Financial Pricing and Performance Measurement Sholom Feldblum, Neeza Thandi July 2003 1 Topics IRR Pricing Model Profit Measures Parameters and Presentation Cost of Holding Capital 2 Pricing DFA Seminar, July 2003 3 Pricing: Non-Insurance Industries Net Cash Flow Analysis Cash flow from operations Company Net Cash Flow Increase in Net Working Capital Capital Investment in Fixed Assets 4 Pricing: Insurance Industry Statutory Accounting Rules matter • constrain flow to equityholders Adaptation of Net Cash Flow Model • applied to P&C 5 Illustration: Accounting Constraint Acquisition Expense ($2,000) Assets ($12,500) $10,000 $2,000 Insurer UEPR ($8,000) ($10,000) $2,500 Surplus ($2,500) $8,000 $2,500 $2,000 $10,000 Policyholder ($10,000) Equityholder ($4,500) 6 Asset Requirement Assets: Required Reserves Statutory Accounting requirements Surplus Capital Allocation procedure vs Asset Need on Economic Basis PV(future costs) Capital 7 Determinants of Equity Flows Asset Flow U/W Flow Invest Inc Flow Tax Flow Increase in Net Working Capital Cash Flow from Operations Equity Flow = Cash Flow from Operations - Incr in Net Working Capital = U/W Flow + II Flow - Tax Flow - Asset Flow 8 INPUTS Policy Characteristics • expense ratio, payment pattern • ultimate loss, payment pattern • premium collection pattern • policy effective date PARAMETERS Investment Rate of Return Marginal Tax Rate Surplus Allocation Statutory Acctg Rules Tax Acctg Rules Level of Reserve Adequacy 9 Use of IRR Model Determination of profit load for prospective pricing Retrospective Measurement of Profitability 10 Overall Process: Pricing Asset flows Inputs Pricing Model Parameters Target Return on Capital U/W flows Investment flows Equity Flows (in terms of premium) Target Premium Tax flows (in terms of premium) Target Combined Ratio 11 Application: Retrospective Analysis Asset flows Inputs Parameters Pricing Model Mapping from Actual CR to Return on Capital U/W flows Investment flows Actual Return on Capital Equity Flows Tax flows Actual CR 103.0% 104.0% 105.0% 106.0% 107.0% 108.0% 109.0% 110.0% 111.0% 112.0% 113.0% Invest Rate of Return = 7.6% + -100 bp 0 bp 100 bp 13.7% 13.0% 12.3% 11.6% 10.9% 10.3% 9.7% 9.1% 8.5% 7.9% 7.4% 15.5% 14.8% 14.1% 13.4% 12.7% 12.1% 11.5% 10.9% 10.3% 9.7% 9.2% 17.3% 16.5% 15.8% 15.1% 14.5% 13.8% 13.2% 12.6% 12.0% 11.4% 10.9% 12 Profit Measurement DFA Seminar, July 2003 13 Accounting Systems Accounting systems vary in how they measure profit. But must all agree on measurement of cash flows: • • • • U/W transactions Investment returns Federal income tax payments Equity Flows 14 Income to Equityholders -D Capital Equity Flow Net Income IRR Acctg System SAP Acctg System Net Incomet = EFCt-1 * IRR on equity flows Net Incomet = Statutory Net Income CCt = Equityflowt - Dividendt CCt = D SAP Surplust Capitalt = sum of CC (from time 0 to time t) Capitalt = Statutory Surplust 15 Simple Example t=0 t = 0.5 UW TRANSACTIONS Premium 1,000.00 Expense - Acquisition 250.00 Expense - General 0.00 Loss 0.00 0.00 0.00 150.00 0.00 CASH FLOWS Asset Flow UW Flow Inv Inc Flow Tax Flow DTA Flow Equityflow IRR (annual basis) t = 1.0 t = 1.5 t = 2.0 t = 2.5 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1,250.00 -40.00 -290.00 0.00 750.00 -150.00 0.00 0.00 47.20 46.89 36.58 17.50 -9.87 -9.76 -10.00 70.00 -32.20 -32.20 14.00 -412.50 -104.87 294.93 40.57 3.0% IRR (semi-annual basis) 0.00 0.00 0.00 0.00 t = 3.0 0.00 0.00 0.00 0.00 0.00 0.00 0.00 800.00 0.00 0.00 -920.00 0.00 0.00 -800.00 36.02 35.46 36.13 -9.81 4.39 4.16 14.00 -16.80 -16.80 40.21 23.05 143.48 1.5% Target return = 12%; Investment return = 8%; Surplus = 25% of WP (1st year) + 15% of Loss Reserves; 16 Accounting System: SAP Equityflow Net Income day before t=0 DCapital Capital 412.50 412.50 t=0 -412.50 -162.50 -162.50 250.00 t = 0.5 -104.87 -44.87 60.00 310.00 t = 1.0 294.93 104.93 -190.00 120.00 t = 1.5 40.57 40.57 0.00 120.00 t = 2.0 40.21 40.21 0.00 120.00 t = 2.5 23.05 23.05 0.00 120.00 t = 3.0 143.48 23.48 -120.00 0.00 24.87 24.87 0.00 17 Accounting System: IRR Equityflow Net Income day before t=0 DCapital Capital 412.50 412.50 t=0 -412.50 0.00 0.00 412.50 t = 0.5 -104.87 6.13 111.00 523.50 t = 1.0 294.93 7.77 -287.15 236.34 t = 1.5 40.57 3.51 -37.07 199.28 t = 2.0 40.21 2.96 -37.25 162.02 t = 2.5 23.05 2.41 -20.64 141.38 t = 3.0 143.48 2.10 -141.38 0.00 24.87 24.87 0.00 18 EVA -D Capital Equity Flow Net Income EVAt = Net Incomet - $ cost of capital = Net Incomet - Capitalt-1 * cost of capital 19 Accounting System: SAP Net Income Cost of Capital Economic Value Added Starting Capital t=0 -162.50 - 0.00% * 412.50 = -162.50 t = 0.5 -44.87 - 5.83% * 250.00 = -59.45 t = 1.0 104.93 - 5.83% * 310.00 = 86.85 t = 1.5 40.57 - 5.83% * 120.00 = 33.58 t = 2.0 40.21 - 5.83% * 120.00 = 33.21 t = 2.5 23.05 - 5.83% * 120.00 = 16.05 t = 3.0 23.48 - 5.83% * 120.00 = 16.49 NPV (at cost of capital) Economic Value Added: -62.49 20 Accounting System: IRR Net Income - Cost of Capital * Starting Capital = Economic Value Added t=0 0.00 - 0.00% * 412.50 = 0.00 t = 0.5 6.13 - 5.83% * 412.50 = -17.92 t = 1.0 7.77 - 5.83% * 523.50 = -22.75 t = 1.5 3.51 - 5.83% * 236.34 = -10.27 t = 2.0 2.96 - 5.83% * 199.28 = -8.66 t = 2.5 2.41 - 5.83% * 162.02 = -7.04 t = 3.0 2.10 - 5.83% * 141.38 = -6.14 NPV (at cost of capital) Economic Value Added: -62.49 21 Parameters & Presentation DFA Seminar, July 2003 22 Cost of Capital Market Benchmark Return Factor Model (CAPM) Historical Experience Risk-Adjusted Discount Rates Risk-Adjusted Capital 23 Investment Return: Accounting Issues Asset allocation: actual vs nominal Book yields vs New money yields Valuation of assets • Statutory valuation portfolio composition 24 Investment Strategy and Pricing different investment yields two different premiums, if all else held same. Two But higher target return on capital offsets higher investment return 25 Surplus Exogenous needs overall amount of surplus Endogenous needs allocation to line/policy 26 Sensitivity to Parameters Target ROC is discretionary Investment Rate of Return is partly discretionary Target Combined Ratio Post-Tax ROC = 12.0% + -250 bp -200 bp -150 bp -100 bp -50 bp 0 bp 50 bp 100 bp 150 bp 200 bp 250 bp -250 bp -200 bp -150 bp 1.056 1.052 1.048 1.044 1.040 1.036 1.032 1.029 1.025 1.022 1.018 1.068 1.064 1.060 1.055 1.051 1.047 1.043 1.040 1.036 1.032 1.029 1.081 1.076 1.072 1.067 1.063 1.059 1.055 1.051 1.047 1.043 1.039 Investment Rate of Return = 8.0% + -100 bp -50 bp 0 bp + 50 bp + 100 bp + 150 bp + 200 bp 1.093 1.088 1.084 1.079 1.075 1.071 1.066 1.062 1.058 1.054 1.050 1.106 1.101 1.096 1.092 1.087 1.083 1.078 1.074 1.070 1.065 1.061 1.119 1.114 1.109 1.104 1.099 1.095 1.090 1.086 1.081 1.077 1.073 1.133 1.128 1.122 1.117 1.112 1.107 1.102 1.098 1.093 1.089 1.084 1.147 1.141 1.136 1.130 1.125 1.120 1.115 1.110 1.105 1.101 1.096 1.161 1.155 1.150 1.144 1.139 1.133 1.128 1.123 1.118 1.113 1.108 1.176 1.170 1.164 1.158 1.152 1.147 1.141 1.136 1.131 1.126 1.121 +250 bp 1.191 1.184 1.178 1.172 1.166 1.160 1.155 1.149 1.144 1.139 1.133 27 Sensitivity to Parameters Surplus Assumption: Exogenous requirements determine overall amount of surplus; allocation to line is discretionary Reserve Leverage Ratio = 15.0% + -1500 bp -1000 bp -500 bp 0 bp +500 bp +1000 bp +1500 bp Premium Leverage Ratio = 25.0% + -1500 bp -1000 bp -500 bp 0 bp +500 bp +1000 bp +1500 bp -250 bp -200 bp -150 bp Investment Rate of Return = 8.0% + -100 bp -50 bp 0 bp + 50 bp + 100 bp + 150 bp + 200 bp +250 bp 105.2% 104.4% 103.6% 102.8% 102.1% 101.3% 106.3% 105.5% 104.7% 104.0% 103.2% 102.5% 107.4% 106.6% 105.9% 105.1% 104.4% 103.7% 108.6% 107.8% 107.1% 106.3% 105.6% 104.9% 115.9% 115.3% 114.7% 114.1% 113.4% 112.8% 117.2% 116.6% 116.0% 115.5% 114.9% 114.3% -250 bp -200 bp -150 bp Investment Rate of Return = 8.0% + -100 bp -50 bp 0 bp + 50 bp + 100 bp + 150 bp + 200 bp +250 bp 105.2% 104.6% 104.1% 103.6% 103.1% 102.6% 102.1% 106.3% 105.7% 105.2% 104.7% 104.2% 103.7% 103.3% 107.4% 106.9% 106.4% 105.9% 105.4% 104.9% 104.4% 108.5% 108.0% 107.5% 107.1% 106.6% 106.1% 105.6% 117.2% 116.8% 116.4% 116.0% 115.7% 115.3% 114.9% 109.7% 109.0% 108.3% 107.5% 106.8% 106.1% 109.7% 109.2% 108.7% 108.3% 107.8% 107.3% 106.9% 110.9% 110.2% 109.5% 108.8% 108.1% 107.4% 110.9% 110.4% 109.9% 109.5% 109.0% 108.6% 108.1% 112.1% 111.4% 110.7% 110.0% 109.4% 108.7% 112.1% 111.6% 111.2% 110.7% 110.3% 109.8% 109.4% 113.4% 112.7% 112.0% 111.4% 110.7% 110.1% 113.3% 112.9% 112.4% 112.0% 111.6% 111.2% 110.7% 114.6% 114.0% 113.3% 112.7% 112.1% 111.4% 114.6% 114.2% 113.7% 113.3% 112.9% 112.5% 112.1% 115.9% 115.5% 115.1% 114.7% 114.3% 113.9% 113.5% 28 Cost of Holding Capital 29 Reserve Valuation Rate Reserve valuation rate (implicit discounting): 0%, 5%, 10% 1030 1020 1010 IRR target 15% 1000 Premium 990 980 970 0% 5% 10% Loss $1,000 paid t=3; expenses $170 paid t=0; invest return = 10%; 30 Components of Premium PV (Loss + Expenses) PV (Taxes) 1040 70 1020 1000 60 PhFC 50 980 960 940 Premium PV(Loss&Exp) 920 40 PV(Taxes) PhFC 30 20 900 10 880 860 0 0% 5% 10% 0% 5% 10% 31 Cost of Holding Capital PV (Loss + Expense) Premium PV(Loss&Exp) 1040 1020 Tax Timing Effect Taxes - CoHC PhFC 120 100 1000 980 60 Tax Timing Effect CoHC 40 PhFC 80 960 940 920 900 20 880 860 0% 5% 10% 0 0% 5% 10% 32 Reserve Valuation Rate Implicit Discounting • Speed up incidence of tax payments due to double discounting of reserves Explicit Discounting • Remove tax timing effect reduce overall premium. 33 Performance Measurement 34 Performance Measurement: Alternatives to EVA Accounting returns • Statutory accounting even further from economic view • Does not include cost of capital Market value added • Not easily attributable to business units or individuals of the company 35 Performance Measurement: Applications of EVA Absolute EVA » Corresponds to profitability Change in EVA » Corresponds to increase in profitability Amortization of EVA » Smooths fluctuations in profitability 36