McClenahan - Insurance Profitability

Question 1

2 ways to measure results of an insurer

Answer 1

Profit

Rate of return

Question 2

Profit

Answer 2

absolute number

• can be used to pay dividends, grow company, etc
• investors & management are interested in profit
• hard to compare companies by looking at just profit

Question 3

Rate of return

Answer 3

expresses profit as percentage of a particular base

• since rate of return is relative to a base, it is a measure of efficiency and can be used to compare companies
• more efficient companies are preferable

Question 4

potential bases for rate of return

Answer 4

Equity

Assets

Sales

Question 5

appropriate denominator to measure economic efficiency

Answer 5

Assets

Question 6

-regulators focus on __ when looking at return of insurers

Answer 6

rate of return

Question 7

rate regulation is

Answer 7

prospective

Question 8

if applied retrospectively

Answer 8

single year of experience is not sufficient to assess the true profitability of the business

-example: low frequency, high severity lines require many years of experience to determine average profitability as most years have no/low losses whereas few years would result in terrible loss experience

Question 9

investment income from policyholder funds

Answer 9

should be recognized in premium calculations

• arises from fact that premiums are paid by policyholder before losses and expenses are paid by insurer
• PH is therefore potentially losing out on some investment income and should receive credit for this

Question 10

Opportunity cost

Answer 10

lost investment income

Question 11

Opportunity cost is affected by 2 factors

Answer 11

1. LOB: some lines have longer intervals before losses are paid; the opportunity cost in these cases are greater since more investment income could have been earned
2. cash needed to support infrastructure of insurer: cash can not be invested; since most of the cash tied up in infrastructure was provided by premiums of prior PHs and current insureds are benefiting from these assets, they should not receive credit for the investment income from money that would be theoretically needed to pay for these

Question 12

Calculation of opportunity cost should be made at and why

Answer 12

risk free rate

-insurer is probably earning a return other than risk free when investing the money but PH is not exposed to any of the risk of insurer’s investment ie if insurer speculates and loses money, PHs do not have to provide for the shortfall

Question 13

investment income on total surplus needs to be segmented into

Answer 13

Investment income from PH funds

Investment income from shareholder funds

Question 14

premium credit should only be given for investment income of

& why

Answer 14

PH funds

• PHs should not receive benefit from investment of surplus:
  1. surplus is not owned by PHs, but rather the owners of insurer
  2. including surplus will penalize high surplus insurers as they will need to charge lower premiums

Question 15

Calculating opportunity cost in general

Answer 15

Sum (PV of cashflows)

PV cashflow = (premium – loss – expense)/(1+r_f)^t

-this number does not represent the money expected to be earned by insurer -> insurer should expect to earn more than risk free rate on its investments

Question 16

ROE

Answer 16

compares profit of insurer to owner’s investment

Question 17

3 problems with ROE

Answer 17

1. return on equity v rate equity
2. surplus allocation
3. regulating ROE is often a complicated method of regulating return on sales

Question 18

Problem with focusing on ROE in rate regulation

Answer 18

is that it forces the regulator to focus on ROE instead of rate equity

-ROE can be distorted by leverage of insurer and therefore rate equity may not apply

Question 19

example for issue #1

Answer 19

if insurer A&B and C&D are proposing the same rates and have the same expected losses, concept of rate equity would imply that they should be treated the same (both approved or both rejected)

• when regulating ROE, this is not the case
• A&C have a 4:1 premium: surplus ratio and B&D have 1:1
• so if regulator declared that 15% ROE is appropriate -> B&D would be approved since they have less than 15% whereas A&C would be rejected
• this is not equitable according to rate equity since A is now being treated differently to B and C is being treated different to D
• insurer can overcharge and be approved if it has a high level of equity and therefore lower ROE and vice versa

Question 20

surplus needs to be allocated to LOB and geographical area

Answer 20

This is artificial allocation because 100% of insurer’s surplus supports each risk not just portion of surplus allocated to the category that risk falls in

-surplus allocation ignores the value of surplus that has not specifically been assigned to the segment

Question 21

one method that regulators use to assign surplus is

Answer 21

with target ratios of premium to surplus (look at premium of specific category and then allocating surplus to category based off target ratio)

• problem with this is that ROE regulation actually becomes return on sales regulation
• regulating ROE is just a complicated way of regulating return on sales

Question 22

regulating return on sales specifies an

Answer 22

adequate profit margin as a percentage of premium

-same concept as markup which is common in other industries

Question 23

return on sales means a lot more to consumer than ROE because

Answer 23

it makes a lore more sense to the consumer

Question 24

return on sales is __ rate regulation

Answer 24

true

as opposed to rate of return regulation because it does not depend on relationship between premium and equity

-No need to allocate surplus

Question 25

regulator needs to determine what a reasonable profit provision in premiums is

Answer 25

- when determining, important to keep in mind that there is a lot of uncertainty in rates determined by insurers - due to this uncertainty, insurer needs to charge an adequate rate of return that provides a margin of safety - CAS statements mention that UW profit and contingencies provision needs to provide for an appropriate after tax return - no common view of what is appropriate

Question 26

If rates are inadequate, insurers will

Answer 26

Tighten UW standards Reduce current volume

Question 27

if insurers perceive that there is less opportunity to achieve a reasonable rate of return, regulators should be able to see the following occur in the market

Answer 27

Increasing size of residual market Reducing degree of product diversity Reduced innovation

Question 28

measuring profitability of an insurance company is rather complicated compared to measuring profitability of other industries

Answer 28

-reason is that there are usually several years before insurer will know total losses which have been incurred since they take time to be reported and develop

Question 29

since there is a lot of uncertainty in estimation of losses

Answer 29

management has the ability to influence the results of the company reported in financial statements by either strengthening or weakening reserves - if insurer is having poor year, it may weaken reserves which will reduce the size of the UW loss resulting in higher profit - when insurer has great year, can strengthen reserves because either reserves are weak or to provide cushion for future years; adjustment will increase incurred loss so insurer will have a good year instead of great

Question 30

impact to financial statements of strengthening/weakening reserves is going to be eventually reversed

Answer 30

-if insurer currently has deficient reserves, current results will look more positive, eventually insurer is going to have to increase reserves which will make future years look less favorable

Question 31

current UW results will be affected by

Answer 31

Current reserving decisions Amortization of past reserving decisions

Question 32

due to these various factors affecting results

Answer 32

it is more difficult for an analyst examining financials of insurer to determine how they really are performing in a given year

Question 33

what items should not be included in the calculation to determine an adequate rate of return

Answer 33

1. Investment return earned in excess of risk-free interest rate: insured is not bearing any of the risk when paying the premium, and should therefore only receive the risk free return; 2. Investment income earned on surplus: Surplus was contributed by the owners of the insurer. The policyholders should therefore not benefit from this money; insurer with larger surplus relative to premium would have to charge lower rates than equivalent insurer with less surplus AKA lower cost for more protection 3. 100% of investment income from policy cash flows: Not all of the cash flow is being invested

Question 34

3 advantages of using premium as a base, rather than equity, for rate regulation purposes

Answer 34

- Results in true rate equity - No need to allocate surplus - Similar to the concept of markup, so understandable