EDUCAT10N COMMI丁 TEE

OF THE
SOCIETY()F ACT∪ ARI巨 S

LiF巨 PRICING S丁 ∪DY NOTE

THE ECONOMICS OF:NSURANCE

HOW iNSURERS CREATE VALUE FOR SHAREHOLDERS

Technical publishing by Swiss Re.

Copyright O 2001 by VG Wort, Verwertungsgesellschaft WORT.
Reproduced with permission of VG Wort, Venrvertungsgesellschaft WORT in the
format Copy via Copyright Clearance Center.

The Education Committee provides study notes to persons preparing for the
examinations of the Society of Actuaries. They are intended to acquaint candidates
with some of the theoretical and practical considerations involved in the various
subjects. While varying opinions are presented where appropriate, limits on the length
of the material and other considerations sometimes prevent the inclusion of all
possible opinions. These study notes do not, however, represent any official opinion,
interpretations or endorsement of the Society of Actuaries or its Education Committee.
The Society is grateful to the authors for their contributions in preparing the study
notes.

LP¨ 113‐ 09 Printed in the USA

Contents

Foreword

1 lntroduction
l.t Why economic value?
1.2 Document structure

2 How insurers create value for shareholders

2.1 Insur'ers are liability-driven financial intermediaries
2.2 Value creation in insurance companies
2.5 Cost of capital for insurers
2.4 Replicating portfolio
')q Products with systematic risk
,A Replication and mismatch risk
Frictional capital costs

3 Economic value of Iiabilities

3.1 A simple example
3-Z Section appendix: incorporating all frictional items to

4 Performance measurement 22
4.1 A simple example revisited 22
4.2 Treasury function and transfer pricing 23
4.3 Performance attribution analysis
4.4 Target setting 26
t-q lncentive compensation 27
4.6 Section appendix: incorporating all frictional items 30

３
5 Managing risk and capital

３
5.1 Drivers of the cost of taking risk
３
5.2 Risk and capital management main issues ３
5.3 Amount of capital required
３

5.4 Type of capital required

４

5.5 lnvesting capital

 
４

Appendix: Literature

2 sws iete sconoml6 otmrmc.

Foreword

The greatest shareholder value is generated bythose insurers who identify

and capitalise on the best business opportunities and have optimum oper-
ating efficiency. There are three important prerequisites for accomplishing
these goals. First. a good understanding ofthe value creation process allows a
clear identification of competitive advantages and an unambiguous allocation
of responsibilhies to specific functions within the organisation. Second, a
framework for meqsuring value creation is indispensable in that it enables
quantification and allocation of performance. And third. a consistent incentive
system is needed to align the interests of management with the value creatiori
goal.

lmplementing a value measurement framework will also foster a better under-

standing ofthe value proposition for insurance or relnsurance - thatthe cost
of taking risk is lower for the insuring entity than lor the client. Understanding
that value propositlon allows employees to better identify value-creating solu-
tions for both their clients and their own companies.

This publication provides this type of framework for understanding and

measuring value creation based on a careful analysis ofthe fundamental
economic principles underlying insurance business, in particular. this frame-
work emphasises the importance of accounting for the iost of holding risk'
capital. lt also shows that it is not the lnvestment management actJvities of an
insurance company, but their business origination skills and efficient capital
cost management that ultjmately enable them to create sustainable value for
their shareholders.

Atthough this publication is founded on a detailed economicstudy, it specifi-

cally caters to practidoners. Examples that clearly demonstrate how to apply
the framework ln practice are provided, making it invaluable for insurance
management seeking to improve long-term profitability. .

コD Lフ
も _/亀 朴 。 亥″
Bruno Porro John H. FiEpatrick
Chief Risk Officer Chief Financial fficer
Swiss He Swiss Re

3 s* 8e Jhe acoomlc of lNEnca .

 1 lntroduction

During the 199Os. many insurancel maikets worldwide experiencod major

changes. Until then, tight regulation had kept competition low and profit mar-
gins high. A strong focus on volume was all that was needed to manage an
insurance company,The high profft margins did the rest. ln such an environ-
ment. it is not surprising that managers were prirnarily assessed on market
share. However. due to the combined effects of deregulation and globalisa-
tion, competition has intensified, bringing margins down. Competition has
come not only from within the industry; the boundaries between banking and
insurance have become increasingly blurred. Moreover, value awaroness has
increased across the entire economy, so that policyholders tend to focus less
on long-standing relationships than on obtaining the best value for money.

As a,result volume alone has become an inappropriate drlver olvalue. lt has

prompted insurers io sell covers at lower prices and to be less cautious in
underwriting in order to protect and increase market share. ln fact prices
dropped so lbw that thd industry was etfectively writing losses in economic
terms. ln its issue of 16 January 1999, The Economist descnbes the insur-
ance industry as "an industry in dire straits". Risks were being underwritten at
half the price of only a fuw years earlier. The seriousness of the situation was
partially masked by cosmetic accounting practices, such as the release of
ieserves accumulated in the past. However, reseTves are not inexhaustible.
and the true economic state of afhirs has already started to show through: the
industni has beeh selling its products at prices below production coslthereby
often destroying shareholder value.

ln a changing environment guiding principles need to be revisited. Forthe '

insurance iniJustry this means that to retum to past levels of profitability. it is
necessary once again to reflect on the underlying mechanism of value cre-
ation. Rules of thumb, such as maximisation of marketshare, frequently break
down when conditions change. To address this need, this publication focuses
on the value creation process in insurance. Having a clear idea of how value is
created and how it can be measured is a necessary first step in managing for
value. An economic value measurd allows products to be priced with built-in
value creation targets. Also, though not easy to implement, h makes it possible
to relate management incentive systems to value creation, thus better aligning
the interests of employees with those of shareholders. Moreover, an economic
value measure allows strategic capital and risk rnanagement decisions to be
. assessed in terms of their ability to enhance company value.

1 ln this publiGtion, the generic tem

lnsurance encompasss EimuBne. Althouqh
the anal!€h ls frdmed ln terms of a shaEholder
comparv, It applls equally well to mutuals.

4 swlss HcTh€ Economls dlnsuEn6

 1,1 \A/hy economic valu!?
lVanagers are ultimately judged on their ability to create value fpr the owners
of the companies they manage.'This is the case today, and always has been in
the past ln cunent years. however. the topic has been the subject of renewed
attention.

'1■ ■,1`● oぅ :● :● ●●
、 、 d)tヽ 、L'S
■● =●
The discussions that have resulted from this increased attention focus less on
iF●
=漱
■oS
p,1ヽ llaに },61● ウ aSI い■!● ぐ。 whether value should be measured at all than on how it should be measured.
by Fcc● :::、 ::ぅ o「 子OCticeヽ ′ 0(16d● ● ・｀
1
"〔

inC● rpOF`｀ 1`Or tii● tinう O Vυ !彗 0マ 絆0(:・0ヽ ′

(ヽ
Both the insurance industry and, more generally, the flnancial services indus-
=● =●
oゃ .:::● u,ol、 lolon theV`10■ 0,
For:ier、 、 try until recently relied heavily on accounting methods to determine the value
卜8`3::ヽ VAヽ 0=5 iO■ ●det、 te::d the lr,rl● ●te of assets and liabilities. However, there is a growing discomfort with these
pl"● sl o:は 鋼 ● a"∝ t覧 縫つdest● F"
ヽュ::ht(ltallti“
=● measures since, as is now widely recognised, they fail to reflect the true dco-
gr,、 マ￨■ c“ n卜 、 I:,lvせ olli゛ ve`
Wi:bξ ot■ t3.・ nomic state of companies.
'3o「
r:rcdit lui!3? fh51 A(:|rtor\ From an economie perspective, assets should be valued at market values and
Augrrct'i99'/
llability cash flows according to best estimates taking into account the time
value of money in an appropriate manner lgnoring thls principle will conceal
important economic informatjon. First artificial valuaton principles will mask
the tue level of value crea€d by a company, a primary concem for share-
holders. For example. property and casualty liabilities are frequendy valued at
nomlnal values, ignoring the impact of lnterest rates. Second, artificial valud-
tion methods may mlslead managerc about the risk associated with key sensF
tivities. For instance, using artificial discount rates may obscure the fact that
insurance liabilhies are potentially exposed to considerable intercst rate risk.
Also. many accounting valuation rules value assets and liabilities conserua-
tively, which amounts to building hidden reserves. This is an open invitation to
one of the most widely used cosmetic accounting techniques: smoothing
resuhs by appropriately timing the release of hidden reserves with the effect
that emerging profits no longer reflect cunent performance. Other acbounting
rules, such as US G,4AP. deliberately qim to smooth the emergence of profits
in order to limit the scope for manipulating reserving levels. However, smooth-
ing distorE the volatiltty and true economic condition of the underlying busF
ness. h may temporarily disguise underlying difflcuhies and prevent corrective
action from being taken while it is still possible. Yet another drawback of
accountiirg measures is thatthe underlying valuation principlei can vary in
detail across different countries, and even dlfferent product lines, making it
Virtually impossible to cor.npare performance.

While these shortcomings may not be critical in a high[ profitable and stable
industry. they have become more pressing as competition and volatility have
increased. These changes have reduced the tolerance for enor in financial
decision making. Moreover, more sophisticated maasures of value are now
required to pmperly assess.the more complex producB that insurers offer.

5 SGnEIh.r@ffioflne@.
 These issues have not gone unnoticed by the accounting profession. ln
particular.the lntemational Accounting Standards Board is in the process of
developing a new standard fcr insurers based on economic valuation
PrinciPIes2.

Also from the actuarial side orfrom consulting firms drawing on standard
banking practice. there has been no lack of attempts to overcome these
deficiencies. ln the life insurancs industry. the embedded value method3
attempts to provide an economic view. However, though embedded values
address the greatest problem of uncovering hidden reserves, it is not based
on economic principles (see Section 4). On the non-life side RAROCa. or
variations thereof. have also been proposed as a posstble way out ofthe
accountjng trap. These methods are more or less straightforward extrapola-
tions from standard corporate finance. However, the standard corporate
finance toolkit, which was developed mainly to deal with industrial compa-
nies, does hot translate well to insurance companies. fu a consequence, these
altemative methods are equally unsuited for insurers,

The inadequacy of the standard corporate finance toolkit is due to the peculi-
arities of the insurance business, a topic that has been the subject of much
attention in recent yearss. The speclal role of capital as a cushion against
unexpected losses, as well as the many inefficiencies associated with holding
this capital within an insurance company - regulatory, fiscal and other iric-
tions - demand a more careful analysis. An important part of our considera-
tions will be devoted to elaborating this point.

1.2 Document structure

This publication defines economic value in the context of insurance and pro-
vides a practical framework for measuring and managing value creation.
.Sectlon.2 describes the value creation process for insurers. Using thq analogy
of a leveraged investment fund, it deiin'es the cost of capital for an insurer.
This shows that.insurers create value chiefly tfrough business origination and
efficient capital cost management rather than through their investment activi-
ties.

For the practitioner. sections 3 and 4 provide a workable tramework for

measuring economic value. This framework is illusfated by way of an example.
Section 3 describes how to measure the economic value of insuiance liabili-
ties. Section 4 shows how to construct an economic balance sheet and
income statement. Jhis chapter also highlights the three core functions within
2 SBe the lnsuEnce A6ounting Standards an insuTance company: business origination. capital and risk rnanaggment
Board's /rsuEnce /ssus Pape6 awilable at and asset management. ln particular, it describes how the performance for
their web page (M.iascorg.uk). each of the three functions should be measured. A comparison with RAHOC
3 The embedded value riethod estimats the
and the Embedded Value rnethod is provided.
wlue sf qcs reserues by dis@unflng the
qpected hxure statutory pmfits from businss
in torce. Section 5 considers how the framework can be used in business steering.
4 RAnOC stands for RiskAd)usted RBtum on stressing the importance of managing frictional capital costs.
Capital. Thls typ8 of measure adjusE fhe
Etums of an InsuEr or bilkror risk and Pub it
ln Elation to capital employed.
A list of selected references is provided. for the interested reader
5 See Frcot and Stein, 1 998, Merton, 1 993.
and Merton andFercld, 1999.

6 sds BE: rhE oconomE of hrm6

2 How insurers create value for shareholders

Shareholders of insurance companies provide risk caphal thai is invested on

their behalf in financial assets. ln so doing, shareholders relinquish direct
control over the management of this capital and expose it to insurance risk
lrrloreover, due to the re(;ulatory and tax environments of insurers, they are at
a competitive disadvantage when investing this capital. lssuing insurance
contracts only croates value after shareholders have been compensated
for the resulting frictioral costs. Howev6c these distinctive costs which are
characteristic for financial intermediaries are generally ovedooked by tradi-
tional accounting practice and standard corporate finance theory.

2,1 lnsurers are lidbility-driven financial intermediaries

ln contrast lo industrial companies, lnsurers do not geirerally leverage them-
selves as a means offinancing attractive business opportunities. lnstead, they
do this because it is an integral part of their business operations. lnsurers
bonow money (premiums) by issuing debt in the form of insurance policies
that pay the lender (policyholder) financial compensation if a pre-specified
uncertain event occurs. The payments the insurer agrees to make are often
uncertain conceming their size and timing.

To 'produce' insurance contracts, insurers rely on diversification and iinancial

markets. By poolihg contracts that are not perfectly conelated. aggregate
losses become more predictable. By investing part of the premiums drey
receive in financial assets, insurers are able to generate the future cash flows
needed to pay expected claims. Thus, lasures are liability4riven financial
intennediaies:they originate flnancial contracts, ie insurance policies, and
use financiai markets to bridge the gap between today's premiums and tomor-
Tow's claims.

A second distinctive feature of insurers is that they hold zsk capital. While
pooling redu.ces uncertainty, unexpected losses may still arise, potentially
jeopardising the insurer's abllityto meet its obligatons. This is a concern for
policyholders and regulators, especially sineo insurance is usually purchased
to transfer unwanted risk. Moreover, unlike bondholders who can readily
reduce their credit risk expolure by holding a welliiversified porrfolio of
bonds with difbrent issuers, policyholders generally cannot mitigate insurer
default risk in any cost-efficient way. For this reason. policyholders usually
accumulate their credit exposure with one or a fuw insureTs and are thus
particularly sensitive to the financial strengrfr of the insurer, where financial
strengr$ is determined by rating agencies and regulators. lnsurers recognise
this need forsecufi by holding risk capital. which provides a cushion against
unexpeeted losses.

7 Swtis Re Th. rmnoolcs rl hfrn6

 2.2 Value creation in insurance companies
.Who■
■●泰さ,● c、 コolketョ ,(ck■ su"● ● !
The balance sheet of an insurance company essentially shows investments in
,1● ● ::01■ 嗅cO sFモ ■イ 」tw:`g as
:le′
financial assets balanced by insurance liabilities and the risk capital provided
綸らVVヽ ヽer(“ itioS.Iol●“vこ !●`i,″
d in tれ ,■ ,11快 ,1, :ミ

l● ヽ饉rerS“aiSi r● こ゛t15,3i:1:An ξ● 1● r｀ らミ l■ :ヽ .
by shareholders. Thus. an insurance company resembles a leveraged invest-
Tい ,sコ in,li,:「 3,● ::、 :1条 ￨じ v9師 ent、 :,● :PS ment fund in which debt is raised through the sale of insuTance policies rather
t響 、
ル1と ,今 卜訳■h11準1,「 :tt,wh,:Frゃ 、い:、 than via'capital marketsG. However. two important features separate insurance
l,、:●。口,3:、 こo`re"::1,t● ●::● ド::、 ines,
::、

companies from investment funds: their competitive disadvantage in investing

dav=ピ ュヽ V● ::StFO.oRccョ ga“ 1,is looFi● g

cti!嗜 ゛●、
メ 1)Iv o、 ′ v● :,oo議 、
:`′ 43● :」 . and their competitive advantage in raising funds.
いow sヽ 31o夕 lo:d● :,:o011ッ い lk● サ Is手 ‐
`ユ
.:lo今
:ャ ￨「

rcinp全 ies asi:ttie。 10)● tl l● ●

:、

`1:Ohiv
On the investm ert side, insurance com panies compare unfavourably to an
l・ ぉ ぃ,“ i“ o● :ぃ ont tru瘍 ,´

investment fund. They are more opaque and operate in a much less beneficial
1-!1e icr)nori:si tax and regulatory environment than investment funds. For example, in con-
J場 Ⅲu`∼ 199, trast to investment funds, insurance company shareholders in most markets
are liable to pay tax twice on the investment return on their risk capital. These
returns are first taxed when they flow through the insurer's taxable earnings
and then again as part of shareholdeds taxable income when distributed as
divldends. This makes it difficult for insurers to create value through investing.

'h*urnrte l:t refjrrrl€d as a i.h--aF Leurlc Conversely, insurers have the.ability a create value by borrowing in the rnuch
t{;llgfng i1s1i-5 ior iivasirit nt. rl!6 less efficient insurance market, ratherthan in caphal markets. The insurance
uilrj€rHiiii(: Fr\rll r: sirnbr lrj paying u$
lQterEst (Eis ior ure u-.a ftl tl8 tunds,- market's inefficiency allows insurers to raise funds by selling policies for more
than their economic cost, ie what it costs to 'produce'them. ln so doing, they
M● nch
γ create value.
"::ヒ
Ju(1,2001,

So why are policyholders willing to pay more than what it costs to produce
the coverthey buy? ln principle, individuals could ent'or a pooling anangement
independent of an insumnce company. However, risk-pooling arrangements
are costly and insurance contracts have been found to provide an efficient
means of lowering these costs. As long as it is choaper to buy the cover from
an insurer, policyholders will be willing.to pay a premlum above the produc-
tion costs of a cover.

The value of the company

to'rts shareholdeE has a.
tangible component
(economic nEt worth) and

閂鯰ド
Marに o vaiue
an intangible component
of the
(fmnchlse wlue) which
repcsents the present
value of economic profits
from future business.

6 Alovenged i、 ′
emment"nd is an in′ est‐

mem fund which nnances he puに hase d

inancial a"eヽ part y by"nd‐ holders.Capkal
and Pany″ debt(leverago.

I s*s BeThe sco0omlcs.of ln$ranc.

 The ability of insurers to create value is reflected in their franchise value. lf
insurers were only able to sell insurance at its economic value, their market
capitalisation would be equivalent to their economic net worthT, However,
insurance companies generallytrade at a premium over economic net worth.
This premium, or franchise value, reflects the present value of investors'
expectations regarding the value created byfuture business. lt is a reminder
that shareholders expect insurers to create value.

2.3 Cost of capital for insurers

Uil to this point, the value creation process has been discussed in general
terms, The following subsections address the more technical aspects of value
creation. Section 3 then shows, by way of example. how they can be applied.

Following the analogy of the previous section, an insured5 opportunity cost of

caphal is the return theit shareholders could otherwise achieve by investing
their risk capital directly themselves plus additional compensation lor various
frictional costs that are specific to insurers. This provides the benchmark for
value creation in insurance.

-i ii:tys 5;:, y15l!i1 tffi krld$ oJ h{'rilless The return thatthey would have otherwise aehieved by investing in a lever-
e-irltF encl oi drcse dlsi*arr.q' losorhg aged fund is called the base cost of capital. lt represents the retum that
i:sks and itrsesting lhg Esir ,rroftt prt-
rilirilrF trnld clrnns or e i.'=id. lflsueertcr investors demand for the financial market risk that their capital is exposed to
cflllpaiics, h-"rr: tt-aditionnil!. not ssrralal'Jd and depends on.the inve$rment slrategy ofthe lnsurer. For example, for a UK
vaiue r)Eatiln iolo'ihesa i-& p6trs Y"1, insurerthat closely matched its insurance liabilities and used the FTSE 100
with !cr."nr sri pgrtful$ pgrFimerFa .'".Jr
index as a benchmark for excess capital, the base cost of capital would be
niq{e$ k ls lc6ible l, delem)ine }rhellsr
tfr" inw^\lm.f,r n)finag#eat Ei(18 o{ ih} equal to the retum on the FTSE 1 00 index This may be surprising at first.
b,:srnls:.rs cra&iing or dss!rBying v3!3€ " However, if a substantial part ofthe rctum on capital is obtained by investing
this capital in finaniial assets, why should this retum component differ from
T. Crpeland f. i{r:llcr, J lnunln
[i:Khreey & CstFpeo.r', lc- the return of a regular investrnent fund.2
l00c
Thus the base cost of capital is equal to the benchmark return on the invest-
ment portblio less the retum required to supportthe insurance liabilities,
known as the replicating portfolio return. This retum is comparable to the cost
of debt for i teveraged investment fund.

This would be the end of the sory were it not for the fact that investing capital
in fnancial markets through an insurance company gives rise to fristional
costs whlch do not arise when invesdng the same'capital more direcfly
through an investmentfund. These costs include compensation for lack of
transparenry and control, forthe additional costs related to potential financial
distress, for rqgulatory restrictions, and for any additlonal tax on investment
lncome. These costs are discussed in further detail below.

Therefore insurers can create value in only two ways: firsL b'y issuing insur-
ance contracts that more than cover the associated 'production' costs, includ-
lng frictional capital costs. Secondly, by achieving an investment resuh that
beats the benchmark implicit in the baSe cost of capital on a risk-adjusted
basis.
7 Economic net wortir denotss the market
value of assets less the the economic Elue ol
liabiltties (debt).

I Sds n( lhe sc6ml6 ol lnsuEnc

 一
鰺
lnsurance company Leveragediovestmentfund Insuranceoperation

Beplicatjng Bepliaaling
portfolid . Fotiolirt

Cost oi capital = Base cost of sapital + Fr,ctional caphal costs

2,4 Replicatingportfolio
Having provided an overview of the value creation process, the following sub-
sections provide further ddtails on the key concepts. namely the replicating
portfolio and frictional capital costs.

ThE replicating, or hedge, port[olio is used to determine the cost of the liability
cash flows and the investment retum required to suppod the insurance liabili-
ties. lt.is simply defined as ths porlfolio that best matches8 the conesponding
liability cash flows. For example, in the case of pure insurance risks, the liabil-
ity cash flow can be replicated using risk-free fixed-income instruments with
appropriate maturities. The market value of the replicating portfolio is then
used to determine the value of the liability cash flows.

Beplicating portfolios hre routinely used in flnance to value cash flows that are
not actively traded. If non-traded assets were not valued relative to traded
ones. investors would arbitrage the difference by essentially purchasing the
cheaper cash flow and selling the more expensive one. This principle is known
as the no-arbitrage principle. lt ensures that clients are not able to arbitrage
the insurer and that value reflects the markel or shareholder, view,

Therefore, the replicating porlfolio provides the cash flows needed to meet
expected firture claims payments, to cove[ expenses. and to service capital
costs, thus'producing' the liability.

Investing in the replicating portfolio will not eliminate all risk, as it is not possi-
ble to match insurance risk by replication. ln principle, this risk component has
no economic cost because it is non-systematic. ie it can be diversified away
by shareholders. However. when insurance risk is held on the balance sheet of
an insurer, it gives rise.to fr"ictional costs, which are considered in Section 2.7.

I This means thatthe inanclal market risk

of the net position - repllcadng portfollo lss
liabiltty - ls minimlsed-

1 0 su* n" ft Economls dlBuEnd

 2.5 Products with systematic risk
So far. the tocus has been on pure insurancr! risk products. The only systematic
riskthatthese products have is interest rate risk, which can be hedged by
holding a matching fixed-income portfolio. However insurance liabilitjes can
and do have many types of systematic risk. ,both expiicit and implicit. For exam-
ple, some life insurance products have a savings component with a retum that
is linked to the performance of the insurer's portfolio, subject to a guaranteed
minlmum rate of retum. From the insurer's perspective. this is equivalent to
issuing a call option on its asset portfolio.The inflation risk embedded in many
forms of insurance is also implicit systematic risk, slnce inflatlon is highly cone-
Iated with financial markets.

Although lesstractable, products with a systematic risk component can be

'produced' in a similar manner. A replicating portfolio can beset up to hedge
the systematic risk embedded in irisurance liabilities. Standard.derivative
pricing techniques and factor models, such as the CAPM9 can typically be
used to construct these portfolios. The remaining risk is Iargely diversifiable
and can be deah with by poollng and holding risk capital.

Systematic risk is frequently not given specific attentjon in insurance valua-

tlon, possibly because the calculations are relaWely complex. Howevet this
practice is dangerous because valuation is particularly sensitive to systematc
rjsk. Shareholders demand a significant premium for bearing this type of risk,
as it cannot be diversified.

2,6 Replication and mismatch risk

It may not always be possible to find a porlfolio of traded instniments that
replicates the expected liability cash flows. For example. the cash flows from
certain life insurance or long-tail business may extend beyond the horizon of
available fxed income investments. This replication rls,t is the consequence of
the strategic decision to be active in the insurance market for this tr'pe of
product lt should be reflected in the ftictional capital costs allocated to this
product

Replication risk is very different in nature from the risk of mismatching.

By investing in the replicating porttolio. the insurer can hedge most o{ its
exposure to systematic risk. This makes it clear that taking systematic risk is
an active choice of the insurer, not an unavoidable consequence of doing
business. The issue of whether or not to mismatch assets and liabilhies will
be further discussed in Section 5.

'.t'
Option to detault and value of liquidity
For convenienci, the repliciting portfolio is constructed using defuult-free and liquid
marke-t insb'uments, In practlce, however, insurars could defauh on.thelr liabiliti*, and
it may be iossible in principle tb replicate the liability daymene usihg less liquid instru-
'
ments. ilrrise intanglble Factm reduce the Elue of the economic liabilities and the
retum required by shareholders. These technical aspects are considered in this section.
Readers not interested in technlcal details can skip this section.

9 Capital Asset Priclng Model

.t}re
1 1 s*s" n* o[ h$mm.
"*rcm16
 The insurer's optien to default
As with standard debt instruments, insurers have the option to default on their liabilities
in the event of insolvency. Foilowing bankruptcy, policyholders may not receive the
full payment entided to them. This option is an asset to the insurer and thus lowers the
value of liab.ility cash flows. As a result, the economic value ol liability cash flows corr*
sponds to their replication value less the value of fre deJault option.

The fact that the option to default is an asset to the insurer does not imply that the
insurer has any interest in defaulting. By defaulting, the insurer generally stands to lose
substantial franchise value.

Excess liquidity and value

・ :nst,a:、 こ●:,,● ,、1,oィ 5● ●●oゝ :、 ヽ
y So far, the economic value of insurance liabilities has been described as the value oi a
「 =お
,torlソ :う 0ぬ oキ ttふ :1サ to,■ ,o阜 綸:n,11● :li6 repllcating porffolio less the value of the lnsurers default option, where the replicating
:n:P'''tと :iCつ 01::“ ,tプ t=● :;{!loご 391● ●
=:ぎ portfolio has been taken to be default-free and liquid. Another component that may also
、
■ich lhev cュ lt=Hg Ht,「 ヽK oFoWiヽ o
decrease the value of liabilities is related to the pEdictabflity of their timing and amount.
●■￨■ 、―tho(1,、 gi:●
`l、 "ヽ
:● s,1'〈
:"11● :t:夕 s
=er●
iヽ

alo hiて ャ,t.・

'ヽ Insurance cash.flows are typicdlly uncertaln regarding both amount and timing. Due
●t8eri:、 1● in
Pゃτ to diversification, howevsc a pool ofcontracts often displays a high degree of pr}
RI、 と dictability both in timing and amount This suggests that replication could actually
ご〔:::● 11■ ,￨
be achleved by using illiquid assets. This is becauset}re replicating portfulio would in
principle not need to be adlusted over tlme. lnstead, it could be held tc maturitylo.

llliquid assgts tend to sell at a d'rscciunt with respectto their liquid counterparts, ie there
is a premiurn for liquidity. Therefore, usinO illiquid instrurnents to replicate could in prin-
ciple lower the productlon costs of liabillties or, equivalently, the cost of bonowing
through lnsurance.

Unforhinately,.illiguid instruments such as corporate bonds usually carry additional risks,

such as defauh subordination and call risk. which make them unsuitable for replication:
they would not resuh in a portfolio that best matches the flnancial market rlsk senlitivity
of the liebllity cash flows. These additlonal risks also make I difficult to quantify the liq-
uidity premium. As a result, there are widely differing vidws on its size.

lnsurance company Leveraged investment fund lnsumnce operatlons

r--------::--
一
ｔ
一
︰
﹄一
嶽一

.------]
Ｍ．
ｄ
︼
ヽ

t"11e Replcaung
■一

M載 ■●
︰
平＝＃一 一＝一一〓

Feplicating
 

bFas_1. p。「t● port olio

一一

li。
， ，

■■●■ ﹁

+
︰
︰■

:■ キ
11‐ 、
十
■三

￨・ : ::::1::
一
■二

・ ::= ￨ :11
■
●

茸暮::にR祓
一

Frictional capital costs

Cost of capital = Base cost of caphal Defauh option
Liquidity wlue ,

10 This condition would typically qclude life

insuEn€ contracts with surender guaEntees
or natural cat"dstrDphe coveEge.

1 2 S*Bs hs The economl*of lnsmnc.

 2.7 Frictional capital costs
Unfortunately, unlike investment funds, insurers are subjeot to An unfavourable
tax treatment and operate in a highly regulated environment where regulations
are designed to protect policyholders ratherthan shareholders. These ineffi-
ciencies or frictions translate into the need to provide shareholders with an
additional return.on their risk capital over and above the base cost of capital.
Frictjonal capital costs represent the insurer's cost of taking insurance risk and
capture the opportunity costs shareholders incur when investing capltal via an
insurance company rather than directly in the financlal markets.

There are essentially four sources of frictional capital costs: double taxation,
costs offinancial distress. agency cosfs and costs ofregulatory restictions.
Section 3 illustrates how to incorporate these costs into pricing, and Section 5
considers how these frictional costs can be managed,

Costs of double taxation

The first component is double-.taxation costs, which has already been men-
tioned. lnsurance companies are taxed on their lnvestment return before it can
be distributed to shareholders. This produces an additional cost component
relative to an investment fund.

Costs of financial distress

The second component amounts tb the compensation for'potential direct and
indirect fnancial distress. Selling insurance introduces the risk that an insurer
wiil experience inancial distress. Financial distress can be costly due to both
direct costs - such as the dead-weight costs ol needing to raise fresh capital,
legal fees and lost value from distressed sales - and indirect costs - primarily
loss o{ reputation and associated.franchise value.

Note that financial distress costs are related to the riskiness of the insurance
business. The resulting. additional return will thus be linked to company-
speciflc insurance risk or the risk of ruin. as opposed to systeFnatic risk, even
though this risk could in principle be diversified by shareholders. Financial
dlsfess costs.thus pmvide the link to actuarial techniques that have tradition-
ally focused on the probability of ruin.

Agency costs
'-ih€ iio*rnnac ln{uslry op3rsle,s a.rrl The third component is agency cost. When shareholders invest via an insur-
tglrortj rn ? tE6.r!3I whl*l Frel.J !t 3c.ir ance conpany, they entrust their capkal to managemenL who take investrnent
r&te tsyr{ueiicn cf sa!€s ! iru:rtt+$Fg iqsl
f!r. inyesics. r.tJo ruspeci tiral ihis hes krl
and underwriting decisions on.their behalf. Shareholders expect management
to tlte iidil',lrFnr)e show'l by iiv?strss to act in their best interests, but this is difficult to conuol due b an intrinsic lack
toerds {lre sscior.' oftransparency. As a result, shareholders require an addiiional return to com-
pensate them for the possibility frat management may not always act strictv in
L?hfiEr\ Sr"llDrs
Janucry l9g7 thelr best interests.

Agency cosb are compamble to mordl hazad in insumnce, which occurs when
the imerests of the poliryholder and the insurer are not in line with each other.
The policyholder is likely to have better information than the insurer conceming
the insured event and may seek to take advantage of this. ln addition. being
insured may encourage less prudent behaviour lnsurers manage this by way of

1 3 sds FElhs E@noM of Mle

 careful contract design and by including the expected cost in premium rates.
Similarly. shareholders require additional compensation for having given up
control over their investments and far not being able to closely monitor the
decisions taken on their behalf.

Cost of regulatory restrictions

.F■
,I:cn:in,t憲 rゃ 、a,9:● ￨“ F」 t● !:oそ
!ヽ The fourth and last component of frictional capital are regulatory capital costs
ぐ報 ital:0「 1● ,`letず γ 「6● SOI｀ 。eョ 〕1、 iⅢ CS
that arise due to regulatory restrictions that may require insurers to hold mini-
,テ

'.tい
●rw、 icヽ c9ri re、 颯 ・ me6t sharel“ :e:ヽ

「 Hミ 1“ 豫 d“ 113“ l.て ｀
V″ t● 11ヽ 01=ヽ ■,iヽ"【Stを X家 =1‐
mum levels of capital to support specific blocks of businessll. These restdc-
ilう :, A■ 負ミ:■ ￨:lah t:le Oゃ tiO:1ミ ●:::ヽ `=St tions may take the form of either conservative reserving standards or minimum
ュIc,P:ta:ヽ 'Xl'd●
し、 :輌 」■ヽ8in iコ V● urabl薔 :tal
caphdl requirements. They create additional potential costs for shareholders,
=ill、
`:、

because this capital is not readily available to support other lines o{ business.
Sclrroder:i It can only be physically accessed byselling the underlyiog business. which
Nr{emb€r 1393 generally gives rise to additional cosb that are heightened by the lack of a
liquid market in insurance llabilities.

As discussed in Section 4. the cost of regulatory restrictions is the focus ofthe

embedded value method.

Cost of capital and the CAPM

lnsurers often confuse tle retum that shareholders demand on capital, ie the cost of
capital. with the cost oftaking risk. Tle retum that investors d'emand for the use of
their c;bital is composed of the base cost of capital - ie the return thst inveistors could
havs obtained by investing those funds in flnancial markets directly - plus frlitlonal
cap[al costs - ie the extra return to compensate them for the fact that insurers are
investing theii. capital through an insurance company to suPPort risk taking in the
lnsurance markets. Not miking this distinction creates difficulties in determining value
created by undi:rwriting activities. Thii is because the benchmarktor underwritlng is
given by the triiiional costs and not by the full cost of capital. ln addition, as rcturns on
financial markets are volatile. the full cost of capltal is a nolsy and unreliable measure
of value creation from the lnsurance side of the businass.

An exclusivL focus on the total cost of capital can be even more misleading ifthe cost
of capital is measured using the CAPM, which was dsvBloPed wit'n industrial compa-
nies ln mind and focuses on the systematic risk a companytakes. lnsurance iompanies
take most of their syslematii risk on the investment side. \r'y'hatever systematic risk is
embedded in insurance liabilities can be hedged by offsetting positions on the asset
side, so systematic risk is not the.most important driver of the cost of taking insurance
risk. The rhore irirportant drivers, frictional capital costs, are not explicitly captured by
CAPIM. This will inevitably lead to wrong conclusions regardlng the cost of taking risk
for insursrs. ln additiori, CAPM provides no, or misleading, guidanceto insurers on how
to manage their cost 6ttafing rist '

thah on the total cost oi capital gives insurers a better measure of value creatlon and
also provides greatertransparency as to how risk and capital management decisions
can minimlse this cost

'I 'l Depending on

the clrcumstances. Eting
agency Estrictlons may be tracked ln a way
simllar to egulatory Estrictions..

1 4 sdss Bo lhe sconomlc of NEncs

 3 Econornic value oflia‐ bilities

The economic value of insurance liabilities is calculated as the present value

of all expected futurd cash flows, including the cost of risk ln this calculation,
the present value should be determined using a replicating portfolio to ensure
that it incorporates cunent financial market information and accounts for the
systematic risk characleristics of the cash flow. The cost of taking insurance
risk is caplured by the frictional costs of holding risk capital. This section illus-
trates this calculation by way of example.

3.1 A simple example

As djscussed in Section 2, the economic value of liabilities is determined by
their replication value, including frictiohal costs. less an allowance forthe
insurer'i option to defuult and any liquidity value of the contract.

This is best illustrated by way of a simple example that will also be used in
Section 4 on performancei measurement The example focuses on the valua-
tion of a pure insurance risk contract with cash flows payable over two years
as shown in the table below.

'lime
Premiums 50
clalms o 70
Expenses 5 1

Risk cap■ al12 20

For simplicity, we start by considering frictional risk capital costs only. This is
suffcient to illustrate the principle. ln the appendix to this section, we
descrlbe how to integrate the other key components, namely the option to
defuuh and the liquidtty value, taxes on investment income, and regulatory
capital costs.

The figures in the above table represent expected values, and all firture cash
flows are assumed to be pald at the end of each yearl3. Hence at ioception this
'I2 Blsk €plrd ls defined as th€ amount of
contract generates a premium of 55 and incurs initial'expenses of 5. The risk
cpital necg$aryto supportfte riskto which
tte comparry is eposed. capital needed to support the confact amounts to 20 during the first and 1 5
1 3 The assumptions used Eiectthe specific during the second year. Risk capital costs are assumed to be paid at the end of
costs to the sntity. Ether than lndustry aveEge each year and amount to 2.5% of risk capital at the start of each year. The first
condttions. For *ample, they reflect the actual
sEp in determining the value added by this hypothe0cal contract is to deter-
axpeNe structuE of the ln$cr i$uing the
contEct Etherthan t}le e+ense stucture ot a mine the net cash flow payable, which is made up of clalms and expenses less
typiGl insurel Norentitfspecmc Numpdons premiums. This msh flow pattern is shown in the table below. Frictional capital
have been recommended where the ob]ectlve costs fren need to be added and the resulting cash flow discounted.
ls to detBrmine the 'alt' value of the cont?cL
Egardlss of who ffindy owns it This Is
analogous to the isue In accounting of
Since the contract covers pure insurance risk only. the cash flows can be
wheherto Elue prcpertyaccording to its replicated using.fixed-income instrumenB of appropriate maturities. Thus the
curent use, eg a bowllng allry. r;r its optimal value ofthe replicating portfolio can be derMed by discounting the expected
potEntial use,.say a pa*ing lol Howmr, our
liabiltty'cash floirvs at risk-free rates of appropriate maturitjes. ln this example,
objec{ve ls to detemlne the vatue of the
we use 5% per annum for the maturities of both one and two yearsl4.
. contEct to tle comparry that issued it re ask

how much h costs them to prcdu@ the liabllty.

14 ln pmaie, the discourt rats should reiest
the canEnt term structure of intErEt Etes.

1 5 SWIS RETho ocono口 厖 o● nwrancl

 The discounted values are also illustrated in the table below which shows that
the.economlc liabilities that need to be established at inception are 4-1.12.
Since the company received an initial payrnent of 50 after expenses, we can
conclude that this contract generates an economic value of 2.88.

Time 0 2
Net cash paymEf,ts 50_00 19_00 -71.00
Risk capital cost 0.oo -0.50 -0.38
Net cash flow after trictional costs 50.00 18.50 -71.38

Economic liabilities 47.12 67.98 0.00

Hence the teplicating portfolio in this'example has a market value of 41.12,

consisting of zero coupon bonds of two yedis' duration with a market value of
64.74 and a short position, or borrowing, in one-year zero coupons with a
market value of -17.62.

This example can also be illustrated in the format of an income statement as

shown below, where investment return is simply the return of the replicating
portfblio. Note that the economic view rccognises all anticipated profrt at the
start ofthe contract

lncome sffiement
Premiums 55.00 50.00 o.oo
inrestment Eturn 0.00 L.30 3.40
Claims 0.00 -30.00 -70.00
Expenses -5.00 -1.00 -1.00
Change in economic liabilities - 47.12 -20.86 6798
Result 2.88 0.50 o.38

Risk charge o-00 -0.50 -0.38

Economic profit .2-AA 0.00 o.o0

As mentioned earlier. insurers create value for shareholders by borowing from

policyholders at below-market interest rates. To highlightthis point the eco-
nomic profrt generated in this example can be expressed in terms of the cost
of borrowing. The cost of .bonowing is given by the internal rate of return
bbsed on the net cash flow. tn this example, the internal rate of return is 2.4y0.
Since the equivalent market yield dvailable to investors i5 5 %, the insurance -
contract generates a spread of Z.6Vo, ln otherwords, this contract provides
the insurer with funds at a bonowing rate oi 2.6% below market Etes. Note
that, when performing this calculation. it is irnportant to Include frictional capi-
tal costs in the net eash flow and to use the replicating portfolio to determine
the equivElent market rate. Moreover. it is often mathematically impossible to
calculate in intemal rate of retum for insurance cash-flow pattems. For these
reasons, we recommend that contracts should be assessed using economic
profit rather than borrowing spreads.

1 6 sm n" ne ol lNutrcs.
"*node
 As noted earliec for the more technically interested reader, the appendix to
this section extends this example by incorporating tre default option and liq-
uidity value, double tax, and regulatory capital costs.

Quantifying.frictional bapital costs

The quantmcaton of capital bosts is difficult ln any valuation framework and requires
a great deal of professional judgement While thjs publication does not offer a recipe
for quantifylng ffiptal costs, thls section provides a rough guide as to howthese costs
may be determined.

DoiJble taxation costs will depend on the tax jurisdiction and on how the assets are
managed. As a rule, tax rates on invesfnent income are readily available and rnay vaiy
dependlng on the type of asset held or dre type of lncome generated. As these rules
are usually explicit, this generally does not present any dtfficultles ln valuatlon. How-
ever. additional assumptions, such as the frequency with whlch capital galns are
reallsed, may well be necessary.

Financial.disfess costs will largely depend on tie rlsk profile of the company - le on
the likelihood offinancial dlstess - and on the value of lts infangible assets or fran-
chise value. Studies of industrial clmpanies have revealed that flnancial dlstress, as
opposed to barikruptcy. results ln cosb of.dround 1O-20% of marketvalue. *ese
costs are Ilkelyto be higher In the lnsumhce industry due to the credit-sensltive nature

...
of policyholdere. An upper range for these costs is the franchise value of the company,

Agency cbsts depend on factors that are hard tb measure. such as repfi;rlon and
transparenby, Nevedheless, they can be esumated by considering marketbompara-
bles. For instance, lpreads on cat bonds. wtich.ari unfamiliar and thus opaque to
invesGrs, can be considered di representing some type of agency charge, Also. the.
discounts typlcally applled by analylts to iompanles wlth.dcess_capital bn thelr
balance sheets can be interpreted as being largely an agency charge. Based on these
types of comparison, Bstlmates oftheir size range between 5 and 2OO basis points
of capftal held.

Begulatory restrictions are akin to liquidity restrictions, which have numemus market
comparables.,These include securities that are issued with tradlng restrlctions, spreads
on private placements, or the sprdad on off-th+.run treasuries, Depending on the
nature of the resffictlons and the composftion ofthe portfolio, estimates for these costs
range between 0 and 2OO baiis points.

Thb deliluh option and liquidity value cair bb quanttfied by considering the spread bn
the standard debt issued by the insurer, orlike insurers. This spread typically'represents
an upper bound because poliryhoiders usually rank above debt holders ln the event
of defuutl lf the underiying liabilities dre'considered to be liquid in the sense dbichbed
previously, then this spreaij shoi.rld be furtiier reduced by the liquidity premium implicit
ln corporaie deblThis liquidity premium can be qudntified using the samemarket
comparables as those used for the regulatory restrlctions.

17 swsn,T腱 g∞ mm csげ ぃ 帥
『 “
 3.2 Section appendix: lncorporating all frictional items
For completeness, this appendix briefly describes how to include the value
of the option to default and liquldity value, taxes on investment income, and
regulatory capital costs.

Default option and liquidity.value

For valuation purposes, thb option to defauh and liquidity value can be incor-
porated into the calculation of the liability value by increasing the discount
rate applied to the net cash flows. For example, if the spread due to default
and liquidity is50 basis points then. as shown in the table below. the eco-
nomic value of the liabilities at inception is reduced by 0.53 to 46.59. This
increases the economic profit to 3,41 .

Note that this does not imply that the replicating portfolio earns this additional
return. As discussed previously. the replicating porffolio best matches the
liability cash flows and is constructed using default-free and liquid instrurnents.
The additional return of 50 basis points reduces the frictional capital costs: the
replicating portfolio does not eam it.

Time 2
Net 6sh flow after
Hctlonal costs 5000 18_50 -71.38

Economic liabilities 46.59 67.65 0.00

lncluding double taxation costs

The example of Section 3 can be further extended to incorporate tax. includ-
ing double taxation costs, assuming a tax rate of 35%. ln addition. assurne
that the total assets held to back the contract are given in the table below.

Time
Regulatory and tax rseryes 100
Risk caphal
Total assets 120

As illustrated in the box on page 1 9, double tax costs can be determined by

assuming thatthe assets held eam a risk-free rate of retum. As
a result, the
'
expected risk-free investment retum is 5% of 1 20, or 6. in the first year and
5% of 85, ot 4.25, in the second year. These returns can then be.incorporated
into the tax.calculation as shown in the income statement below.

1 8 s*g n" ft6 sonome of hsffinc

 lncome statemetrt 0 1 2

Premiums 55.00 50_00 0.00

Total investment retum
0.00 6_00 4_25
Claims -30.60 -70.00
≧Il=_____¨ 、
E:`E壼 _________________」 199________二 ■129_________二 」 L29
Change in regulatOry reserves -100.oo 30_00 70.00
Tax result -50.00 55.00 3.25

■ax 17.50 -19_25 -1.14

lncluding this in the original net cash flow and discounting. allowing forthe
defuuh option and liquidity value, results in an initial economic liabilityvalue of
65.86 and a conesponding economic profit of 1.64. This is shown in the
table below.

Time 0
Net ash flow aiter
frlstional costs 50.00 18.50 -71_38
Tax 1■ 50 -19.25 -1.14
Nst 6h flow after tu 6■ 50 -0.75 -72.51

Econo「 nic liabilities 65.86 68、 73 0.00

Valuing tax on investment income

Tax on investment income provides a good example of how replication can be used for
valuatidn pufposes. h is particularly useful because it shows how common intuition
and practice cin lead to misleading results.

The future tax payment ls equal to the investment r8turn earned on the capital invested
muhjplied bythe appropriate tax rate. For example, lfthe capltal invested is 1O0, the
retum 1 O%, and the tax rate 3 5%, then the tax payment would be 3.5.

To replicate thls payment we can use the followlng strateg\4 First, invest an amount
equil to tire tax rate flmes the capital in the same assat category
as the underlying
capttal, ln this example this would mean investing 35. whlch would be worth 38.6 at
year-ind.

Second, borrow by'ss-uing a zbro coupori bond with a iace value equal to the tax Ete
times thg capital. ln ihis example. the bond rculd pay 35 at.ysar-end

Hente the year-end.total caih flow on thli portfolio would be 38.5 less 35, which
-eqrials
the t6x payment oJ 3.5. Note that the yaarcnd value of this portfolio is ahrr'ays.
equal to the tax piymenL no matter whqt return i! eamed on thi: underliing assets. As
a ieiulL it replicates the tax pdymBnt.
a'.
The i:resent value offiis reilib;ting portlolio is equal to the caphal invested of 35 less
the amount bonowdd. Ai the tax will be due with Virilal certalnty, the borrowlng. should
be discounted ai rlsk+ee rates. Hence the amount bonowed would cost 33.33. assum-
lng a 5% risk-free rate. Therefore the total cost of the rePlicaflng portfolio is 1.67.

1 I sws BeThe Ef l6umc.

"conomte
 Anotherway of looking atthis is thatthe tax payment could be valued using risk-free
rates of return. ln other words, value thB tax payment assuming that the capital is
invested in risk-free instruments. ln this example. this would be given by 35% of 5
discounted at 5%, or 1.67.

Regulatory capital costs

The calculation of regulatory capital costs is complicated because these costs
depend on the size of the economic liabilities but at the same'time are part of
economic liabilhies. This creates a circular calculation. Neveftheless, this can
be overcome relatively easily.

The following income statements and balance sheets show the calculation
assuming regulatory costs of 1%. Fegulatory costs are.assumed tb be paid
at the end of the interval based on the restricted capital at the start of the
interval. This calculation assumes thatthe minimum regulatory capitai,require-
ments are 5 at inception and 3 at time one. The regulatory reserves were
given in the previous section.

Income statement o
Premiums 55.00 50.00 0.00
lnvestment return 0.o0 J.5 I 3.44
Claims 0.o0 -30.00 -70.00
Expenses -5.00 -1.00 -1.00
Change in economic liabilties -66.27 -2.51 68.77
B€forltu resuh -16.27 19.81 1-21

Tax 17_50 -18.31 -0.85

After-tax resuh 1-?3 1.50 0.36

Default and value 0.O0 0.33 0.34

Double faxation 0.00 -0.94 -0.28
RIsk cdst -0.50 -0.38
Requlatory capital cost 0.00 -0.39 -0.04
Capitdl costs 0.00 - 1.50 -0.36

Economic profit I 13 0.oo o.00

The balance sheet shows the fuil breakdown of the liability value. Note that
th'e above regulatory capital costs are simply equal to the restricted capital at
the start of the interval multiplied by the 1% Iiquidity charge.

20 .swrs n" Ihe 6m@tr of xBlm6

 Also note that the default option and liquidity value are reported separately
under the total assets. This is because there is more uncertainty associated
with the quantiflcation oi this component and it is controversial, since deterio-
ration in credit quality increases valUe. A decline in'credit rating would increase
the profitability of existing business, but possibly atthe expense oithe fran-
chise value. As the franchise value is not Included in these eccinomic flnancial
statements, it is important to separately quantify the impact of a reduction in
credit rating on the existing business.

Balance sheet 0 1 2
Assets
Investm ents 120.00 85.00 0.00
0_33 0.00
■て
ial a痰 :eヽ 120_63 85.33 0.00

ιね力′
Zたたs

66.67 0.00
9ii9g!!trg]E!I'tv-
Expense provlsions 1.86 0.95 0.00
Deferied tax liabilitv 18_21 0.81 0.00
Double tax liability 1.15 0.27 0.00
RIsk captal o)`■ l liability O.82 0_36 0.00
Regulatory cost liabi:ity O.41 0.04 0.00
Economic Iiability
1些鮭 豊 1生 璽 里 L__型 ____型 聖 ____型
Rest"cに ld shareh● :der capita1 38.73 r4.23 0.00
unres01cted shareholder capta1 15.00 12.00 0.00
昴olコ 1 liabH‖ es 120.63 85_33 0.00

2 1 s.bs R".fhe of lnenice

"conomt6
4 Performance measurement

The previous sections have illustrated the importance of economic value and
the way in which economic value is determined. This section shows, by way
of example, how to structure an insuTance company's financial statements to
faoilitato performance measurement on an economic basis.

Performance measurement is a key component in value management Histori-

cal performance should feed back into compensation arrangements, risk
management. and future pricing assumptions (see Section 5). lvlonitoring the
economic value of the company is also essential for managing capital and
capacity levels and is important for shareholder communication. Thereiore. a
key ingredient in managing value is a set of financial statements that
a) deterririne the economic capital of an insurer and the return achieved on
that economic capital and b) explain the drivers of historical performance.

The underlying method used in performance measurement should be the

same as that used in valuation or pricing. As a result economic performance
measurement is based on the same underlying principles as those discussed
in previous chapters. These include the use of expected value assumptions,
the use of replicating porrfolios, and the incorporation of frictional capital
'costs. Moreover, economic periormance measurement should recognise al!
anticipated profit at fie incepiion of the contract.

4,1 A simple example revisited

ln Section 3, we demonstrated the basic structure of the economic income
statement and balance sheet for a single contract. ln this section, we will
extend that example to include deviations from expected cash flows as well.as
the investment returns earned on actual investments held. We also show how
the economic result can be attributed to the various functlons within tne com-
pany. Before doing this, we will recapitulatethe example in Section 3.

The expected cash flows at inception are shown in the table below:

■me 0 2
PBmiums 55;-_ _ q_0_._
Cialms 0
q
Expenses 1

li"irsEIsl- 20 15

Again, starting with the simplest case of zero tax and regulatory capital.costs,
providing that everything develops as expected and under'the assumption
that interest rates do not change. the value ofthe contract atthe end ofthe
first interval is as Jollows:

■mel
ffi
Expense provisions
Risk €pital coat liability 0.36
Economic llability 67.98

22 swrs na TbE economtB of h$Bncs

 .Now suppose that the one-year interest rate at the end of the first year is 6%.
rath6rthan 5% as bxpected, and all other assumptions remain the same. Then
the value of this contract is shown in the table below. The economic liabiiity
has reduced from the original expectation because the expected future cash
flows are now discounted at a higher interest rate.

■rne l
Discounted llability 66.04
Expense provisions __
oqL
Bisk capital cost Iiability 0.35
Economic liability 67_33

ln addhion to the change in interest rates, assume that the actual claims and
expenses paid at the end of the first yeai are 25 and 2. reipectively, rather
than 30 and 1 as expected. The corresponding economic income statement
is shown below.

■mel
Premiums 50.00
lryestment rqturn
{replicating portfolio) 1.71
Claim● -25.00
Expenses -2.00
Change in economlc liabllities - 20.21
Result 4.50

Risk charge -0_50

Economic profrt 4-00

Note thatthe investment return has reduced from 2,36 in the projected
income statement calculated at inception to 1.71. This.reflects the value
reduction ofthe repllcating portfolio due to the increase in interest rdres. Note.
howeveLthatthe change in economic liabilities is now - 20.21, comparedto
the expected value of - 20.86 at time zero. The replicating portfolio therefore
immunises the result from changes in interest rates.

The economic profit of

4 results from claims being 5 lower than expected and
expenses being t
higher than expected- The change in interest rates has no
impact or the economic result.

4,2 Treasuryfunction and transfer pricing

The income statement.in the previous sectiori is based soleiy. on the replicating
porlfolio. However, insurers generally do not invest in the replicating poftfolio
and the ovareill flnancial statements should reflect the performance
ofthd actual investment portfolio held. Furthermore, they should distinguish
between eamings generated by underwritin'g activities ind eamings generated
by investment activities. This is achieved by introducing atreasuryfunction.

2 3 sw|s nq Thr ffinodc of lnsnncs

 The treasury function is used to properly allocate investment returns and
capital costs beMeen the underwriting and investment activitjes within an
insurer. This need not necessarily be an explicit function within the organisa-
tion. but it is always implicit. lt is used to.split the overall financial statements
into investment, treasury and underwriting components using the replicating
portfolio and a Strategic Asset Allocation (SM) benchmark portfolio, as
shown in the graph below+.

Economic B-S

lnvestments B-S
/ Treasury B-S UndeMriting B-S

躙
TAA and stock seleqtion
+
Oveall risk tolerance
+
lnsumnce,
repliction risk

The process underlying this approach can be summarised as follows.

As the undeiviriting function specialises in insuTance risk,.it minimises hs

exposure to financial market risk by purchasing the replicating portfolio from
the treasury, This ensures thatthe underwriting performance is not influenced
by investment decisions. The underwriting function is supported by share-
holder capital held in the treasury balance sheet. The cost of providing this
support is represented by the frictional capital costs paid.

The treasury function determines the level of financlal risk that the company
should take for stategic reasons by specifying the SAA benchmark for the
invesfnent function. As a result the treasury balance sheet is comprlsed of
assets represented by a loan to the investment funstion of the SAA i:ortfolio
and liabilities represented by bonowing from the underwflting function of the
rcplicating portfo.lio. Therefore. the treasury function isolates the impact of the
strategic asset-liability mismatching decision. The shareholder capital. or
equity. in the company resides in the treasury balance sheet Note that by
specifying the SA,A, tre tredsury function tacitly determines the base cost of
capital.

15 For slmpllclty, thls grdph scludes the

deiauh optlon and llquldttyElue compdnents.
The lmpact of these mmponants !s lllGtrated
ln the gEph ln Section 2.

24 Sus n" ThE Ecmomt*of lmcncs

 The investment fuflction uses the S,4A as a benchmark. but has discretion.
within.limits, on tactlcal asset allocation and stock selection. The investment
bilance sheet includes the actual investment portfolio as the asset anij the
SAA benchmark as the liability, The investment balance sheet separately iden-
tifies the impact of investment decisions.

The above sepamtion implies a conesponding separation ofthe income stale-

menf This can be illustrated by extending the above example. Assume that
the insurer in this example holds total assets of I20 at inception that eam a
return of 10%, compared with a retum of 9% on the SAA benchmark for a
similar level of markei rislc Then the investment function adds value of 'l % of
assets or 1.2 and the overall income statement is structured as shown below.

‐
lncome statement :iotal lnsuEnce lnvestment Treasury
Irsrrqri-- 50.00 50.00
Investment retum 12.00 1.71 12.00 -1.71
Claims -25.00 -25.00
Expenses -2.00 -2.00
Change in liabilities - 20-21 -20.21
Fesult 14.79 4.50 12.00 -1.71

Base cost of capital -3.09 0.00 -10.80 1.71

Risk capital cost -0_50 -0_50
Capifdl Gosts -9.59 -0.50 -10.80 1-71

Economic profit 5.20 4.00 1.20 0.00

The insurance functjon receives the retum on the replicating portfolio from the
teasury function. The lnvestment function receives the total investment retum
and is charged with the return on the SAA benchmark. The treasury function
is.not a profit centre; it is merely used to iransfur payments between the
investrnerfi and insurance.functions. h pays out the return on the replicating
portfolio to the insurance function. subsequently receives the return on the
SAA benchmark 1 0.80, and is charged with the overall base cost of caphal

- 9.09 (1.71 in aggregate).

Note that, in this example. the expenses of the investment function have been
included in the insurance function's. expenses. This is becauso the insurance
function. is assumed to pay a fee to the investment function that precisely
matches their expenses. ln practice, these fues and expenses may be explic-
itly reported to assess whetherthe additional expenses associated with active
management are justified by additional retums.

The appendix to this sBstion shows howto include the option to default and
the value of liquidity;double taxation costs and regulatory capital costs.

25 smng.Ihemoomansrrc
 4,3 Performanceattributionanalysis
While the economic income statement records the overall result it is generally
insufficientto fully explain it. This difficulty is exacerbated if multiple business
lines; with contracts having different inception dates, are consolidated together
in a single statement. To address this, a performance attribution analysis is
required.

A performance attribution analysis is designed to explain the overall resuh in

terms of the key drivers of value. On the insurance side. the minimum require-
ment for an attribution analysis is to split the overall result by main line of
business and into the contribution from new business and from existing busi-
ness. This could be extended by splitting the performance of existing business
by year of inception. For the new business. the result should be compared
with the initial profit targets set For the existing business. the expected resutt
is zero and any deviations should be explained. For example, by identifying
the irnpact of aoy changes to the reserving assumptions or by identitying the
impact of experience being different from each key assumption. As the impor-
tance of these factors vary by product and market, it is not posslble to produce
a generalised insurance attribution analysis,

On the investment side, an attribution analysis would split the investment

economic profit into the key factors driving investment performance, including
asset allocation, cunency selection, stock selection, or sector selection. This
information is essential for understanding the result so that appropriate rnan-
agement action can be taken where necessary.

4,4 Target setting

As discussed previously, shareholders typically expect insurers to earn an
economic profrt, and this expectation is impticitly reflected in the company's
franchise value. Only if shareholder proft expectations are exceedeU willtlre
share price increase. As a resulL for incentive compensation and in communi-
cating with shareholders, it is important for managers trp set economic profit
targets.

The franchise value of an insurer provides an overall yardstick for value cre.
ation, but h says nothing about when this economic profit is expected to arise
or which units are expected to dellver it. lt is possible to estimate the annual
profit expectations by multiplying the frhnchise value by a suitable discount
rate, which reflects cunent long-term interest rates and a systematic risk pre-
mium associated with realising firture new business sales. This approach
assumes that the franchise value reflects a constant profit stream paid in
perpetuity. However, there is no mechanistic way of seffing proft targets for
individual business units.

The targets for individual business units should be based on a range of con-
siderations relating to the cunent and likely future competitive state of the
local insurance market. This is. and always has been, one o-f the key tasks of
manaQement to Judge the level of profit that maximlses long-term value.
These targets should be benchmarked against other companies operatinj in
similar circumstances, if possible. They should also be added up and com-

25 s** ne Th6 amnomlc of lnsuranca

 pared with the overall target implicit in the franchise value. This comparison
provides management with an inilication of the extent to which the market is
over or undervaluing the company. This information is invaluable for investor
relations and capttal planning.

4,5 lncentivecompensation
Having an incentive compqnsation system linked to economic profit is not only
an essential part of encouraging value cfeation. but is also vhal for risk man-
agement. The primary cause of financial fiascos is usually a misalignment of
incentives.

However. effective incentive systems need to be carefully constructed and do

not simply entail including economic proft.in bonus calculations. lncentive
compensation should be unambiguously linked to economlc value creation,
ln addition, senior management must be seen to be fully committed to value
managernent and employees need to be well informed about the value rneas-
ure. The value measur€ must be accepted as being fair.

lmplementing economic valus-based incentives in insurance is furthercompli-

cated by the nature of the insurance business. lnsurers make risk-taking .

decisions on an exarre basls - ie before risks are realised. An ideal incentive

system would reward decision makers for making the right decision exante
rather than reward them for being forh.rnate or penalise the6 for being unfor-
tunate. ln most cases. however. tlie performance of buslness units and
managers can be'measured'only on an expost basis - ie after risk is realised.
An ex ante system would also be difficult to justify to shareholders, and would
probably result in increased agency costs.

lmplementing an incentive system for insurers is also compllcated because

it should be based on the full downside of the risk as well as on the full
upside. Givin!managers who create.economic profits on an expost basis a
bonus, but not penalising those managers who produce negative economic
profits, gives managers a free put option. They can maxirnise the value of this
option by maximislng the amount of risk taken. But this behaviour leads to
poor operating efficiency and puts the solvency of the firm bt risk

lncluding the full downside of risks in an incentive system can be problematic.

particularlyfor low-frequency, high-severity risks. One soltrtion is to implement
a deferral system whero bonuses a16 initially paid into a trust and only paid
out to employees after a number of years. Negativa bonuses can then be
offset against any positive balance in'the bonus trust. ln effect the defenal
system averages outthe riskiness of economic profit h also encourages
employee retention if the trust is not paid out when the employee I'eaves the
flrm, However, the amount of smoothins that can be accomplished with a
deferml system is limited, since incentives lose their impact when the phyout
is extended far into the tlture. This is a particular dfficulty for long-tail busi-
ness, such as casualty and some life lines of business where even a five-year
defurral system is relatively shorl

2 7 sss 8* The econmlc of lnsuincs

 It is reasonable to base incentives on total economic profit for executives who
are responsible for a.diversifled poftfolio of risks. However. for line managers
at a lower level, the pofrion of total compensation tied to economic profit is
Iimited by the riskiness ofthe underlying business. For high-risk business,
which produces either losses or extreme proflts, it would be unacceptable to
base compensation entirely on economic profit

For employees below the line management level, incentives based upon tie
economic profit produced bytheir business units are less effective. This is
because the impact of an individual bn the performance of the group is dituted.
A more effective incentive system at this level would identily the drivers of
profit that an individual can impact and then link compensation to those drivers
only. For example, in companies where the underwriting function is separate
from the marketing function, it is advisable to implement a two-stage incentive
system. Underwriters calculate the economic value of insurance contracts.
This economic value is used as a benchmark to measure the performance of
the markoting unit Marketing staff are rewarded for selling insurance above
this economic value. Underwriters are rewa[ded lor producing ex artg risk
prices that are in line whh their ex posr costs. ln this incentive system, it is
important that the incentives for underwriters be symmetric - ie they are
penalised when the expost cost is either hlgher or lower than their ex arte
price. ln irractice, this implies a high baseline bonus that is subsequently
reduced to the extent that the pdce was higher or lower than cost

Compailson with other value measures

Embedded Value
The.embedded_value method is most popularwith British life insurance companies. lt
calculates the value of exis'ting business, termed in-force value, as the discounted
tuture statutory profrts that are expected to emerge on thls business. The risk dlscount
rate usbd in this calculatioh is intended to represent the insuier's overall cost of capital
and is typically around 3% above risk-free rates. The embedded value ls then given by
the sum of the in-force value and the market value of the i;tatutory shdreholder capital.
The reason given for basing fie embedded value calculation on statutory accounB is
that they determine when the capltal is avallable for distribution.

The embedded value method is a special case oithe economic iramework described
in this publication. lt can be derived by using expected earned rates on the backing
assets rathei than spot forward yields, by setting the rlsk capital costs to zero, and by
setting the i'egulatory capital cost to the difference between the risk discount rate and'
the exp,ected earned, rate. This indicates that the embedded value method is noi based
on ec6nomic principies for the following realohs: . .

Firstly, usiog the embddded value method, value is based on the ccimposrtion ofthe
.backing assets rather than on the ilsk characteristics of t'ne cash flows being valued,
This is because the projected statutory proftts are calculated iricoiporating expected
investment retums. Forexample, the proJected investment c'ash flows on corporate
bonds are assumed to be the future coupons multiplied by the irrobability that the
'
bond ls nor in default. As spreads on corporate bondS are typlcally greater than thelr
conesponding defuult probabiltties; the embedded value method generally places a
hlgher in-force value on business backed by corporate mther than govemment bonds.

28 Swtss Fe ths econfits of lNEncE

 The embedded value method creates a bias towards high-yield investm-'nts that is not
justified from an economic perspective. The value of the liabilities should be independ-
ent of the composition of the backing assets.

As a resutt, the embedded value method fails to respect a fundamental Princlple of

financial economics: thatthe cost of capital should depend on the use offundings and
should only depend oh the source of funding to the extentthat the source offundlng
affects frictional costs, such as tax and costs of financial diskess. Whether a project is
funded by equtty br debt should be largely irrelevant to its value, In so dolng, the
embedded value hethod does not properly account ior the difference between non-
diversiflable, or systematjc, versus diversifiable risk.

Secondly, the embodded value method lavies frlctional capital costs solely on the
basis of regulatory restrictions. lt does not expllcitly allow for fllctional rjsk capital costs,
Thus, in the extreme, if two lines of business were wTitten in different territories, the
one line belng virtually risk-free but requlrlng high regulatory reseryes, the other bding
risky but only requlring low levels of regulatory reserves. Then the embedded value
method would penalise the former line regardleSs of the level of risk lnherent in the
other Iine-

Thirdly, under the'embedded value method, the level of the regulatory capital charge is
highest for business backed by the lowest yielding assets. This would tyPically mean
thatthe least risky business would be allocated the highest frictional capital co!-ts.

Lastly, as the embediedvalue method is based on expected cash flows it does not
eaiily accommodate optioni and guaranti:es. The economic method properiy allows
for these by valuing thern based on a coireiponding replicating porffolio. Valuing these
options based on expected cash flows is likely.to understate their vali:e..

HAFOC
BAROC, or risk-adjusted return on capital, is a performance measure that is typlcally
defined as discounted economic profrt divided by risk capital, There are many different
variatlons to the name and calculation of this measore. h ls not inconsistent with the
economic framework outlined in this publication and cbn bi a useful steering measure
tf caphal rere a scarce resource.

lf capltal were plentitut. then the only criteria for accepting business should be whather
economic piofit ls positive. Converse[, ff capital were scarce, then it should be allo-
cated. to the projects that 6re expected to €arn the griiatest econofric Profit relative to
the capftal invested, Thls relationship is quantified bythe HAHOC measure and is
equivaleQt to piEfit targets based.on fisk capital.
1l*rtino
The diff'rculties with RAHOC measures tend tb d.ise bscause of the measures of profit
or capiial that are sometinies used. ln many cases, capital costs are not included in the
eco-nomlc proflt measure.,lnstead, they are lncorporated in a BABOC hurdle mte, This is
problematic.because th'rs approach impligitv assumes that all.capital.costs aB prcpor-
tjonate to economlc cafiital. Hbwever. t]ris is generally not the case foi regulalory and
tai iosts.

AnotherprobLm ;th the application of RAROC. hurdle rates lles in the way tlre hurdle
rate ii
calculated. ln mafi caies. the hurdle rate is measured using the CAPM modei.
As stressed preiziously;the baptal costs incurred is a resultofwiiting insurance risks
are primirily frictional ;apital costs. CapiEl cost measures based upon CAPM largely
lgnore these costs, stressing lnstead the base cost of capital that is primarily incurred
on the investment side ofthe business.
16 This is a consequ8nce of the Modigliani
and Miller prcposttions.

29 swk ReThe economlcsof lnsucne

 Some versions of RAROC also consider capital utilisation only in the initial year, This
tends to overstate the profitablllty of longer-term contracts. Properly constructed,
HAROC measures should include the discounted risk capital over the duratlon of the
contract. ratherthan just lnitiiil rlsk capital-

Some RAROC measures also discount expected retums at the expected eamed
investment rate, This approadh has similar problems to the embeijded value method.
h does not prdperly value systematic risk and it is biased towards higher yielding
backing assets, h is important that the rcplicating portfolio replicates the systematic
risk in the coriesponding cash flows. Note that risk capltal generally does not properly
accolnt for systematic risk because it ls measured rolative to the insurer's insolvency,
ratherthan market risk

If misinterpreted, FIAI]OC can also create incentives to talg excessive investrnent risL
When a company takes more investment risk the amount of economic capital allo-
cated to investment dsk rises and the amount allocated to insurance risks genemlly
falls. As a resuh. BAROC results for insurance units v/ill tend to iise ds.insurers increase
.their investrnent risk. However, this does not necessarily imply that the proftablltty of
the company has.increased.

4:6 Section appendix lncorporating all frictional items

To make the above example more realistic, tax company default risk. and
regulatory restrictions on capital should also be included. This is illustrated in
the financial statements shown below. These statements are based on the
original assumptions and further assume that statutory reserves are equal to
undiscbunted expected future claims and that in addition regulators require
minimum capital of 5 at inception and 3 attime l.

A tax rate of 35% has been used. where tax is payable on the statutory result
and is initially due at inception.

The allowance for the insurer's defauh option and liquidity valLie is assumed
to be an additional spread of 50 basis points. The impagt ofthis spread has
been included in the base cost of capital for the instrancd opemtions in the
income statement and under the assets in the balance sheet. As mentioned
previously, this enables the impact of a change in credit rating to be isolated
and excluded if necessary.

The income statement shows that the insurance operations achieved an eco-
nomic profit of 2.60 after tax, which is simply the pre-tdx profit of 4 less tax
at 35%. The investment operation achieved an economic proft of 0.78. which
is the pr+.tax outperformance of 1.20 less tax at 35%. The overall economic
profit is equal to 3.38.

3 0 s*s Re The aonomE ol lnsEnc€

 lncome statBment Total lnsunnce lnvEstment Treasury
PEmiums 50.00 50.00
lnvestment retum 12.00 4.63 12100 -4_63
Claims -25.00 -25.00
Expenses -2_00 -2_00
Change in liabilities - 2.14 -2■ 4
Beforetax resuh 32_86 25.48 12_00 -4.63

Tax -22_75 -19.71 -4.20 1.16

result 10.11 7,80

'Base cost o{ capital -5.84 -10.80 4.63

Doubla tartion 0.00 -2.62 3.78 -1.16
Bisk charge -0.50 -0_50
Begulatory chargf; -0.39 -0.39
Capital costs -6.73 -3.18 ―■02 3.47

Economic profit L.OV 0.78 0.00

Note thatthe investrnent retum allocated to the insurance function is consider-

ably higher than in the previous example. This largbly reflects the return on the
pofttolio that replicates the double taxaton payment As in the original simplF
fied example, this illustrates that the insurance function resuh is lmmunised
from changes in investrnent conditions.

ln addition, the llne 'rtem double taxation does not add any additional costs to
the insurer overall because tax on investment income is already included in
the tax line 'rtem. The double taxation line item is used to re-allocate the tax
incurred on the SAA benchmark to the lnsuranca and treasury functions.

The balance sheet shows that the total economic shareholder capital is 1 6.5 9.
Of this total, 4.59 cannot be realised r,n;,ithout infringing the regulatory restric-
tions and 12 can be reallsed without restriction. lt also shows the full breakdovrn
of the economic liabllities, including the default optlon and liquidity lalue,

Balance sheet
,4ssets
Investments 85_00
Default option and Iiquidity Elue 0.32
Total assets 85.32

UADilfuES
Discounted Iiability 66.04
Egense provisiore 0.94
Detered tax liability 1.O3
Double tax liability 0,33
Risk capital cost liability 9.35
Regulatory cost liability 0.04
Economic tiability (before detuult dption) 68.73
lg1lged sharcholder Gpha
Unrestricted ihareholder 12.00
liotal liabilrties

3 1 sr;i* n.. Ttr *onomt* d hsmncE

5 N/anaging risk and capital

Ivleasuring the economic value of insurance contTacts Tenders tmnsparent

the costs of producing insurance and thus reveals the actions insurers can
take to manage these costs. O{ particular importance is managing the cost of
taking risk, which is determined by frictional capital costs. These are often
a significant component in providing insurance coverage. However. they are
often managed inefficlently or.even ignored.

lnsurers have many opportunities to manage capital costs. F-or example,

diversification and hedging are toolb that can be used to lower the amount of
caphal a company needs to support insurance risks. Holding tax-efficient
investments. such as equities that allow tax deferral on capital gains, reduces
the cost of holding capital. Risk transfer to financial and reinsurance markets .
can also.be used effectively whenever the cost of taking risk is higher than the
cost of tran#erring risk

The assessment of most risk and capital management strategies iS compli-

cated by the factthatthey inevitably involve a trade-off between risk and
retum. For instance, investing in equities can save on tax expenses and resuh
in higher investrnent returns. bu.t can also involve tiking more risk and there-
fore increase capital costs. As a result. the abilityto quantifythe risk-return
trade-off on company value is a critical ingredient for effective risk and capital
management .

5.1 Drivers of the cost of taking risk

The goal of risk and capital management should be tb enhance operatJng
'
efficiency by minimising the costs of taking risk. This requires a deep under-
standing of the drivers of capital costs as well as the tools that insurers have
at their diiposal to influence those drivers. The sources ofthese costs were
discussed in previous sections. Here, we emphasise the drivers ofthose costs.

Base cost of capital

The base cost of capital is the benchrnark return on the asset portfolio less the
retum on the replicating portfolio. As a resuh, the base cost of capital depends
on the insurer's investment strategy. An insurer who invests his capital con-
servatively will have a lower base cost than one who pursues an aggressive
investrnent strategy.

However, the base cost of cdpital does not directly impact value creaion or
operating efficiency. This is because shareholders do not benefrtfrorn a strat-
egythat only changes the base cost of capital. ln principle. they could unwind
changes to the base cost of capital by making corresponding changes to their
own portfolios. For example, if an insurer switched from equities to bonds,
then shareholders could in principle nullify the impact of this by selling equiv-
alent bonds and purchasing equivalent equities in their own pbrtfolios. Share.
holders would only benefrt indirectly to the extent that the investment strategy
reduces operating and frictional costs. Though it obviously has an important
impact on the eamings ofthe company, the base cost of capital perse is not'
a driver of value creation. h just represents thi appropriate reward for the level
of f nancial market risks to which shareholders' capital is expoied and there-
fore merely provides a minimum benchmark for asset management

3 2 su* n" ThE Economle sf Insucncg

 Double tax
lnsurers in most counties pay tax on the investment income they receive from
their capital base. lnvestors could avoid this tax ifthey held these investments
either directly or in an investment fund. The tax payments on capital income
are a cost of holding capital in an insurance company and therefore are a cost
of mking risk

lnsurers can manage their double tax costs by their fnancing and investment
decisions. For instance, insurers can finance therlselves with hybrid equity,
which has the tax characteristics of debl blrt the risk characterlstics of equity.
They can also hold their investments in low-tax environments and invest in
assets that are taxed favourably. Even the choica of active or passive manage-
.ment styles influences the tax burden on capital income. These issues will be
discussed in more depth later.

Cost of financial distress

Taking lnsurance risk increases the probabllity that an insurer will experience
financial distress. Financial diitress can be costly due to both direct costs,
such as legal fees and lost value from distressed sales, and indirect costs, pri-
marily loss of reputation and franchise value. Generally, indirect costs are t}le
dominant source of costs from financial distress and so this cost is sensitive to
the size of the company's franchise value. Companies with a substantial fran-
chise value therefore have an incen{ve to control their risk level. This can be
achieved by either holdlng a greater amount oi risk capltal or by the use of risk
transfer.

An additional benefit of efflciently controlling risk is that it reduces the level of

noise or unnecessary volatility in fie profft and loss statement This is particu-
larly important because of the high level of agency costs ln the lnsurance
Industry. Eliminating noise helps insurers to clearly demonstrate their ability to
create sustdinable value.

Agency costs
lnvestors are naturally reluctant to allow someone else to manage their money
forthem.simply because there is always a possibilitythatthey may not man-
age the money in their best interest This is true for any investmenl but is
particularly important for an insurer because the insurance industry is not
transparent to outsiders. This makes it difficult for investoc to monitor the
decislon making of insurers. As a resuh investors demand a higher retum on
their caphal.

Beprrtation, transparency, and incentive structures are critical factors for

reducing agency costs. Reputation is a particularly importantfactorfor agency
costs. A long racord of doing the right thing with investors' money makes
investors more comfortable with the potential future decisions of the com-
pany. A good repLtation wkh investors is a valuable asset for an insurer and
can form a significant part of a company's franchise value. However, reputa-
tion needs to be constantly reinlorced because ofthe relative opaqueness of
insurance companies. Once shareholders lose confidence in management, it
is extremely diff cult to. lestore,

33 Sw疇 RcThoommm皓 of應 umce

 Transparency is improved by better and more timely, rather than more volumi-
nous, repbrting. There are limits to the amount of information that investors can
efficiently process and producing this information is costly. Moreover, client
confidentiality and competitor pressures limit the type of information that can
be disclosed. As far as the relevance of the infomation disclosed is concemed.
accounting proft and loss statements are notoriously bad indicators of value
creation for insurance companies, as investors are well aware. lnsurers have a
.long history of using numerous accounting mechanisms to smooth pro{its. This
may be advantageous in the short-term, but in the long run makes investors
distrustful and is likely to.be counterproductive. As a result, many companies
are now reporting their internal measurei of value creation to shareholders in
an effortto improve transparency.

,Agency costs can be further reduced if these internal measures are linked to
incentive compensation: this obViously assumes that the measures are valid
and accepted by shaieholders. This better aligns tile interests of managers
with the interes.ts of shareholders.

The scale of a company also impacts the transparency it can achieve because
large companies aTe more likely to get press coverage and be {ollowed by
financial analysts. Financial analysts spend a great deal of time sorting
through accounting statements trying to get a better. picture of shareholder
value creation that they then pass on to shareholders.

Lastly, the life cycle of the company is an important determinant of agency

costs. Young companies have typicatly not had a chance to establish a reputa-
tion. Because they are generally small. it is a]so harder for them to get their .

message across and so transparency suffers. This creates a considerable

barrier to entry ln th6 insurance market

Begulatory capital costs

Regulators impose restrictions on the level of capital held to support insurance
business. These restrictions result in potential liquidity costs because this capi-
tal is not readily available to support other lines of business.

The primary driver of this cost is the regulatory environment the business is
written in. To a limited extent, insurers can exercise control over this cost by
effi cient risk transfer.

5.2 Risk and capital management main issues

The process of risk and capital management can be broken down into three
basic decisions:

How lnuch capital to hold? How much capital does the company need to operate
efflciently? What can be done b manage regulatory and rating agency require-
m-ents? How can the company be steered to improve diversification? Can tle com-
pany opeErE more efficiently by transfening riskto financial or reinsumnce markets?

What type of capital? ls equity the only option? How to invest.capttaP Should
the company mismatch asseb and liabilities? How much market risk should it take?

34 swtss ne ]l1e sonomlG o,lnsurancs

 All these decisions are critical factors in determining the cost of taking risk, and
companies that properly manage them will have a competitive advantage.
However, making the right management decisions is not always easy, since it
generally involves muttiple trade-offs. For example, investing in equities rather
than bondi can lower the tax burden on investment income, but can also
increase the amount of capital the company needs to hold. Or, all else remain-
ing equal. holding more capital reduces the cost of fnancial distress but
incrbases double taxation costs. Having a framework for measuring the impact
of risk and capital management decisions on the cost of taking risk is therefore
an invaluable decision-making tool.

An integrated approach to risk and capital management

Most risk and caphal management decisions must also be made centrally.
The cost of taking risk depends on the risk and capital structure of the entire
firm, not on single operating units or lines of business. Allowing business
units to make unilateral decisions oh issues. such as reinsurance programs or
caphalisation, can result in one business.unit offsetting the decisions of other
business units. This will result in higher overall costs.

As a result, the traditional separation of risk and capital management decisions

into virtually isolated treasury risk managemenL and investment managBment
functjons is likely to result in inefficient risli and capital managoment.

5.3 Amount of capital required

From an economic perspective, the right amount of capital is detqrmined by
balancing benefits against costs. Although holding as litde capital as posslble
will certainly lower double tax, agency costs, and increase the value of the
option to deFault on eisting liabilities, itwill also keep away profitable clients,
who are credit-sensitive, and puts the franchise value of the firm at rislc
Conversely, holding too much capital will increase frictional c?rpftal costs to
a point where. in spite of the increased financial strength, policyholders will
not be willing to pay the higher premiums needed to cover.them. These
considerations need to be carefully weighed up to determins the optirnal
amount of capital that maximises company value.

As shown in the graph below this depends critically on the size of the insurer's
franchise value. If an insurer has little franchise value. then it can o:tract value
for shareholders by minimising the amount of capital held. This increases the .
value of the shareholders'optlon to default on the existing insurance liabiiities.
HoweVer, this relationship is well understood by reguiators who generally pre-
vent this itrategy from being pursued.

In the more normal situatjon where an insuier has a substantal franchise value,
the level at which poliryholders are prepared to pay the highest margins largely
deGrmines the optimal level of capital. This is a complex decision and requires a
thorough understanding ofthe preferences ofthe target client market. This deci-
sion is frequently driven by mting agency requirements, which creates $e need
to efficiently manage the level of capital required to secure a particular rating.

35 smsna:TtrE gconomtGof kBmcs

 Other important considerations in determining the optimal level ol caphal have
already been discussed: they include the value of the defuult option and the
level of frictional capital costs. Holding more capital reduces financial distress
costs and decreases the value of the default option, but increases double tax
cosb. and alency costs. ln principle, a model of all these costs should be
constructed to determine the optimal level of capital.

Optimal
Caphal costs
●ョ一

too high
”＞ ●り一

Put option
〓ＯＣ●﹄﹂

I
Franchise
１ １ １←

at risk

Capital

lnsurers have two tools at their disposal for managing their overall level of risk
and consequentlythe amount of capltal they need to hold: diversification and
isk tansfer

Diversification
By pooling independent risk, insurers can reduce the riskiness oftheir balance
sheet Eifectively managing diversification, however, can be a challenge.

When market units price and write business, they need to know ahead of time
how the risk they are underwriting diversifies with the other risks on the
company's books. Risks that diversify well are less costly for the company to
underwrite than risks that do not. lf risks werc written one at a time, this
would not be ditficult to measure. However, market units within an insurer all
write business simultaneously, so that a capital and capacity planning cycle is
necessary.

Atthe beginning of this cycle; risk and capital managers, togetherwith market
units, must decide how much of a particular risk will be undervwitten in the
course of the planning cycle. A capital plan must also be developed to support
those risks, whether the risk will be kept on the books of the insurer and
backed with caphal ortransfened via financial or reinsurance ma*ets. Based
upan this plan, the expected cost of taking various risks may be determined
and these costs may be included in actuar,ial pricing.

36 s.s as Th€ aconodBdNEncE

 lnsurers will inevitably deiviate from the plan as market conditions change.
which will impact the cost of taking risk For performance measurement pur-
poses, it is.not appropriate to change the level of frictional costs for market
units ifthey have no control overthese deviations. However, when a market
unit deviates from the plan - eg by writing more, or less, business than
expected - that market unit should bear the full costs of the deviation.

The time horizon of the capltal and capacity planning process should be long
enough to allow market units to implement a business plan. and short enough
to keep the company sufficiently flexible to react to changing market condi-
tions and opportunities.

Bisk transfer
Risk transfer can be used effectively as a capital substitute whenever the cost
of fansferring risk is lower than the cost of keeping that risk on the company's
books. Risk can be transferred elther to financial markets or to TeinsuTance
markets.

Bisks can be transfened to financial markets by hedging or securitization,

depending on the type of risL Systematic risk embedded in Insurance liabill-
ties. for example interest rate rish can be hedged by taking offsettlng posF
tioris on the asset side of the balance sheet ln many cases, the offsetting
position is a simple long position. For more complex risks, howevet the offset-
ting position may k]Volve deriyatives, for instance in tre case of life contr'acts
with a guaranteed minimum retum. lnsurers have the option of purchasing
those derivatives from derivative houses or else constructing those derivatives
themselves through the use of dynamic hedging. The choice should b6 based
upon both transaction costs and on whether the company wishes to avoid
potential dynamic hedging risk

Securithation can also be used to transfer insurance risks to financial markets.

The value proposition for securjtization is clear. Due to thelr immense size,
financial markets have enormoLls potential for diversifying rish which enables
them to hold that risk.without incuning the potential costs associated.with
fnancial distress. Packaging insurance risks togetherwith capital to support
the risk into a security and then floating that security on financial markets alsb
gets that capital out of tre double.tax insurance environment

Agency costs, howevec pose a formidable banier to the realisation of securiti-

zation's potential. Insurers will always know their portfolio of risks better than
outside investors, especially those notfamiliar with insurance risks. Conse-
quently, there is always the adverse selection risk that insurers will try to
transfer only unfavourable risks, keeping favourable risks on th.eir books. The
sizeable risk premlums that the ma*et cunently demands for lnsurance
securitizations clearly demonstrates that irvest:rs are not yet comfortable
investing in and managing insurance risks directly. Apparently, they preferto
take those risks indirectly by holding shares in insurance companies, thereby .

allowing insurers to manage lnsurance dsk for them and avoiding moral
hazard problems. Despite the clear advantages of securitization, this market

37 swks 8a:Iha acononts oilnsEnce

 will not take off until a dedicated class of insurance-risk investment managerc
develops.

lnsurers can also reduce their cost of taking risk through the use 6f reinsur-
ance. The value proposition for reinsurance is well developed. Professional
reinsurers are specialised in obtaining a low cost of taking risk. They generally
are well'diversified and have large capital bases, good access to capital
ma.rkets, and expertise in carrier management to minimise tax and regulatory
bu rdens.

Direct insurers can, of course, obtain all of those characteristics themselves.

and some global insurers have already done so. Theability to transfur risk to
reinsurers and leverage their low cost of taking risk, however, enables compa-
nies to maintain a focus on geographic regions and lines of business where
they create the most value, without putting themselves at a disadvantage in
terms of their cost of taking risk

Risktransfer in reinsurance markets does involve costs, however. Transaction

costs are high and moral hazard and adverse selection problems reduce the
efficlency ofthe reinsurance market. However. new reinsurance structures are
targeted at reducing moral hazard and.adverse selection problems and allow
insureB to transfer only the risks that are most costly for them to keep. Better
use of information technology is also reducing transactions costs and.resulting
in a more competitive market.

Signalling capital
Signalling caphal refers to capital in excess of economic capital that insurers
must hold in cjrder to satisfy external requirements. such as regulatory or rating
agency requirements.

Hegulators and rating agencles musi apply simple and universally applicable
capital requirements. ln addition. they preferto er on the conservative side.
As a result, lt is somdtimes the case that regulators and rating agencies
require more capital than is economically justified. Insurers can manage the
amount oJ signallirig capital by choosing to transfer risks where extemal
requirements are onerous. Beinsurance and accounting structures also exist
that reshape risks into a more regulatory and rating agency-friendly forrn.

38 sws na The
"onomls
oflnsuEncr
 5.4 Type of capital required
lnsurers hold capital to increase their ability to pay their insurance Iiabilities
even under adverse circumstances. Insurers have an increasing number of
choices for how they finance.that capital. All of these choices vary In terms of
both the cost of holding that capital and the security thoy provide. As a result
the optimal-capital structure will be a trade-off between the amount of capital
the company must hold and the frjctional costs of holding that capital.

Equity
Equity is the saiest {orm o{ capital since shareholders cannot demand divldend
payments, nor can they demand repayment of their capital. However, because
of disadvantaQed tax treatment. it is also the mbst expensive form of capital.
Corporate profhs, which accrue to share investors, aro taxed whereas interest
payments. Which accrue to bond investors, are treated as expenses and are tax
deductible.

Debt
Senior debt iinance cannot be used to support insurElnce risks since in the case
.of defuult senior debt is repaid firsl Debt that is subordinated to insurance
liabilities could in theory be used to suppon risk taking. However, in practice,
it is seldom used. {or a numbdr of reasons. To support risk taking, the subordF
nated debt must be longer in durdtion than insurance liabilities. ln practical
terms, this means that subordinated debt must be continually recalled and
new longerduration debt issued. ln general. regulaton and rating agencies
also do not treat this debt as risk-bearing caphal.

Hybrid debt and equity

New classes of debt and equity have been developed ln recent years. These
new formi of finance are collectively refened to as hybrid and they blur the
traditional line between equity and debt. ln general, though, the objective of
these new structures is to get the tax treatment of debt and the risk character-
lstics of equity.

There is a wide range of hybrid structures. Which structure an insurer uses

will depend cin ihe tax and r6gulatory environment. ln general, though, there
are limits to how much hybrid debt or equity an insurer can use. Few of
these structures are true perpetual sources ol capital. They will eventually be
redeemed, so they do not provide tre same level of security as equity capital.

Contingent capital
lnsurers also have the.option of ananging for contingent capital - contractu-
alV obligated investments that trigger under pre.defined condhions. The
advantage of this sort of financing is that the capital is kept off balance sheet
and so is'not subJect to taxation. By using contingent capital, however, the
insurer exposes itself to credit risk of the contingent capital provider. Regula-
tois therefore often lirnit the amount of contingent capital an insurer may use
to support risk taking.

39 SW“ R『 ヽDE"mmい rmm

0“ 口
 5.5 lnvesting capital
The third key issue of risk and capital management is concemed with deter-
mining the optimal investment strategy.

Market risk
Due to an historical focus on reporting accounting profrts, insurers have often
invested in high-yield products. The value proposition for yield. however, is
unclear since to get a higher yield, the insurer must normally take additional
risk and will incur additional frictional costs as a result

The market risk that an insurer takes is passed directly on to shareholders who
could have invested in these instruments directly..lnsurers can therefore only
create value bytaking market risk if investors preferto have an insurer manage
these investments for them despite the fact that they w,ll be surrendering
control of these investments which, in addhion. will be held in a regulated and
'taxed vehicle. As this is not likely to be the. case, this suggests that insurers
should focus on thelr core competency of originating and managing insurance
risk by hedging market risk as iar as possible. However, another consideration
to be taken into account is that other frictional costs may create incentives for
insurers to take investment risks.

Tax on investment ihcome

ln many cases, the biggest capital cjost an insurer incurs is the tax payment
on capjtal income. Howevec there are many opportuniiies for an insurerto. .
manage this cost through the choice of investments and management style.

Tax codes can differ greafly from jurisdiction to jurisdiction. However, in most
countries capital gains are taxed preferentially to ihvestment income. The
nominal tax rate on capital gains is often .lower ln some countries capital
gains are not taxed at all. Caphal gains also carry the benefit of defenal since
they are only taxed at realisation. By postponing the realisation of capital
gains, insurers can gain the time value of money on their defarred taxes.

The amount gained by deferml ofcaphal gains depends on how long capital
gains are defered and on the pre\railing interest rate. The graph below shows
the effective tax rite on capital gains as a percentage ofthe nominal tax rate
for varying realisation rates and interest rates. lf an insurer is very aggressive
about postponing the realisation of gains. the tax rate can be reduced suF
sfantially. For inshance. if the insurer realises just I 0% of unrealised gains each
year - an average investment horizon of just under 1 O years - the effective
tax rate drops to two thirds of the nominal tax rate. Reducing the realisation
rate to 5% - average investment horizon of 1 5 years - cuts the effuctive tax
rate to about half the nominal tax rate.

40 swna Th6r@nomlcsof lGuEncB

 Interest Ete

０
０
％
-4%

８
０
__

％
-5% 6%

■■ 主 ●Ｅ・

６
０
％
●“ｃＬ Ｘｃ” ｏいつｏｐ〓ロ

ＥＯｒい

４
。
％
ｏメ ︸

２
０
％ ｉ
０

I I I I I I I 1 1
1O0% 80% 500/6 40% 2O'/" Ooh

Capital gains Ealization rate

P/6 of tqtal unrealiad gains)

Favourable tax treatment of capital gains does create an incentive for insurers
to invest in equities. Howevet investing in equities generallY m6ans taking
more market risk and this creates additional frictional capital costs which will
offset some, if not all. of the gains from lower tax rates.

Uquldity
Anotherfrictional consideration in determining an insurer:s optimal investment
strategy is liquidity. Insurance is a cash-rich industry. The cash flow in from
premiums and investrnent income is often signmcantly greater than the cash
flow outfrom claims and expenses. ln addition, insurers usually keep large
amounts of liquid assets on their balance shaet. As a result, many insurers
have more liquidity than they need to suppoit their.business.

lnsureTs can extractvalue from this excess liquidity by investing in illiquid

investments, such as corporate bonds, private equity, and restristed public
equity. These assets retum a hlgher yield to compensate investors fortheir
illrqurotty.

It is important to note that though nobod denles the existence of a liquidity

premium in asset retums, opinions vary widely as to its order of magnitude.
The difficulty in establishing the size of the liquidity premium is mainly due
to the fact that illiquid instruments usually also carry other risk sueh as credit
risk making it difficuh to objectively attribute the spread over govemment
bonds to any particular factor.

The additional market risk containpd in illlquid investments also needs to

be covered by risk capital. The fact that h js impossible to capture the liquidity
premium without incurring other risk means that the premium needs to be
weighed against the frictional coss implied bythe additional risktaken.

41 sdss Fe fhe e.m@16 of ln$mce

Mean variance optimisation
It is also important to manage the diversification of investments in such a way
that the investment risk taken by the company is efficient in the sense that. for
a given level of market risk the chosen portfolio yields the highest expected
return. OtheMise. the company will be taking unnecessary investment risk
This efficient portfolio can be identified using a Markowi? mean variance type
approach. lt is important. though, thatthis analysis is done net of liabilities
and net o{ taxes.

ln general. because of regulatory and rating agency restrictions, it will not be

possible to be on the "efficientfrontrer', so companies must strive for the best
possible portfolio.

42 s.g Befn" oltnsu@@

""onoDlcs
 References

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“vin McGmν
Sαond Edition(Bostoru l● “ ■Hll) "ea｀
ρ
"cace′
Derag′ R.′ し,andに Ostaszewsk,1997 Managing tneは liabl■ y ofa
pmper″ _nabl ty lnsurance cOmparγ ,″ ,θ ノ
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η″ο
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,″ οθ .

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g οFaa"蒟pヵ θ″Sん (Chl∽ gO:The
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comitee on iE@nce lLondon: lntemational Accounting Standards
Committee)

43 swbs ReTli" eonomtcof hiuEnc.

John Hancock Paul Huber Fablo KDch
GEup Rlsk Matragement Financial lvlanagemert Group Risk Management
John Is Deputy Head ofth€ Ouailti€tive Paul is afinancial officer in Swiss Be'i Pablo ls Head o, Ouaditative Risk
Risk Manaoemrnt Mdhods grcup within Financial ManaEement and lnvesor Management Methods wlti Swiss Re's
Swiss Re's Goup Risk Managemem Reldions unit" Specialising in Llfe & Group Risk Management unit Be{ore
unil Prior to joining Swiss FE in 1998, Health and Eludio[ related topics, he loining Swiss Be in 2000, he mrked for
John @rked for the World Bank and has been engaged in a numbsr of *E- J.P. Morgan in Zurlch and held seveEl
8FA a conslEnt to the bankjng indus- tegic projecB. including acqulsitions, dsk msnagemeil related poshions
fy on credit dsk managemert issus. pricing, securitization and ffitegic within the \Mdedhur lnsuEnce Goup.
John holds Ph-D. and BA degrees from asset allocation, etiorto joinlng Swiss . Pablo holds a Ph.D. in Mathemetics from
the UniwGlty of PenEylvania, where Re ln 1998, Paul worked for the fund the Universlty of Zurich- PEviously, he
he speciallzed in iinance, and an MA ln manager Gaffiore and forthc life has publlshed on mathematical, optlon
eonomis lrcm GeorgBtom Univecity. asurer Old Mdual. He holds a Ph.D. th@retj@l and insuEnce bpics.
in Bctuarial science trom the Clty Uni-
veBity in London and a B.Sc. lrom the
Univ€Eity of the W'rtffile6rand, South
Africa. He ls a Fellow of t|e lnsim
ol Acilaries,

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The economl€ of lnsuancq Hm insurcrs

cE# value tor sh@holders (2001);
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Noh-prcportlonal ElnsuEnce ac@uft ing
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The rurcff phenomenon ('1998);
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Tide
The 6conomics of insunnce
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(2d edhionl

A!tho6:
John Hancock Pa{l Huber, Pablo Koch

GEphic design:

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UC, Technical Communicatons,
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