RISK AND RETURN: ACTUARIAL CONSIDERATIONS
(FIN - 10)
FINANCIAL MODELS and RATE OF RETURN PERSPECTIVES
Russ Bingham
Vice President and Director of Corporate Research
Hartford Financial Services
Seminar on Ratemaking
Las Vegas, NV
March 11-13, 2001
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Contents
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“Building Blocks”: The Fundamentals
Reported Financials and Economic Value Concepts
Rate of Return
 Important Model Attributes
 Parameter Consistency
 Return Measures and Their Equivalency
The Fundamental Insurance Total Return Model
 Underwriting, Investment & Leverage Components
Aspects of Insurance Total Return
Exhibits: Balance Sheet, Income, Cash Flow & Returns
 Standalone single policy/accident year
 Calendar year results from ongoing business
Conceptual Commentary
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“Building Blocks”: The Fundamentals
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Balance Sheet, Income and Cash Flow Statements
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Accounting Valuation: Conventional (statutory or
GAAP) and Economic (present value)
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Development “Triangles” of Marketing / Policy /
Accident Period into Calendar Period
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Policy (or Accident) / Calendar Period
Development Triangles
Balance Sheet, Income, Cash Flow
Policy
Period
Prior
1997
1998
1999
2000
2001
Reported
Calendar
1997
X
X
====
Sum
Calendar Period
Historical
Future
1998
1999
2000
2001
X
X
X
X …...
X
X
X
X …...
X
X
X
X …...
X
X
X …...
X
X …...
X …...
==== ====
====
====
Sum
Sum
Sum
Sum
Total
Ultimate
--> Sum
--> Sum
--> Sum
--> Sum
--> Sum
--> Sum
Rates are set across the policy period “row” but regulatory
review is often based on the calendar “column” sum.
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Shortcomings of Reported Financials
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Missing key elements of total return - absence of market value basis
omits important information necessary to more fully judge
performance
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Assets and Liabilities (fully adequate reserves and time value discount)
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“Below the line” surplus adjustments, such as unrealized gains, do
not flow through “income”.
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Lacks more relevant current (i.e. policy / accident period)
performance focus
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Biased against longer tail and higher combined ratio business
which conceals profitability of commercial to a greater degree than
personal lines
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Economic Value Concepts
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Economic valuation presents a financial view in which all assets
and liabilities are market valued (cash equivalent)
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Considers the estimated magnitude and timing of future cash flows
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Focus on performance related to current actions (i.e. policy or
accident period) rather than performance related to when reported
(i.e. calendar period)
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Economic income is the change in economic value over a period in
time
 “comprehensive income” perspective (FASB 130)
 tight balance sheet, income and cash flow linkage
 no “below the line” adjustments
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Rate of Return Models: Important Attributes
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Focus on Cash Flow
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Inclusion of surplus with flow controlled by risk-based rules
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Operating (i.e. policyholder) cash flows maintained separately
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Economic value with after-tax discounting
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NPV income formulation (with and without risk adjustment)
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Development of NPV balance sheet liabilities
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Policyholder and shareholder rate of return calculations
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Rate of Return: Parameter Consistency
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Dealing with Risk
 IRR cost of capital based total return
 NPV risk-adjusted total return equal to risk-free rate
 NPV total return (without risk-adjustment) equal to cost of
capital
 Beta of Equity versus Beta of Liabilities
Surplus Flows
 Controlling required amount and timing
– Liability / surplus relationship
– Multi-period aspect
 Surplus flow components
– Surplus contribution and its release
– Investment income on contributed surplus
– Release of operating earnings
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Rate of Return Measures
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Income on Investment
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Cash Flow Internal Rate of Return Basis
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Conventional Calendar ROE: Income / Average Equity, including
Retained Earnings
Nominal Ultimate ROE (“steady state” calendar equivalent)
Discounted Ultimate ROE (net present value rate of return)
Risk-adjusted Ultimate ROE (risk-adjusted NPV rate of return)
“ROE like” Underwriting and Operating returns also
Shareholder IRR (also Underwriting IRR and Operating IRR)
Shareholder (i.e. Investor Perspective)
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Shareholder Cash Dividend Yield Realized
Shareholder Total Return: dividend plus stock price appreciation
(sorry can’t provide formula for this one)
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Equivalency in Rates of Return
For Single Policy - Exhibit 1
 (1) IRR
 (2) Net present value ROE
 (3) Total policy ultimate nominal ROE
 (4) Shareholder annual dividend yield realized
For Multiple Policy Ongoing (steady state, no growth) - Exhibit 2
 (5) IRR
 (6) Annual nominal ROE while at steady state (income /
beginning contributed surplus)
 (7) Shareholder annual dividend yield realized
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The Fundamental Insurance
Total Return Model
(1) Total Return = Operating Return X Operating Leverage
+ Investment Rate of Return on Surplus
Operating Return = Underwriting Rate of Return
+ Investment Rate of Return on
Policyholder Liability “Float”
OR
(2) Total Return = Underwriting Return X Operating Leverage
+ Investment Return X Asset Leverage
Operating Leverage = Net Liabilities / Surplus
Asset Leverage = Invested Assets / Surplus
Insurance Consists of Underwriting, Investment & Financial Leverage
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The Components of Insurance Total Return Underwriting, Investment & Leverage
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Underwriting Return is the price for the transfer of risk to the company
associated with the policyholder related cash flows. When positive the
company is being paid for the transfer of risk. When negative the
company is incurring a cost to acquire the funds from the policyholder
and must depend on the investment spread to generate a profit.
 Investment Return represents the yield on invested assets (from both
policyholder supplied funds and surplus). The spread between the
Investment Return applicable to policyholder supplied funds and the
Underwriting Return must be positive if the company is to generate a net
operating profit from underwriting.
 Operating Return is the sum of underwriting return and investment
return. This is the risk charge paid by the policyholder.
 Leverage (based on surplus requirements needed to meet specified
underwriting, investment and financial risk tolerances) creates a
magnifying effect on both return and volatility.
 Total Return reflects the shareholder oriented return, comprised of
levered operating return plus the investment return on surplus.
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Aspects of Insurance Total Return
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The Total Rate of Return, as well as the Underwriting and
Investment Rates of Return, can be determined on either
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a cash flow basis, via the Internal Rate of Return (IRR) or
as a Return on Equity formed by the ratio of Income to Equity in
which the financials are in EITHER Nominal or Present Valued terms
The present value rate of return using a risk-adjusted discount
rate will equal the risk-free rate, since by definition risk has been
eliminated.
Leverage is controlled by specifying rules governing the flow of
surplus and dividend (distribution of earnings) to maintain a
uniform risk profile over the life of the policy
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Contributed surplus governed by constant liability / surplus ratio
Investment income on surplus dividended as earned
Operating earnings distributed in proportion to per period liability
exposure
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Total Return Model Example
Total Return = Oper Return X Oper Levg + Invest Rate of Return on Surplus
14.9% = 3.7% X 3.0 + 3.9%
not risk-adjusted
6.0% = 0.7% X 3.0 + 3.9%
risk-adjusted basis
Oper Return = Und Rate of Return + Invest Rate of Return on PH “Float”
3.7% = -0.2% + 3.9%
not risk-adjusted
0.7% = -0.2% + 3.9% - 3.0%
risk-adjusted basis
CAPM Reference Data:
Risk-Free interest rate
Risk Premium
Equity Beta
Indicated cost of capital
Liability Beta
Indicated risk adjustment
Indicated risk-adjusted discount rate
6.0%
8.9%
3.9% after-tax
1.00
14.9%
-0.52
4.6%
1.4%
3.0% after-tax
0.9% after-tax
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Simplified Ratemaking Spreadsheet
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Conceptual Commentary
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Reported income and returns (and other financials as well)
follow conventional accounting rules which govern the timing of
income recognition and are potentially a misleading basis for
rating, regulation & financial analysis. Economic rules produce
different results.
Retained earnings are largely irrelevant to economic accounting.
Unearned premium reserve is not cash, and thus not economic.
Non risk-based leverage levels involve concessions to the rating
agencies and create non-economic based constraints.
Economic value is realized either by converting assets and
liabilities to market via sale, or over time to “earn” the discount
value.
ROE calculation - change the formula (income / beginning
period contributed surplus). Do not include retained earnings
and do not average the equity.
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