Ferrari - Relationship of UW, Investment, Leverage, and Exposure to Total Return on Owners’ Equity Flashcards
Investors are interested in
ROE
Society is interested in
ROE
Regulators/actuaries are interested in
ROS
in most industries, leverage results from
taking out loans
for an insurer, leverage arises from
from its reserves since these are essentially loans from the PH
investment income I/A can be thought of as
main source of return to insurer
just like other industries, return is modified by
amount of leverage R/S
leverage can either cause returns to
increase or decrease
direction depends on relationship between I/A and U/R:
direction depends on relationship between I/A and U/R:
() = (I/A + U/R)
- if insurer has UW profits, (+U/R), term in () Is positive (assuming positive investment income) so it makes sense for insurer to keep writing business
- if U/R is negative, but absolute value is less than I/A, term in () is still positive, implying that is still profitable to keep writing business
- if U/R is negative and causes term in () to become negative, it makes sense for insurer to stop writing business since writing business will reduce ROE
term U/R (in case of UW losses) can be thought of as
interest cost incurred by firm to use the reserves which were contributed by the PHs
Interest: Underwriting returns, U/R = U/P * P/S * S/R
**The reserves are similar to loans from the insureds to the insurer (and are therefore non-equity capital). The underwriting losses are the interest on these loans.
The Underwriting Loss can be thought of as the cost of borrowing money from the policyholder. These losses are uncertain, and therefore variable.
interest on a normal loan
is known in advance of the loan
The underwriting loss is not known until many years in the future.
With debt loans
analysts know that higher amounts of loads will result in higher interest rates. However, higher amounts of reserves for insurers, due to higher amounts of written premium, may not necessarily result in higher discount rates, due to the reduction in risk from diversification.
The Impact of Insurance Leverage
- for companies in all industries, increased leverage results in increased volatility of results
- insurers share this property, increased insurance leverage results in increased variability in returns
- greater level of risk associated with an increased leverage
Optimum Capital Structure
is the mix of owners’ equity and liabilities which maximized value of the firm
2 factors which affect the value of the firm
Expected earnings stream
Rate at which this stream is discounted by the market (discount rate)
mix of owners’ equity and liabilities affect
both of these factors -> so impacts value of the firm
↑ R/S →
2 relationships
↑ R/S → ↑ Earnings stream → ↑ Firm Value
↑ R/S → ↑ Volatility → ↑ Discount Rate → ↓ Firm Value
can be seen that writing more business and therefore growing reserves has
both a positive and negative impact on the value of the company
-key is to find amount of reserves at which value of company reaches a peak (optimal capital structure)
in order to assist in the calculation of optimum capital structure, actuary should determine:
- expected relationship between I/A and U/R and resulting impact on expected earnings stream of writing more business
- increase in probability of unfavorable results due to higher volatility and resulting impact on insurer value due to higher discount rates applied by market
accounting for debt in optimal capital structure for non-insurer is simpler than accounting for __ in calculation for insurer
& reasons
reserves
- with debt, valuation analysts know that an increased level increases risk and therefore results in demands by creditors for higher interest rates
- relationship is not straight forward for insurers; earlier conclusion that increasing reserves results in higher volatility to insurer is derived from holding everything else constant; in reality, higher level of reserves implies a higher amount of premium written; possible that this higher level of premium will increase the diversification of risk and have a negative impact on variability of results
when determining optimal capital structure, one factor have to account for
is volatility of investment earnings stream
if investment earnings stream is very volatile
insurers reduce the leverage from reserves in order to prevent total risk from getting too large
there are multiple uses of the determination of optimal cash structure
- if public believes that the company is not insuring enough people, it may be able to justify this by demonstrating the optimal capital structure calls for a relatively low reserve/surplus ratio
- it can be seen if an overly aggressive investment portfolio is driving the low ratio of reserves: surplus from the optimal cash structure analysis
- if the optimal structure requires a higher reserve: surplus ratio than average company, this may suggest that the industry is overcapitalized
some people may conclude from ROE equation that premium volume must be expanded as long as I/A remains above U/R
- conclusion ignores additional risk that arises from writing more premium
- Ferrari’s conclusions are derived by focusing on certain variables in the equation and holding everything else constant
- in reality, variables do interact with eachother
incorporating these __ into formulae would result in more accuracy
interrelationships
3 such interactions include
- ↑P/S → ↓I/A
Driven by:
- higher portion of surplus from current business and is therefore in the form of either cash or agent’s balances; this can not be invested
- higher ratio of P/S results in more risk to owners’ equity; to compensate, insurers will need to follow more conservative investment policies
2. ↑U/P → ↑P/S - higher underwriting profit means that insurers can write more business
**A growth in P/S may cause U/P to decrease, as the underwriting standards may need to be loosened for the insurer to grow.
- ↑U/P → ↑I/A
- similar, higher UW profit means that insure can engage in more aggressive investments
Ferrari did mention 1 relationship in his paper:
U/P would decrease from higher P/S due to UW standards being loosened in order for the company to grow
-Balcarek argues that this relationship is not strong as insurer can avoid this decrease in U/P by ensuring that current UW standards are maintained while growing the business
two reasons why the investment gain on assets may increase and two reasons why it may decrease if premiums increase
Increase: -more money to invest from the additional premiums -due to the increased diversification, the company can undertake more aggressive investments
Decrease: -Higher portion of the assets are uninvestable (agents’ balances) -The increase in leverage may call for more conservative investments
insurance leverage ratio
This looks at the relationship between the money “borrowed” from the policyholders (reserves) and the owner’s investment in the company (surplus)
R/S
S = surplus + equity in UEPR
R = admitted assets – S
Insurance Exposure
P/S
Looks at dollars of premium written that are backed by each dollar of surplus
Use of return measures
i. Investors: To determine which company to invest in
ROE. Prefer companies that generate a higher return from a given equity investment.
ii. Regulators: To make sure rates are not excessive, inadequate, unfairly discriminatory
ROS. Want insurers to earn a reasonable markup relative to sales
iii. Society: To determine which companies are best using resources
ROA. Prefers that companies use the assets efficiently
An insurer’s reserves are a form of
non-equity financing and provide a form of leverage for the insurer
Non equity financing increases
volatility of the insurers earnings
This will result in:
- a larger discount rate when valuing the insurer
- possible increased earnings
The two effects will offset to some degree depending on the amount of leverage.
