Ferrari - Total Return on Owner's Equity Flashcards
What is the choice between total assets or net worth as the appropriate investment base for computing rates of return from Society’s Point of View?
Form society’s point of view the critical measure of return in on total assets since society is the ultimate winner or loser regardless of how the resources in a business venture are financed.
Insurance leverage and reserve capital
Total return on equity = T/S = (I/A)*(1+R/S) + (U/P) * (P/S)
(1+R/S) is the insurance leverage factor, depends on the size of reserve relative to surplus. The formula does not require a mutually exclusive choice between equity or total assets as an investment base, but rather clearly points out their interdependence.
In one simple equation we see the relationship among return on Equity (the investors’ viewpoint), return on assets (society’s viewpoint) and return on sales (the regulators’ and actuaries’ viewpoint)
T: total after-tax return to the insurer
I: Investment gain or loss (after tax)
U: UW profit or loss (after tax)
P: Premium income
A: Total assets
R: Reserves and other liabilities (exclude equity in UEP)
S: Stockholder’s equity (capital, surplus, and equity in UEP)
What does the Insurance Leverage factor (1+R/S) and the Insurance exposure (P/S) measure
Insurance leverage factor: the amount of leverage of reserves relative to surplus
Insurance Exposure factor: Amount of premium that can be written given surplus
Explain how Reserves can be Viewed as Non-Equity Capital
T/S = I/A + R/S * (I/A + U/R)
Interpretation of the formula requires R be viewed as “reserve capital”, that is, the amount of total investable assets that has been supplied by other than the owners. Underwriting losses can be considered as the “interest” that the insurer has paid for the use of R dollars of reserve capital.
The formula indicates that it is to the benefit of the owners to continue to write insurance in the event of underwriting losses as long as ratio I/A exceeds the absolute value of a negative U/R.
Describe two reasons why the analysis of reserve as capital is not as stragithforward as the analysis of debe capital.
- The interest on debt capital is fixed while the interest on reserve capital is not - it’s the underwriting gain or loss.
- When you acquire more debet, the interest you pay tends to increase. It’s possible that when it comes to reserve capital, the interest rate decreases the more you borrow. This happens because the total losses become more predictable.
Influence of leverage on stockholders’ equity on firms value
The leverage ratio or the reserve-surplus ratio serves as an indicator or a partial determinant of the riskiness of the owner’s investment in the firm. As leverage (1+R/S) increase, the volatility of returns increase so the discount rate may also increase, which lowers the value of firm.
Optimal capital structure - What are the two crucial variables that are generally accepted as the determinants of the value of a firm?
- Expected earning stream 2. The rate at which that stream is capitalized by the market
Optimal capital structure - Why optimal reserve position is not independent of the invesment policy.
The actuarial determination of probability of ruin or insolvency should be extended to include the determination of the probabilities of unfavorable returns to owners and the lowering of market valuation of the company.
The actuarial analysis of the optimal capital structure must also include an analysis of the quality and earning capacity of the assets. The amount of non-equity capital that may be safely undertaken is depends on the degree of variability in the investment earning stream. The greater the variability of earnings the lower prescribed debt-equity ratio. Thus, the optimum reserve position is not independent of the investment policy.
Discussion: why does increase in the P/S ratio will likely lead to lower investment return on assets I/A?
- as premium increases more of the firm’s assets will be tied up in non-marketable securities such as agents’ balance. 2. In order to keep the overall riskiness of the company constant, taking on more insurance risk will require a shift to a more conservative investment strategy.
Discussion: Why does the P/S ratio move in the same direction as the underwriting profit U/P?
more profitable the business the more insurance risk you can assume without increasing the risk of insolvency.
Discussion: Underwriting profits and investment return on assets will move in the same direction
higher underwriting profits allow for more risk-taking on the investment side, which is usually associated with higher average return.
