1. DISCOUNTED CASH FLOW MODELS and RATE OF RETURN PERSPECTIVES (FIN - 29 & 30)
Russ Bingham
Vice President and Director of Corporate Research Hartford Financial Services
Seminar on Rate Making
San Diego, CA
March 9 & 10, 2000

2. Discounted Cash Flow Models and Rate of Return Perspectives Summary
Discounted cash flow is a common approach used to assess financial performance. The purpose of this session will be to review this technique in the broader context of general financial models as applied in insurance. A discussion of the essential “building blocks” upon which models should be constructed will be followed by a review of various rate of return measures that result from them. Specifically, this will compare the policy / accident period to the calendar period view as well as compare the IRR and ROE rate of return calculations. Examples will be presented to demonstrate their fundamental equivalency. The policyholder and shareholder rate of return perspectives will also be reviewed.

3. Contents “Building Blocks”: The Fundamentals
Conceptual Critique of Conventional Accounting
Shortcomings of Reported Financials
Economic Value Concepts
Rate of Return Models: Important Attributes
Rate of Return: Parameter Consistency
Rate of Return Measures and Their Equivalency
The Fundamental Insurance Total Return Model
Components of Total Return: Underwriting, Investment & Leverage
Aspects of Insurance Total Return
Exhibits: Balance Sheet, Income, Cash Flow & Returns

4. “Building Blocks”: The Fundamentals
Balance Sheet, Income and Cash Flow Statements
Accounting Valuation: Conventional (statutory or GAAP) and Economic (present value)
Development “Triangles” of Marketing / Policy / Accident Period into Calendar Period

5. Policy (or Accident) / Calendar Period Development Triangles
Balance Sheet, Income, Cash Flow
Calendar Period
Policy Historical Future Total
Period Ultimate
Prior X X X X X … > Sum
X X X X X … > Sum
X X X X … > Sum
X X X … > Sum
X X … > Sum
X … > Sum
==== ==== ==== ==== ====
Reported Sum Sum Sum Sum Sum
Calendar

6. General Shortcomings of Reported Financials
Missing key elements of total return - absence of market value basis omits important information necessary to more fully judge performance
Lacks more relevant current (i.e. policy / accident period) performance focus
Biased against longer tail and higher combined ratio business which conceals profitability of commercial to a greater degree than personal lines

7. Specific Shortcomings of Reported Financials
Total Assets are affected by changing and somewhat arbitrary definitions of non-invested assets. (Suggest realignment with only Invested Assets on “left” side, net liabilities and equity on the right.)
Income affected by premium earning, deferred acquisition and reserve estimation, all of which can be altered.
“Below the line” surplus adjustments, such as unrealized gains, do not flow through “income”.
Significant market value adjustments are ignored when Equity is reported -
loss reserve adequacy/inadequacy and discount value
some invested assets

8. Economic Value Concepts
Economic valuation presents a financial view in which all assets and liabilities are market valued (cash equivalent).
Considers the estimated magnitude and timing of future cash flows
Focus on performance related to current actions (i.e. policy or accident period) rather than performance related to when reported (i.e. calendar period)
Economic income is the change in economic value over a period in time
“comprehensive income” perspective (FASB 130)
tight balance sheet, income and cash flow linkage
no “below the line” adjustments

9. Conceptual Commentary
Reported income and returns (and other financials as well) follow conventional accounting rules which govern the timing of income recognition and are potentially a misleading basis for rating, regulation & financial analysis. Economic rules produce different results.
Retained earnings are largely irrelevant to economic accounting
Unearned premium reserve is not cash, and thus not economic.
Leverage levels involve concessions to the raters and create non-economic based constraints.
Economic value is realized either by converting assets and liabilities to market via sale, or over time to “earn” the discount value.
ROE calculation - change the formula (income / beginning period contributed surplus). Do not include retained earnings and do not average the equity.

10. Rate of Return Models: Important Attributes
Focus on Cash Flow
Inclusion of surplus with flow controlled by specified rules
Operating (i.e. policyholder) cash flows maintained separately
Economic value with after-tax discounting
NPV income formulation (with and without risk adjustment)
Development of NPV balance sheet liabilities
Policyholder and shareholder rate of return calculations

11. Rate of Return Models:Reaching a Common Ground - Structural Modifications
To Convert Myers-Cohn Into a Rate of Return Model
Inclusion of surplus
Economic value with after-tax discounting
NPV income formulation (with risk adjustment)
NPV income formulation (without risk adjustment)
Development of NPV balance sheet liabilities
Policyholder and shareholder rate of return calculations
To Align Internal Rate of Return Model With Both Policyholder and Shareholder Perspectives
Separation of operating (i.e. policyholder) cash flows

12. Rate of Return: Parameter Consistency
Dealing with Risk
IRR cost of capital based total return
NPV risk-adjusted total return equal to risk-free rate
NPV total return (without risk-adjustment) equal to cost of capital
Beta of Equity versus Beta of Liabilities
Surplus Flows
Controlling amount required and timing of flows
Liability / surplus relationship
Multi-period aspect
Surplus flow components
Surplus contribution and its release
Investment income on contributed surplus
Release of operating earnings

13. Rate of Return Measures
Income on Investment
Conventional Calendar ROE: Income / Average Equity, including Retained Earnings
Nominal Ultimate ROE (“steady state” calendar equivalent)
Discounted Ultimate ROE (net present value rate of return)
Risk-adjusted Ultimate ROE (risk-adjusted NPV rate of return)
“ROE like” Underwriting and Operating returns also
Cash Flow Internal Rate of Return Basis
Shareholder IRR (also Underwriting IRR and Operating IRR)
Shareholder (i.e. Investor Perspective)
Shareholder Cash Dividend Yield Realized
Shareholder Total Return: dividend plus stock price appreciation

14. Equivalency in Rates of Return
For Single Policy - Exhibit 1
(1) IRR
(2) Net present value ROE
(3) Total policy ultimate nominal ROE
(4) Shareholder annual dividend yield realized
For Multiple Policy Ongoing (steady state, no growth) - Exhibit 2
(5) IRR
(6) Annual nominal ROE while at steady state (income / beginning contributed surplus)
(7) Shareholder annual dividend yield realized

15. The Fundamental Insurance Total Return Model
(1) Total Return = Operating Return X Operating Leverage
+ Investment Rate of Return on Surplus
Operating Return = Underwriting Rate of Return
+ Investment Rate of Return on
Policyholder Liability “Float” OR
(2) Total Return = Underwriting Return X Operating Leverage
+ Investment Return X Asset Leverage
Operating Leverage = Net Liabilities / Surplus
Asset Leverage = Invested Assets / Surplus
Insurance Consists of Underwriting, Investment & Financial Leverage

16. The Components of Insurance Total Return -Underwriting, Investment & Leverage
Underwriting Return is the price for the transfer of risk to the company associated with the policyholder related cash flows. When positive the company is being paid for the transfer of risk. When negative the company is incurring a cost to acquire the funds from the policyholder and must depend on the investment spread to generate a profit.
Investment Return represents the yield on invested assets (from both policyholder supplied funds and surplus). The spread between the Investment Return applicable to policyholder supplied funds and the Underwriting Return must be positive if the company is to generate a net operating profit from underwriting.
Leverage (based on surplus requirements needed to meet specified underwriting, investment and financial risk tolerances) creates a magnifying effect on both return and risk.
Total Return reflects the shareholder oriented return, comprised of levered operating return plus the investment return on surplus.

17. Aspects of Insurance Total Return
The Total Rate of Return, as well as the Underwriting and Investment Rates of Return, can be determined on either
a cash flow basis, via the Internal Rate of Return (IRR) or
as a Return on Equity formed by the ratio of Income to Equity in which the financials are in EITHER Nominal or Present Valued terms
The present value rate of return using a risk-adjusted discount rate will equal the risk-free rate, since by definition risk has been eliminated.
Leverage is controlled by specifying rules governing the flow of surplus and dividend (distribution of earnings) to maintain a uniform risk profile over the life of the policy
Contributed surplus governed by constant liability / surplus ratio
Investment income on surplus dividended as earned
Operating earnings distributed in proportion to per period liability exposure

18. Total Return Model Example
Total Return = Oper Return X Oper Levg + Invest Rate of Return on Surplus
14.9% = 3.7% X % not risk-adjusted
6.0% = 0.7% X % risk-adjusted basis
Oper Return = Und Rate of Return + Invest Rate of Return on PH “Float”
3.7% = -0.2% + 3.9% not risk-adjusted
0.7% = -0.2% + 3.9% - 3.0% risk-adjusted basis
CAPM Reference Data:
Risk-Free interest rate 6.0% 3.9% after-tax
Risk Premium %
Equity Beta
Indicated cost of capital %
Liability Beta
Indicated risk adjustment 4.6% 3.0% after-tax
Indicated risk-adjusted discount rate 1.4% 0.9% after-tax

21. Simplified Ratemaking Spreadsheet