Financial Pricing in Property and Liability Insurances, Evidence From the Egyptian Insurance Market

Financial Pricing in Property and Liability Insurances, Evidence From the Egyptian Insurance Market

Hamed Abd Elkaway El Kawaga (Faculty of Commerce, Tanta University, Tanta, Egypt) and Asharf Sayed Abdelzaher (Faculty of Commerce, Beni-Suef University, Beni Suef, Egypt)
DOI: 10.4018/IJCRMM.2018100104

Abstract

The use of pricing a model's insurance derivatives in corporate risk management, particularity in insurance has grown rapidly recently. Financial prices for insurance reflects equilibrium relationships between risk and return or, minimally, avoid the creation of arbitrage opportunities. The major objective of this article is to provide evidence that in the Egyptian insurance market during the period 2002-2013, using Black-Scholes model, there was a transfer of wealth from policyholders to insurance companies via overvaluation of insurance premiums. This contribution may have some crucial implications in terms of the “fairness” of pricing insurance contracts.
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Introduction

The researchers used different models to determine the price of property and liability insurance and these models can be divided to two main types: traditional actuarial models and financial models. Financial pricing differs from traditional actuarial pricing by considering the role played by markets in determining the price of insurance, thus policies prices should reflect equilibrium relationships between risk and return. On the other hand, traditional actuarial models take supply – side perspective, this approach is gradually being replaced by the financial pricing approach reflecting models developed by both actuaries and financial economists (Cummins, Phillips, & Smith, 1999).

The major differences between the two types of models are: The traditional actuarial models tend to focus on supply and demand in the insurance markets and do not give much attention to the behavior of the company’s owners beyond the assumption that they are risk averse and focus only on the results of the underwriting activities, but disregard the income of the investment activities this may have several negative consequences such as:

  • Ignoring the broad concept of justice’s considerations which includes horizontal justice (achieving justice between stockholders and policyholders) and vertical justice which focuses on achieving high level of fairness between the successive generations of policyholders;

  • Insurers collect premiums and pay the claims in the future. As a result, they can invest the accumulated premiums. Therefore, ignoring the return on investments (ROA), while determining the premiums is unjust for the policyholders;

  • The claim that the investment return is indirectly reflected on the pricing process through covering the losses of the underwriting activity in the years when the claims exceed the premiums is unfair even if it sometimes achieves horizontal justice, it does not achieve vertical justice between the successive generations of policyholders;

  • Since the influence of the limitations of the underwriting policy, which includes price determination, cannot be ignored, it is difficult to separate the insurance market and the stock markets from the expected results of the insurance company’s investment portfolio, including the required rate of return on equities and the influence of the prevailing circumstances in the stock market on both. On the other hand, the financial models consider the underwriting activities and the investment activities at the same time. Naturally, this policy has a considerable influence when the company is determining prices, whether when underwriting the profit margin or determining premiums. Thus, it takes into consideration the return of the investment activities in addition to the underwriting activities. This is necessary because of the period between receiving premiums from the policyholders and claims payment. Therefore, insurance companies hedge through investing the premiums in a short-term asset, and temporarily keep them in their securities portfolios which include treasury bills issued by the government, savings deposits and certificates of deposit issued by banks.

Short-term securities are advantageous, as they are easily circulated and marketable. In this aspect, using the financial choices models is considered one of the best tools of the financial management of liquid cash in managing the financial hardships of insurance companies. Moreover, the companies which keep these securities can sell them or liquidate them to cash when needed, since they are considered semi-monetary assets.

In the last few decades, insurance companies’ interest in the financial investment has risen due to many reasons, among which is the rise of monetary inflation rates with its negative influence on the policy of pricing property and liability insurances, and the rise in the general level of long-term and short-term interest. In this framework, the investment in financial assets is considered a main source of return that insurance companies use to provide the required cash to cover expenses and pay the short-term obligations that cannot be delayed.

The policyholders deserve a share of the return resulting from the investment activities, at least in the form of concessions on the collected premium.

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