McClenahan Flashcards
Profit
McClenahan
excess of revenues over expenses
Rate of return
McClenahan
relative measure of efficiency = ratio of profit to some desired base (ex: equity, assets, sales, etc.)
Sources of profit (2)
McClenahan
- UW profit
2. investment income
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
Requirements for opportunity cost calculations (4)
McClenahan
opportunity cost calculations should:
- be based on expected CFs associated w/LOB
- reflect that not all CFs become invested assets (some are reinvested in firm)
- be based on the risk-free rate (not investment performance)
- not reflect investment income on surplus
Assumptions about cash flows in the McClenahan paper (3)
McClenahan
- premiums are paid in full at policy inception
- expenses are paid at mid-term
- losses are paid at the midpoint of each year
Candidates for the denominator of rate of return (2)
McClenahan
- equity
2. sales
Return on equity (ROE)
McClenahan
ROE = NPV(CFs) / equity
Problems with using ROE to measure ROR for rate regulation (2)
(McClenahan)
- forces regulator to forgo rate equity for rate of return equity
- requires equity to be allocated to LOB and jurisdiction, which is often artificial
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
Reasons that LOB/jurisdiction allocations are artificial (2)
McClenahan
- entire amount of surplus stands behind every risk
2. ignores the value of unallocated surplus
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
Return on sales (ROS)
McClenahan
ROS = NPV(CFs) / premium
Benefits of ROS (4)
McClenahan
- useful to consumers b/c it is comparable to a mark-up on normal consumer goods
- independent of relationship b/w premium and surplus
- represents true rate regulation rather than rate of return regulation
- does not require artificial allocation of surplus
Potential market consequences when insurers do not believe they can earn reasonable ROR (4)
(McClenahan)
- tightened UW standards or reduced premium volume
- expanded size of residual market
- decreased # of insurers in voluntary market
- decreased product diversity and innovation
