Capital Allocation and the Price of Insurance Discussion

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Capital Allocation and the Price of
InsuranceDiscussion
Financial Services

• 11 July 2007

Andrew RearBerlin
CONFIDENTIAL www.oliverwyman.com
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Review of paper M A activity of insurers
increases diversification benefits and decreases
the prices charged by the merged entity

• Core of the work presented by Jeungbo Shim is an
  empirical analysis of capital allocation and
  prices charged by insurers following MA activity
• In the M A transactions under consideration,
  economic capital requirements (in terms of
  capital-to-liability ratios) have been reduced
• Bigger portfolio, hence more diversification
  benefits
• Confirmed by outside-in-analysis of respective
  insurers
• Following MA activity, insurers have decreased
  their prices
• Due to lower capital requirements when accounting
  for higher diversification benefit
• Work establishes empirical link of business
  units change in prices and their change in
  capital requirement (using a marginal capital
  allocation approach) following MA activity

Diversification matters and is reflected in
pricing
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The results of the work are in line with industry
practice and trends
Accounting for diversification in determining
required capital . . .
. . . and using required economic capital in
pricing decisions

• Many insurers capture diversification benefits in
  their internal capital models
• Solvency II will also account for diversification
  benefits
• New SP capital model also adjusts for
  diversification effects

• Many insurers have developed risk-adjusted
  pricing frameworks
• Economic return is compared to economic capital
  requirements
• Often based on economic capital requirements
  after diversification benefits
• MCEV also accounts for required economic capital,
  in particular for unhedgeable risks

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The business question How far should this go?
Is diversification always good?
How far should you reduce pricing

• Reduced capital requirements are a competitive
  advantage
• but there are two pitfalls
• Expertise
• Investor surprises

• Pricing is the mechanism through which
  competitive advantage is demonstrated
• but does rational pricing behaviour prompt an
  apparently irrational pricing cycle?

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