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35 Cards in this Set

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Introduction
This chapter is about how an Insurance Company should measure its capital, profit, and growth — in short, its performance. Management needs a well thought-out system for measuring performance.
Considerations in Choosing Performance Measures
The Growth Indicators and Performance Measures chosen must be appropriate, given the company’s:
 mission
 objectives (see below)
 organization
 distribution (sales/marketing) system
 products
An Ins Co’s or MCO’s Audiences, and their concerns:
 Management (Board of Directors)
 concerned with the needs of rating agencies, shareholders, and ph’s
 Shareholders
Value to shareholders is a function of
 growth
 profits (dividends)
 financial strength (capital)
 Providers
 Agents/brokers
 Regulators
 concerned with ins cpy solvency (adequacy of capital and reserves)
 Rating Agencies
 concerned with ins cpy solvency and with riskiness of business written
 Policyholders (individuals and er groups)
 want low premiums but also insurance company stability (a conflict)
EXAMPLES OF POSSIBLE COMPANY OBJECTIVES
Note: each line of business might have its own objective.
Quantitative Objectives
 Surplus and Stability
 financial strength
 a particular rating from agencies (like AA or better)
 a particular Profitability (ROE = .15 or Loss Ratio = 72% or Profit Margin= 30%)
 compliance with a particular regulation
 a target persistency rate

 Growth (means “sales and new business”) (usually in conflict with the above)
 Mergers/acquisitions
 systems development
 a particular new product
 a specific market share
 expansion of the sales force

Qualitative objectives
 developing a reputation for quality / fairness / integrity
 a highly-skilled workforce
 special 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 the company’s growth is self-financing
 externally, by borrowing (if profit margins are sufficient to cover interest owed)
 (difficult for BC/BS organizations.)
 by using reinsurance
 (this reduces the amount of risk assumed and therefore reduces the amount of RBC that must be held, thus freeing up capital for the company’s use)
 From the parent company or subsidiary
 by raising premium rates (difficult, because of regulations and policyholder lapsation)

Capital gains (Interest Income) are insignificant for Group Insurance, since there are few invested assets.
 Implication: GAAP adjustments to Statutory reporting and reserving are small.
Choosing a Measurement of RBC (Risk-Based Capital) for your Company:
The Standard Benchmarks (formulas) for RBC must be modified for your company, b/c:
 RBC is intended to provide a “reasonable safety” margin, and the definition of “reasonable safety” will vary depending on the company’s objectives, products, and audience.
 Extra “Vitality Surplus” will be needed to carry out corporate objectives like mergers and acquisitions, systems development, internal growth, etc. which vary among companies.
 The company’s RBC formula needs to satisfy regulators. Depends on specific rating desired.

Once your cpy’s RBC formula is chosen, you must test that RBC formula's effect on pricing.
In other words, see how the products must be priced in order to achieve the needed surplus.

 If the RBC formula causes a product to be uncompetitive, then either:
 the surplus formula is too conservative, or
 the product is too risky and should be withdrawn.
PROFIT MEASURES
Profit Margin
Profit Margin
= ratio of earnings to premiums
over a year
or
= Present Value of future Profits / Present Value of future premiums
over a multi-year period
Underwriting Gain
Note: “Gain” means PROFIT, not gain as in actual vs. expected. The terms “underwriting profit” and “underwriting gain” are synonymous.
UG = Premiums – Losses – Expenses
If Losses and Expenses are expressed as dollar amounts, then Underwriting Gain will be a dollar amount.
If Losses and Expenses are expressed as percentages of the year’s premium, then Underwriting Gain will be expressed as a percentage of the year’s premium.

(See numerical example below)
Operating Gain
Operating Gain equals Underwriting Gain plus Investment Income (as a percent of premiums, in this textbook).

OG = UG + II
Make sure that all the addends are on the same basis — pre-tax or after-tax — before attempting to compute Underwriting Gain or Operating Gain.
Loss Ratio:
LR = incurred claims / earned premiums
or, equivalently,
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
 LR automatically adjusts for growth (since denominator is premiums, a growth measure)
That is, the LR has the same interpretation regardless of the size of a company. Two different sized companies can compare LR’s.

Problems with Loss Ratios
 Loss Ratios may be distorted by
 reserve adjustments
 seasonality
 cyclicality
 thus, the actuary must use judgment before interpreting them.
Return on Equity (ROE)
ROE = GAAP operating gain / GAAP capital and surplus

But for Group Insurance, GAAP is almost the same as Statutory. So, for “GAAP capital and surplus” we just use the statutory Risk-Based Capital. Thus:
ROE = OG / RBC.
ROE is unitless, like 0.37. It is not a percent of premium.

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 the ROE measure:
 GAAP surplus may differ from statutory surplus. GAAP Surplus understates the amount of capital needed to support the business.
 ROE figures are often misunderstood, and not readily available
 for Service Businesses (like ASO), ROE is very high and nearly meaningless.
 Long delay before profitability problems are recognized.
Recommendations that would allow management to intervene more quickly:
 Break down the ROE objective into smaller, weekly objectives.
 Choose specific objectives for each product line.
 Don’t just rely on accounting measures.
Statistics that are preferable to ROE:
 ratio of Underwriting Gain to premiums
 Loss Ratio
It’s full of problems, too, but at least it’s easy to understand.
 Economic Value Added (see below)
Economic Value Added (from a project)
 Defined as the excess of profit over the cost of capital
EVA = (ROE – CoC) * amount of capital invested in the project
Cost of Capital has two interpretations, which are both equivalent. The simplest definition of CoC is the interest rate that you could earn by doing “nothing” with your money. For example, suppose you have $100,000 currently in a mutual fund earning 7% per year, and you are considering withdrawing this money to open a restaurant. Then your CoC is 7%*. If the restaurant earns you $10,000 in profit in one year, then the venture has added value. In fact, the EVA from this investment is
(.10 – .07) * $100,000 = $3,000.

For a company, management must decide every year whether to pay out dividends to the shareholders, or whether to retain earnings. If the company chooses not to pay out dividends, the shareholders expect the company to do something worthwhile with that capital; that is, to produce at least as great a return on that money as it would have by paying out the dividends. The rate of return the company would have produced for the shareholders is the cost of capital.

*Note: Technically, the alternative investment must be at the same risk level for this CoC definition to apply.
Advantages of using EVA:
 EVA represents the process of adding value
 Projects which do not pass ROE criteria may pass EVA criteria
ROE could be negative but EVA still positive, or vice versa.
 Directs management’s attention to unapparent strategies like reducing the cost of capital, which ROE misses.
GROWTH MEASURES
Premium Equivalents (PE’s)
 The growth measure should be consistent with the capital & profit measures. Since those were based on premiums, growth measurement should also be based on premium.

 However, “Group operations typically offer a variety of products with different deductibles, risk-sharing devices, and other characteristics. Adding up the premiums for all of these products . . . [is] like trying to combine apples and oranges.” – GI, p. 871

 Traditional Premium Equivalents are conversions of the premiums for each product into the premiums that would have been generated if the customer had bought traditional, fully-insured indemnity insurance.

 However, traditional PE’s aren’t consistent with (“don’t track”) the measurements used for capital and profits, because traditional PE’s don’t take into account the different riskinesses of different products.
An insurance company sells many products, some of which it is at no risk for. (for example, the “Administrative Services Only” service that it provides to self-insuring employer groups)
The insurer’s profit (i.e. margins charged) and capital (RBC) are higher for risky products than for nonrisky products. So it would be better if the PE’s took product riskiness into account.

 Risk-based Premium Equivalents (RBPE’s) include such an adjustment. To use them:
1. Split company into different blocks of business, and each has its own surplus formula.

2. Determine Risk-based Premium Equivalents for each block of business, by dividing the traditional PE’s (that is, the plain premiums converted to fully-insured indemnity insurance basis) by the relative risk factors for the lines of business.

3. The RBC formula can be restated in such a way that it tracks closely with RBPE’s.
Reasons why Premium Equivalents are necessary:
 Growth measure should be based on premiums
 Ins cpy’s products differ in benefits, deductibles, risk-sharing
 premiums are like apples and oranges.
Advantages of using Risk Based Premium Equivalents:
 they track closely with growth in surplus and expected profits.
Secondary growth measures
Premium is the number one growth measure, but the following measures can help to explain underlying reasons for growth in premium income:
 New cases sold
 Number of group contracts in force
 Number of employees and dependents covered (exposure)
 Commissions
DISTORTIONS AND HOW TO ELIMINATE THEM
Reserving
 Reserves reflect both new claims and revised estimates for old claims, so it’s hard to tell what period caused losses
Solutions:
 Avoid this difficulty by tracking each year’s business as separate block for calculating loss ratios
 Hold accounts open until claim runout is finished (called the incurral year basis)
Seasonal Trends
Caused by
 annual changes in deductibles
 holiday nonutilization
Solutions:
 Use 12-month rolling average Loss Ratios
 adjust reserves by seasonal factors
Cyclical Trends
 Group health will show losses in three out of every six years in a typical “underwriting cycle”
Solutions:
 Therefore, Profit objectives should be long term
 Make sure accumulation of current-period financial results is done on a consistent basis over that long term.
Inflation and Trend
 With health care costs (and premiums) rising at over 10% per year, you can have the illusion of growth even if there is none.
Solutions:
 Earned Premiums should be adjusted for trends and inflation.
Asset Growth
 The Cpy must be able to split apparent growth into true growth (more premiums coming in) and Asset Growth (due to investment income earned on existing assets)
Service Businesses
Examples: ASO business, PPO’s (which take no insurance risk), UM divisions.
 Little risk and little monetary capital involved.
 The Resources (capital) are people, information, and technology
 ROE is often very high and nearly meaningless.
Solutions:
 Better profit measures for service business are Return on Sales (profits/revenue), or Profit per Employee.
HOW CAPITAL, PROFIT, AND GROWTH MEASURES INTERRELATE
Recall that Value to shareholders is a function of
 growth
 profits (dividends)
 financial strength (capital)
 These components cannot be managed separately; there are fundamental relationships between them.
For this section, assume:
 No capital gains or losses
 no changes in reserve basis
 Statutory and GAAP financial statements are identical
This means that the book value of any asset or liability is equal to the market value of that asset or liability. Book Value is a statutory, usually conservative, measurement, whereas GAAP is a realistic measurement.
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.

 If the company grows faster than this, its Risk-Based Capital requirement will get too large and the company will not be able to satisfy it.

 Note: For a mutual or nonprofit company that doesn’t pay dividends,
sustainable growth rate = ROE.

Example:
If a company is growing (from new sales and premiums) at 6%, and medical cost trends are 10%, then the company’s premiums are growing at 16% per year. The company must achieve an ROE of at least 16% (causing the sustainable growth rate to be at least 16%) in order to finance its capital requirements.

If the company intends to pay annual dividends of 3%, then it needs to earn an ROE of 19% in order to finance the 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.

Notes
 The textbook uses the term “book value” to mean the book value of the company’s surplus. So:
BVi = Book value of surplus at the end of year i = BVi (assets) – BVi (liabilities)

 Book Value is a snapshot of surplus at one point in time, whereas Book Profit refers to earnings over a period of time.
Following surplus from one year to the next, we have:

BVi-1 + BPi – Di = BVi
[ year i-1 ] [ year i ]

In other words, beginning-of-year surplus, plus profits earned less dividends paid out, equals end-of-year surplus.

We will now rewrite each symbol in terms of the beginning-of-year surplus.
 Earnings are equal to the surplus times some profit measure (usually we use ROE). That is, BPi = ROE * BVi-1.
 Dividends are equal to surplus times the dividend payout rate, d. That is, Di = d * BVi-1.

 Assume that the company has no free surplus at the beginning of the year. That is, surplus is exactly equal to Risk-Based Capital: BVi-1¬ = RBCi-1.
 A growth rate is sustainable if the end-of-year surplus will also remain at least equal to Risk Based Capital. Thus, set: BVi = RBCi.
 Since Risk-Based Capital formulas are designed to track the company’s growth, assume that RBCi / RBCi-1 = (1 + g)
where g is the sustainable growth rate, a decimal between 0 and 1
 These last three assumptions together give us: BVi = BVi-1 * (1+g).

To recap, we now have:

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.
1
GROWTH / CAPITAL / PROFIT MEASUREMENT FOR MCO’s vs. TRADITIONAL INSURERS
Differences on the cost side (pay-out)
 MCO’s have a broader array of financial mgmt choices than Traditional group insurance cpys:
 MCO’s can vary the amount of risk assumed (using risk-sharing w/providers; reinsurance)
 For MCO’s, different reimbursement methods to providers are possible (capitation, Ffs, etc.)
 For MCO’s, in-network and out-of-network benefits are different from each other.
Similarities on the pay-in side
 The pay-in component is similar for MCO’s and Traditionals, since it is just a monthly premium received from each Er group, whether the insurer is a Traditional or an MCO.
CAPITAL BUDGETING
Capital Budgeting means the financial evaluation of different possible investments.
 What is the ROI of the proposed investment?
 Is the potential reward worth the risks?
 Is the proposed investment the most cost-effective way to achieve the objective?
Group operations face unique challenges in capital budgeting:
 Health cost trends are high, and hard to predict
 Some medical lines of business can’t finance their own growth
 Earnings often cyclical
 Difficult to measure profitability or ROI, except over a several-year period
Recommendations in Budgeting:
 Develop a long-term, strategic business plan
 Translate the strategic plan into a financial budgeting plan, which projects:
 sources of capital
 usage of capital
 hurdle rates for each line of business (minimum ROI required)
 Periodically analyze each line of business: See if value is being created or destroyed.
Considerations in this analysis:
 Difficult, since ROI is cyclical
 ROE can be used as a proxy for ROI
 but ROE suffers from the problems described earlier in this document
 Take corrective action on lines of business that are failing to reach their hurdle rate
 product redesign
 Add up all lines of business, to see if the whole operation is self-financing.

Done.