Risk, Capital and Profit in Insurance

An insurer remains solvent as long as assets exceed liabilities in value. Both assets and liabilities fluctuate in value in an unforeseen manner. An insurer with no margin in the value of its assets over its liabilities is therefore exposed to failure. The chance of failure is reduced if such a margin is created. This margin may be recognised as net assets, or capital. Capital is not a costless commodity. As will be seen in Section 6, it needs to be financed partly from premiums paid by policy owners. The components of premium providing this finance will appear as profit margins. Thus, there is a fundamental relationship between solvency, capital and profit. Policy owners, taken in the aggregate, suffer a loss, consisting of unpaid claims, when their insurer becomes insolvent. They will therefore be willing to contribute some level of profit margin to support capital which protects against insolvency. There is, however, a limit to the level of capital they will willingly support. This level will be reached when the incremental cost of capital (in terms of premium margin) exceeds the value provided by it in the increased policy owner security. In a free and rational insurance market, levels of capitalisation and profit margins should settle, at least on average over a medium term, at values which reflect this balance between security and the cost providing it. In order to understand fully the relationship between solvency, capital and profit, it s necessary first to understand: - The sources of risk which threaten solvency; - The relation between capital and solvency; - Market levels of capitalisation; - The relation between capital and profit margins. These subjects are examined in Sections 3,4,5 and 6 respectively. The calculation of equilibrium capitalisation of insurers with different distributions of underwriting by line of business, and the associated profit margins, addresses one of the unsolved problems of insurance pricing. This concerns the amount of capital which should be regarded as supporting a line of business ("alocation of capital") in so-called "fair-pricing" of that line. This subject is pursued in Section 7. A numerical example is given in Section 8.