Ferrari

Question 1

Total Return on Equity Formula

Answer 1

T/S = I/A (1 + R/S) + U/P * P/S or T/S = I/A + R/S ( I/A + U/R)

where
T = I + U
S = A - R
S = Surplus + Capital + Equity in UEPR
Insurance Leverage Factor = (1 + R/S)
Insurance Exposure = P/S

Question 2

To determine optimal reserve : surplus ratio consider:

Answer 2

1) Expected earning stream.

2) Rate at which earnings are capitalized by the market.

Question 3

Several reasons it is important to analyze the optimal capital structure:

Answer 3

1) If the public views the industry as having a capacity problem, it could be that investors demand a lower leverage ratio.
2) A capacity problem may be attributable in part to aggressive investment portfolios that force the optimal capital structure to a low leverage ratio.
2) Alternatively if the optimal structure demands a higher leverage ratio than currently held, we could view the industry as being overcapitalized.

Question 4

What three groups of stakeholders are represented in Ferrari’s equation?

Answer 4

Investors = T/S (Return on Equity) = Investors try to maximize return on equity for their investment

Society = I/A (Return on Assets) = Society uses this to examine if the company has used its capital efficiently

Regulator = U/P (Return on Sales) = Regulator wants to make sure the rate is not excessive or inadequate

Question 5

Insurance Leverage Factor Details

Answer 5

Can be viewed as non-equity financing where reserves are borrowed from policyholders and is available for investing. If UW gains positive then capital was free. R/S (I/A + U/R)

If too high, then may be unprofitable due to volatility in earnings.

If too low, then firm may be overcapitalized since it can borrow at R/S and pay interest U/R.

Question 6

Debt vs Reserve Capital

Answer 6

Debt capital is fixed but reserve capital is volatile and arises from the delayed nature of paying losses. Insurance leverage results from this deferred nature of liabilities.

Question 7

Continue writing business if:

Answer 7

I/A + U/R > 0

U/P = 1 - Combined Ratio

Question 8

Balcarek’s Relationships

Answer 8

Greater underwriting profit (U/P) means the insurer can invest more aggressively (I/A).

Greater underwriting profit (U/P) means the insurer can write more premium per amount of surplus (P/S).

Writing more premium (P/S) means more of the assets are uninvested (I/A) because there will be more cash and agent balances due. The risk in equity is greater which means assets would be invested more conservatively.