Chapter 8 Insurance Pricing

Prof . Deepak Tandon

IILM Gurgaon
 Insurance Costs and fair
premium

 Premium received to cover the

Expected Losses and
administartive costs
 Expected profit for compensation
of cost for sale of coverage
 Fair Insurance Premium = EL costs +Investment Income
+Administrative costs + Fair Profit Loading
 Points to be taken care

 Insurance Companies want to make

money or avoid losing money
 Insurance buyer are looking for low
premium and good quality of coverage
 One or more insurers can predict
differences in expected claim costs across
the customers at a sufficiently low cost
 Low Premiums = Cost Based Prices
 Risk Classification + Class Rate Customers
 Claims paid

 Claims paid at 1 year $100 how much

money needed for collection to pay
 P+rP=P(1+r)=100
 P(1+r)=100 100/(1+r)=P
 2nd Year
 P(1+r)+ rP(1+r)=100
 P+rP=100/1+r Divide again by 1+r
 P=100/(1+r)^2
 DEPOSIT INSURANCE
Method I: Equity Price
Experience
 Deposit insurance can be modeled as a put
option on the bank’s assets (Merton, 1977)
 Input parameters:
 Volatility of equity returns
 Bank leverage (market value of equity over debt)
 Degree of regulatory capital forbearance
 Limited application:
 Need market valuation of the bank’s net worth
(listed banks in market-oriented countries)
 Method II: Default
Experience

 Expected loss pricing

Expected loss=Expected default probability*Exposure*Loss given
default

 Expected loss = Size of the loss to the deposit

insurer as percentage of insured deposits
 Expected default probability = The bank’s
estimated probability of default
 Exposure = Amount of insured deposits
 Loss given default (LGD) = Loss to deposit
insurer as a percentage of the total defaulted
exposure
 Estimating LGD

 Historical experience of deposit

insurer
 US FDIC’s historical loss rate equals
8% of bank assets
 In developing countries, loss rates
of 50 % and up are typical
 Good indicators: loan concentration,
business mix, structure of bank
liabilities
 Estimating Default
Probability

 Historical default probabilities

 Implied by historical losses of the deposit insurer
 Implied by a bank’s credit ratings on deposits
 Implied by a bank’s interest rates on uninsured
debt (e.g. interbank deposits, subordinated debt)
 p=(y - rf )/(1+y), where p is probability of
default on default risky debt, y is the yield on a
zero-coupon default risk debt, and rf is the yield
on a zero-coupon default risk-free debt (all with
the same maturity)
 Pricing Design Features

 Ex-ante funding vs. ex-post funding

 Flat-rate premium vs. risk-based premium
 Levy on total deposits vs. levy on insured
deposits
 Broad coverage vs. narrow coverage
 Coverage limit
 Co-insurance
 Include or exclude foreign-currency deposits
 Comparing Design
Features

Design feature
 Coverage limit  3.2 times per capita
GDP
 Co-insurance
 28% of countries
 FX deposits
 68% of countries
 Interbank deposits
 26% of countries
 Funded
 87% of countries
 Management  51% of countries public
 Compulsory  87% of countries
membership  41% of countries
 Risk-based premium
 Insurability

 Insurability of a risk is greater if:

 Losses occur with a high degree of randomness
 Maximum possible loss is very limited
 Average loss amount upon occurrence is small
 Losses occur frequently
 Insurance premium is high
 Possibility of moral hazard is low
 Coverage of the risk is consistent with public policy
 The law permits the cover
 Insurance Coverage and
Premia

 Cost of deposit insurance can be dramatically

reduced by reducing the coverage of insurance
 Reducing the coverage reduces (at least)
proportionally the deposit insurance cost
 Reduction in actuarially fair premium could be larger
if the reduction in the coverage reduces the asset risk
of the bank
 Since the per dollar premium is higher with higher
asset risk, limiting the coverage has a larger impact
on reducing the cost of deposit insurance in
developing countries
 Risk Diversification and
Premia
 Non-systemic risk can be diversified away by
pooling assets of banks
 Potential for risk diversification is larger in:
 larger countries; countries with many banks; countries with
different types of banks (ceteris paribus)
 Price of deposit insurance of a group of banks is
lower than the weighted average of the price of
deposit insurance for each individual bank
 Case-study: Korea. Fair premium (% of deposits):
 2.81%, if measured as weighted average of individual
premia
 1.44%, if measured as a pool of assets
 Risk Differentiation and
Premia

 Exclusion of risky banks can significantly

reduce the cost of deposit insurance
 Unless some of these banks have great
diversification potential
 Case-study: Korea. Fair premium (% of
deposits):
 1.44% (if measured as a pool of assets) – all
banks
 1.28% (if measured as a pool of assets) –
excluding the three riskiest banks (in terms of
equity volatility)
 Is Deposit Insurance
Underpriced?
 For comparison purposes, estimated fair premiums
should be expressed as a percentage of insured deposits
 Estimated fair premiums are higher than actual
premiums in many countries – even if estimated on the
basis of conservative estimates
 On the basis of equity prices:
 No capital forbearance: 5 out of 21 countries (24%) underpriced
 With 3% capital forbearance: 9 out of 21 countries (43%) underpriced
 On the basis of bank credit ratings:
 8% loss rate: 5 out of 32 countries (16%) underpriced
 50% loss rate: 22 out of 32 countries (69%) underpriced
 Pricing the Adoption of
Deposit Insurance: The
Case of Russia
 Alternative methods:
 Compare with actual premiums and historical losses in
other (comparable) countries
 Estimate actuarially fair premium on the basis of the
discussed methods
 Take design features into account
 Estimates of fair premium for Russia are higher
than the proposed premium of 0.6% of deposits
 Default experience suggests a premium of about 4%
 Equity price experience suggests a premium between
about 2% and 4% (or even higher depending on the
enforcement of capital rules)
 Conclusions

 Explicit deposit insurance should not be

adopted in countries with weak institutional
environment
 Pricing deposit insurance as accurately as
possible is important, but not easy
 However, there are several methods that can
help in estimating actuarially fair premiums
 There exist several design features that can
limit the cost of deposit insurance