Ferrari

Question 1

Possible investment bases for calculating rates of return (2)

(Ferrari)

Answer 1

1. total assets (investable funds)

2. net worth (capital & surplus)

Question 2

Reasons that total assets are the preferred investment base for calculating rates of return (2)

(Ferrari)

Answer 2

1. total assets overcome difficulties caused by seasonal variations in assets and differences in debt/equity ratios
2. society prefers total assets b/c the mechanism in which businesses are financed is irrelevant from society’s POV

Question 3

Relationship between after-tax returns, investment profit, and UW profit

(Ferrari)

Answer 3

after-tax return = investment profit + UW profit

T = I + U

Question 4

Stockholder’s equity (S)

Ferrari

Answer 4

stockholder’s equity = capital + surplus + equity in UPR

Question 5

Relationship between stockholders’ equity, total assets, and reserves & other liabilities

(Ferrari)

Answer 5

stockholders’ equity = total assets - reserves & other liabilities
S = A - R

Question 6

Reserves and other liabilities and equity in UPR

Ferrari

Answer 6

reserves & other equities exclude equity in UPR (b/c it is considered part of stockholders’ equity)

Question 7

Total return on equity (general form)

Ferrari

Answer 7

total ROE = after-tax return / stockholders’ equity

total ROE = T / S

Question 8

Ferrari’s first formula (basic equation for total ROE)

Ferrari

Answer 8

T / S = (I / A) * (1 + R/S) + (U / P) * (P / S)

total ROE = investment return % * insurance leverage factor + UW profit % * insurance exposure

Question 9

Return measures and relevant point of view (3)

Ferrari

Answer 9

1. investors’ POV = ROE = T/S
2. society’s POV = return on assets = I/A
3. regulators’/actuaries’ POV = return on sales = U / P

Question 10

Insurance exposure factor and interpretation

Ferrari

Answer 10

insurance exposure = P / S

high ratio indicates insolvency risk

Question 11

Leverage ratio and leverage factor

Ferrari

Answer 11

reserves-to-surplus ratio = R / S

leverage factor = 1 + R / S

Question 12

Ferrari’s second formula (reserves as non-equity capital)

Ferrari

Answer 12

T / S = (I / A) + (R / S) * ((I / A) + (U / R))

total ROE = investment return % + leverage ratio * (investment return % + UW profit / reserves)

Question 13

Reserve capital

Ferrari

Answer 13

amount of total investable assets that have been supplied by sources other than owners

Question 14

View of UW losses as interest

Ferrari

Answer 14

UW losses can be considered interest the insurer has paid for use of reserve capital (U / R)

**variable interest rate

Question 15

Ferrari’s conclusion for when insurer’s should continue to write business and interpretation

(Ferrari)

Answer 15

continue to write business as long as (I / A) + (U / R) > 0

non-equity financing from reserves (U / R) will add to firm’s income stream as long as the cost of financing reserves is < returns from invested assets

Question 16

Ferrari’s key findings on the impact of insurance leverage, R / S (2)

(Ferrari)

Answer 16

1. leverage ratio can indicate riskiness of owners’ investment in the firm (high ratio = high risk)
2. increases in leverage ratio increase variability of operating returns (= volatility of earnings)

Question 17

Problem of finding the optimal capital structure (= R/S ratio or debt-to-equity ratio) of a firm

(Ferrari)

Answer 17

balancing holding the optimal composition of liabilities and maximizing firm’s value

Question 18

Firm value is determined by (2)

Ferrari

Answer 18

1. expected earning stream

2. discount rate at which stream is capitalized by the market

Question 19

Reasons that analysis of reserve capital (= insurance leverage) is more complicated than analysis of debt capital (2)

(Ferrari)

Answer 19

1. cost of borrowing reserve capital is variable whereas the cost of borrowing debt capital is fixed
2. increase in debt capital requires an increase in interest rate, but the diversification benefit of increased reserves through increased writings may offset the cost of taking on additional risk

Question 20

Ferrari’s conclusion about determining the optimal capital structure (= R/S ratio)

(Ferrari)

Answer 20

must consider investment strategy (quality and earnings capacity)

firm’s with volatile investment earnings should have lower leverage ratios (= R/S)

Question 21

Balcarek’s issues with Ferrari’s equations (2)

Ferrari

Answer 21

1. Ferrari concludes that if (I / A) + (U / R) > 0 firm’s should continue to write business and expand premium, but expanding premium can expose the firm’s equity to more risk
2. formulas work best in a static environment, but in reality the relationships should be dynamic

Question 22

Balcarek’s interaction observations in Ferrari’s equations (3)

(Ferrari)

Answer 22

1. increased P / S leads to decreased I / A
2. increased U / P leads to increased P / S
3. increased U / P leads to increased I / A

Question 23

Reasons that increased P / S leads to decreased I / A (2)

Ferrari

Answer 23

1. proportion of un-invested assets (cash & agent’s balances) tends to rise
2. higher P / S ratios indicate higher risk to owner’s equity, which should result in a more conservative investment strategy