Flashcards in Ferrari Deck (23)

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1

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Possible investment bases for calculating rates of return (2)

(Ferrari)

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1. total assets (investable funds)

2. net worth (capital & surplus)

2

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

(Ferrari)

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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

3

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

(Ferrari)

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after-tax return = investment profit + UW profit

T = I + U

4

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Stockholder's equity (S)

(Ferrari)

### stockholder's equity = capital + surplus + equity in UPR

5

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

(Ferrari)

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stockholders' equity = total assets - reserves & other liabilities

S = A - R

6

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Reserves and other liabilities and equity in UPR

(Ferrari)

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

7

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Total return on equity (general form)

(Ferrari)

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total ROE = after-tax return / stockholders' equity

total ROE = T / S

8

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

(Ferrari)

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

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

9

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Return measures and relevant point of view (3)

(Ferrari)

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1. investors' POV = ROE = T/S

2. society's POV = return on assets = I/A

3. regulators'/actuaries' POV = return on sales = U / P

10

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Insurance exposure factor

(Ferrari)

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insurance exposure = P / S

high ratio indicates insolvency risk

11

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Leverage ratio

(Ferrari)

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reserves-to-surplus ratio = R / S

leverage factor = 1 + R / S

12

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

(Ferrari)

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

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

13

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Reserve capital

(Ferrari)

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

14

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View of UW losses as interest

(Ferrari)

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

**variable interest rate

15

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

(Ferrari)

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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

16

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

(Ferrari)

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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)

17

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

(Ferrari)

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

18

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Firm value is determined by (2)

(Ferrari)

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1. expected earning stream

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

19

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

(Ferrari)

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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

20

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

(Ferrari)

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must consider investment strategy (quality and earnings capacity)

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

21

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

(Ferrari)

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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

22

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

(Ferrari)

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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

23