whycanfinancialfirmschargefordiversifiablerisk.docVIP

Why Can Financial Firms Charge for Diversifiable Risk? Andrew Smith, Ian Moran and David Walczak DRAFT Discussion Paper Comments welcome Please do not quote without our permission Abstract: It is widely accepted that capital markets do not demand a premium for risk that investors can diversify. On the other hand, insurers’ and banks’ pricing models frequently include an allowance for total risk, diversifiable or not. Why then do competitive product markets not eliminate these pricing margins? We propose an answer to the puzzle, by analysing the frictional costs that financial institutions incur in the course of their risk-bearing function. A series of worked examples demonstrate the implications for pricing, risk management, and financial reporting. Author Contact Details: Andrew Smith BW Deloitte, Horizon House 28 Upper High Street Epsom, Surrey KT18 7LJ Great Britain. tel +44 1372 824811 e: andrewdsmith8@ Ian Moran tel +44 1372 824143 e: imoran@ David Walczak Deloitte Touche 400 One Financial Plaza Minneapolis MN 55402 USA tel +1 612 397 4509 , e: dwalczak@ Introduction Pricing and accounting have sometimes been uneasy stable-mates in the financial services industry. Firms have been prepared to make an initial accounting loss on a customer, in order to recoup profits later, for example in the sale of life business under UK statutory reporting. In fewer cases, the opposite situation applies and accounting standards permit the recognition of immediate profit when a customer relationship commences, for example when reporting under embedded value techniques. Fair value accounting will bring financial statements closer than ever before to the assumptions used for product prices. The final form of an insurance accounting standard is some way off, and retail banking is even further from fair value reporting. However, no accounting standard, however well constructed, could comprise a full blueprint for economic pricing. There are good e