Panning

Question 1

Describe asset-liability management (ALM).

Answer 1

The objective of ALM is to measure and manage the degree to which the economic value of an insurer is adversely exposed to changes in interest rates.

Question 2

Define franchise value

Answer 2

Franchise value is the economic value to the firm of future renewals.

Although not reflected in accounting rules, franchise value can be a significant portion of insurer’s market value.

Question 3

True or False?
ALM recognizes franchise value

Answer 3

False, ALM fails to recognize existence of franchise value.

Question 4

Complete the sentence:
Franchise value is exposed to ______ risk.

Answer 4

Franchise value is exposed to interest rate risk since is consists of PV of expected CFs from renewed business.

Question 5

Describe Panning’s model characteristics

Answer 5

1. Firm writes all of its business on Jan 1 of each year.
2. Firm pays all expenses for the year on Jan 1 of each year.
3. On Dec 31, firm learns true value of losses and LAE on policies it wrote in Jan and pays those on Dec 31.
4. Firm’s expenses and expected losses are identical every year.
5. If firm makes a profit it immediately dividends that amount to its shareholders.
6. If firm incurs a loss, it immediately raises equity to restore its surplus to initial amount. This surplus is identical each year.

Question 6

Describe the strategy behind Panning’s model.

Answer 6

Growing business as quickly as possible in each year to maximize profits from future renewals.

Question 7

Describe 3 implications from Panning’s model regarding franchise value.

Answer 7

1. Franchise value is real
2. Franchise value is exposed to interest rate risk due to discounting of future CFs.
3. Despite being important, franchise value tends to be invisible to senior management and is largely unmanaged.

Question 8

Calculate untaxed net income for a firm.

Answer 8

Untaxed NI = P - L - E + (S + P - E)*y = kS

P = WP
L = Expected Losses
E = Expenses
S = Surplus
y = risk-free rate
k = target return on surplus

(P - L - E) represents UW income

(S + P - E)*y represents investment income

kS represents target dollar return on surplus

Question 9

Calculate premium required to achieve target return on surplus

Answer 9

P = (S*(k-y) + L)/(1+y) + E

Question 10

Calculate the Current Economic Value (C) of a firm

Answer 10

C = S + P - E - L/(1+y)

Question 11

Calculate book value of a firm

Answer 11

Book value = C

Question 12

Calculate franchise value of a firm assuming constant retention over time.

Answer 12

F = (P - E - L/(1+y))*d/(1-d)

d = cr/(1+y)

cr = client retention %

Question 13

Calculate franchise value assuming cr1 retention for year 1 and cr2 retention thereafter.

Answer 13

F = (P - E - L/(1+y))*cr1/((1+y)(1-d))

d = cr2/(1+y)

Question 14

Calculate the Total Economic Value (TEV)

Answer 14

TEV = C + F

Question 15

Calculate the market value of a firm

Answer 15

Market Value = TEV

Question 16

Identify 3 quantities that increase when client retention % (cr) increases

Answer 16

1. Franchise value (F)
2. Ratio of market value to book value (TEV/C)
3. Franchise value as % of TEV (F/TEV)

Question 17

Briefly explain why fixed target return (b=0 thus k = a) is problematic and provide a better approach.

Answer 17

Interest rates may rise to exceed that level.

Better approach might be to price policies such that target return is risk-free rate plus risk premium (k = a + by).

Question 18

Calculate P using dynamic k (k = a + by)

Answer 18

P = (S(a+(b-1)y) + L)/(1+y) + E

Question 19

Calculate F using dynamic k (k = a + by)

Answer 19

F = crS(a+(b-1)y)/((1+y)(1+y-cr))

assuming all components are constant going forward

Question 20

Calculate duration of Franchise Value

Answer 20

Df = (a-b+1)/((1+y)*(a+by-y) + 1/(1+y-cr)

Question 21

Calculate duration of Total Economic Value

Answer 21

D_TEV = (DcC+DfF) / (C+F)

Most of the time, Dc = 1

Question 22

Calculate duration of Current Economic Value (when not 1)

Answer 22

Dc = (Da(S+P-E) + DlL/(1+y)) / C

Question 23

Explain why duration of premiums might be higher than duration of losses and expenses (2).

Answer 23

1. Premium CFs are very sensitive
2. When interest rate increases, P CF decrease due to pricing policy

So, impact is doubled (both PV and future P decrease)

The first impact if unavoidable, but the second can be minimized by adopting different pricing strategy

Question 24

Describe 2 methods to reduce duration of invested assets

Answer 24

1. Change the composition of firm’s investment portfolio
2. Purchase derivative securities that modify firm’s asset portfolio.

Reducing duration of invested assets can help reduce TEV.

Question 25

Describe 2 problems with managing interest rate risk by lowering duration of invested assets.

Answer 25

1. The greater the franchise value, the more difficult it is for the firm to manage interest rate risk of TEV by reducing duration of investment portfolio.
   Firms would have to reduce Da to 0 or even below o to achieve (latter is impossible)
2. Benefits of implementing duration reduction strategy would be invisible to regulatory bodies and rating agencies.
   Instead, these entities would only see the accounting figures of the firm which may actually lead them to conclude firm is increasing risk rather than reducing it.

Question 26

Describe a pricing policy that can reduce duration of total economic value

Answer 26

Allow P to change with interest rates by setting it such that k = a + by is achieved.

We can optimize pricing policy by selecting a and b that retain target return on surplus of k but reduce duration of total economic value (as low as 0)

Question 27

Describe a limitation to the proposed solution to reduce duration of TEV (set s.t. k = a + by)

Answer 27

Any desired combination of k and target duration can only be rigidly maintained for a narrow range of interest rates.

Large changes in interest rates will disrupt the combination established.

This is a bit of a moot point because same limitation already applies to standard ALM due to nonlinearity of prices relative to interest rates.

Question 28

Provide an advantage to the proposed solution to reduce duration of TEV (set s.t. k = a + by)

Answer 28

Avoids potential rating agency and regulatory risk associated with strategies seeking to reduce duration of firm’s franchise value by managing duration of its invested assets.

This is because the dynamic pricing policy described is invisible to external audiences.