A Theory of the Demand for Underwriting

We examine the demand for underwriting and its effect on equilibrium in an insurance market in which insureds know their risk type, but insurers do not. Our analysis indicates that a set of policies including one that requires buyers to take an underwriting test can constitute a full coverage Nash equilibrium when perfect classification is possible. We also find that underwriting equilibria, in which low risks obtain greater coverage than they would without underwriting, widely exist in a Wilsonian market with nonmyopic insurers. Our findings provide a potential explanation for why empirical evidence on adverse selection is mixed.     

On the Demand for Portfolio Insurance

While insurers manage underwriting risk with various methods including reinsurance, insurers increasingly manage asset risk with options, futures, and other derivatives. Previous research shows that buyers of portfolio insurance pay considerably for downside protection. We add to this literature by providing the first evidence on the cost of portfolio insurance, the payoff to portfolio insurance, and the relative demand for portfolio insurance across VIX levels. We find that the demand for portfolio insurance is relatively high at low levels of VIX, suggesting purchasers demand more downside protection when this protection is cheap on an absolute basis (but expensive on a relative basis). We also provide the first evidence on the hedging behavior of specific investor classes and show that the demand for portfolio insurance is driven by retail investors (individuals) who buy costly insurance from institutional investors. Results are consistent with other types of paradoxical insurance‐buying behavior.     

Product-market strategy and underwriting performance in the United Kingdom’s property–casualty insurance market

Drawing on a framework from the organizational economics literature, we utilize a panel data design to examine empirically the effect of motor insurance and liability insurance business on the overall underwriting performance of insurers operating in the United Kingdom’s (UK) property–casualty insurance market. We find that participation in liability insurance contributes positively to underwriting performance, whereas motor insurance is associated with inferior underwriting performance. Additionally, we find that higher reinsurance ratio is associated with better underwriting performance, but reduced profit margins. Our results show that higher leverage too is associated with better underwriting performance. We conclude that our results could have potentially important commercial and/or policy implications.     

Effects of business diversification on asset risk-taking: Evidence from the U.S. property-liability insurance industry

We investigate the effect of line-of-business diversification on asset risk-taking in the U.S. property-liability industry. The coordinated risk management hypothesis (Schrand and Unal, 1998) implies a negative relation between underwriting risk and investment risk. Consistent with this hypothesis we find that diversified insurers take more asset risk than non-diversified insurers, and that the degree of asset risk-taking is positively related to diversification extent. Our results are robust to corrections for potential endogeneity bias, selectivity bias, and alternative diversification and asset risk measures. We also provide event study evidence that further supports the coordinated risk management hypothesis. Specifically, we find that when a focused firm diversifies, it increases its asset risk relative to firms that remain focused, and when a diversified firm refocuses, it reduces its asset risk relative to firms that remain diversified.     

Does operating risk affect portfolio risk? Evidence from insurers' securities holding

This study empirically examines, in the setting of insurance companies, the hypothesis that investors facing more operating risk may behave as if they were more risk averse in investment decisions. Specifically, we study how operating risk from underwriting insurance policies affects insurers' risk taking behavior in their portfolio investments. We find that insurers with higher volatilities in underwriting incomes and cash flows are more conservative in their financial investment risk taking – they have lower credit risk exposure in their bond investments, as well as lower portfolio weights on risky bonds and equities. Further, insurers' portfolio risk exposure is sensitive to the risk of permanent underwriting income shocks but insensitive to the risk of transitory shocks. Transitory operating risk, however, is significantly related to portfolio risk when insurers face tight financing constraints. Our findings suggest a substitutive effect of operating risk on investment decisions by financial institutions.     

Systemic Risk,Financial Crisis,and Credit Risk Insurance

Differing from conventional insurance firms whose underwriting business does not contribute to systemic risk, credit risk insurance companies providing credit protections for debt obligations are exposed to systemic risk. We show that credit risk insurers (CRIs) underperformed conventional insurance companies during the 2007–2009 financial crisis, and such underperformance is attributed to the greater systemic risk of CRIs. We also find that the credit spreads of insured bonds increase significantly after their insurers are downgraded or put in the negative watch list. We control for alternative factors affecting bond credit spreads and the result is robust.     

Adverse Selection in Term Life Insurance Purchasing due to the BRCA1/2 Genetic Test and Elastic Demand

Consumer groups fear that the use of genetic testing information in insurance underwriting might lead to the creation of an underclass of individuals who cannot obtain insurance; thus, these groups want to ban insurance companies from accessing genetic test results. Insurers contend that such a ban might lead to adverse selection that could threaten their financial solvency. To investigate the potential effect of adverse selection in a term life insurance market, a discrete‐time, discrete‐state, Markov chain is used to track the evolution of twelve closed cohorts of women, differentiated by family history of breast and ovarian cancer and age at issue of a 20‐year annually renewable term life insurance policy. The insurance demand behavior of these women is tracked, incorporating elastic demand for insurance. During the 20‐year period, women may get tested for BRCA1/2 mutations. Each year, the insurer calculates the expected premiums and expected future benefit payouts which determine the following year's premium schedule. At the end of each policy year, women can change their life insurance benefit, influenced by their testing status and premium changes. Adverse selection could result from (i) differentiated benefits following test results; (ii) differentiated lapse rates according to test results; and (iii) differentiated reactions to price increases. It is concluded that with realistic estimates of behavioral parameters, adverse selection could be a manageable problem for insurers.     

The Risk Balls Game: Transforming Risk and Insurance Into Tangible Concepts

The Risk Balls game is used as a game in an introductory insurance course to demonstrate in a tangible way the notion of risk and its relationship to insurance. Through playing with the ``risk balls,' each one representing a different type of risk, the students experience feelings of anxiety about risk, and later, the sense of anxiety reduction when they transfer the risk balls to insurers. The game incorporates complex concepts of risk transfer and risk reduction via pooling and sharing of risk. The mathematical implications of the law of large numbers are physically felt in the classroom when the students experience the relief associated with transferring the risk balls to insurers. The discussion that ensues during the game includes aspects of the underwriting process; moral hazard; adverse selection; the role of agents, insurers, and regulators; and the nature of the insurance contract. The game of risk balls stimulates lively group discussions and provides hands-on experience with risks such as premature death risk or fire risk and the fears associated with them.     

CEO Turnover and Ownership Structure: Evidence From the U.S. Property–Liability Insurance Industry

This article examines the impact of ownership structure on the relation between firm performance and chief executive officer (CEO) turnover in the U.S. property–liability insurance industry. Theoretical implications of stock versus mutual ownership structures on the performance–turnover relation are ambiguous. Our empirical results indicate that CEO turnover is less responsive to firm underwriting performance in mutual insurers compared to stock insurers. In fact, we find that while CEO turnover for stock firms is negatively related to prior performance, no such relationship is found for mutual insurers. These results hold while controlling for board structure and other relevant factors.     

Capital and Risk Revisited: A Structural Equation Model Approach for Life Insurers

The role of risk in the capital structure decision of firms is a vast topic in finance. Commonly, models of the interrelationship between risk and capital enumerate as many risk factors as possible by appropriate proxies, with the goal of detailing their individual effects. In this study of the life insurance industry for 1994 through 2000, we take a broader, holistic view of enterprise risk, identifying two groups of insurer risk factors that arise from the major activities of life insurers: investing and underwriting. We call the group of risk factors associated with investing asset risk, and the group associated with underwriting product risk. After specifying other important determinants of capital structure as controls, we allow all other risk factors to find expression in residual error. Within this framework, our focus is to compare two candidate measures for the role of proxy for asset‐related risks. One measure, called regulatory asset risk (RAR), derives from the regulatory tradition of concern with solvency and is related to the C‐1 component of risk‐based capital. The other measure, called opportunity asset risk (OAR), is motivated by traditional finance concerns with market risk and reflects volatility of returns. Product‐related risks are proxied by underwriting exposures in different product lines. We employ structural equation modeling (SEM), which uses longitudinal factor analysis. SEM is an innovative technique for such studies, in dealing effectively with multiple structural equations, autocorrelated panel data, unobserved underlying factors, and other issues that are not simultaneously addressed in other methodologies. We find that RAR and OAR are not equivalent proxies for asset risks. Although overlapping to some extent, each illuminates different aspects of the asset risk–capital interrelationship. In particular, RAR does not seem to affect the capital structure decision of small firms, although OAR does. We interpret this to suggest that small firms as a whole are not as sensitive in their capital decisions to the proxy of regulatory concerns as to the proxy of market opportunity. This contrasts with large insurers, for whom both RAR and OAR have significant effects on capital that comport with the finite risk hypothesis. More detailed analysis suggests that the lack of effect of RAR for small insurers may result from RAR's proxying some factors that induce finite risk for part of the small insurer sample, and other factors that favor the excessive risk hypothesis.     

Organizational Structure,Board Composition,and Risk Taking in the U.S. Property Casualty Insurance Industry

This study examines the impact of organizational structure and board composition on risk taking in the U.S. property casualty insurance industry, addressing different risk‐taking behaviors from different perspectives. The risk‐taking measures include total risk, underwriting risk, investment risk, and leverage risk. The evidence shows that mutual insurers have lower total risk, underwriting risk, and investment risk than stock insurers. In terms of board composition variables, we find that some board composition variables not only have impact on risk‐taking behaviors but also affect different risk measures differently. Thus, using different risk measures is better than using one risk measure to assess risk‐taking behavior. Finally, we conclude that an insurer can control its total risk through management of underwriting, investment, and leverage risks that determine an insurer's risk profile.     

我国产险公司承保亏损原因分析及建议

近年来,我国产险市场保持快速增长,但自2006年起承保效益连续出现大面积亏损,严重影响产险公司偿付能力。本文分析了产险公司承保效益情况,并剖析了造成普遍亏损的原因,认为要扭转产险行业普遍亏损的现状,保险企业要转变经营理念,提升自身经营绩效及经营水平;保险监管部门要在尊重市场规律基础上,推出有效的监管措施,为促进有序竞争提供制度保障。     

Systemic Risk in the Insurance Sector: A Review and Directions for Future Research

This article reviews the extant research on systemic risk in the insurance sector and outlines new areas of research in this field. We summarize and classify 48 theoretical and empirical research papers from both academia and practitioner organizations. The survey reveals that traditional insurance activity in the life, nonlife, and reinsurance sectors neither contributes to systemic risk nor increases insurers’ vulnerability to impairments of the financial system. However, nontraditional activities (e.g., credit default swap underwriting) might increase vulnerability, and life insurers might be more vulnerable than nonlife insurers due to higher leverage. Whether nontraditional activities also contribute to systemic risk is not entirely clear; however, the activities with the potential to contribute to systemic risk include underwriting financial derivatives and providing financial guarantees. This article is not only likely of interest to academics but also highly relevant for the industry, regulators, and policymakers.     

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.     

Insurance Redlining and Disparate Impact: The Application of a Federal Civil Rights Doctrine to Homeowners Insurance

ABSTRACT: Allegations of inner-city insurance redlining are increasingly facilitated through the jurisprudence of "disparate impact," a legal doctrine holding that a policy or practice based on race-neutral criteria may nevertheless constitute illegal discrimination if it has a disproportionate adverse impact on racial minorities or women. Disparate impact analysis would require insurers to document a precise cause-and-effect relationship between a challenged underwriting variable and its associated risk. Moreover, they would be required to show that no "less discriminatory" risk-assessment technique is available. If it is not possible—or too costly—to meet this burden, insurers will have no choice but to abandon the use of those risk-selection practices and cost-based pricing mechanisms that yield a disparate racial impact. This will result in higher premiums and less insurance availability for consumers. Furthermore, dubious charges of unfair discrimination will exacerbate racial tensions and divert attention from the social and economic pathologies of which insurance costs are merely symptomatic.     

Firm Size and Growth in the United Kingdom Life Insurance Industry

This study tests whether the organic growth rates of United Kingdom (UK) life insurance firms are independent of size, as predicted by Gibrat's (1931) Law of Proportionate Effects. Using data for 1987–1996 and the three subperiods, 1987–1990, 1990–1993, and 1993–1996, we find that smaller life insurance firms tended to grow faster than larger ones in the 1987–1990 period and that larger life insurers tended to grow faster than smaller ones in the 1990–1993 and 1993–1996 periods. But over the ten‐year period, we find no significant difference between the growth rates of small and large firms, thus supporting Gibrat's Law as a long‐run tendency in the UK life insurance industry. When we examine firm‐specific determinants of asset growth, we find evidence in 1987–1996 and 1987–1990 that more diversified life insurance firms experienced higher growth rates on average than more specialized life insurers. We also find that the growth of life insurance firms was related to input costs during the 1990–1993 and 1993–1996 subperiods.     

Adult Polycystic Kidney Disease and Critical Illness Insurance

Abstract

Adult polycystic kidney disease (APKD) is a single-gene autosomal dominant genetic disorder leading to end-stage renal disease (ESRD, meaning kidney failure). It is associated with mutations in at least two genes, APKD1 and APKD2, but diagnosis is mostly by ultrasonography. We propose a model for critical illness (CI) insurance and estimate rates of onset of ESRD from APKD using two studies. Other events leading to claims under CI policies are included in the model, which we use to study (a) extra premiums under CI policies if the presence of an APKD mutation is known, and (b) the possible costs arising from adverse selection if this information is unavailable to insurers. The extra premiums are typically very high, but because APKD is rare, the possible cost of adverse selection is low. However, APKD is just one of a significant number of single-gene disorders, and this benign conclusion cannot be assumed to apply to all genetic disorders taken together. Moreover, ignoring known genetic risks in underwriting sets a precedent that could have unintended consequences for the underwriting of nongenetic risks of similar magnitude.     

Contingent Commissions and the Management of the Independent Agency

Insurance agencies continue to exist as an important distribution mechanism because they give their contracting insurers advantages in risk selection and enable insurance applicants to transfer complex risks. While independent agencies are compensated by upfront commissions, a key component of their profitability is tied to contingent commissions. A contingency arrangement represents ex post compensation normally tied to underwriting profitability, volume, and annual growth. We report two actual contingency contracts in the context of a decision process for choosing among contingency offerings by insurers. We incorporate both uncertainty and correlation among key variables to arrive at values for competing contracts, then use a downside risk approach that helps agency owners select the better contract. The approach offered in this article is scalable to a selection problem for any number of contingency arrangements.     

Genetics,Alzheimer’s Disease,and Long-Term Care Insurance

Abstract

This paper applies a model of Alzheimer’s disease (AD) developed by Macdonald and Pritchard (2000) to the question of the potential for adverse selection in long-term care (LTC) insurance introduced by the existence of DNA tests for variants of the ApoE gene, the ε4 allele of which is known to predispose one to earlier onset of AD. It computes the expected present values (EPVs) of model LTC benefits with respect to AD for each of five ApoE genotypes, weighted average EPVs with and without adverse selection, and sample underwriting ratings. The paper concludes that adverse selection could increase costs significantly in a small LTC insurance market only if current population genetic risk is not much smaller than that observed in case-based studies, and if carriers of the ε4 allele are very much more likely to buy LTC insurance. Finally, the paper considers the cost of a combined retirement package, providing both pension and LTC insurance, and shows that it can reduce adverse selection.     

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.