Insurance Economics Summary

Timothée Maurer MscAs 19.01.
2015
Insurance economics summary

Chapter 1: Introduction: insurance and its economic role
Uncertainty and risk
- Different degrees of uncertainty:
 Where the structure of the system and the cause-effect relationships are known
 With known probability distributions: uncertainty of the first degree (risk)
 Without knowledge of probabilities
 Arising out of game situations: uncertainty of second degree
 Complete ignorance with regards to the set of feasible strategies and hence their
probabilities of occurrence.
- Risk is measurable and thus insurable while true uncertainty is non-measurable and
uninsurable
Self-insurance and self-protection
- Self-insurance or loss reduction:
 Measures that lowers the negative consequence of a loss event given its occurrence.
Impacts the loss amount
 Example: buying fire extinguisher, installing fire sprinkler system, etc…
- Self-protection:
 Measure that lowers the probability of a loss event but not its extent. Impacts the
probability of loss occurrence.
 Example: Driving carefully and slowly, bank demanding a mortgage to secure a loan
Definition of insurance
- Means or procedure that reduces uncertainty with respect to the future
- The exchange of an uncertain loss of unknown magnitude for a small and known loss
- The exchange of money now for money payable contingent on the occurrence of certain
events
- Guaranteed information concerning certain states of its purchasers which improves their
information regarding outcomes of their decisions while not concerning states of nature
Insurance products
- Most important products
o Personal: life, occupational pensions, health, accident
o Liability: public and product liability, professional liability, personal liability, building
liability, owners and contractors liability, directors & officers liability
o Motor: Automobile, water vehicles, aircrafts
o Property/ technical: household, real estate, fire, theft, flood, business interruption,
building contractor, machinery, IT
o Other: transport, guarantee, epidemics, travel, legal protection, wedding etc…
- Differentiation criteria of insurances
o Insurer and regulation: private & social insurer
o Business line: life & non- life
o Object or type of risk: personal, property and casualty insurance
o Definition of benefits: damage or stated benefit
o Insurance obligation: optional and compulsory
o Impact on the balance sheet: insurance of assets or liabilities
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Timothée Maurer MscAs 19.01.2015
o Target group: private, commercials and enterprises

o Number of insureds: individual and group insurance
o Financial impact: income maintenance and protection of assets
Natural catastrophes and man-made disasters

- Natural catastrophes:
o Floods
o Storms
o Earthquakes
o Cold, frost
o Hail
- Man-made disasters
o Major fires, explosion
o Maritime disasters
o Aviation disasters
o Mining accidents
o …
Insured loss vs economic loss

- Amount paid by the insurance vs financial damage suffered by the economic due to a natural
catastrophe or man-maid disasters
Economic importance of insurance
- How to measure insurance industry’s relevance for an economy
o Size if the industry (firm, employees)
 Number of insurance companies in a country
 Number of employees
 Development/growth
o Premium income and development
 Life insurance
 Non-life insurance
 Reinsurance
o Insurance penetration and density
 Insurance penetration as premium income over GDP
 Insurance density as premium income over inhabitants
o Sum of consumer and producer surplus
Premiums, penetration and density

- Insurance premium: amount of money charged for certain insurance coverage
- Insurance density (units per capita): total insurance premiums / total population  measures
revenue potential of market
- Insurance penetration (in %): total insurance premiums / GDP  measures degree of
development of a market
The s-curve for insurance:
- The penetration increases with GDP per capita
Economic functions of insurance:
1. Improvement of risk allocation
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2. Protection of assets
3. Capital accumulation and transformation
4. Mobilization of financial resources
5. Governance control
6. Support of the state
- Insurance contributes to economic efficiency and fosters economic growth in several ways. In
particular, it allows individuals to venture into new and profitable businesses by protecting
existing wealth
Risk allocation and assets protection
- Improvement of risk allocation:
o More efficient risk allocation and minimization of transaction costs
o Reduces losses from damages through monitoring
o Reduces follow-up losses through immediate payouts to remove defects
o Due to moral hazard, individuals enter more risks (since insurable), however net
income for insurers increases (higher premiums)
- Protection of assets
o Encourages individuals to conduct risky, but profitable business
o Fosters willingness to undertake risky ventures
o Preserves income and consumption in case of a loss
o Levels out income stream along phases
- Capital accumulation and transformation
o Reserve funds are invested in money and capital markets
o Premiums are paid at beginning of insured period, while payout occur with a lag
o Reserves for catastrophic events and provisions for losses are built up
o Forces development of financial markets: life business requires for long term
investment opportunities
- Mobilization of financial resources
o Savings take place while building up capital for retirement
o Mobilization of capital from healthy productive individuals to non-productive groups
Governance control and support of the state

- Governance control
o Risk pricing gives information for decisions, i.e. puts cost on risk taking by
management
o Control: higher risks are punished with higher premiums
o High premiums are an incentive to reduce high risk behaviour
- Support of the state
o Financial relief to government: insurance covers losses which otherwise would have
been borne by community
o E.G. state doesn’t carry full burden of personal losses through sickness, injury,
unemployment or catastrophes: insurance relieves public social safety net
Insurer and their investments
- Insurers invest mostly in:
o Pension fund
o Mutual funds
o Insurance assets
o Sovereign wealth funds
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o Hedge funds
- They invest in trough different asset classes:
o Corporate bonds
o Bank debt
o European government debt
o Public equity
- Reinsures invest via:
o Mortgages/covered bonds
o Infrastructure/project finance
o Direct SME loans
o Private equity
Microinsurance
- Typically refers to insurance products designed for low-income individuals. Micro refers to
the relatively small financial transaction size or lower premiums that each insurance policy
generates
- Its core elements are:
o Simplicity
o Insurance principles
o Accessibility
o Affordability
o Flexibility
- Differs from traditional insurance:
o Size of premium
o Coverage limit
o Product features
o Distribution
o Policy administration
o Target customers
- Opportunity for insurers to tap into new market segments and support economic and insurance
growth of emerging markets.
- Key distinguishing features of microinsurance: SEE SLIDE 69
Organizational forms of insurers
- Stock company
o Owners provide capital and receive profits
o Corporate management runs insurer
o Information asymmetry: owner vs management
- Mutual company
o Owners = policyholders
o Right for profits mostly through customer relationship
o Information asymmetry: policyholders vs management
- Lloyd’s
o Capital providers are valled members
o Memvers form syndicate which underwrites a policy
o Each member responsible for his/her portion of walth
o Owner = manager
Lloyd’s market
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- Market where members join together as syndicates to insure risk

- Underwriting members provide capital and act as syndicates managed by managing agents
- Process:
o Client discusses insurance needs with broker
o Broker approaches syndicates for term
o Syndicate underwriter will price, underwrite risks and handle claims
o Each syndicate member provides capital to support underwritten risk (“funds”)
Chapter 2: Risk: Measurement, perception and utility functions

Risk as a random variable
- Concept of risk and chance consolidated into r.v.
- In insurance practice, buyer = risk, risk = loss producer, insurers receive premiums
- For actuarial analysis of a risk, only the difference between premium income (treated as non-
random) and loss payments during a certain time interval is relevant. It’s determined by the
loss distribution.
Measurement of risk
- Dimension 1: probability of occurrence
o From the insurers point of view: probability of paying a loss of certain amount
o Lies between 0 and 1 and determined by experience
o Shifts over time due to changes in the environment, technology, climatic condition
o Example: survival curve
- Dimension 2: severity of the consequences
o Valuation required: distinguish consequences by type
o Example: number of deaths or injured, material and immaterial damages
- The risk of a defined event usually is measured by its relative frequency of occurrence.
Utility
- In economics, utility is a representation of preferences over some set of goods and services. In
finance, utility is applied to generate an individual's price for an asset called the indifference
price. Utility functions are also related to risk measures, with the most common example being
the entropic risk measure.
- Perception of probabilities of occurrence vs subjective valuation of consequences
Risk aversion
- Risk neutrality: risk = expected damage (loss), no risk aversion
- Risk aversion or certainty preference
o Typical characteristic of human beings from the economic perspective
o When comparing choices with uncertain results, people dislike and avoid dispersion
around a given expected value. They accept dispersion (volatility) only if it comes
with a higher expected value.
o Formally for an utility function U:
U ( W ) ≥ EU ( W + z )W :wealth levelsz : random payoffsE ( z )=0
o U should be concave
o Jensen’s inequality for concave U: E [ U ( W ) ] ≤ U ( E [ W ] )
- Maximization of the expected utility
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o Increase in the volatility must be compensated by an increase in the expected value.

Risk aversion also means that downward stochastic deviations from the expected
value receive a higher subjective weight than upward deviations.
Fundamentals of decision theory

- Decide between 2 risks, two random variable X and Y
- Under risk, many different decision concepts can be used
o Based on normative concepts (Bernoulli)
o Based on empirical observation (behavioural theory)
- Decision principles
o Mean µ: expected value principle
o Mean-variance µ-σ: expected value and standard deviation
o Bernoulli principle
St.Petersburg paradox
 For a player which plays with a flipped coin and wins 2 if H and 0 if T: the game has an
expected value that grows beyond limit. Nevertheless, nobody will pay more than a small
amount of money to play it.
Risk utility function and expected utility principle (Bernoulli Principle)
- Decision problem under uncertainty:
o Assignment of mutually exclusive consequences to choices, along with their
probabilities of occurrence
o Valuation of these consequences using a risk utility function
o Form the expected utility by multiplying the utility values with their respective
probability of occurrence and then summing up.
- Decision rule: choose the alternative with the highest expected utility
- Bernoulli principle: calculate the expected utility of an action a i by weighting the utility values
by πj and summing up:
EU [ ai ] =∑ π j v [ cij ] , EU :expected utility
j
Property of Utility function
Implication from utility function concavity

- If risk averse has a choice between 2 risky projects  He will always choose the one with the
smaller loss.
- A risk averse prefers the risky project with smaller fluctuation around an expected value
(given).
- A risk-averse is prepared to pay a price to avoid a risky project in favour of the sure
alternative
- In the case of a sure loss/ gain, there is no willingness to pay for avoiding the risky alternative
- When choosing between 2 risky projects with the same expected value, individuals prefer the
one with the smaller dispersion. Downward deviation from the expected mean (“losses”) are
valued more than upward deviation (“gains”) of equal size.
Certainty equivalent and risk premium
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- Utility associated with expected value of a binary prospect:

v¿
- Expected utility of the risky prospect
EU [ W ] ≔ π∗v [ W 1 ]+ ( 1−π )∗v∗[W 2 ]
- In case of risk aversion:
v [ EW ] > EU [W ]
- Certainty equivalent:
W s=v−1 [ EU [ W ] ]< EW , with EU [ W ]=E [ v [ W ] ] , EW =E[W ]
Willingness to pay for certainty and risk premium
- Willingness to pay for certainty can be expressed:
o As the risk or safety premium in absolute terms
o As the maximum insurance premium the consumer would accept
- Risk premium ρ making the individual indifferent between an alternative with certain wealth
and one with risky wealth, formally:
v [ EW −ρ ] =EU ¿
i. e , ρ=EW −v−1 [ EU [ EW +~
X ]]
- see slide 94-95
Measurement of risk aversion
- Utility function U and wealth W
- Absolute risk aversion (Arrow-Pratt):
−U ' ' (W )
ARA ( W )=
U '(W )
- Relative risk aversion (Arrow-Pratt- Definetti):
−U ' ' ( W )
RRA=W ∗ARA ( W )= ∗W
U' (W )
- Risk tolerance:
1 −U ' (W )
RT ( W )= =
ARA (W ) U ' '(W )
- Type of risk aversion
o Along absolute risk aversion
 CARA: constant absolute risk aversion
 DARA: decreasing absolute risk aversion
 IARA: increasing absolute risk aversion
o Along relative risk aversion
 CRRA: constant relative risk aversion
 DRRA: decreasing relative risk aversion
 IRRA: increasing relative risk aversion
Example of utility function
Name Formula ARA RRA RT Properties

γ γ∗W 1 CARRA /IRRA
W
Exponential U ( W )=−e −γ
,γ>0
utility N
Power utility W 1−γ γ γ W DARA /CRRA
U ( W )= , W , γ >0 W
1−γ γ
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Logarithmic U ( W )=log (W ) ,W > 0 1 1 W DARA /CRRA

utility W
Quadratic U ( W )=W −α W 2 ,α >0 2α 2 αW 1−2 αW IARA/ IRRA
utility 1 1−2 αW 1−2 αW 2α
>W
2α
- Illustration
o Exponential: “Modest individual” - requires little to cover basic needs, more money
does not bring substantially more utility:
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o Power utility :
9
o Quadratic utility : “ Dagobert “ - even being rich, additional wealth brings substantial

utility:
Chapter 3: Insurance demand

Risk utility function and risky prospects
- Demand for insurance is the result of two interacting determinants:
o The objective component is the fact that an asset is exposed to risk
o The subjective component is reflected by risk aversion
- These determinants are subsumed in the risk utility function.
- Individuals are assumed to have good knowledge of the probabilities of occurrence and the
financial consequences of associated events. They must be able to envisage a possible future
situation in terms of money
- Proba of occurrence and financial consequences describe the risk situation (risky prospect) of
an individual
- A risk prospect can be modified by avoiding risks, reducing their probability of occurrence or
severity of consequence by preventive effort, and by buying insurance coverage.  rise of a
set of prospects
Risk aversion and expected utility maximization principle
- For decision-taking, the agent must have a preference relation or a decision rule defined over
risky prospect  take risk aversion into account
- The individual is supposed to prefer a certain (safe) average of distribution to the distribution
(lottery) itself.
- One is willing to buy insurance in order to have certain rather than volatile wealth
- The expected utility maximization principle by Bernoulli is the rational rule
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Expected utility maximization principle:

- Resolving the decision-making problem: Under uncertainty, the individual needs to have
precise notion of:
o The alternative actions
o The probabilities with which possible states occur
o A function mapping the actions into consequences
o A preference ordering or risk utility function defined over consequences
EU [ c ij ] =∑ π j v [ c ij ] ≡ EU [ ai ] ≡ ∑ π j v [ a j , s j ]
j j
with π j ≥0∧∑ π j =1c ≔ c [ a , s ]∧¿c ≔ c [a ¿ ¿ 2 , s ]for all s ,then ¿

1 1 j 2 j j
j
EU [ c 1 ] ≥ EU [ c 2 ] if ∧only if a1 ≽ a 2 (at least as preffered as)
- Selection criterion
o The decision maker choses a 1 over a 2, if and only if:
EU [ a1 ] > EU [ a1 ] , with positive 1 st derivation∧negative 2 nd
- The decision maker is indifferent between a 1 and a 2 , if and only if:
EU [ a1 ] =EU [ a1 ]
Theory of insurance demand: basic model

- Objective is to study the demand for insurance coverage
- Strongly simplified model framework
- Consumer point of view: choose indemnity amount, such that expected utility of future wealth
is maximized
- Supply of insurance coverage and level of the insurance premium are given.
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Indifference curve for a risky prospect of the binary type
- W 1=W 2 (=45° line) is the certainty line; points on it indicate equally wealth across the two
states, situation of certainty. The marginal utility of a possible wealth increment must be the
same along the certainty line.
- Marginal rate of substitution:
- Intersection of indifference curve and certainty line:
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Optimal insurance coverage given marginally fair premium
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Full insurance leads to a utility increase because the indifference curve through C is higher-valuated
than the one through point A.
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Optimal insurance coverage with proportional and fixed loadings
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No insurance coverage caused by an excessive fixed loading
Premium functions and demand for coverage
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Insurance demand and risk aversion

In the presence of proportional loading, consumers with more marked risk aversion are predicted to
opt for higher insurance coverage than those with weaker risk aversion
Insurance coverage and prevention effort

- Probability of occurrence and amount of loss were predetermined up to this point but the
insured can exert preventive effort to lower the dimensions of risk (self-insurance and self-
protection)
- Insurance and preventive effort are substitutes
- They also can be complements (insurer reducing price in exchange of honouring preventing
effort)
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Loss-reducing effort and market insurance
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Extensions to the simple model

Each model will focus on one constant which will be assumed as variable (formula stays the same)
- Basic model is:
EU =( 1−π )∗v [ W −P ( I ) ] + π∗v [W −P ( I ) −L+ I ]
- State dependent utility function (irreplaceable assets)
- Random initial wealth position (additional risks)
- Determination of the premium function (market, regulation ect…)
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- Multiple loss levels (several levels of losses, partial or full)

- Knowledge about the probability π (subj./objective risk probabilities, asymmetric information)
- Observation of the insured loss (e.g. insured fraud)
- Multiperiod models (experience rating, bonus/malus systems): Summation of basic model
over time
Chapter 4: Insurance supply

Introduction
- Risk pricing:
o How to set premiums depending on the properties of the particular risk and the whole
insurance pool?
 Premium principles in risk theory
 Investor requirements
- Risk pooling
o What are the advantages of collecting risks in an insurance pool?
 Law of large numbers: how large should insurers be?
 Function of insurance
- Risk sharing
o How can insurers and ultimately insurance buyers profit from risk sharing between
insurers?
 Theorem of arrow-lind
 Role of the insurance sector
Traditional premium calculation
- Risk theory of insurance focuses on the underwriting activity of the insurer, neglecting capital
investment
o Description and forecasting of the liabilities resulting from the underwriting of risks
- Claims from the insurance portfolio arise irregularly and in different amounts. They form a
stochastic process in time, consisting of two components:
1. Uncertain number of claims
2. Uncertain amount of claim
- Parallel to this claims process, there is a premium income process which is considered as non-
stochastic
Development of premium income, claims and surplus over time
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Probability of ruin or insolvency

- Probability of ruin can be reduced by
o Increasing the surplus S0 in the starting period through more equity capital (resulting
in a parallel upward shift of the premium and surplus processes).
o Increasing the surcharges λ on the fair premium (resulting in a steeper slope of the
premium and surplus processes).
- However, success I not guaranteed
- Importance of timing of claims for the risk of insolvency
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Premium calculation principles: desired mathematical properties

- Non-negative loading: the premium shouldn’t be less than the expected loss
o ΠX≥ E[X]
- No rip-off: the premium shouldn’t be limited by the maximum loss if there is a finite
maximum
o ΠX≤ E[X]
- No unjustified loading: the premium shouldn’t contain an unjustified safety loading
o Π X =E [ X ] , for constant X
- Consistency: Premium should increase by the same amount if losses increase by a fixed
amount
o Π X +c =Π X + c , for constanct c
- Additivity: the total premium should not be affected by the pooling of independent risks
o Π X +Y =Π X + Π Y , for independent risks X ∧Y
- Scale invariance: the premium should be scalable:
o Π a∗X =a∗Π X , for a> 0
Premium calculation principles: based on the net (fair) premium

- Equivalence or net (pure) premium principle:
o Π X =E [ X ]
- Expected value principle:
o Π X =( 1+θ ) E [ X ] , with loading factor θ >0
- Variance principle
o Π X =E [ X ] +αVar [ X ] with α >0
- Standard deviation principle
o Π X =E [ X ] + β √ Var [ X ]with β> 0
Premium calculation principles: derived implicitly from a decision rule

- Principle of zero utility:
o u ( w )=E [ u ( w+ Π X − X ) ] with wealth w
- Exponential principle (exponential utility, risk aversion β; independent of wealth)
o Π X =β−1 logE [ e βX ] with β> 0
- Esscher-principle (insurance company risk aversion h)
E [ X ehX ]
o Π X= with h>0
E [ ehX ]
Financial model of insurance pricing
- Liberalization of the insurance markets: the premium principle have been losing importance
- Pricing in underwriting to be compatible with maximizing the market value of the insurance
company: CAPM is applied to the company
- Under increasingly competitive conditions, the market demand determines price: probability
theory can only be used to determine a lower limit price at which offering a product ecomes
viable for he insurance company
Insurance CAPM: the idea
- Financial insurance pricing: application of the CAPM to premium calculation
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- The calculation of premiums is a genuine management activity. In the interest of the owners of
the insurance company, it must be performed in a way that guarantees them a return on their
investment that matches returns normally prevailing on the capital market after adjustment for
risk.
- This argument calls for 2 steps:
1. The expected return on equity capital must be related to underwriting and capital
investment as the two core activities of insurance company management.
2. Equality with the condition prevailing on the capital market needs to be
introduced as a requirement
Premium determination in practice
- 5 relevant drivers:
1. Rating/tariffing
2. Additional ratings
3. Additional loadings
4. Calculated profit
5. Addition/rebates
Risk pooling: law of large numbers
- Risk pooling describes the consequence of writing a pool of a large number of small, similar
(identical), independent contract: E.G. car insurance, health insurance
- In insurance, economies of scale are thought to be grounded in theory at least as fara as
underwriting is concerned because they are implied by the law of large numbers
- This law states that the arithmetic mean x́ of n stochastic variables with the same expected
value µ and the same variance σ2 approaches µ when n increase towards infinity. The
arithmetic mean becomes an ever more reliable estimation of the expected value since its
standard deviation decreases with n
- Therefore, an insurer that succeeds in building a portfolio containing more and more risks
with the same expected loss can estimate expected loss per unit with increasing precision
based on recent experience. It needs less reserves per premium for unforeseen deviations from
expected value.
Insurer’s relative risk
- Total losses of a portfolio consisting of n units (insured objects, persons, or firms) during a
period are given by :
n n
1
Ln=∑ x i=n∗x́ with average loss equal ¿ x́= ∑ x i
I=1 n i=1
- Provided claims are independent of each other (0 covariance between them), the variance of
the x́ amounts equal to
1 2 σ2
Var ( x́ ) = n σ =
n2 n
- Therefore the mean claim x́ has a standard deviation given by
σ
σ x́ =
√n
Risk spreading: Arrow-Lind Theorem
- A particular insurance risk van be borne by
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o One single insurer

o Many (re-)insurers who split the risk
- The Arrow-Lind theorem: the sum of the premiums for each of the identical syndicate
members converges to the expectation for large members
Π X =n∗Π ( n ) : net premium principle
So that competitive insurance markets are sometimes assumed risk neutral
Chapter 5: Information asymmetry: moral hazard and adverse selection

Information asymmetry
- In the insurance economics literature, the buyers of insurance are usually assumed to know
more about their risk type and their future preventive behaviour than the insurance company.
Therefore, it’s the insurer who suffers from a lack of information.
- Examples:
o Non-observability of the risk type (high/low risk)
o Ignorance of the efforts taken on by the policyholder for loss prevention and
containment
Consequences of information asymmetry
- Moral Hazard (hidden action)
o Information asymmetry exists with respect to the behaviour of the contractual partner
after signing the contract
- Adverse selection (hidden information)
o Information asymmetry exists with respect to the risk type (private information) of the
contractual partner
Moral hazard: definition and categorization
- It is related to human behaviour
- In economic theory, moral hazard stands for the change in unobservable behaviour induced by
the existence of a contract that provides protection against risk. This change is assumed
unobservable for the insurance company  the policyholder alters his behaviour after signing
the contract
- Due to moral hazard, either the probability or the amount of loss can increase
- 2 type of moral hazard:
1. Ex-ante moral hazard: moral hazard before a loss occurs
2. Ex-post moral hazard: moral hazard after a loss occurs
Examples of moral hazard:
- Ex-ante with regard to the probability of loss
o Policyholder may behave more riskily after signing the contract (opting for more
lucrative course of action)
o Policyholder may reduce costly loss prevention or self-protection measures after
signing the contract
- Ex-ante with regard to the amount of loss
o Policyholder may reduce costly self-insurance measures after signing the contract
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- Ex-post moral hazard with regard to the amount of loss

o Policyholder chooses costly repairing after the loss has occurred
o Ex-post moral hazard may or may not be legal (extreme case of insurance fraud)
- Other ex-ante moral hazard examples
o Car insurance: driving less carefully
o Accident insurance: engaging in dangerous activities
o Health insurance: seeking medical care more often
o Property insurance: taking less care of premises
o Fire insurance: not installing or maintaining smoke detector or fire sprinkler
Seat belt example:

- Moral hazard problem:
o Introduction of seat belt was considered as a major step forward to reduce fatal car
accidents
o In the first years, the number of injured/accident decreased but the number of
accidents increased
o So much that the number of fatal casualties stayed constant, less driver injured bit
more cyclists and pedestrians (externalities behaviour);
o Finally the repair industry profited
- Conclusion: people with safety belt insurance felt less inclined to drive safely
- Peltzman effect: people adjust behaviour to regulation in a way which contradicts the intended
effects of regulation
Ex-ante moral hazard and probability of loss
- Decision about the amount of preventive effort V
- The probability of loss π is not predetermined but depends negatively on V.
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- Amount of preventive effort V: the insurance buyer maximizes his expected utility as a
function of V:
- For simplicity :
- Taking the derivative of expected utility w.r.t V leads to:
- Condition for an interior solution V*>0:
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Therefore, prevention has a marginal return that consists of the reduced probability of
incurring the utility loss given by v[1]-v[2]<0. It also has a marginal cost, which amounts
to the wealth spent on it. At the interior optimum, the expected value of marginal utility
equals the certain marginal cost in utility terms.
Case of full cover
- The expected utility reduces to:
EU ( V )=v [W 0−V −P ( I ) ]
- Since v[1] = v[2], it causes the marginal return to become 0 and the equation then becomes:
Implying V* = 0
- Thus: full insurance coverage is predicted to cause zero prevention regardless of risk aversion.
In general the amount of preventive effort V and the coverage α are negatively correlated.
Ex-ante moral hazard and impact on the premium calculation
- Insurer’s premium calculation must take into account ex-ante moral hazard effects
- In order to cover the expected loss (risk-neutral), the premium must be
P ( I ) =π { V ( I ) }∗I
This uses publicly available information on the loss probability and its dependence on
preventive effort V, and on the observable amount of coverage I=α*L
- It is reasonable to structure the premium according to the amount of coverage, knowing that
additional coverage likely induces ex-ante moral hazard. The adjustment of premium in
response to higher coverage is given by:
First term: “fair” premium rate

Second term: loading from moral hazard
- The loading will be greater:
o The more effective prevention measures are (dπ/dV <<0)
o The higher the moral hazard (dV/di <<0)
o The higher the cover α < 1
Ex-post moral hazard: case of insurance fraud

- Policyholder gives a notification of a claim C* to the insurer with C*≥C, where C denotes the
true claim size
- Some policyholder are honest (C*=C) and some commit fraud(C*>C)
- Policyholder are assumed to maximize their expected utility.
- Insurer perspective: “costly state verification”: insurer can control the notification and check
whether C*=C or if fraud has taken place (C*>C)
- Checking the notification done by the policyholder goes along with cost k.
- If the policyholder commits fraud, he will not get an indemnity payment and has to pay a
penalty B.
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- Several possible outcomes exist (game theory).

- Given a certain objective function for the insurer (ex: maximizing expected profits), the
optimal controlling intensity π (= % of all claim notifications) can be deriver: π increases with
decreasing k and increasing B
Conclusion
- Moral hazard can lead in general to
o Higher than “fair” premium (loading)
o Lower coverage demand
o Rationing of insurance can incentivize to self-insure or self-protect
o More expensive insurance coverage
- Insurance fraud: extreme, illegal form of moral hazard
Adverse selection: definition
- At the time of contracting, insurers lack knowledge about the true risk of an insurance buyer.
They can’t fend off high risks.
- Individuals know their own risk better than the insurance company and they use it when
buying insurance contracts in
o Car insurance: reckless driver or not
o Health insurance: healthy/unhealthy lifestyle
o Property insurance: house equipped with/without a lot of self-protection measures
- But certain risks are heavily over/underestimated by policyholders due to problems in risk
perception. The insurer is better informed about the probability of loss occurrence
- Adverse selection may undermine equilibrium in a private insurance market
Adverse selection: consequences
- The bad products or customers are more likely to be selected
- Example: an insurer that sets one price for all costumers is likely to attract more insurance
buyers with higher risks and less insurance buyers with lower risks. In fact, for the bad risks
the premium might be too low, for the good risks the premium might be too expensive.
Hidden characteristics problem: the market of lemons
- Examines basic markets for used cars: there are good one and bad one (lemons)
- The logic:
1. A new car is a good car with probability q, a bad car with (1-q)
2. Owner drives, good idea of quality, his new good car probability q* is more
accurate than q
3. As he sells the car, he knows more about the quality than the buyers.
4. Market price is established for used cars of a certain type
5. Car = worse than average => seller happily trade
Car = better than average => might not be willing to trade below value
6. More bad cars traded than good cars: average quality decreases, prices decrease,
and, ultimately, car trading stops
- The consumers can’t judge the quality of the individual vehicles, but know the distribution for
a given car type
o Consumer will thus in general offer an average price corresponding to a car with
average quality
o Provider of better than average vehicles retreat, since the sale is unfavourable for
them.
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- Effects:
o Average quality decreases
o Price offer of consumers decreases
o More providers retreat
- This circumstance can lead to market failure: no market is formed, even though purchase and
sale would be beneficial for both sides.
Hidden characteristics problem: application of model to insurance companies
- There exists a range of policyholders in between two limits
o Highest risks: fair premium = Pmax
o Lowest risks: faire premium = Pmin
o Risk-price-distribution between Pmax and Pmin
- Insurer cannot observe the true characteristic of a given policyholder  the insurer will offer
an average price P* for the insurance coverage
o Only attractive for policyholders with a fair price P≥P*
o Policyholder representing a risk with a fair price P<P* will not accept the offer
o New risk distribution  recalculation is necessary
o Extreme case: market failure
- Approach can provide explanations why certain insurance type are not offered on the market
(e.g. private unemployment insurance)
Unsustainability of a pooling equilibrium
- Distinguish a low risk type with a low probability of loss from a high risk type with a higher
probability
- Consider expected utility and wealth levels
- Slope of indifference for low-risk type:
- Slop of indifference curve for high-risk type:
- Since πH> πL, the indifference curve of the high risk must run flatter than the one pertaining to
the low risk
- Insurance company: by assumption does not know the probability of loss pertaining to the 2
types of risks
- At best, it knows the average value in the population (share h of high-risk types, share (1-h) of
low risk types:
- Slope of indifference for a pooling contract (M):
30
- Since πH> π́ > πL we obtain the following ordering of the slopes (abs. value):
31
Adverse selection in a single period framework: conclusion

- Pooling equilibrium
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o In a single period framework, a pooling equilibrium can always be broken up by a

competitor and is therefore not sustainable
- Reaction equilibrium
o Given a sufficiently long planning horizon on the part of insurers and certain degree
of concentration on the market for insurance, a reaction equilibrium is predicted that
makes pooling contracts sustainable. Uses a different expectation rule: each firm
assumes that any policy will be immediately withdrawn which becomes unprofitable
after that firm makes its own policy offer.
- Separating equilibrium
o A separating equilibrium in the case of two risk types consists of a pair of contracts,
one with comprehensive coverage but high premium for the high-risk type and the
other with partial coverage but low premium for the low-risk type. However, it can be
broken up by pooling contract if the share of low-risk types is sufficiently high.
Adverse selection in a multi-period context
- When the analysis is extended over several periods, the insurer has the possibility of learning
from consumers’ loss experience. It infers the true probability of loss with increasing
accuracy.
- The concomitant adjustment of premiums is called experience rating; it often takes the form of
a bonus-malus scheme.
- Idea: good risk with worse contract in first period, with the prospect ot get a much etter
contract if no loss occurs
o 1st period: high risk type (H) or pooling contract with experience rating (M)
o 2nd period: high-risk type contracts unchanged; M-type future contract depends on loss
(yes/no renegotiation), identity revelation through contract choice.
- Enables insurer to attract low risks without a loss to separate contract
Adverse selection in a mutli-period context: decision sequence in experience rating
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- Period 1:
o All low and part (1-θ) of high risk choose pooling contract (M)
o Part θ of high risks buys contract (H): full cover at high premium
- Period 2:
o Loss/accident: two contracts H an LA are offered
 High risk: full cover at high premium
 Low risk: high excess at low premium
o No loss/accident: two contracts HN and LN are offered
 Low risks can get benefits, as high risks get benefits too
 High risk: full cover at lower premium
 Low risk: higher cover at low premium
Adverse selection in multi-period context: contract properties and market equilibrium
- During the first year, there is a pooling contract with partial coverage, combined with a
separating contract for the second year
- The separating contract of the second year offers full coverage to high and partial coverage to
the low risks
- The second-year premiums are experience rated, awarding rebates for no claims to both types
of risk who are without loss
- The premium rebate for no claims paid to the high risks is financed by a loading contained in
the premium of the first-year pooling contract
- In equilibrium, the insurer has positive expected first-year profits and negative second-year
ones (summing to 0 in present value). By paying back the first-year surcharge through the
second-year premium rebate, the IC can prevent the low risks from changing to a competitor.
At the same time, the high risks enjoy guaranteed renewability on previously defined terms.
- Nash equilibrium: with all IC finding their optimum on the basis of the same information and
the same contractual configuration, there is no incentive for any one of them to deviate.
Means for preventing adverse selection and market failure
- Signalling
o Documentation of self-insurance or protection measures (anti-theft device in motor
insurance)
o Conditions precedent to the policyholder (as a part of the contract)
o Maintenance schedule and other documents
- Screening
o Experience rate making
o Medical exam
- Self-selection
o Policyholder can choose different deductibles and provides information regarding his
type of risk
Tools and regulations to lower signalling costs and improve insurance allocation
- Incentive to self-insure: bad becomes better, through reduce premiums
- National rationing of insurance: bad cannot over demand coverage
- Information disclosure: no claims if not all insurance policies disclosed (no double insurance)
- No supplementary insurance: multiple coverage makes it hard for insurer to distinguish good
and bad by product choice
- Bonus/malus systems: historical experience helps to distinguish good from bad
- Tax on premiums: less coverage demanded from bad
34
Chapter 6: Financial management and regulation in insurance companies

Main characteristics
- The balance sheet of an insurance company is characterized on the asset side by high share of
capital investments, on the liability side by reserves for future claims held by buyers of
insurance (reserve for future losses in the case of non-life business, reserves for future benefits
in the case of life insurance).
- The balance sheet is a financial statement that summarizes a company’s asset, liabilities and
shareholders’ equity at a specific point in time. These 3 segments give investors an idea as
what the company owes and owns as well as the amount invested by the shareholders.
Most important positions on an insurer’s balance sheet
- Assets side
o Investments (>50%): debt securities, equities, real estate, short-term investments
o Other assets
o Receivables
o Cash
- Liabilities side
o Technical provisions (reserves) (>50%)
o Other liabilities
o Equity (>20%)
Liabilities
- Show the origin of the funds (coming from outside the company) that are invested in the
company’s assets.
o Reserves for unearned premiums
o Reserves for losses and expenses
o Reserves discounting to present value
o Future policyholders’ benefits
o Deposits and other outstanding claims of policyholders
o Total if insurance reserves
o Minority shareholders
The income statement

- Aim
The income or operational statement informs about the success in transactions associated with
risk underwriting, reinsurance, and capital investment. However, published figures crucially
depend on changes in loss reserves (non-life) and reserves for policyholder benefits (life).
Income statement positions (5-6 to know)
- Gross premiums written and policy fees
- Premiums ceded to reinsurers
- Net premiums written and policy fees
- Net changes in reserves for unearned premiums
- Premiums and policy fees earned
- Net income from wealth management
- Net returns from capital investments
- Realized profits and losses from capital investments
- Other income
35
- Total income
- Losses paid, including expenses, non-life business
- Benefits paid and expenses, life business
- Changes in technical reserves
- Participation in surplus and profit by policyholders
- Administrative expense
- Other operational expense
- Interest expense on debt
- Cost of restructuring, mergers and acquisitions
- Amortization of goodwill
- Total losses, benefits and expenses
- Net income before tax and minority shares
Objectives of the insurer
- Profit maximization
- Growth
- Solvency
Performance measures in insurance companies
- Growth
o Premium income
o Profit
o Market share
o …
- Risk bearing ability
o Solvency ratio
o Risk-adjusted return measures
o Technical cover ratio
36
- Profitability
o Loss ratio
o Expense ratio
o Combined ratio
Profitability KPI
- Loss ratio = loss paid / net premiums earned
o From the point of view of the policyholders, a high loss ratio is beneficial because it
shows that much of premiums paid are returned to them in the aspect of insurance
benefits.
o From the insurer point of view, a high loss ratio
1. May reflect a generous consumer accommodation policy, which enhances the
reputation of the company as a reliable contractual partner
2. Can also result from careless past underwriting policy permitting to earn
premiums in preceding years, with losses accumulating in the current period.
o Non-life business is comparatively volatile, resulting with high losses that are
followed by others with favourable loss experience.
- Expense ratio= (administrative + other operational expense) / net premiums earned
o Relatively higher ratio are observed for younger companies whose sales effort
typically generates premiums only with a lag.
o This ratio is lower in life insurance, reflecting the higher degree of product
standardization.
- Combined ratio = loss ratio + expense ratio
o This ratio measures the profitability of underwriting activity, pitting losses paid and
expenses against net premiums earned
o If the value is larger than 100% the underwriting result as a whole is negative.
o However, a negative underwriting result does not indicate a threat to the solvency of
the company because is usually is balanced by returns from capital investment.
o A positive underwriting result is only necessary in periods where the insurer achieves
an unfavourable return on its capital investments.
Objectives of regulation
- Regulation of the insurance industry is justified in the main by consumer projection.
o Claims held by policyholders against their insurance company are at the centre of
attention
o In the event of bankruptcy, policyholders lose their claims to promised benefits. These
claims can be substantial particularly in the case of life insurance.
- Major arguments based on the peculiarities of the insurance industry
o Ruinous competition (due to decreasing margin cost)
o Uncertain premium calculation (e.g. unexpected series of extremely high losses)
o Lack of transparency (e.g. quality assessment by customers)
o Need for co-operation (e.g. for large risks)
o Need to avoid excessive insolvencies (e.g. shareholder returns vs. solvency)
Three main categories of regulation

- Price regulation
o Transparency for consumers and payment of claims under all circumstances
o Side effect: uniform premiums strangle price competition between insurers.
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- Product regulation
o Product differentiation may undermine price regulation
o Side effect: product regulation may obstruct product innovation
- Regulation of capital investment
o Under premium compliance, insurers may still suffer losses on their capital
investment endangering their solvency
o Prohibition or limits to the portfolio share of certain types of investment is risky and
prescription of others.
o Side effect: limitation of the scope of diversification, may run the risk of increasing
the risk of insolvency rather than reducing it.
Solvency regulation: Solvency II
- Key objectives
o Improved consumer protection
o Modernized supervision
o Deepened EU market integration
o Increased international competitiveness of EU insurers
Chapter 7: Insurance operations

Process landscape of an insurance company
1) Management process
a. Planning, management and development functions
b. Indirect market orientation
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c. Examples:
i. Strategic management
ii. Business development
iii. Network management
iv. General management
2) Support processes
a. Support function
b. Indirect market orientation
c. Examples:
i. Human resources
ii. IT
iii. Accounting
iv. Sourcing
v. Reinsurance
vi. Logistics and infrastructure
vii. Sales support
viii. …
3) Operational business processes
a. Functions providing market services
b. Market orientation
c. Examples : chain of value creation
Chain of value creation in an insurance company
- Product and market development
o Product development
 Market research and analysis of target groups
 Actuarial services and product development
 Coordination of portfolios
o Marketing
 Definition of target market and clients
 Market pricing
 Communication and branding
o Distribution
 Distribution management
 Customer advising / sales
 Distribution support
- Internal services
o Underwriting
 Definition of underwriting criteria
 Handling of applications and examination of risks
 Risk assessment and selection
o Administration / customer service
 Contract administration
 Customer service
 Customer data analysis
- Claims management
o Notification and registration of claims
o Claim coverage audit
o Settlement and closing of claim (payment)
41
- Asset management
o Asset-liability management
o Strategic / tactical asset allocation
o Portfolio management, clearing and accounting
Main insurance distribution channels

- Direct writers : insurer’s own sales offices with employed sales personnel
- Exclusive agents: independent sales agents in exclusive dealing with the insurer
- Independent agents or brokers: independent agents with activity on behalf of several insurance
companies
- Distribution network of another firm: banks, travel agencies, employers, etc…
- Direct selling: use of telephone, internet and mail for contract applications
Distribution channels: comments
- Life insurance:
o Bancassurance is the dominant distribution channel in Europe
o Agents is the second
o Brokers the third
- Non-life insurance
o Agents is the strongest
o brokers is the second
o direct writing is the third
Access points used for buying insurance

- Traditional channels
o Tied agent (26%)
o Independent agent (14%)
o Telephone, mail, retailer (~15%)
o Banks (8%)
- Modern channels
o Web direct (21%)
o Aggregator (9.3%)
o Other web (4%)
o Smartphone (0.6%)
Concept of a distribution management model

- Framework and strategic guidelines
o Corporate strategy
o Market objectives and profitability
o Channel mix
o Customer mix
o Product mix
o Marketing and positioning
o Pricing
o CRM
o Customer service
o Service
o Sales force
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General facts about claims management

1) On average, 60-70% of all premiums are consumed by claim pay-outs (in non-life insurance)
2) Claims management is usually perceive as an important lever towards higher customer
satisfaction
3) The communication of a proper claims management is crucial for a good branding of
insurance companies
Three competing main strategic targets
1) Minimization of claims volume
2) Minimization of claims administration costs
3) Maximization of customer satisfaction
Core elements of a standard claims management model
- Main process stages:
1) Notification of claim
2) Registration of claim
3) Claim coverage audit
4) Settlement of claim
5) Closing of claim
- Claim triage in 3 categories and processing in 3 back office levels
o Level 1: pay-out claims
o Level 2: standard claims
o Level 3: complex claims
Chapter 8: current trends and challenges in the insurance industry
44

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Insurance Economics Summary

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Timothée Maurer MscAs 19.01.

Insurance economics summary

o Target group: private, commercials and enterprises

Natural catastrophes and man-made disasters

Insured loss vs economic loss

Premiums, penetration and density

Governance control and support of the state

- Market where members join together as syndicates to insure risk

Chapter 2: Risk: Measurement, perception and utility functions

o Increase in the volatility must be compensated by an increase in the expected value.

Fundamentals of decision theory

Property of Utility function

Implication from utility function concavity

- Utility associated with expected value of a binary prospect:

Name Formula ARA RRA RT Properties

Logarithmic U ( W )=log (W ) ,W > 0 1 1 W DARA /CRRA

o Quadratic utility : “ Dagobert “ - even being rich, additional wealth brings substantial

Chapter 3: Insurance demand

Expected utility maximization principle:

with π j ≥0∧∑ π j =1c ≔ c [ a , s ]∧¿c ≔ c [a ¿ ¿ 2 , s ]for all s ,then ¿

Theory of insurance demand: basic model

Indifference curve for a risky prospect of the binary type

- Intersection of indifference curve and certainty line:

Optimal insurance coverage given marginally fair premium

Optimal insurance coverage with proportional and fixed loadings

No insurance coverage caused by an excessive fixed loading

Premium functions and demand for coverage

Insurance demand and risk aversion

Insurance coverage and prevention effort

Loss-reducing effort and market insurance

Extensions to the simple model

- Multiple loss levels (several levels of losses, partial or full)

Chapter 4: Insurance supply

Probability of ruin or insolvency

Premium calculation principles: desired mathematical properties

Premium calculation principles: based on the net (fair) premium

Premium calculation principles: derived implicitly from a decision rule

o One single insurer

Π X =n∗Π ( n ) : net premium principle

So that competitive insurance markets are sometimes assumed risk neutral

Chapter 5: Information asymmetry: moral hazard and adverse selection

- Ex-post moral hazard with regard to the amount of loss

Seat belt example:

- Taking the derivative of expected utility w.r.t V leads to:

- Condition for an interior solution V*>0:

First term: “fair” premium rate

Ex-post moral hazard: case of insurance fraud

- Several possible outcomes exist (game theory).

- Slop of indifference curve for high-risk type:

- Slope of indifference for a pooling contract (M):

Adverse selection in a single period framework: conclusion

o In a single period framework, a pooling equilibrium can always be broken up by a

Chapter 6: Financial management and regulation in insurance companies

The income statement

Three main categories of regulation

Chapter 7: Insurance operations

Main insurance distribution channels

Access points used for buying insurance