Value Creation in the Insurance Industry

Authors

  • John Hancock,

  • Paul Huber,

  • Pablo Koch


  • 1

    In this article the generic term insurance encompasses reinsurance.

  • 2

    In its August 1997 report European Insurance: Paying Claims to Value-Based Analysis, Credit Suisse First Boston writes: ``Traditional measures such as EPS (Earnings per Share), are easily influenced by accounting practices, and do not incorporate risk or the time value of money. Furthermore, in our opinion they do not help investors to understand the intricate process of value creation. Value destroying growth can be simultaneously achieved with EPS growth'' (Banger, 1997).

  • 3

    See the International Accounting Standards Board's Insurance Issues Papers available at its Web site (http://www.iasc.org.uk).

  • 4

    Embedded value is the discounted value of statutory profits expected to arise in the future from business in force at the valuation date, together with the value of shareholders' funds.

  • 5

    RAROC adjusts the returns of an insurer or bank for risk and puts it in relation to used capital.

  • 6

    A leveraged investment fund is an investment fund that finances the purchase of financial assets partly by fund holders' capital and partly by debt (leverage). The analogy of an insurance company to an investment fund is captured nicely in the following quote from the January 16, 1999, issue of The Economist: ``When world stock markets took a summer plunge, insurance shares dived twice as far. When equities recovered in the autumn, insurers also rose faster than the market. This amplification of movements in the stock market helps to explain two things. First, why investors in insurance are biting their nails these days as Wall Street, once again, is looking vulnerably overvalued. And second, how shareholders really think of insurance companies: as little more than highly leveraged investment trusts'' (The Economist, 1999, p. 61).

  • 7

    Net asset value denotes the market value of assets less the economic (market) value of liabilities (debt).

  • 8

    This is not always the case, as the examples of many life insurance products show.

John Hancock is the Deputy Head of the Quantitative Risk Management Methods unit within Group Risk Management at Swiss Re. Paul Huber is a financial officer within the Financial Management unit of Swiss Re. Pablo Koch is head of the Quantitative Risk Management Methods unit within Group Risk Management at Swiss Re.

Abstract

Using the insights of current research in corporate finance and financial institutions, the authors briefly present a consistent economic framework for looking at insurance. Shareholders of insurance companies provide risk capital that is invested in financial assets and therefore earns the market return of the assets it is invested in. However, due to the legal and fiscal environment insurance companies are in, they have a competitive disadvantage at investing, and this gives rise to frictional capital costs. The core competence of insurers is in managing the size of these frictional capital costs. Insurers must ensure that they can sell insurance for a price in excess of what they need to produce the cover they sell and compensate the incurred frictional costs on risk capital. It is through the ability to do so that insurers create shareholder value.

Ancillary