Flashcards in McClenahan Deck (15)

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1

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Profit

(McClenahan)

### excess of revenues over expenses

2

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Rate of return

(McClenahan)

### relative measure of efficiency = ratio of profit to some desired base (ex: equity, assets, sales, etc.)

3

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Sources of profit (2)

(McClenahan)

###
1. UW profit

2. investment income

4

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Opportunity cost to the insured

(McClenahan)

###
insured suffers a cost = lost risk-free income from advance payment of funds (premiums) to the insurer that are not yet required for infrastructure, loss payment, or expense payment

opportunity cost = PV(CFs) based on the risk-free rate

5

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Requirements for opportunity cost calculations (4)

(McClenahan)

###
opportunity cost calculations should:

1. be based on expected CFs associated w/LOB

2. reflect that not all CFs become invested assets (some are reinvested in firm)

3. be based on the risk-free rate (not investment performance)

4. not reflect investment income on surplus

6

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Assumptions about cash flows in the McClenahan paper (3)

(McClenahan)

###
1. premiums are paid in full at policy inception

2. expenses are paid at mid-term

3. losses are paid at the midpoint of each year

7

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Candidates for the denominator of rate of return (2)

(McClenahan)

###
1. equity

2. sales

8

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Return on equity (ROE)

(McClenahan)

### ROE = NPV(CFs) / equity

9

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Problems with using ROE to measure ROR for rate regulation (2)

(McClenahan)

###
1. forces regulator to forgo rate equity for rate of return equity

2. requires equity to be allocated to LOB and jurisdiction, which is often artificial

10

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Example of problem with ROR regulation

(McClenahan)

### 2 companies with identical profit and premiums, but different equity levels might receive different decisions for the same proposed rates based on perceived excessive ROE

11

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Reasons that LOB/jurisdiction allocations are artificial (2)

(McClenahan)

###
1. entire amount of surplus stands behind every risk

2. ignores the value of unallocated surplus

12

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Problem with using benchmark premium-to-surplus ratios to solve ROR regulation problem

(McClenahan)

### adds complexity and is effectively the same as regulating return on sales

13

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Return on sales (ROS)

(McClenahan)

### ROS = NPV(CFs) / premium

14

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Benefits of ROS (4)

(McClenahan)

###
1. useful to consumers b/c it is comparable to a mark-up on normal consumer goods

2. independent of relationship b/w premium and surplus

3. represents true rate regulation rather than rate of return regulation

4. does not require artificial allocation of surplus

15