Einladung zur Vortragsreihe aus Finanz- und Versicherungsmathematik

Dr. Andrew Smith
Bacon & Woodrow

The Effect of New Theory on Insurance Company Management

The traditional basis of insurance lies in statistical analysis of failure probabilities. Provided insurers can charge a sufficient margin above the mean cost of claims, they can grow indefinitely, with an acceptably low probability of being ruined. Furthermore, insurers may be able to charge lower premiums if they have more capital or can take equity market risks on the asset side, especially if the portfolio is well diversified and the insurer has a long time horizon. A whole industry in "Asset-Liability Modelling" has grown up using these premises.

More recently, financial theory has challenged some of these traditional ideas. Should shareholders be concerned about risks other than the risk of ruin? Is there really a free lunch from holding equities for a long time? Why would a competitive insurance market allow providers to charge a risk premium for diversifiable insurance risk? Further pursuit of these ideas, along the lines of Modigliani & Miller, rapidly leads to the insight that the capital or investment strategies of an insurer are irrelevant, from a shareholder value basis. Taking more risks may imply a higher return, but both risk and return are passed on to the shareholder who sees no gain overall, whatever his time horizon. Furthermore, in this simple world, there should be no relationship between competitive insurance premiums and the actual investments held by insurers.

More recently there has been some convergence of views. The hypotheses of Modigliani and Miller include the absence of various frictional costs. In practice, these costs are material and can be explicitly modelled. A consideration of these costs leads to modifications of the neo-classical company model. The frictional costs turn out to be vital in consideration of company strategy with regard to pricing, capital and investments. As a result of this recent research, Asset-Liability Modelling is developing from practitioner lore into an intellectually respectable financial discipline. However, many unsolved issues remain; implementation details are hotly contested among the insurance community.

Andrew Smith will demonstrate some examples of company management decisions, and analyse these from the perspective of the various frameworks in the context of realistic insurance and capital market models. He will explain how the lack of theoretical consensus has led to a diversity of views determined by commercial considerations. For example, equity fund managers advocate efficient-frontier based theories that generate free lunches in the equity market. Product marketers, especially if paid on a commission basis, prefer theoretical frameworks which could justify lower product prices. He will outline how decision making currently works in practice, and will discuss the likely consequences if economic theory becomes better understood in the practitioner community.