McClenahan - Insurance Profitability Flashcards
2 ways to measure results of an insurer
Profit
Rate of return
Profit
absolute number
- can be used to pay dividends, grow company, etc
- investors & management are interested in profit
- hard to compare companies by looking at just profit
Rate of return
expresses profit as percentage of a particular base
- since rate of return is relative to a base, it is a measure of efficiency and can be used to compare companies
- more efficient companies are preferable
potential bases for rate of return
Equity
Assets
Sales
appropriate denominator to measure economic efficiency
Assets
-regulators focus on __ when looking at return of insurers
rate of return
rate regulation is
prospective
if applied retrospectively
single year of experience is not sufficient to assess the true profitability of the business
-example: low frequency, high severity lines require many years of experience to determine average profitability as most years have no/low losses whereas few years would result in terrible loss experience
investment income from policyholder funds
should be recognized in premium calculations
- arises from fact that premiums are paid by policyholder before losses and expenses are paid by insurer
- PH is therefore potentially losing out on some investment income and should receive credit for this
Opportunity cost
lost investment income
Opportunity cost is affected by 2 factors
- LOB: some lines have longer intervals before losses are paid; the opportunity cost in these cases are greater since more investment income could have been earned
- cash needed to support infrastructure of insurer: cash can not be invested; since most of the cash tied up in infrastructure was provided by premiums of prior PHs and current insureds are benefiting from these assets, they should not receive credit for the investment income from money that would be theoretically needed to pay for these
Calculation of opportunity cost should be made at and why
risk free rate
-insurer is probably earning a return other than risk free when investing the money but PH is not exposed to any of the risk of insurer’s investment ie if insurer speculates and loses money, PHs do not have to provide for the shortfall
investment income on total surplus needs to be segmented into
Investment income from PH funds
Investment income from shareholder funds
premium credit should only be given for investment income of
& why
PH funds
- PHs should not receive benefit from investment of surplus:
1. surplus is not owned by PHs, but rather the owners of insurer
2. including surplus will penalize high surplus insurers as they will need to charge lower premiums
Calculating opportunity cost in general
Sum (PV of cashflows)
PV cashflow = (premium – loss – expense)/(1+rf)^t
-this number does not represent the money expected to be earned by insurer -> insurer should expect to earn more than risk free rate on its investments
ROE
compares profit of insurer to owner’s investment
3 problems with ROE
- return on equity v rate equity
- surplus allocation
- regulating ROE is often a complicated method of regulating return on sales
Problem with focusing on ROE in rate regulation
is that it forces the regulator to focus on ROE instead of rate equity
-ROE can be distorted by leverage of insurer and therefore rate equity may not apply
example for issue #1
if insurer A&B and C&D are proposing the same rates and have the same expected losses, concept of rate equity would imply that they should be treated the same (both approved or both rejected)
- when regulating ROE, this is not the case
- A&C have a 4:1 premium: surplus ratio and B&D have 1:1
- so if regulator declared that 15% ROE is appropriate -> B&D would be approved since they have less than 15% whereas A&C would be rejected
- this is not equitable according to rate equity since A is now being treated differently to B and C is being treated different to D
- insurer can overcharge and be approved if it has a high level of equity and therefore lower ROE and vice versa
surplus needs to be allocated to LOB and geographical area
This is artificial allocation because 100% of insurer’s surplus supports each risk not just portion of surplus allocated to the category that risk falls in
-surplus allocation ignores the value of surplus that has not specifically been assigned to the segment
one method that regulators use to assign surplus is
with target ratios of premium to surplus (look at premium of specific category and then allocating surplus to category based off target ratio)
- problem with this is that ROE regulation actually becomes return on sales regulation
- regulating ROE is just a complicated way of regulating return on sales
regulating return on sales specifies an
adequate profit margin as a percentage of premium
-same concept as markup which is common in other industries
return on sales means a lot more to consumer than ROE because
it makes a lore more sense to the consumer
return on sales is __ rate regulation
true
as opposed to rate of return regulation because it does not depend on relationship between premium and equity
-No need to allocate surplus
regulator needs to determine what a reasonable profit provision in premiums is
- when determining, important to keep in mind that there is a lot of uncertainty in rates determined by insurers
- due to this uncertainty, insurer needs to charge an adequate rate of return that provides a margin of safety
- CAS statements mention that UW profit and contingencies provision needs to provide for an appropriate after tax return
- no common view of what is appropriate
If rates are inadequate, insurers will
Tighten UW standards
Reduce current volume
if insurers perceive that there is less opportunity to achieve a reasonable rate of return, regulators should be able to see the following occur in the market
Increasing size of residual market
Reducing degree of product diversity
Reduced innovation
measuring profitability of an insurance company is rather complicated compared to measuring profitability of other industries
-reason is that there are usually several years before insurer will know total losses which have been incurred since they take time to be reported and develop
since there is a lot of uncertainty in estimation of losses
management has the ability to influence the results of the company reported in financial statements by either strengthening or weakening reserves
- if insurer is having poor year, it may weaken reserves which will reduce the size of the UW loss resulting in higher profit
- when insurer has great year, can strengthen reserves because either reserves are weak or to provide cushion for future years; adjustment will increase incurred loss so insurer will have a good year instead of great
impact to financial statements of strengthening/weakening reserves is going to be eventually reversed
-if insurer currently has deficient reserves, current results will look more positive, eventually insurer is going to have to increase reserves which will make future years look less favorable
current UW results will be affected by
Current reserving decisions
Amortization of past reserving decisions
due to these various factors affecting results
it is more difficult for an analyst examining financials of insurer to determine how they really are performing in a given year
what items should not be included in the calculation to determine an adequate rate of return
- Investment return earned in excess of risk-free interest rate: insured is not bearing any of the risk when paying the premium, and should therefore only receive the risk free return;
- Investment income earned on surplus: Surplus was contributed by the owners of the insurer. The policyholders should therefore not benefit from this money; insurer with larger surplus relative to premium would have to charge lower rates than equivalent insurer with less surplus AKA lower cost for more protection
- 100% of investment income from policy cash flows: Not all of the cash flow is being invested
3 advantages of using premium as a base, rather than equity, for rate regulation purposes
- Results in true rate equity
- No need to allocate surplus
- Similar to the concept of markup, so understandable