McClenahan - Insurance Profitability

Question 1

2006Q22: Explain why the following items should not be included in the calculation to determine an adequate rate of return.

(1) Investment Return earned in excess of risk-free interest rate
(2) Investment Income earned on surplus
(3) 100% of investment income from policy cash flows

Answer 1

(1) An interest rate earned in excess of risk free rate is raward for the insurer. This is due to the fact that insured will not have to pay more if investment return fall below risk free rate.
(2) An insurer with more surplus would be able to charge lower rates for more protection. The policyholders do not own surplus and any return on surplus is associate with placing the surplus at risk
(3) much of premium collected is immediately spend on expenses and do not generate investment income.

Question 2

2009Q9 Different types of participants in the insurance industry use various measures of return to analyze insurance operations.

Identify three of these participants and briefly describe the primary objective of each in analyzing returns, and the best measure of return that satisfies their primary objective.

Answer 2

1. Insueres: To make profit and determin which line of business are better/worse or need changes to rates or UW standards

Return on Premium: measures the profitability of contracts and adequacy of rates

2. Investors: To determin which company to invest in

Return on Equity: can compare across companies and industries to select best investment

3. Regulators: to make sure rates are not excessive, inadequate, unfairly discriminatory

Rate of Return on Sales: similar to mark up, allows true rate regulations.

Question 3

Three Choices for the denominator when determining rate-of-retrun

Answer 3

1. Assets: might be appropriate to measure economic efficiency
2. Equity: clearly the favorite of those seeking to measure relative values of investments.
3. Sales: favored by those who view profit provisions in the context of insurance rates themselves

Question 4

Why does it make more sense to focus on dollar profit rather than rate of return in a regulated rate environment?

Answer 4

Because the role of the regulator is to assess the fairness of the profit load in the insurance rates. As such, insurers charging the same premiums should be treated the same, independent of their respective equity bases.

Question 5

2005Q22 List and briefly describe three problems that arise when p&c insurance rate levels are regulated using a ROE model.

Answer 5

1. It requires allocation of surplus to LOB and jurisdiction. This allocation is meaningless because the entire surplus of the campany stands behind every policy.
2. ROE takes the focus away from rate level. Two insurers with identical rates but different amounts of surplus will be treated differently.
3. Customers understand underwriting profits in the context of rates. ROE means nothing to them.

Question 6

What are the three shortcomings with equity allocation to line of business or jurisdiction?

Answer 6

1. ROE basis ignores the value inherent in the unallocated portion of surplus (e.g. the additional protection resulting from the unallocated surplus of a large multi-line company would not be available to policyholders of a small monoline company)
2. no recognized equitable allocation basis
3. Any artificially allocation of surplus in no way limits a company’s liability to pay claims. The entire surplus of an insurer supports all of the reserves related to all of the claims and policies issued by the company.

Question 7

2006Q22.b Describe three advantages of using premium as a base (return on sales), rather than equity, for rate regulation purposes

Answer 7

1. Provides meaningful information to consumers because it is similar to the concept of a markup in retail business
2. Equally applicable to all insurers without the problems associated with allocation of equity.
3. Results in true rate regulation rather than rate of return regulation.

Question 8

How to determine the benchmark return on sales?

Answer 8

Measuring historical insurance profitability is difficult given the uncertainties associated with association of the loss component. McClenahan recommends relying on observable market behavior: - composition of the residual market - the number of insurers in the voluntary market - degree of product diversity and innovation