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Flashcards in McClenahan Deck (15)
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excess of revenues over expenses


Rate of return


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


Sources of profit (2)


1. UW profit
2. investment income


Opportunity cost to the insured


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)


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


Assumptions about cash flows in the McClenahan paper (3)


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


Candidates for the denominator of rate of return (2)


1. equity
2. sales


Return on equity (ROE)


ROE = NPV(CFs) / equity


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


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


Example of problem with ROR regulation


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)


1. 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


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


Return on sales (ROS)


ROS = NPV(CFs) / premium


Benefits of ROS (4)


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


Potential market consequences when insurers do not believe they can earn reasonable ROR (4)


1. tightened UW standards or reduced premium volume
2. expanded size of residual market
3. decreased # of insurers in voluntary market
4. decreased product diversity and innovation