Financial Pricing and Performance Measurement Sholom Feldblum, Neeza Thandi July 2003

Topics IRR Pricing Model Profit Measures Parameters and Presentation Cost of Holding Capital

Pricing DFA Seminar, July 2003

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

Pricing: Insurance Industry Statutory Accounting Rules matter constrain flow to equityholders Adaptation of Net Cash Flow Model applied to P&C

Illustration: Accounting Constraint

vs Asset Need on Economic Basis Asset Requirement Required Reserves Surplus Assets: 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 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

INPUTS PARAMETERS Investment Rate of Return Policy Characteristics Marginal Tax Rate Surplus Allocation Statutory Acctg Rules Tax Acctg Rules Level of Reserve Adequacy Policy Characteristics expense ratio, payment pattern ultimate loss, payment pattern premium collection pattern policy effective date

Use of IRR Model Determination of profit load for prospective pricing Retrospective Measurement of Profitability

Overall Process: Pricing Target Return on Capital Pricing Model Asset flows U/W flows Investment flows Tax flows (in terms of premium) Inputs Equity Flows (in terms of premium) Target Premium Parameters Target Combined Ratio

Application: Retrospective Analysis Inputs Asset flows U/W flows Investment flows Tax flows Parameters Equity Flows Pricing Model Actual Return on Capital Mapping from Actual CR to Return on Capital

Profit Measurement DFA Seminar, July 2003

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 -D Capital 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

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

Accounting System: SAP

Accounting System: IRR

EVA -D Capital Equity Flow Net Income EVAt = Net Incomet - $ cost of capital = Net Incomet - Capitalt-1 * cost of capital

Accounting System: SAP

Accounting System: IRR

Parameters & Presentation DFA Seminar, July 2003

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 ROC is discretionary Investment Rate of Return is partly discretionary

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

Components of Premium PV (Loss + Expenses) PV (Taxes) PhFC

Cost of Holding Capital PV (Loss + Expense) Tax Timing Effect Taxes - CoHC 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 Absolute EVA Change in EVA Amortization of EVA Corresponds to profitability Corresponds to increase in profitability Smooths fluctuations in profitability