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
