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Prelim_1_S08_Answer_Key - Part 1 Short Answer(10 points...

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Part 1: Short Answer (10 points each; 50 points total) 1. What is the significance to insurers of the limited antitrust exemption granted by the McCarran Ferguson Act of 1945? The limited antitrust exemption allows insurers to share loss information for ratemaking purposes. This is especially useful for small insurers since having a larger amount of data makes loss estimates more reliable. 2. An insurer expects that the rate of return on investments (r) is increasing over the next few years. What effect, if any, would you expect this to have on insurance premiums charged by the insurer? Briefly explain. A higher rate of return on investments should reduce the insurance premium (if it has any effect). Because insurers collect premiums at the date a policy is sold, they can invest the premiums until losses must be paid. A higher rate of return on investments means that the insurer may collect less in premiums and to have enough to pay losses (in expectation) when they come due. 3. Briefly explain why investing in safety up to the point of achieving zero chance of losses is not desirable. The total cost of risk to society or to a firm includes the cost of safety investments along with the cost of losses. If the incremental cost of safety investments is positive (MC of safety > 0), then investing up to the point at which there is zero chance of loss (MB of safety = 0) is an overinvestment in safety. Minimizing the total cost of risk when safety investments are costly will leave us with some residual risk of loss. 4. Briefly explain how a company’s financial statements may be used in determining the importance of risk management. A company’s financial statements may be used to identify risk exposures (by looking at the nature of assets, sources of income and expenditures) and to identify the company’s ability to bear losses (by looking at assets, cash flows, profitability, debt, growth). The importance of risk management is determined by the amount of risk a company bears in relation to its ability to bear that risk (without encountering financial distress). Financial statements are mainly used to tell us the ability to bear risk. 5. What is reinsurance? Why is it useful? Reinsurance is a form of insurance that insurance companies can purchase from other insurance companies. Reinsurance transactions involve transferring loss paying responsibility for part of an insurance company’s losses to the reinsurer (through a contract that the reinsurer gets paid for, of course). Reinsurance is useful in diversifying an insurance company’s risk and in protecting an insurance company from losses that are too large for it to bear. Through reinsurance an insurance company can reduce its insolvency probability or reduce the amount of capital it must hold to keep a constant level of insolvency probability.
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