Roth - Analysis of Rate of Return without Using Leverage Ratio

Question 1

What is the controversy regarding surplus allocation and leverage ratio?

Answer 1

The problem is that the insurance business involves a wide range of risks true premium to surplus ratios can vary widely between insurers writing the same line of business.

Since all of the surplus stands behind all of an insurer’s risk, it can not be allocated to line or state in a realistic fashion.

Question 2

Give an example of different premium to surplus ratio of two insurers writing the same line of business.

Answer 2

Two insurers currently writing the same premium volume in automobile liability insurance, one insurer has large reserve from business written in prior years and another, new insurer which has no loss reserve from prior years. The required risk-based surplus would be different for the two insurers.

Question 3

What are the sources of risk contributing to surplus need?

Answer 3

(1) . UWriting risk - the adequacy of the premium to pay losses and expenses
(2) . Investment Income risk - whether or not the expected investment income or interest yield is realized
(3) . Reserve risk - the leverage of total reserves to surplus, particularly the loss and expense reserves.
(4) . Social risk - such as inflation, changes in the law, and changes in claim frequency due to the economy.

There are risk interactions between the lines of insurance and between the various sources of risk. => if surplus were determined separately, then the aggregate surplus would be too great.

Question 4

How can the rate of return for stock insurers be determined?

Answer 4

The rate of return for stock insurers in measured by the rate of return on book value, but the return to the investors is the rate of return on market value. These rates of return are connected by the market value to book value ratio.

Question 5

What is the proper measure of income for determining profitability?

Answer 5

Change in surplus adjusted for dividends and paid-in capital.

Question 6

What provisions need to be included in the required rate of return (for both mutual and stock insurers)

Answer 6

(1) Expense and claim inflation - estimated using historical rate of claim inflation
(2) increase in aggregate reserve - use growth rate in industry loss reserve on an inflation adjusted basis (only include the growth in old business, subtract growth rate in premium)
(3) increase in demand for insurance - assume P/S ratio is constant

Question 7

How to calculate total economic income (ds)

Answer 7

ds = Net Underwriting Gain or Loss + Net Investment Income + Net Realized Capital Gains or Losses + Other Income - Dividends to policyholders - Federal Taxes + Change in Net Unrealized Capital Gains or Losses + Change in Non-admitted Assets + Change in Liability for Reinsurance + Change in Foreign Exchange + Change in Excess Statutory Reserve (no longer exists) + Other Write-in Intems = Total Economic Income First 6 items comprise the statutory net income and the remaining represent adjustment to surplus shown in the statutory statement.

Question 8

Why economists don’t trust book value statistics?

Answer 8

1. It is easy to inflate assets far above resale value
2. It include intangible such as “good will” and the value of brand names
3. There is a preference among most investors to look at P/E ratios.

Question 9

Roth comments that the law does not require a fair and reasonable rate of return, but only the fair and reasonable opportunity to make a fair and reasonable return. Why? (2 reasons)

Answer 9

1. Inefficient insurers should not be protected, nor should efficient insurers be penalized
2. Heavily capitalized insurers should not be forced to give up the additional investment income