Finance and Insurance:

Converging or Diverging?

Stephen Mildenhall
Midwestern Actuarial Forum
March 2003

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Overview
Insurer Financial
Structure k
t o c
S
He
d
Div ge or
ers Insurance
ify?
Risk
Securitized
within
ra ge
bit Finance
o A l E q’ l
r
N era
n
Ge Mu
tu a
l

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Mysteries - Paradigms
 Why do companies engage in earnings
management?
 Why do insurance companies expect a reward
for diversifiable risk?
 Why do stock companies buy insurance?

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Mysteries - Structure
 Why do insurers write policies more cheaply
than banks offer letters of credit?
 Why does capital still flow into an industry
plagued by poor returns?
 Is the industry over or under capitalized?
 Is securitization the answer to all industry
woes?

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Mysteries - Humorous
 Why do insurers write policies their actuaries
know will lose money?
 Is the insurance cycle inevitable?

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 Finance and Insurance
Insurance Stock Option

Source Source
of Risk of Risk
Risk

Risk

Risk
Premium Contingent Equity Contingent
Losses Dividends

Insurance Market Capital Market Option Market

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 Finance and Insurance
Capital Insurance
Paradigm Markets Markets
Risk and Price non-
Systematic risk
Return systematic risk
CAPM, APT, CIR,
Risk Bearing
Diversification Partial & General
through pooling
Equilibrium Models
Options pricing, Traditionally
Hedging Comparables, No- impossible,
arbitrage Reinsurance!
Comparables, Long/short positions,
liquid, transparent
Insurable interest,
Replication markets, standardization unique products
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 Finance and Insurance
Comparison of Risk Bearing
Trade to Manage Diversify to Manage
Hedge Real world Dual-trigger Diversify
Black-Scholes financial financial/ Stock
idealization option insurance Bond
Adjust instrument Insurance
probabilities Cat Bond

No arbitrage Efficient Market

Comparables determine Need general theory to
unique price determine unique price

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Finance and Insurance
Complete Markets and Insurance
 Complete Market: every pattern of cash flows can be
replicated by some portfolio of traded securities
 Insurance products are not redundant: they add to the set of
available securities
 A redundant insurance contract would be redundant!
 Insurance risk is residual, unhedgable risk
 Insureds would hedge themselves and only insure residual risk
 Insurance creates uncorrelated assets for investor/insured
 Cannot use no arbitrage pricing techniques to determine price
of non-redundant securities
 Need supply and demand; general equilibrium theory

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Finance and Insurance
Comparison of Pricing Methods
 Redundant securities can be replicated as a package of other
securities
 Can be hard to determine replicating package
 Black-Scholes solved packing problem for stock options
 No arbitrage: price of a package is sum of prices of pieces
 If replicating package is unique then price uniquely determined
 Black-Scholes packaging is unique
 Replicating “Pricing Factory” can make price of redundant
securities independent of supply and demand
 Contrast to Actuarial Pricing
 No consensus on risk and profit loads
 Numerous risk-load approaches used in industry
 Searching for general equilibrium theory
 Actuarial pricing is equivalent to stock pricing, not option pricing

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Finance and Insurance
Market Pricing for Cat Bonds
 Pricing Cat Bonds
 Relationship to corporate bond pricing and to insurance pricing
 (In-)Consistency with financial theories
 Issue of skewness in asset returns
 Greed: Positive skewness is perceived as good
 Fear: Negative skewness is perceived as bad
 Insurance returns are negatively skewed
 You do well, you do OK
 You do badly, you do really badly
 Most asset returns are symmetric or positively skewed
 Mainstream finance would suggest either CAPM or adjusted
probability approach
 Wang’s adjusted probability framework helps reconcile two
pricing paradigms
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Finance and Insurance
Earnings Management
 Consistent earnings often stated management goal
 Is goal consistent with financial theory?
 CAPM ignores non-systematic risk
 Lower cost of capital? Internal capital?
 Tax
 Types of earnings management
 Demonstrate actual earnings more effectively
 Match one-time expense and gains
 Misleading investors on source or level of income
 Hide true risk?
 Does requirement to “book to best estimate” increase
insurance industry cost of capital?
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 Financial Structures
Insurer Risk Considerations
 Costs of financial distress  Costs of volatility of results
 Rating essential  Concave tax schedules
 Higher price for more secure
 Hard for analysts to track
product true performance
 Cost of credit  Prevents company from
investing in profitable
 Capital: expensive to replace
business opportunities
 Asymmetric information in new  Capital: an expensive way
equity issues
to manage risk
 Insurer reluctance to release  Double taxation of
proprietary information investment earnings
 Easy to change risk portfolio  Lower ROE
 High costs and taxation  Perils of corporate bloat,
discourage dividends owner-manager agency
 Regulation problem

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 Financial Structures
Insurance Company Structure
Owners, policyholders, and managers have different goals and objectives

Managers Owners Policyholders

• Increases probability •Owners have call on
of insolvency - costly to residual value
managers •Risky investments
•Decreases free cash Leverage? more valuable to owners
•Proportionately
increases any fixed
management ownership

Lloyds Mutual

Optimal capital structure a trade-off between benefits of increased leverage to

minimize owner-manager conflict, and decreased leverage to
minimize owner-policyholder conflict 14
 Financial Structures
Insurance Company Structure
Where is
Stock Securitized Mutual
• Hard-to-quantify risk solution? • Easy-to-quantify risk
• Uw discretion vital • Little/no need for uw discretion
• Potentially difficult for owners to • Easy for owners to track and
track and control uw actions control uw actions
• Sophisticated and knowledgeable • Important because mechanisms
policyholders available for owners to control
managers more limited
Helps minimize owner-manager
Solves owner-policyholder conflicts
conflicts

Stock Insurance Companies Mutual Insurance Companies

Owners and manager interests Merge owners and policyholders

more effectively aligned Good for less sophisticated pol’holders
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 Financial Structures
Insurance Company Structure
 Mutual companies more common in personal lines, WC
 Stock companies more common in commercial and
specialty lines
 Where does securitized solution fit?
 “UW and done” approach divorces uw decision from results
 Does not appear to solve owner-manager conflict or owner-
policyholder conflict
 Cat bonds involve very little or no underwriting judgment
 Minimize potential owner-manager conflict
 Similar to mutual fund structure
 Short-tailed claim settlement (until Northridge)

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Financial Structures
Grim State of Industry
 Concentration of bad news in commercial insurance
 Asbestos
 Terrorism
 Low investment returns and bond defaults
 Medical cost inflation
 Three straight yearly declines in total industry surplus
 Adjust industry picture for AIG and Berkshire
 Over 50% of total P/C insurance market capitalization
 Post-9/11 market should have been ripe for
securitized solutions

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 Financial Structures
9/11: Capital Market Reaction
 Securitization advocates had great
expectations
 Market disappointed
 Reaction swift and consistent
Group Capital Raised 9/11 Loss Net New Capital Pct Total
Bermuda Startups 6.3B 0.0 6.3 58%
Existing Bermuda Cos. 3.5 1.8 1.7 16%
North American Cos. 2.3 1.1 1.2 11%
Lloyds/London 1.0 0.1 0.9 8%
Other 2.4 1.7 0.7 6%
Total 15.5 4.7 10.8 100%

All amounts in $B
Source: IBNR Weekly 1/6/2002
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Financial Structures
9/11: Capital Market Reaction
 Investors utilizing Bermuda companies and start-ups,
rather than existing US-based P/C companies
 No A & E hang-over
 No reserve development on prior years
 Tax and accounting benefits
 New shells a “clean play” for investors to “flip”
 75% of net capital went to Bermuda
 Securitized solution not suited to opportunistic
writings and exercise of underwriting judgment
 Even stock startups had some difficulty “putting capital to
work”
 Underwriting and technical talent greater constraint than
capital

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Financial Structures
Subsequent Market Reaction
 Several successful IPOs in  Existing companies with
last six months deep pocket parents getting
 Endurance Specialty contributions
Holdings (ENH)  CNA
 Montpelier Re (MRH)  Zurich
 Platinum Underwriters  American Re
Holdings (PTP) = old St.  Fireman’s Fund
Paul
 Premier brands able to raise
 AXIS announces IPO for
$517M, March 2003
capital
 Travelers
 Bermuda insurers bucking
 AIG
trend in current unfavorable
IPO environment
 Chubb

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Financial Structures
Kemper
 Experience in 2001-03 confirms investor fear
of legacy risks
 Financial flexibility limited by mutual company
structure
 Strong current accident year operating
performance
 First major insurance entity to voluntarily
cease underwriting activities
 RBC correctly picked up problems
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 Financial Structures
Kemper

Service Shell Companies

NATLSCO Renewal Rights
Employees
Securitas/Swiss Re
Kemper Capital Cypress
Insurance NewCo Gilbert Global
Companies Insurance

Run-off
Consideration
Commission No reinsurance
relationship with KIC;
no liabilities for old
claims

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Conclusions
 Insurers should look at returns and pricing in financial
services
 Securitization does not provide compelling solutions to
any existing insurance problem
 Stock insurance company remains ideal way to
securitize risk
 Insurance company function is to bear hard-to-quantify,
residual risk
 Asbestos could kill legacy companies without deep-
pocket parents
 Perceived convergence with financial institutions
barometer of market?
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References and Links
 Links and references are available on
my web site, along with a copy of this
presentation:
http://www.mynl.com/pptp/maf2003.html
 Please email any comments on this
presentation to [email protected]

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