Risk management for property casualty insurance companies
This thesis addresses the need to reduce inefficiencies in management of insurance company risk capital. The laxity in managing the cost of capital is a result of dysfunctional property/casualty risk classification and capital accumulation practices in the insurance industry. We reclassify risk based on both peril and financial functional features, in order to capture all the facets of risk affecting a firm and ultimately to achieve optimal capital allocation. With the purpose of reducing inefficiencies in mind, we explore and isolate the impact of regulation on insurance company profitability. We use barrier option pricing models to mimic the impact of solvency requirements on firm-wide risk. This methodology of measuring risk is better than plain vanilla option pricing models, in that, through the option to an early default, we are able to capture the economic significance of financial distress, and allocate firm-wide risk capital. The firm-wide risk is incidentally used to empirically test the impact of risk on the cost of carry, the quality of operational profitability and forward asset commitment per unit of liabilities. Our empirical test confirms a strong relationship between firm-level risk, and the cost of carry, return on policyholders' surplus and the cost of capital per contract underwritten. The results are better than previous results obtained using plain vanilla option-pricing models and reveal the importance of incorporating solvency requirements in defining the economic significance of insolvency. The results also points to the importance of advised risk classification procedures to the whole process of integrated risk measurement and financing, which we explore in this study.