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Nicole Seaman

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Learning objectives: Calculate and interpret loss ratio, expense ratio, combined ratio, and operating ratio for a property-casualty insurance company. Describe moral hazard and adverse selection risks facing insurance companies, provide examples of each, and describe how to overcome the problems.

Questions:

703.1. In its annual report, Acehouse Property-Casualty presents a summary of selected key ratios (but where we've hidden four of the values):



Each of the following statements it true EXCEPT which is false?

a. The Expense Ratio of 30.0% includes loss adjustment expenses
b. The Expense Ratio of 30.0% includes marketing expenses and commissions paid to brokers
c. Because its combined ratio is greater than 100.0%, Acehouse is NOT a profitable business
d. For each $1.00 in premiums received, Acehouse pays out (and/or reserves for payouts) about $0.75 in claims to its customers


703.2. Two of the key risks facing insurance companies are moral hazard and adverse selection. Three of the following examples are illustrations of moral hazard, but one is an example of adverse selection. Which is the example of adverse selection?

a. An individual buys health insurance and consequently increases their demand for health care services
b. A cell phone owner buys a "total equipment protection" insurance plan and, consequently, becomes more careless with the phone
c. Because it is backed by a government-sponsored deposit insurance plan, a bank is less worried about losing depositors and consequently it takes on more risks
d. A health insurance company is mandated by government to offer the same price (premium cost) to all new customers so that it cannot increase the relative price of riskier customers and consequently it attracts more high-risk customers


703.3. Catastrophe (CAT) bonds are a popular derivative instrument for hedging catastrophic risk. A CAT bond pays a higher-than-normal interest rate and is often issued by a subsidiary of an insurance company. Each of the following is TRUE about the features of a CAT bond EXCEPT which is false?

a. For an insurance company, issuing CAT bonds is an alternative to reinsurance: the interest or principal can be used to meet claims
b. CAT bonds tend to have little or no correlation to market returns such that their total risk can be diversified away in a large portfolio
c. A drawback of CAT bonds is the covered loss depends on a definition of "catastrophic loss" which is inevitably subjective and qualitative so that the issuer's basis risk is high
d. An inevitable feature of catastrophic risk is that the loss events are highly dependent on each other; the loss events are not independent and usually they are not even nearly independent

Answers here:
 
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ZOAL

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703.1: a) because loss adjustment expenses are related to claims or technical.
703.2: d)
703.3: b) because correlations can be high or low depending of the type of triggers choosed
 

David Harper CFA FRM

David Harper CFA FRM
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Hi @ZOAL I agree with 703.2.D, but I disagree with
  • 703.1.a. is true because "The expense ratio for an insurance company is the ratio of expenses to premiums earned in a year. The two major sources of expenses are loss adjustment expenses and selling expenses. Loss adjustment expenses are those expenses related to determining the validity of a claim and how much the policyholder should be paid. Selling expenses include the commissions paid to brokers and other expenses concerned with the acquisition of business. Expense ratios in the United States are typically in the 25% to 30% range and have tended to decrease through time." -- Hull
  • 703.3.b is true because triggers should not be (highly) correlated to market returns, to my knowledge, whether the trigger is indemnity, index, parametric or modelled
 

ZOAL

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Hi @ZOAL I agree with 703.2.D, but I disagree with
  • 703.1.a. is true because "The expense ratio for an insurance company is the ratio of expenses to premiums earned in a year. The two major sources of expenses are loss adjustment expenses and selling expenses. Loss adjustment expenses are those expenses related to determining the validity of a claim and how much the policyholder should be paid. Selling expenses include the commissions paid to brokers and other expenses concerned with the acquisition of business. Expense ratios in the United States are typically in the 25% to 30% range and have tended to decrease through time." -- Hull
  • 703.3.b is true because triggers should not be (highly) correlated to market returns, to my knowledge, whether the trigger is indemnity, index, parametric or modelled
Thank you for the clarification David
 

Nicole Seaman

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@ZOAL

I just wanted to make sure that you were aware that there is a paid section of the forum. Paid members have access to David's in-depth answers, explanations and discussions when they purchase a study package. All of our daily practice questions are part of our paid practice question sets, and this is why we only provide the in-depth answers to paid members. :)

Nicole
 

ZOAL

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@ZOAL

I just wanted to make sure that you were aware that there is a paid section of the forum. Paid members have access to David's in-depth answers, explanations and discussions when they purchase a study package. All of our daily practice questions are part of our paid practice question sets, and this is why we only provide the in-depth answers to paid members. :)

Nicole
Hi Nicole. Yes know. Thank you for reminding me. Regards
 
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