Feldblum: IRR Models Flashcards
Three stimuli for more accurate pricing models
- Time value of money (cash flows)
- Competition and expected returns
- The rate base
Why an insurer would not target a positive UW profit margin
Resulting rates may not be competitive
Markets for insurance transactions
- Product market (insurer policyholder); influenced by supply and demand
- Financial market (equity provider insurer); expected returns influenced by risks of insurance operations
Decision rule of IRR model
Accept investment opportunity which IRR > opportunity cost of capital
IRR
Rate at which NPV of cash flows equals zero
Relationship between surplus and internal rate of return
More surplus allocated to a policy, lower policy IRR
When NPV and IRR give different results
Strange cash flows
Mutually exclusive projects
Differences are in decision rules, not mathematics
IRR and NPV as inverse functions
IRR: implied discount rate is function of NPV
NPV: NPV is function of discount rate
When IRR model causes problems
Outflow then inflow then outflow -> two positive roots
Why there may be sign reversals that complicate IRR model
Inaccuracies or oversimplifications, not true reversals in expected flows
Rule of interest with IRR
At low interest rates, wise to defer income for larger total return; at high interest rates, deferral of income may be expensive
Reasons IRR and NPV analyses give different results for mutually exclusive projects
IRR model assumes cash reinvested at IRR, which may not be reasonable
2 reasons reinvestment rate = IRR
Practical criticism of IRR
If IRR < Cost of capital but still positive, regulator may believe insurer is profitable; presentation of results is crucial in rate filings
7 risks surplus is meant to protect against
