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

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

3. Pricing
DFA Seminar, July 2003

4. 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

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

6. Illustration: Accounting Constraint

7. 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

8. 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

9. 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

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

11. 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

12. 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

13. Profit Measurement
DFA Seminar, July 2003

14. 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

15. 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

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

17. Accounting System: SAP

18. Accounting System: IRR

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

20. Accounting System: SAP

21. Accounting System: IRR

22. Parameters & Presentation
DFA Seminar, July 2003

23. Cost of Capital Market Benchmark Return Factor Model (CAPM)
Historical Experience
Risk-Adjusted Discount Rates
Risk-Adjusted Capital

24. Investment Return: Accounting Issues
Asset allocation: actual vs nominal
Book yields vs New money yields
Valuation of assets
Statutory valuation  portfolio composition

25. 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

26. Surplus Exogenous needs  overall amount of surplus
Endogenous needs  allocation to line/policy

27. Sensitivity to Parameters
Target ROC is discretionary
Investment Rate of Return is partly discretionary

28. Sensitivity to Parameters
Surplus Assumption: Exogenous requirements determine overall amount of surplus; allocation to line is discretionary

29. Cost of Holding Capital

30. 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%;

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

32. Cost of Holding Capital
PV (Loss + Expense)
Tax Timing
Effect
Taxes - CoHC
PhFC

33. 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.

34. Performance Measurement

35. 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

36. 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