Ferrari Flashcards
Possible investment bases for calculating rates of return (2)
(Ferrari)
- total assets (investable funds)
2. net worth (capital & surplus)
Reasons that total assets are the preferred investment base for calculating rates of return (2)
(Ferrari)
- total assets overcome difficulties caused by seasonal variations in assets and differences in debt/equity ratios
- society prefers total assets b/c the mechanism in which businesses are financed is irrelevant from society’s POV
Relationship between after-tax returns, investment profit, and UW profit
(Ferrari)
after-tax return = investment profit + UW profit
T = I + U
Stockholder’s equity (S)
Ferrari
stockholder’s equity = capital + surplus + equity in UPR
Relationship between stockholders’ equity, total assets, and reserves & other liabilities
(Ferrari)
stockholders’ equity = total assets - reserves & other liabilities
S = A - R
Reserves and other liabilities and equity in UPR
Ferrari
reserves & other equities exclude equity in UPR (b/c it is considered part of stockholders’ equity)
Total return on equity (general form)
Ferrari
total ROE = after-tax return / stockholders’ equity
total ROE = T / S
Ferrari’s first formula (basic equation for total ROE)
Ferrari
T / S = (I / A) * (1 + R/S) + (U / P) * (P / S)
total ROE = investment return % * insurance leverage factor + UW profit % * insurance exposure
Return measures and relevant point of view (3)
Ferrari
- investors’ POV = ROE = T/S
- society’s POV = return on assets = I/A
- regulators’/actuaries’ POV = return on sales = U / P
Insurance exposure factor and interpretation
Ferrari
insurance exposure = P / S
high ratio indicates insolvency risk
Leverage ratio and leverage factor
Ferrari
reserves-to-surplus ratio = R / S
leverage factor = 1 + R / S
Ferrari’s second formula (reserves as non-equity capital)
Ferrari
T / S = (I / A) + (R / S) * ((I / A) + (U / R))
total ROE = investment return % + leverage ratio * (investment return % + UW profit / reserves)
Reserve capital
Ferrari
amount of total investable assets that have been supplied by sources other than owners
View of UW losses as interest
Ferrari
UW losses can be considered interest the insurer has paid for use of reserve capital (U / R)
**variable interest rate
Ferrari’s conclusion for when insurer’s should continue to write business and interpretation
(Ferrari)
continue to write business as long as (I / A) + (U / R) > 0
non-equity financing from reserves (U / R) will add to firm’s income stream as long as the cost of financing reserves is < returns from invested assets
Ferrari’s key findings on the impact of insurance leverage, R / S (2)
(Ferrari)
- leverage ratio can indicate riskiness of owners’ investment in the firm (high ratio = high risk)
- increases in leverage ratio increase variability of operating returns (= volatility of earnings)
Problem of finding the optimal capital structure (= R/S ratio or debt-to-equity ratio) of a firm
(Ferrari)
balancing holding the optimal composition of liabilities and maximizing firm’s value
Firm value is determined by (2)
Ferrari
- expected earning stream
2. discount rate at which stream is capitalized by the market
Reasons that analysis of reserve capital (= insurance leverage) is more complicated than analysis of debt capital (2)
(Ferrari)
- cost of borrowing reserve capital is variable whereas the cost of borrowing debt capital is fixed
- increase in debt capital requires an increase in interest rate, but the diversification benefit of increased reserves through increased writings may offset the cost of taking on additional risk
Ferrari’s conclusion about determining the optimal capital structure (= R/S ratio)
(Ferrari)
must consider investment strategy (quality and earnings capacity)
firm’s with volatile investment earnings should have lower leverage ratios (= R/S)
Balcarek’s issues with Ferrari’s equations (2)
Ferrari
- Ferrari concludes that if (I / A) + (U / R) > 0 firm’s should continue to write business and expand premium, but expanding premium can expose the firm’s equity to more risk
- formulas work best in a static environment, but in reality the relationships should be dynamic
Balcarek’s interaction observations in Ferrari’s equations (3)
(Ferrari)
- increased P / S leads to decreased I / A
- increased U / P leads to increased P / S
- increased U / P leads to increased I / A
Reasons that increased P / S leads to decreased I / A (2)
Ferrari
- proportion of un-invested assets (cash & agent’s balances) tends to rise
- higher P / S ratios indicate higher risk to owner’s equity, which should result in a more conservative investment strategy
