Robin: UW Profit Provision Flashcards
methods to calculate the UW profit
- CY investment income offset: adjusts traditional profit provision for investment income
2. Present value offset: adjusts traditional profit provision by comparing investment income of a particular line to income of a reference line
- CY ROE method: not covered
- PVI/PVE method: not covered
5. PV cash flow return: selects provision necessary to produce a PV of cash flow equal to PV change in equity
- risk adjusted discounted cash flow: derives the provision from fair premium
- internal rate of return: not covered
methods require number of steps
- calculate the premium using the unique assumptions and methodologies of the method
- the combined ratio is then calculated
- provision is determined from the combined ratio
there is question of how much UW profit is adequate
one school of thought & problems
-one school of thought is that provision is adequate if it results in adequate total profit after investment income and taxes have been considered
- approach presents some problems:
1. not obvious how to apply in ratemaking
2. there is question of what is an adequate total return
3. ratemaking is conducted on prospective PY basis but total return is measured on CY basis
5 Types of UW Profit
in general there are different types of UW profit provision that may be referred to:
- provision included in manual rates/filings to change manual rates
- corporate target UW profit provision
- breakeven UW profit provision
- charged UW profit provision
- actual UW profit
corporate target UW profit provision
this should be sufficient to generate an expected return similar to that provided by investments with similar risk
breakeven UW profit provision
these provide a rate of return to stockholders equal to rate of return on risk free investments; stockholder receives no compensation for risk borne
charged UW profit provision
rate achieved after applying experience and schedule rating modifications as well as other adjustments ie WC premium discount to manual rate
actual UW profit
these will differ from charged provisions as provision for losses and expenses more likely won’t be accurate; also because the actual CAT loss in a year most likely won’t match the provision
paper examines methods used to determine
profit provisions in rate filings or profit targets/breakeven profit provisions
CY investment income offset procedure
**method adjusts the traditional UW profit provision to account for investment income
-this method is based on CY data
final UW profit provision = traditional UW profit provision – investment income offset
CY investment income offset procedure advantages and disadvantages
Advantages:
- data is easily obtained and verified using the annual statement
- since figures are reported in filed documents, it is less likely that insurer is making pessimistic projections in order to increase profit provision
- CY investment portfolio yields are relatively stable compared to investments initiated in certain year
Disadvantage:
- since CY results are retrospective, they may not be totally applicable to prospective ratemaking ie if there are changes in growth and loss experience
- lack of economic theory supporting calc & results distorted if large change in volume or reserve adequacy
*This is a problem as the provision is therefore hard to justify
CY offset: analysis should be performed over
several iterations since the permissible LR is used as determinant of profit provision but this provision impacts the permissible LR
Present Value Offset Method
**similar to method 1, method adjusts the traditional UW profit provision for investment income; assumption is made that traditional provision reflects the investment income from a reference line
- it applies an offset that is based on difference between:
1. present value of losses for short tail reference line (assumes traditional provision is appropriate for this line)
2. present value of losses for line under review
3. offset = difference in PV loss patterns * projected LR
final UW profit provisions = traditional UW profit provision – offset
there are a few options of rates at which to discount losses to calculate the PV
Portfolio yield from a recent year
Estimated portfolio yield for year in which rates will be in effect
New money yield
new money yields are more suited
to prospective nature of ratemaking but historical prospective yield are more stable and verifiable (but not necessarily representative of the future)
PV offset method advantages and disadvantages
Method advantages: accounts for investment income in a simple manner, not distorted by rapid growth/decline, no need to select a target return or allocate surplus
-Since the offset method depends on the PLR, which is of a prospective nature, it is not affected by rapid growth. Changing reserve adequacy will impact this method, only if it affects the loss payout patterns
Disadvantage: have to choose discount rate, have to choose payment pattern
1 criticism of Standard underwriting profit margin
This was number was user input; there is no evidence supporting it.
1 criticism of After-tax new money yield
This is not necessarily equal to the portfolio’s actual yield, so again means the provision is harder to support.
PV Cashflow Return Model
**method selects an UW profit provision necessary to produce a PV of total cashflow discounted @ investment ROR = PV of changes in equity discounted @ target ROR
-model focuses on cashflows from a single policy
Cashflow = UW cashflow + investment income – tax
why is equity is discounted @ target ROR and cashflows are discounted @ investment ROR
- equity is discounted @ target ROR as this is target value that the insurer wants to achieve with cashflows
- cashflows are discounted @ investment ROR as this is yield that is actually being earned
PV Cashflow Return Model advantages and disadvantages
Method advantages: PV of UW cash flows is what most people think about with regards to UW profit
Method disadvantages: it is not clear what sort of profit is being measured; cash flows do not have same timing as GAAP income
Risk adjusted discounted Cashflow Model
**method calculates fair premium and derives profit provision from this
- risk adjusted discount rate can be derived using CAPM equation
- this equation is usually used to value stocks
Fair premium =
risk adj PV of UW cashflows + PV of taxes
PV UW cashflow = PV prem – PV loss – PV expense
it is difficult to use it to value liabilities
as there is no active market where liabilities are traded and therefore little data exists from which to calculate parameters
Risk adjusted discounted Cashflow Model: discounting
Only losses are discounted @ risk adj rate
Other components are discounted @ risk free rate
Each component is discounted to end of 1st year
Risk adjusted discounted Cashflow Model advantages and disadvantages
Method advantages: great intuitive appeal, grounded in modern financial theory as it attempts to directly calculate the fair premium as opposed to relying heavily on user inputs/ assumptions., not necessary to determine a target rate of return
Method disadvantages: it is hard to determine beta
Setting the appropriate premium levels for policies and used the Risk adjusted Discounted Cash Flow Technique
(1+i)P= PV losses + PV expenses + tax rate*[(1+i)P – PV expenses – PV losses using tax purposes discount rate] + tax rate*investment income
**PV = PV @ t=1
Model construction questions
Should surplus be included in model
How should the surplus requirement be determined
How should risk be incorporated into model
Is it better to use cashflows or income flows
How to reflect income taxes
Parameter selection questions
What discount rate should be sued
What is the right target return
2 ways in which profit provision can be regulated
- rate of return approach: rates should be regulated to ensure that companies are able to achieve an adequate return; supporters of this approach argue that insurers should be regulated in same fashion to utility companies
- constrained free market theory: premiums will move to optimal level from initial starting point: manual rates via market forces; direct regulation is not necessary
issues with 2 ways in which profit provision can be regulated
- problem with 1st is that insurers should not be compared to utility companies
- utilities are ‘natural monopolies’
- structure of insurance industry is greatly different: there are large number of firms, most with relatively low market shares
- latter approach is therefore more applicable
