Financial Pricing and Performance Measurement

Sholom Feldblum,

Neeza Thandi

May 2003

Topics

IRR Pricing Model

Profit Measures

Parameters and Presentation

Cost of Holding Capital

Pricing

Pricing: Non-Insurance Industries

Net Cash Flow Analysis

Company

Cash flow from operations

Increase in Net Working Capital

Capital Investment in Fixed Assets

Net Cash Flow

Pricing: Insurance Industry

Statutory Accounting Rules matter• constrain flow to equityholders

Adaptation of Net Cash Flow Model• applied to P&C

UEPR($10,000)

Surplus($2,500)

Equityholder($4,500)

Insurer($8,000)

AcquisitionExpense($2,000)

Policyholder($10,000)

Assets($12,500)

$2,000

$10,000

$2,500

$10,000 $2,500

$8,000

$2,000

Illustration: Accounting Constraint

Asset Requirement

Required Reserves SurplusAssets:

Statutory Accounting requirements Capital Allocation procedure

vs

Asset Need on Economic Basis

PV(future costs) Capital

Determinants of Equity Flows

Asset Flow U/W Flow Invest Inc Flow Tax Flow

Equity Flow = Cash Flow from Operations - Incr in Net Working Capital

Increase in Net Working Capital

Cash Flow from Operations

= U/W Flow + II Flow - Tax Flow - Asset Flow

Policy Characteristics

• expense ratio, payment pattern

• ultimate loss, payment pattern

• premium collection pattern

• policy effective date

Investment Rate of Return

Marginal Tax Rate

Surplus Allocation

Statutory Acctg Rules

Tax Acctg Rules

Level of Reserve

Adequacy

INPUTS PARAMETERS

Use of IRR Model

Determination of profit load for prospective pricing

Retrospective Measurement of Profitability

Overall Process: Pricing

Inputs Asset flows

U/W flows

Investment flows

Tax flows

(in terms of premium)

Target Return on

Capital

Parameters

Equity Flows (in terms of premium)

Pricing Model

Target Premium

Target Combined Ratio

Application: Retrospective Analysis

Inputs Asset flows

U/W flows

Investment flows

Tax flowsParameters

Equity Flows

Pricing Model

Actual Return on Capital

Invest Rate of Return = 7.6% +Actual -100 bp 0 bp 100 bp

CR103.0% 13.7% 15.5% 17.3%104.0% 13.0% 14.8% 16.5%105.0% 12.3% 14.1% 15.8%106.0% 11.6% 13.4% 15.1%107.0% 10.9% 12.7% 14.5%108.0% 10.3% 12.1% 13.8%109.0% 9.7% 11.5% 13.2%110.0% 9.1% 10.9% 12.6%111.0% 8.5% 10.3% 12.0%112.0% 7.9% 9.7% 11.4%113.0% 7.4% 9.2% 10.9%

Mapping from Actual CR to

Return on Capital

Profit Measurement

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

Income to Equityholders

Equity Flow

- Capital

Net Income

Capitalt = sum of CC (from time 0 to time t)

Net Incomet = EFCt-1 * IRR on equity flows

CCt = Equityflowt - Dividendt

IRR Acctg System SAP Acctg System

Net Incomet = Statutory Net Income

CCt = SAP Surplust

Capitalt = Statutory Surplust

Simple Examplet = 0 t = 0.5 t = 1.0 t = 1.5 t = 2.0 t = 2.5 t = 3.0

UW TRANSACTIONSPremium 1,000.00 0.00 0.00 0.00 0.00 0.00 0.00Expense - Acquisition 250.00 0.00 0.00 0.00 0.00 0.00 0.00Expense - General 0.00 150.00 0.00 0.00 0.00 0.00 0.00Loss 0.00 0.00 0.00 0.00 0.00 0.00 800.00

CASH FLOWSAsset Flow 1,250.00 -40.00 -290.00 0.00 0.00 0.00 -920.00UW Flow 750.00 -150.00 0.00 0.00 0.00 0.00 -800.00Inv Inc Flow 47.20 46.89 36.58 36.02 35.46 36.13Tax Flow 17.50 -9.87 -9.76 -10.00 -9.81 4.39 4.16DTA Flow 70.00 -32.20 -32.20 14.00 14.00 -16.80 -16.80Equityflow -412.50 -104.87 294.93 40.57 40.21 23.05 143.48

IRR (annual basis) 3.0% IRR (semi-annual basis) 1.5%

Target return = 12%; Investment return = 8%; Surplus = 25% of WP (1st year) + 15% of Loss Reserves;

Equityflow Net Income Capital Capital

day before t=0 412.50 412.50

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

Accounting System: SAP

Equityflow Net Income Capital Capital

day before t=0 412.50 412.50

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

Accounting System: IRR

EVA

Equity Flow

- Capital

Net Income

EVAt = Net Incomet - $ cost of capital

= Net Incomet - Capitalt-1 * cost of capital

EconomicNet Income Cost of Capital Starting Capital Value Added

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

Economic Value Added: -62.49

NPV(at cost of capital)

Accounting System: SAP

EconomicNet Income - Cost of Capital * Starting Capital = 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

Economic Value Added: -62.49

NPV(at cost of capital)

Accounting System: IRR

Parameters & Presentation

Cost of Capital

Market Benchmark

Return Factor Model (CAPM)

Historical Experience

Risk-Adjusted Discount Rates

Risk-Adjusted Capital

Investment Return: Accounting Issues

Asset allocation: actual vs nominal

Book yields vs New money yields

Valuation of assets• Statutory valuation portfolio composition

Investment Strategy and Pricing

Two different investment yields two different premiums, if all else held same.

But higher target return on capital offsets higher investment return

Surplus

Exogenous needs overall amount of surplus

Endogenous needs allocation to line/policy

Sensitivity to Parameters

Target Combined Ratio

Post-Tax Investment Rate of Return = 8.0% +ROC -250 bp -200 bp -150 bp -100 bp -50 bp 0 bp + 50 bp + 100 bp + 150 bp + 200 bp +250 bp

= 12.0% +-250 bp 1.056 1.068 1.081 1.093 1.106 1.119 1.133 1.147 1.161 1.176 1.191-200 bp 1.052 1.064 1.076 1.088 1.101 1.114 1.128 1.141 1.155 1.170 1.184-150 bp 1.048 1.060 1.072 1.084 1.096 1.109 1.122 1.136 1.150 1.164 1.178-100 bp 1.044 1.055 1.067 1.079 1.092 1.104 1.117 1.130 1.144 1.158 1.172-50 bp 1.040 1.051 1.063 1.075 1.087 1.099 1.112 1.125 1.139 1.152 1.166

0 bp 1.036 1.047 1.059 1.071 1.083 1.095 1.107 1.120 1.133 1.147 1.16050 bp 1.032 1.043 1.055 1.066 1.078 1.090 1.102 1.115 1.128 1.141 1.155

100 bp 1.029 1.040 1.051 1.062 1.074 1.086 1.098 1.110 1.123 1.136 1.149150 bp 1.025 1.036 1.047 1.058 1.070 1.081 1.093 1.105 1.118 1.131 1.144200 bp 1.022 1.032 1.043 1.054 1.065 1.077 1.089 1.101 1.113 1.126 1.139250 bp 1.018 1.029 1.039 1.050 1.061 1.073 1.084 1.096 1.108 1.121 1.133

Target ROC is discretionary

Investment Rate of Return is partly discretionary

Sensitivity to Parameters

Reserve Investment Rate of Return = 8.0% +Leverage Ratio -250 bp -200 bp -150 bp -100 bp -50 bp 0 bp + 50 bp + 100 bp + 150 bp + 200 bp +250 bp

= 15.0% +-1500 bp -1000 bp 105.2% 106.3% 107.4% 108.6% 109.7% 110.9% 112.1% 113.4% 114.6% 115.9% 117.2%-500 bp 104.4% 105.5% 106.6% 107.8% 109.0% 110.2% 111.4% 112.7% 114.0% 115.3% 116.6%

0 bp 103.6% 104.7% 105.9% 107.1% 108.3% 109.5% 110.7% 112.0% 113.3% 114.7% 116.0%+500 bp 102.8% 104.0% 105.1% 106.3% 107.5% 108.8% 110.0% 111.4% 112.7% 114.1% 115.5%

+1000 bp 102.1% 103.2% 104.4% 105.6% 106.8% 108.1% 109.4% 110.7% 112.1% 113.4% 114.9%+1500 bp 101.3% 102.5% 103.7% 104.9% 106.1% 107.4% 108.7% 110.1% 111.4% 112.8% 114.3%

Premium Investment Rate of Return = 8.0% +Leverage Ratio -250 bp -200 bp -150 bp -100 bp -50 bp 0 bp + 50 bp + 100 bp + 150 bp + 200 bp +250 bp

= 25.0% +-1500 bp 105.2% 106.3% 107.4% 108.5% 109.7% 110.9% 112.1% 113.3% 114.6% 115.9% 117.2%-1000 bp 104.6% 105.7% 106.9% 108.0% 109.2% 110.4% 111.6% 112.9% 114.2% 115.5% 116.8%-500 bp 104.1% 105.2% 106.4% 107.5% 108.7% 109.9% 111.2% 112.4% 113.7% 115.1% 116.4%

0 bp 103.6% 104.7% 105.9% 107.1% 108.3% 109.5% 110.7% 112.0% 113.3% 114.7% 116.0%+500 bp 103.1% 104.2% 105.4% 106.6% 107.8% 109.0% 110.3% 111.6% 112.9% 114.3% 115.7%

+1000 bp 102.6% 103.7% 104.9% 106.1% 107.3% 108.6% 109.8% 111.2% 112.5% 113.9% 115.3%+1500 bp 102.1% 103.3% 104.4% 105.6% 106.9% 108.1% 109.4% 110.7% 112.1% 113.5% 114.9%

Surplus Assumption: Exogenous requirements determine overall amount of surplus; allocation to line is discretionary

Cost of Holding Capital

Reserve Valuation Rate Reserve valuation rate

(implicit discounting): 0%, 5%, 10%

IRR target 15%

970

980

990

1000

1010

1020

1030

0% 5% 10%

Premium

Loss $1,000 paid t=3; expenses $170 paid t=0; invest return = 10%;

Components of Premium

0

10

20

30

40

50

60

70

0% 5% 10%

PV(Taxes)PhFC

PV (Loss + Expenses) PV (Taxes) PhFC

860

880

900

920

940

960

980

1000

1020

1040

0% 5% 10%

PremiumPV(Loss&Exp)

Cost of Holding Capital

860

880

900

920

940

960

980

1000

1020

1040

0% 5% 10%

PremiumPV(Loss&Exp)

PV (Loss + Expense)Tax Timing

EffectTaxes - CoHC PhFC

0

20

40

60

80

100

120

0% 5% 10%

Tax TimingEffectCoHC

PhFC

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.

Performance Measurement

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

Performance Measurement: Applications of EVA

» Corresponds to profitability

» Corresponds to increase in profitability

» Smooths fluctuations in profitability

Absolute EVA

Change in EVA

Amortization of EVA