1. 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

2. 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?

3. 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?

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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…

11. 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

12. 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 …

13. 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

14. Thank you for your attention!
Shuang Yang