Financial Pricing and Performance Measurement
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Transcript of Financial Pricing and Performance Measurement
Financial Pricing and Performance Measurement
Sholom Feldblum,
Neeza Thandi
May 2003
Topics
IRR Pricing Model
Profit Measures
Parameters and Presentation
Cost of Holding Capital
Pricing
Pricing: Non-Insurance Industries
Net Cash Flow Analysis
Company
Cash flow from operations
Increase in Net Working Capital
Capital Investment in Fixed Assets
Net Cash Flow
Pricing: Insurance Industry
Statutory Accounting Rules matter• constrain flow to equityholders
Adaptation of Net Cash Flow Model• applied to P&C
UEPR($10,000)
Surplus($2,500)
Equityholder($4,500)
Insurer($8,000)
AcquisitionExpense($2,000)
Policyholder($10,000)
Assets($12,500)
$2,000
$10,000
$2,500
$10,000 $2,500
$8,000
$2,000
Illustration: Accounting Constraint
Asset Requirement
Required Reserves SurplusAssets:
Statutory Accounting requirements Capital Allocation procedure
vs
Asset Need on Economic Basis
PV(future costs) Capital
Determinants of Equity Flows
Asset Flow U/W Flow Invest Inc Flow Tax Flow
Equity Flow = Cash Flow from Operations - Incr in Net Working Capital
Increase in Net Working Capital
Cash Flow from Operations
= U/W Flow + II Flow - Tax Flow - Asset Flow
Policy Characteristics
• expense ratio, payment pattern
• ultimate loss, payment pattern
• premium collection pattern
• policy effective date
Investment Rate of Return
Marginal Tax Rate
Surplus Allocation
Statutory Acctg Rules
Tax Acctg Rules
Level of Reserve
Adequacy
INPUTS PARAMETERS
Use of IRR Model
Determination of profit load for prospective pricing
Retrospective Measurement of Profitability
Overall Process: Pricing
Inputs Asset flows
U/W flows
Investment flows
Tax flows
(in terms of premium)
Target Return on
Capital
Parameters
Equity Flows (in terms of premium)
Pricing Model
Target Premium
Target Combined Ratio
Application: Retrospective Analysis
Inputs Asset flows
U/W flows
Investment flows
Tax flowsParameters
Equity Flows
Pricing Model
Actual Return on Capital
Invest Rate of Return = 7.6% +Actual -100 bp 0 bp 100 bp
CR103.0% 13.7% 15.5% 17.3%104.0% 13.0% 14.8% 16.5%105.0% 12.3% 14.1% 15.8%106.0% 11.6% 13.4% 15.1%107.0% 10.9% 12.7% 14.5%108.0% 10.3% 12.1% 13.8%109.0% 9.7% 11.5% 13.2%110.0% 9.1% 10.9% 12.6%111.0% 8.5% 10.3% 12.0%112.0% 7.9% 9.7% 11.4%113.0% 7.4% 9.2% 10.9%
Mapping from Actual CR to
Return on Capital
Profit Measurement
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
Income to Equityholders
Equity Flow
- Capital
Net Income
Capitalt = sum of CC (from time 0 to time t)
Net Incomet = EFCt-1 * IRR on equity flows
CCt = Equityflowt - Dividendt
IRR Acctg System SAP Acctg System
Net Incomet = Statutory Net Income
CCt = SAP Surplust
Capitalt = Statutory Surplust
Simple Examplet = 0 t = 0.5 t = 1.0 t = 1.5 t = 2.0 t = 2.5 t = 3.0
UW TRANSACTIONSPremium 1,000.00 0.00 0.00 0.00 0.00 0.00 0.00Expense - Acquisition 250.00 0.00 0.00 0.00 0.00 0.00 0.00Expense - General 0.00 150.00 0.00 0.00 0.00 0.00 0.00Loss 0.00 0.00 0.00 0.00 0.00 0.00 800.00
CASH FLOWSAsset Flow 1,250.00 -40.00 -290.00 0.00 0.00 0.00 -920.00UW Flow 750.00 -150.00 0.00 0.00 0.00 0.00 -800.00Inv Inc Flow 47.20 46.89 36.58 36.02 35.46 36.13Tax Flow 17.50 -9.87 -9.76 -10.00 -9.81 4.39 4.16DTA Flow 70.00 -32.20 -32.20 14.00 14.00 -16.80 -16.80Equityflow -412.50 -104.87 294.93 40.57 40.21 23.05 143.48
IRR (annual basis) 3.0% IRR (semi-annual basis) 1.5%
Target return = 12%; Investment return = 8%; Surplus = 25% of WP (1st year) + 15% of Loss Reserves;
Equityflow Net Income Capital Capital
day before t=0 412.50 412.50
t = 0 -412.50 -162.50 -162.50 250.00
t = 0.5 -104.87 -44.87 60.00 310.00
t = 1.0 294.93 104.93 -190.00 120.00
t = 1.5 40.57 40.57 0.00 120.00
t = 2.0 40.21 40.21 0.00 120.00
t = 2.5 23.05 23.05 0.00 120.00
t = 3.0 143.48 23.48 -120.00 0.00
24.87 24.87 0.00
Accounting System: SAP
Equityflow Net Income Capital Capital
day before t=0 412.50 412.50
t = 0 -412.50 0.00 0.00 412.50
t = 0.5 -104.87 6.13 111.00 523.50
t = 1.0 294.93 7.77 -287.15 236.34
t = 1.5 40.57 3.51 -37.07 199.28
t = 2.0 40.21 2.96 -37.25 162.02
t = 2.5 23.05 2.41 -20.64 141.38
t = 3.0 143.48 2.10 -141.38 0.00
24.87 24.87 0.00
Accounting System: IRR
EVA
Equity Flow
- Capital
Net Income
EVAt = Net Incomet - $ cost of capital
= Net Incomet - Capitalt-1 * cost of capital
EconomicNet Income Cost of Capital Starting Capital Value Added
t = 0 -162.50 - 0.00% * 412.50 = -162.50
t = 0.5 -44.87 - 5.83% * 250.00 = -59.45
t = 1.0 104.93 - 5.83% * 310.00 = 86.85
t = 1.5 40.57 - 5.83% * 120.00 = 33.58
t = 2.0 40.21 - 5.83% * 120.00 = 33.21
t = 2.5 23.05 - 5.83% * 120.00 = 16.05
t = 3.0 23.48 - 5.83% * 120.00 = 16.49
Economic Value Added: -62.49
NPV(at cost of capital)
Accounting System: SAP
EconomicNet Income - Cost of Capital * Starting Capital = Value Added
t = 0 0.00 - 0.00% * 412.50 = 0.00
t = 0.5 6.13 - 5.83% * 412.50 = -17.92
t = 1.0 7.77 - 5.83% * 523.50 = -22.75
t = 1.5 3.51 - 5.83% * 236.34 = -10.27
t = 2.0 2.96 - 5.83% * 199.28 = -8.66
t = 2.5 2.41 - 5.83% * 162.02 = -7.04
t = 3.0 2.10 - 5.83% * 141.38 = -6.14
Economic Value Added: -62.49
NPV(at cost of capital)
Accounting System: IRR
Parameters & Presentation
Cost of Capital
Market Benchmark
Return Factor Model (CAPM)
Historical Experience
Risk-Adjusted Discount Rates
Risk-Adjusted Capital
Investment Return: Accounting Issues
Asset allocation: actual vs nominal
Book yields vs New money yields
Valuation of assets• Statutory valuation portfolio composition
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
Surplus
Exogenous needs overall amount of surplus
Endogenous needs allocation to line/policy
Sensitivity to Parameters
Target Combined Ratio
Post-Tax Investment Rate of Return = 8.0% +ROC -250 bp -200 bp -150 bp -100 bp -50 bp 0 bp + 50 bp + 100 bp + 150 bp + 200 bp +250 bp
= 12.0% +-250 bp 1.056 1.068 1.081 1.093 1.106 1.119 1.133 1.147 1.161 1.176 1.191-200 bp 1.052 1.064 1.076 1.088 1.101 1.114 1.128 1.141 1.155 1.170 1.184-150 bp 1.048 1.060 1.072 1.084 1.096 1.109 1.122 1.136 1.150 1.164 1.178-100 bp 1.044 1.055 1.067 1.079 1.092 1.104 1.117 1.130 1.144 1.158 1.172-50 bp 1.040 1.051 1.063 1.075 1.087 1.099 1.112 1.125 1.139 1.152 1.166
0 bp 1.036 1.047 1.059 1.071 1.083 1.095 1.107 1.120 1.133 1.147 1.16050 bp 1.032 1.043 1.055 1.066 1.078 1.090 1.102 1.115 1.128 1.141 1.155
100 bp 1.029 1.040 1.051 1.062 1.074 1.086 1.098 1.110 1.123 1.136 1.149150 bp 1.025 1.036 1.047 1.058 1.070 1.081 1.093 1.105 1.118 1.131 1.144200 bp 1.022 1.032 1.043 1.054 1.065 1.077 1.089 1.101 1.113 1.126 1.139250 bp 1.018 1.029 1.039 1.050 1.061 1.073 1.084 1.096 1.108 1.121 1.133
Target ROC is discretionary
Investment Rate of Return is partly discretionary
Sensitivity to Parameters
Reserve Investment Rate of Return = 8.0% +Leverage Ratio -250 bp -200 bp -150 bp -100 bp -50 bp 0 bp + 50 bp + 100 bp + 150 bp + 200 bp +250 bp
= 15.0% +-1500 bp -1000 bp 105.2% 106.3% 107.4% 108.6% 109.7% 110.9% 112.1% 113.4% 114.6% 115.9% 117.2%-500 bp 104.4% 105.5% 106.6% 107.8% 109.0% 110.2% 111.4% 112.7% 114.0% 115.3% 116.6%
0 bp 103.6% 104.7% 105.9% 107.1% 108.3% 109.5% 110.7% 112.0% 113.3% 114.7% 116.0%+500 bp 102.8% 104.0% 105.1% 106.3% 107.5% 108.8% 110.0% 111.4% 112.7% 114.1% 115.5%
+1000 bp 102.1% 103.2% 104.4% 105.6% 106.8% 108.1% 109.4% 110.7% 112.1% 113.4% 114.9%+1500 bp 101.3% 102.5% 103.7% 104.9% 106.1% 107.4% 108.7% 110.1% 111.4% 112.8% 114.3%
Premium Investment Rate of Return = 8.0% +Leverage Ratio -250 bp -200 bp -150 bp -100 bp -50 bp 0 bp + 50 bp + 100 bp + 150 bp + 200 bp +250 bp
= 25.0% +-1500 bp 105.2% 106.3% 107.4% 108.5% 109.7% 110.9% 112.1% 113.3% 114.6% 115.9% 117.2%-1000 bp 104.6% 105.7% 106.9% 108.0% 109.2% 110.4% 111.6% 112.9% 114.2% 115.5% 116.8%-500 bp 104.1% 105.2% 106.4% 107.5% 108.7% 109.9% 111.2% 112.4% 113.7% 115.1% 116.4%
0 bp 103.6% 104.7% 105.9% 107.1% 108.3% 109.5% 110.7% 112.0% 113.3% 114.7% 116.0%+500 bp 103.1% 104.2% 105.4% 106.6% 107.8% 109.0% 110.3% 111.6% 112.9% 114.3% 115.7%
+1000 bp 102.6% 103.7% 104.9% 106.1% 107.3% 108.6% 109.8% 111.2% 112.5% 113.9% 115.3%+1500 bp 102.1% 103.3% 104.4% 105.6% 106.9% 108.1% 109.4% 110.7% 112.1% 113.5% 114.9%
Surplus Assumption: Exogenous requirements determine overall amount of surplus; allocation to line is discretionary
Cost of Holding Capital
Reserve Valuation Rate Reserve valuation rate
(implicit discounting): 0%, 5%, 10%
IRR target 15%
970
980
990
1000
1010
1020
1030
0% 5% 10%
Premium
Loss $1,000 paid t=3; expenses $170 paid t=0; invest return = 10%;
Components of Premium
0
10
20
30
40
50
60
70
0% 5% 10%
PV(Taxes)PhFC
PV (Loss + Expenses) PV (Taxes) PhFC
860
880
900
920
940
960
980
1000
1020
1040
0% 5% 10%
PremiumPV(Loss&Exp)
Cost of Holding Capital
860
880
900
920
940
960
980
1000
1020
1040
0% 5% 10%
PremiumPV(Loss&Exp)
PV (Loss + Expense)Tax Timing
EffectTaxes - CoHC PhFC
0
20
40
60
80
100
120
0% 5% 10%
Tax TimingEffectCoHC
PhFC
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.
Performance Measurement
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
Performance Measurement: Applications of EVA
» Corresponds to profitability
» Corresponds to increase in profitability
» Smooths fluctuations in profitability
Absolute EVA
Change in EVA
Amortization of EVA