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Negative underwriting loss turning into positive profit — Explore the role of investment income for U.S. Property and Casualty insurers Shuang Yang Department of Risk, Insurance and Healthcare Management Fox School of Business, Temple University 18th APRIA Annual Conference Moscow State University, Moscow July , 2014
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Background and Motivation
Insurers underwriting income is subject to cycles, involving the alternation of hard and soft markets On industry level, despite continuous years’ negative underwriting results, U.S. Property and Casualty insurers could still maintain a positive net income because of their positive investment income Despite continuous years’ negative underwriting results, the majority of U.S. property and casualty insurers still maintain a positive net income because of their positive investment income It then raises interesting questions to think about the role of investment income plays for U.S. insurers. Is it purely a compensation for the underwriting loss to sustain their revenue, or to produce a stable source of income so that they could make insurance premium more affordable to their customers?
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Our Research What is the determinant factors of investment income for U.S. Property- Casualty insurers? On the firm-level, explore the factors that affect the amount of insurers’ investment income What is the role of investment income for U.S. Property- Casualty insurers? Extra profit? A compensation for the underwriting loss? To produce a long-term source of income so that they could make insurance premium more affordable?
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Hypothesis Development
H1: Insurers’ investment income is affected by their firm-specific characteristics as well as capital market conditions H2: Insurers’ investment income plays a role in their total revenue H2a: Insurers invest money to earn extra profits H2b: Insurers invest money to offset negative underwriting losses to strike a balance These characteristics include firm size, leverage ratio, rating grade, organizational form, distribution system, investment portfolio structure and the lagged loss reserve
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Data and Sample Data for this analysis include
National Association of Insurance Committee (NAIC) database: insurer characteristic Best’s Key Rating Guide(BKG): firm level underwriting and investment information Center for Research in Security Prices (CRSP): returns of the value-weighted market portfolios Federal Reserve Economic Data (FRED): risk-free rate Sample: U.S. Property and Casualty insurers from 1999 to 2013 Time span: 15 years in total Sample size: over 20,000 firm-year observations Sample selection criterion: exclude firm with missing values to construct a balanced panel
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Methodology Estimation Approach
Model: Pooled OLS regression model to study the determinants α i is an intercept, and β is the coefficient for each of the independent variable Random error εit represents purely random variation
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Methodology Definition of variables: Dependent variable:
Investment income-- amount of net investment income for each insurer in our sample Independent variables are divided into three categories: Financial quality related variables: Firm Size: Ln(Total Asset); Best’s Key Rating Grade; Net Leverage ratio Other firm-specific variables: Lagged loss reserve; Proportion of investment into risky asset; Organizational form; Distribution system Control variables for market condition: Interest rate
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Net Investment Incomet
Summary Statistics Variables Mean STD Min Max Net Investment Incomet -398.0 9996.0 Loss Reservet-1 52.555 45.959 -99.9 100.0 Ln(Asset)t 11.483 1.896 5.89 18.66 High_Gradet 0.673 0.469 1 Direct Dummyt 0.190 0.392 Stock Dummyt 0.746 0.435 Net Leveraget 2.61 1.770 -0.3 12.9 High_riskt 70.318 19.172 163 Interest Ratet 2.569 1.99 0.14 6.07 We did some simple data cleaning to clear the outlier and the results are shown here
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Empirical Results Variables Definition Estimates Firm Size
Ln (Total Asset) 64.246*** High_Grade Equals to one if the firm has a Best rating above A- and zero otherwise 51.164*** Net Leverage Net premiums written divided by policyholders’ surplus 64.572*** Lagged loss Reserve The amount of loss reserve in the previous year 1.363*** Stock Dummy Equals to one if the insurer is a stock company and zero otherwise 9.870*** Direct Dummy Equals to one if insurer writing business directly and zero otherwise 3.957 High_risk Percentage of investment into stock and derivative market 1.103*** Interest Rate Risk-free rate 6.734*** And this slide shows the definition of variables as well as their empirical results we estimated using our data and sample. All those variables we are interested in carries the expected sign and are quite significant, except the direct writer dummy which stands for the distribution system. Financial quality variables have positive coefficients which indicates that firms with better financial quality might be better able to invest their money and earn more
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The role of investment income?
Explore the role of investment income to insurers: a preliminary analysis using correlation matrix Correlation matrix of underwriting income, investment income and the net profit Pearson Correlation Coefficients Matrix Underwriting Income Investment Income Net Profit Investment Income *** (0.0001) *** (0.0001) ** (0.0140) Number of Observations: N = 36 Next we will move to our second research question which is about the role of investment income. We will do a preliminary analysis using correlation matrix 1. What we can notice is that the correlation between UI and Net Profit is about 0.96 which is extremely high and the magnitude of this correlation is quite significant. 2. What is also highly significant is the correlation between…
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Discussion Main takeaway: A review over the hypothesis H2:
Underwriting results appears to be negatively correlated with investment income but highly positively correlated with the net profit In years when insurer suffers from severe underwriting losses, the investment income tend to increase A review over the hypothesis H2: H2a states that investment income is intended to earn excessive profits and H2b claims that insurers make investment to compensate for the underwriting losses H2b is favored over H2a to interpret the outcome based on the evidence from correlation matrix So, to summarize, a piece of evidence in support of H2b to show that in years when insurer suffers from severe underwriting losses, the investment is higher than average to strike the balance on industry level
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Discussion Why insurers can maintain a stable investment income despite their negative underwriting income? Different operating mechanism between underwriting and investment business Insurance companies generally employ more conservative investment strategies thus their investment results are subject to less fluctuations Insurers maintain a relatively low level of leverage and high amount of capital to back their obligations to their policyholders and this would require more financial solidity and stability …
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Conclusion Insurer’ investment income is related to their firm-specific characteristics: Positively associated with the financial quality related variables, including firm size, Best’s financial rating score, and net leverage ratio Lagged loss reserve has a significant positive impact on the outcome Stock insurers normally earn higher investment income than mutual insurers Distribution system have no significant impact on net investment income Based on our empirical findings: The role of investment income is more to compensate for underwriting losses than making excessive profits since we’ve detected a strong negative correlation between investment income and underwriting income
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Thank you for your attention!
Shuang Yang
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