CAS Seminar on Ratemaking1 Provisions for Profit and Contingencies Charles L. McClenahan, FCAS, ASA,...
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Transcript of CAS Seminar on Ratemaking1 Provisions for Profit and Contingencies Charles L. McClenahan, FCAS, ASA,...
CAS Seminar on Ratemaking 1
Provisions for Profit and Contingencies
Charles L. McClenahan, FCAS, ASA, MAAA
William M. Mercer, Inc.
CAS Seminar on Ratemaking 2
Provisions for Profit and Contingencies
What is Our Goal?– CAS Statement of Principles
“The underwriting profit and contingency provisions are the amounts that, when considered with net investment and other income, provide an appropriate total after-tax return.”
CAS Seminar on Ratemaking 3
Provisions for Profit and Contingencies
Two Issues
– What’s appropriate?
– How do you measure return?
CAS Seminar on Ratemaking 4
Provisions for Profit and Contingencies
What’s appropriate?
CAS Statement of Principles -
Risk charge for “random variation from the expected costs” must be “consistent with the cost of capital”
- Included in underwriting profit provision
“Charge for any systematic variation of estimated costs from the expected costs … should be reflected in the … contingency provision.”
NOTE THAT BOTH REFER TO “EXPECTED COSTS”
CAS Seminar on Ratemaking 5
Provisions for Profit and Contingencies
Return on what?
– Economic efficiency - Assets– Investment efficacy - Equity– Rate equity - Sales
CAS Seminar on Ratemaking 6
Provisions for Profit and Contingencies
Rate regulation v. rate of return regulation– Example: Co. A Co. B Co. C Co. D
Proposed rate $100 $100 $110 $110
Leverage 4:1 1:1 4:1 1:1
Identical product, service, market
Expected loss and expense = $95
CAS Seminar on Ratemaking 7
Provisions for Profit and Contingencies
$0
$25
$50
$75
$100
$125
$150
Equity Loss & Expense Profit & Contingencies
Company A Company B Company C Company D
CAS Seminar on Ratemaking 8
Provisions for Profit and Contingencies
Rate equity requires that A and B (or C and D) be treated identically
$0
$25
$50
$75
$100
$125
$150
Equity Loss & Expense Profit & Contingencies
Company A Company B Company C Company D
CAS Seminar on Ratemaking 9
Provisions for Profit and Contingencies
$0
$25
$50
$75
$100
$125
$150
Loss & Expense Equity Profit & Contingencies
Company A Company BCompany C Company D
EXCESSIVE
REASONABLE
Assume 15% “appropriate” return on equity
CAS Seminar on Ratemaking 10
Provisions for Profit and Contingencies
One $100 rate and one $110 rate are reasonable– 5.0% ROE and 13.6% ROE
One $100 rate and one $110 rate are excessive– 20.0% ROE and 54.5% ROE
Rate regulation subordinated to rate of return regulation
$0
$25
$50
$75
$100
$125
$150
Loss & Expense Equity Profit & Contingencies
Company A Company BCompany C Company D
EXCESSIVE
REASONABLE
CAS Seminar on Ratemaking 11
Provisions for Profit and Contingencies
Allocation of equity– No such thing as Iowa homeowners surplus
» Entire surplus stands behind every risk
– Allocation ignores value of unallocated surplus» Treats $100 million equity company with 1% Iowa homeowners
same as $1 million equity Iowa homeowners specialist
– Problems with allocation basis» Assignment of investment portfolio
» Tracking incremental gains/losses in equity by line
» Problem in case of allocated surplus exhaustion
CAS Seminar on Ratemaking 12
Provisions for Profit and Contingencies
“Benchmark” or “normative” ratios
– Regulators assume or mandate assumed leverage (writings-to-surplus) ratio by line of business
– Example» Assume return on equity is 12.5%
CAS Seminar on Ratemaking 13
Provisions for Profit and Contingencies
0%
5%
10%
15%
20%
25%
30%
0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0
Writings-to-Surplus Ratio
Return on Equity
Return on Sales
CAS Seminar on Ratemaking 14
Provisions for Profit and Contingencies
What happens if we use a “benchmark” risk ratio of 3:1 to allocate surplus to this line
CAS Seminar on Ratemaking 15
Provisions for Profit and Contingencies
0%
5%
10%
15%
20%
25%
30%
0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0
Writings-to-Surplus Ratio
Return on Equity Target
Return on Sales Target
Return on Equity
Return on Sales
CAS Seminar on Ratemaking 16
Provisions for Profit and Contingencies
Let’s eliminate the target returns and focus on what really happens
CAS Seminar on Ratemaking 17
Provisions for Profit and Contingencies
0%
5%
10%
15%
20%
25%
30%
0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0
Writings-to-Surplus Ratio
Return on Equity
Return on Sales
CAS Seminar on Ratemaking 18
Provisions for Profit and Contingencies
Result is a constant 4.17% return on salesEliminates problems with allocation
BUT
Return on sales, not equity is regulated
0%
5%
10%
15%
20%
25%
30%
0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0
Writings-to-Surplus Ratio
Return on Equity
Return on Sales