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
DCapital
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
DCapital
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