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Gillam, FCAS VP/Actuary – National Council on Compensation Insurance

ABSTRACT

There is much discussion today on the topic of rate of return, without a clear definition of its parameters. This monograph carefully defines the return and the investment, numerator and denominator of the rate. The author debunks certain common misuses of accounting terms. There can be no investment income on a loss reserve. Return on capital is not the same thing as return on surplus, which is close to meaningless. An example relating the return on investment to the profit provision in the rates is provided.

the reader. which relates the profit loading in rates to the return on capital invested in the insurance company.The Rate of Return on Investment in the Business of Insurance By William R. the numerator and denominator of the rate of return. FCAS VP/Actuary – National Council on Compensation Insurance Introduction There is much discussion today on the topic of rate of return. Gillam. and the reader should remain careful and critical. not that of his employer. without a clear definition of its parameters. The writer’s perspective is his own. It is hoped that the presentation elicits a higher understanding of the elements and considerations necessary to measure the return on investment in the insurance business. this article is written as though the author’s opinions are unequivocal truths. Outline This paper provides a high level perspective on the following questions: 1) What is the capital invested in an insurance enterprise? . For ease of presentation. This monograph carefully defines the return and the investment. The source of the following material is the NCCI Internal Rate of Return model. or any of the various parties to the insurance transaction. The point of view of the investor should be differentiated from those of the policyholder or the statutory surplus (if that has a point of view).

i. assets minus liabilities. The capital invested in a stock company may change over time. The latter is a balancing item. The investment in an insurance company must not be confused with policyholders' surplus.e. when he provides capital to an enterprise of a specific level of risk. we want to propose how it should be measured and related to the provision for profit in the rates. whose expected total return is the cost of capital.. as well as underwriting return. nor is there any in-depth consideration of realized or unrealized capital gains. In other words. From this point of view. The foremost impediment is that rates must generally be made before insurance is provided. the appropriate measure of the numerator is total return. tax is not considered. This monograph does not discuss what the actual cost of capital is or should be in the insurance industry.Exactly how much capital does the investor have committed? This invested capital is the denominator in the rate of return. the cost of capital can be thought of as the rate of return an investor expects. but in a way only loosely related to the size of the policyholders' surplus. and the value of each of these is quite volatile. not how much it should be. 3) What is the correct provision in rates to achieve the targeted return on invested capital? This is the ratemaker's non-trivial chore. or targets. This is consistent with the point of view of the investor. 2) What is the return on capital invested in the insurance business? For purposes of this monograph. generally using estimates of loss and expense and cash . For simplicity. including investment income and capital gains.

The loss process is stochastic. . The future is uncertain. Some provision for this should be in the rate. It tends to be of the same magnitude as written premiums.flow models of the insurance transaction. Invested Capital The capital invested in an insurance company is not the same as the surplus. It is better to think of surplus as a budgetary requirement of the business of insurance. and even models which use statistical distributions recognizing process variance will be fraught with parameter risk. and this should probably be related to the relative difficulty of pricing specific coverage. Note that surplus supporting UPR is a slight variation on the traditional premium to surplus rule of thumb which says the ratio of written premium to par surplus ought not be significantly more than two. It should become clearer in the example below that the necessary. but models will have to be deterministic. Unearned premium represents highly uncertain liability for losses that have not yet occurred. A sample calculation using the internal rate of return model is provided below. invested capital must fill the gap. and the ratio of UPR to surplus should be about the same. This paper does not discuss derivation of such a provision. To the extent underwriting (including investment income on the cash flow of the process) does not provide adequate surplus. It is no accident it is called the policyholder's surplus rather than "the investors'" or "owners'" surplus. particularly Unearned Premium and Loss Reserves (UPR and LR). or "par". surplus determines required capital investment. Surplus is necessary to support liabilities which are uncertain.

In order to measure investment income generated by the insurance transaction. . It is very difficult to do such an analysis starting with statutory accounting. For purposes of this exposition. Both approaches are outside the scope of this paper. Such an estimate would be independent of the overcapitalization or under-capitalization of specific insurers. the values could be estimated empirically. perhaps using Risk Based Capital techniques. usually. Return on Investment Interest rates and inflation are moderate and stable today. inconsequential. Perhaps the ratio of loss reserves to surplus ought to be no more than five. Alternatively. it is necessary to analyze the cash flows of the transaction. most losses have been reported. but perhaps with a lower requirement than UPR since reserves are evaluated after the associated premium has been earned and. especially if there is any confusion between investible assets and liabilities.Loss reserves are a major estimated liability item which require a par surplus. perhaps using a regression on the sample ratios of the many companies writing the subject line of business. that time is past. Return to the insurance business has become as much a function of cash flow and the time value of money as the underwriting results. this monograph considers both the insurance transaction and its potential for investment income from the point of view of the investor. the author has selected a UPR to surplus ratio of two and a LR to surplus ratio of four. There may have been a time when it was nice but At the risk of hammering a point. In recent years. This par surplus could undoubtedly be more accurately estimated. but will probably never go back to the low (and stable) rates of the first half of this century. investment income has made the difference between the failure and success of many major insurance companies.

With a high combined ratio. investment income accrues to assets. The loading must consider not only these three things. return on investment. Rates must be made before the cash flows are known. is why measuring return on surplus leads to distortions. we can back solve for the invested capital by an accounting analysis of what is necessary to satisfy surplus requirements. This. The cash flow from underwriting is a stochastic process. more capital must be invested to return surplus to par. The greater the difficulty. Ratemaking The profit loading in rates does not bear a simple algebraic relationship to the expected underwriting profit. and the rate of return to the investor would decrease. the greater the loss reserve but the lower the potential for investment income on funds provided by premium income alone. but also the estimated cash flows of premium. and (I've added) the par reserve to surplus ratios. the uncertainty of those estimations. Without additional investment. Writing to a high combined ratio reduces assets while generally increasing liabilities.There can be no investment income on loss reserves. as Charlie Hachemeister was fond of relating. Generally. Modeling these lends a great potential for parameter risk. the greater the risk. In effect. loss and expense. Given cash flow patterns for premium and loss. This could change return as a function of surplus in ways that are not intuitive. not liabilities. cash flow models are necessary to relate the profit provision in the rates to the return on investment. or premium to surplus ratios. Investment Income can accrue to the necessary invested capital as well as the cash flow from underwriting. the higher the combined ratio. Consideration must be made for the relative difficulty of estimating adequate rates. income and surplus will both be reduced. in part. .

1% and +20.The following is a simple model of a hypothetical insurance transaction from the point of view of the investor. as it might be to a regulator. a politician or even a carrier bent on competition. Other cash flow models are possible.6% return. (Dollar figures are rounded to whole dollar. as a second experiment.) The initial calculation using a 5% underwriting profit provision results in an 18. we try using the lower profit provision of 0%.2% return on investment. We also calculate the rates of return on surplus as +31. Thus. The reader should ask the question: exactly whose return is this? .5% for the respective scenarios. and calculates the internal rate of return. This results in a +11. Suppose this rate is unacceptably high.

or $45.Internal Rate of Return Model 1.200 Assets (1500)(1. For simplicity. assume no taxes. The profit loading in the rates is $50 or 5% of the premium. after expenses have been paid. Liabilities UPR LR $1. Initial Calculation.5)(500) + (0.625 Par Surplus (0. Evaluating @ 7/1/98.545 80 $ 1. Balance @ 1/1/98. let's assume the $700 loss has occurred.03) Necessary additional capital investment $1.25)(700) $ 425 . paid immediately. Par surplus to LR is 0. Expenses are $250. Interest income has been 3% of $1. Start up company will write $1. but has not been paid.500 $ 500 Par Surplus *Necessary to support surplus of $500. paid at year-end.50.25.000 in premium 1/1/98.500 for six months. Half the premium has been earned.000 Assets Cash from premium transaction Necessary Capital Investment* $ 750 750 $1. Losses are $700. Liabilities UPR LR $ 500 700 $1. half of the UPR. Par surplus to UPR is 0.000 0 $1.

974v = 0 Solving v.5 . Liabilities UPR LR $ $ 0 0 0 Assets (1.03)-(700) Surplus $ 974 $ 974 The ending surplus is returned to the investor.625)(1. which discounts the invested cash flows to ø. all premium is earned. The Internal Rate of Return is the rate.1% . We can easily calculate the total return as a percent of average surplus. Using v = () 750 + 80v.920 v = . the end of the year. U/W Profit Investment Income ($45+$49) Total Income Surplus (500 + 425) ÷ 2 Rate of return $ 50 $ 94 $ 144 $ 463 31.@ 12/31/98. The cash flows are the initial $750. $700 losses are paid and investment income of $49 accrues to the assets supporting the transaction.5 = .846 i = 18.2% the internal rate of return to the investor. the addition of $80 at six months and the return of $974 surplus at year-end.

write $950 in premium.25)(700) @ 12/31/98 add $48 investment income. @ 1/1/98 Liabilities UPR LR $ 950 0 $ 950 Assets Cash from premium transaction Necessary Capital Investment* $ 700 725 $1. Assets $48 + $1. half of the UPR. the internal rate of return is i = 11. @ 7/1/98 Assume $43 of investment income Liabilities UPR LR $ 475 700 $1.5% .468 120 $1.2.6% $ 413 $ 936 0 The total return is $91 on average surplus of $444. or a rate of +20. After reducing the profit loading in the rates.175 $1.588 Assets (add 43) Additional Capital Par Surplus (.5)(475)+(.588.$700 Liabilities Liquidating this.425 $ 475 Par Surplus *Necessary to support surplus of $475. and pay the losses.

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