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Insurance Capital as a Shared Asset

Published online by Cambridge University Press:  17 April 2015

Donald Mango
Donald Mango*
Affiliation:
GE Insurance Solutions, 6 Hunt Lane, Gladstone, NJ, 07934, USA, Tel.: +1-908-234-1756, Fax: +1-908-234-1690, E-mail: don.mango@ge.com
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Abstract

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Merton and Perold (1993) offered a framework for determining risk capital in a financial firm based on the cost of the implicit guarantee the firm provides to its subsidiaries to make up any operating shortfall. Merton and Perold assume the price of such guarantees is observable from the market at large. For an insurer, this may not be a realistic assumption. This paper proposes an insurance-specific framework for determining the cost of those parental guarantees, and utilizing that cost in pricing and portfolio mix evaluation. An insurer’s capital is treated as a shared asset, with the insurance contracts in the portfolio having simultaneous rights to access potentially all that shared capital. By granting underwriting capacity, an insurer’s management team is implicitly issuing a set of options to draw upon the common capital pool — similar in structure to letters of credit (LOC), except they are not loans but grants. The paper will (i) discuss the valuation of parental guarantees, beginning with Merton and Perold; (ii) treat insurer capital as a shared asset and explore the dual nature of insurer capital usage; (iii) offer a method for determining insurer capital usage cost; and (iv) demonstrate how this method could be used for product pricing and portfolio mix evaluation using economic value added concepts.

Keywords

Merton-Peroldcapital allocationcapital consumptioneconomic value added
Type
Workshop
Information
ASTIN Bulletin: The Journal of the IAA , Volume 35 , Issue 2 , November 2005 , pp. 471 - 486
Copyright
Copyright © ASTIN Bulletin 2005

References

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Ruhm, D. and Mango, D. (2003) A Risk Charge Calculation Based on Conditional Probability, presented at the 2003 Thomas P. Bowles Jr. Symposium; available online at www.casact.org/coneduc/specsem/sp2003/papers/ruhm-mango.doc. Google Scholar
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