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28 Cards in this Set

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Considerations in Choosing Performance Measures
Measures must reflect company’s:
 mission
 objectives
 organization
 distribution system
 products
 audiences (see next)
An Ins Co’s or MCO’s Audiences, and their concerns:
 Management
 concerned with rating agencies, shareholders, and ph’s
 Shareholders
 want: growth, profits, dividends, financial strength
 Providers
 Agents/brokers
 Regulators (concerned with solvency)
 Rating Agencies (concerned with solvency and risk)
 Policyholders (want low prems but also stability)
Examples Of Possible Company Objectives
Quantitative Objectives
 Surplus and Stability
 financial strength
 AAA rating
 ROE = .15
 compliance
 target persistency rate
 Growth
(usually in conflict with the above)
 Mergers/acquisitions
 systems development
 a new product
 market share

Qualitative objectives
 quality
 skilled workforce
 stronger distribution channels

Moral: Objectives will satisfy some audiences but not others.
CAPITAL and RISK-BASED CAPITAL MEASURES

Capital is available to an Ins Cpy:
 if growth is self-financing
 by borrowing — but difficult for BC/BS’s
 by using reinsurance (reduces RBC)
 From a parent company or subsidiary
 by raising premium rates (difficult b/c of regulations and lapses)
Choosing a Measurement of RBC (Risk-Based Capital) for your Company:
Make sure you add this section to study note “TSA 36 – Required Surplus”.
Standard RBC Benchmarks must be modified, b/c:
 “reasonable safety margin” depends on company’s objectives & products
 “Vitality Surplus” needed for corporate objectives
 depends on rating desired

Test the RBC formula's effect on pricing.
 If the RBC formula causes a product to be uncompetitive, then either:
 the formula is too conservative, or
 the product is too risky and should be withdrawn.
PROFIT MEASURES
Profit Margin
Underwriting Gain
Operating Gain
Loss Ratio
Return on Equity (ROE)
Economic Value Added
Profit Margin
Profit Margin
= ratio of earnings to premiums
or
= Present Value of future Profits / Present Value of future premiums.
Underwriting Gain
UG = Premiums – Losses – Expenses
Operating Gain
OG = UG + Investment Income
Loss Ratio:
LR = incurred claims / earned premiums
or
LR = 1 – ER – PR
where ER = Expense Ratio = expenses / earned premiums
PR = Profit Ratio = profits / earned premiums

Advantages of Loss Ratios:
 commonly used and easily recognized
 Automatically adjust for growth

Problems with Loss Ratios
 Distorted by
 reserve adjustments
 seasonality
 cyclicality
 Actuary must use judgment
Return on Equity (ROE)
ROE = GAAP operating gain / GAAP capital and surplus
or:
ROE = OG / RBC.

Other equivalent formulas for ROE:
 Earnings / Surplus
 Book Profit / Book Value
 Net Income / Shareholders Equity
(See “How Capital, Profit, and Growth Interrelate”, below, for more information)
Problems with Return on Equity
 GAAP surplus understates the capital needed by a business.
 misunderstood, and not readily available
 for Service Businesses, ROE is very high and meaningless.
 Long delay before profitability problems are recognized.
Recommendations:
 Break down the ROE objective into smaller objectives.
 Choose goals for each product line.
 Don’t just rely on accounting measures.
Better statistics:
 ratio of Underwriting Gain to premiums
 Loss Ratio
 Economic Value Added

See numerical example in chapter notes.
Economic Value Added
EVA = (ROE – CoC) * amount of capital invested in the project

(See examples in chapter notes)

Advantages of using EVA:
 Projects which do not pass ROE criteria may pass EVA criteria
 find unapparent strategies like reducing the cost of capital.
GROWTH MEASURES
Premium Equivalents (PE’s)
 Growth measure must be consistent with capital & profit measures.
 so it should be based on premiums.
 Traditional PE’s convert premiums into the equivalent traditional, fully-insured indemnity premium.
 but Traditional PE’s don’t vary by product risk.
 Risk-Based PE’s include a risk adjustment.
 Each block of business has its own required surplus formula.
 Divide PE by the relative risk factor to get the RBPE.

see numerical example in chapter notes.
Secondary growth measures
The following can help explain underlying reasons for growth:
 New cases sold
 Number of contracts in force
 Number of ees/dep’ts (exposure)
 Commissions
DISTORTIONS AND HOW TO ELIMINATE THEM
 Reserving
 hard to tell what period caused losses

Solutions:
 track each year’s business as separate block
 use incurral year accounting
 Seasonal Trends
 Caused by annual deductibles and by holiday nonutilization

Solutions:
 Use 12-month rolling average
 adjust reserves by seasonal factors
 Cyclical Trends
 6-year “underwriting cycle”

Solutions:
 Profit objectives should be long term
 accounting method consistent from year to year.
 Inflation and Trend
 causes illusion of growth even if there is none.

Solutions:
 Earned Premiums should be adjusted.
 Asset Growth
 split growth into true growth (more premiums) and Asset Growth (investment income)
 Service Businesses
 Examples: ASO business, PPO’s, UM divisions.
 Little risk and little capital involved.
 The Resources are people, information, and technology
 ROE is often very high and nearly meaningless.

Solutions:
 Better profit measures are Return on Sales (profits/revenue), or Profit per Employee.
HOW CAPITAL, PROFIT, AND GROWTH MEASURES INTERRELATE
 These components cannot be managed separately.
For this section, assume:
 No capital gains
 no changes in reserve basis
 Statutory and GAAP financial statements are identical
The Sustainable Growth Rate
The fundamental link between growth, profit, and capital is:
sustainable growth rate = ROE – dividend payout rate.
growth measure profit measure capital measure

 The sustainable growth rate is the maximum rate at which a group operation can grow without the use of external capital.

Example:
If a company is growing (from new sales and premiums) at 6%, and medical cost trends are 10%, and dividends will be 3%, then the company must achieve an ROE of at least 19% to finance its capital requirements.
Derivation of the Sustainable Growth Rate
Definitions:
 Let BVi denote the book value of the company’s surplus at the end of year i.
 Let BPi denote the book profit (earnings) earned by the company during year i.
 Let Di denote dividends paid out during year i.

BVi-1 + BPi – Di = BVi
BVi-1 + ROE * BVi-1 – d * BVi-1 = BVi-1 * (1+g)
[ year i-1 ] [ year i ]

Dividing the equation on the second line by BVi-1, we have:
1 + ROE – d = (1 + g), or: g = ROE - d.
That is, sustainable growth rate = ROE – dividend payout rate.
GROWTH / CAPITAL / PROFIT MEASUREMENT FOR MCO’s vs. TRADITIONAL INSURERS
Differences on the cost side (pay-out)
 MCO’s have more financial choices:
 varying risk-sharing
 varying reimbursement methods
 Two benefit types: in-network and o-o-n.
 The pay-in side is similar for MCO’s and Traditionals.
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CAPITAL BUDGETING
Capital Budgeting means the financial evaluation of different possible investments.

Challenges in capital budgeting for Group Insurance:
 costs trends high and hard to predict
 Some LOB’s can’t finance their own growth
 Earnings often cyclical
 Difficult to measure profitability
Recommendations in Budgeting:
 Develop a long-term, strategic business plan
 Translate into a financial budgeting plan:
 sources of capital
 usage of capital
 hurdle rates for each LOB
 Periodically analyze each LOB: See if value is being created or destroyed.
Considerations:
 Difficult to tell, since ROI is cyclical
 ROE can be used as a proxy for ROI
 but ROE suffers from problems (see earlier)
 Take corrective action
 e.g. product redesign
 Add up all lines of business, to see if the whole operation is self-financing.

Done.