mechanism is unable to achieve second‐best, we characterize the factors that determine the magnitude of the shortfall. Overall, our results speak to the robust performance of relatively simple market mechanisms and associated incentive systems in resolving resource allocation problems within firms.