10_Panning

Question 1

Define franchise value.

Answer 1

Franchise value is the economic value to the firm of future renewals.

Question 2

Identify three things that increase as client retention increases.

Answer 2

1. Franchise value
2. The ratio of market value to book value
3. Franchise value as a percentage of total economic value

Question 3

Briefly explain how it is possible for the duration of premiums to be higher than the duration of losses and expenses (given that premium and expense cash flows occur at the beginning of the year and loss cash flows occur at the end of the year).

Answer 3

This phenomenon occurs because premiums are interest sensitive.

Question 4

Briefly describe two ways in which premiums are impacted when interest rates increase. For each one, determine if the impact can be minimized by adopting a different pricing strategy.

Answer 4

1. The present value of future premiums declines (cannot be minimized)
2. The number of dollars of future premiums declines since the formula for premium P has k - y in the numerator and 1 + y in the denominator (can be minimized)

Question 5

Formula for a Firm’s Total Economic Value

Answer 5

Total Economic Value = Current Economic Value + Franchise Value

Question 6

Describe two problems with managing interest rate risk to a firm’s total economic value by lowering the duration of the firm’s assets.

(2 aspects of the practical dilemma associated with managing franchise value)

Answer 6

1. The greater the franchise value, the more difficult it is for the firm to manage the interest rate risk of its total economic value by reducing the duration of its investment portfolio. Firms would have to reduce the
   duration of their invested assets to zero or even below zero (the latter of which isn’t possible in practice)
2. The benefits of implementing the duration reduction strategy would be invisible to regulatory bodies and rating agencies. Instead, these entities would only see the accounting figures of the firm which may actually lead them to conclude that the firm is increasing risk rather than reducing it

Question 7

Describe a pricing policy that can reduce the duration of the firm’s total economic value.

Answer 7

Allow the premium P to change with interest rates by setting it such that a target
return on surplus of k = a + by is achieved.

We can optimize the pricing policy by selecting a and b parameters that retain the target return on surplus of k but reduce the duration of total economic value even further (as low as zero).

Question 8

Describe one advantage and one disadvantage of using a dynamic pricing policy to manage the duration of the total economic value.

Answer 8

Advantage: Avoids the potential rating agency and regulatory risk associated with strategies that seek to reduce the duration of the firm’s TEV by managing the duration of its invested assets. This is because a dynamic pricing policy is invisible to these external audiences.

Disadvantage: Any desired combination of a target return on surplus AND target duration of total economic value can only be rigidly maintained for a narrow range of interest rates.
[large changes in interest rates will disrupt the combination established]