McClenahan: Insurer Profitability

Question 1

Opportunity cost to policyholder

Answer 1

Paying out premium funds in advance of losses - losing out on investment income

Question 2

Why investment income on surplus should be excluded from ratemaking process

Answer 2

Surplus does not belong to the policyholders

Question 3

3 bases to use in calculation of rate of return

Answer 3

1. Equity
2. Losses
3. Sales

Question 4

Two basic problems with ROE as a basis for measuring rate-of-return in rate regulation

Answer 4

1. Concept of rate equity would be violated (subordinates rate equity to rate-of-return equity)
2. Requires equity be allocated to LOB and jurisdiction

Question 5

Discounting opportunity cost

Answer 5

Risk-free rate, as policyholder is not subject to insurer investment risk

Question 6

Two factors impacting opportunity cost

Answer 6

LOB (longer tail, higher opportunity cost)

Cash needed to support infrastructure

Question 7

Two components of insurer’s investment earnings

Answer 7

Question 8

Return-on-sales

Answer 8

Relates profit provision in the premium to the premium itself

Understandable

Does not require surplus allocation

Question 9

3 examples of changes to the structure of the industry if rates are inadequate

Answer 9

Increase size of residual market

Reduce innovation

Reduce degree of product diversity

Question 10

Three advantages to using premium as a base for rate regulation purposes

Answer 10

Results in true rate equity

No need to allocate surplus

Similar to concept of markup (understandable)