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GI Chapter 41 Measuring Capital, Profit, and Growth

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

Qualitative objectives
ï‚Ÿ quality
ï‚Ÿ skilled workforce
ï‚Ÿ 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:
ï‚Ÿ if growth is self-financing
 by borrowing — but difficult for BC/BS’s
ï‚Ÿ by using reinsurance (reduces RBC)
ï‚Ÿ From a parent company or subsidiary
ï‚Ÿ 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
ï‚Ÿ depends on rating desired

Test the RBC formula's effect on pricing.
ï‚Ÿ 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 the product is too risky and should be withdrawn.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:
ï‚Ÿ commonly used and easily recognized
ï‚Ÿ Automatically adjust for growth

Problems with Loss Ratios
ï‚Ÿ Distorted by
 reserve adjustments
 seasonality
 cyclicality
ï‚Ÿ 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:
ï‚Ÿ Earnings / Surplus
ï‚Ÿ Book Profit / Book Value
ï‚Ÿ Net Income / Shareholders Equity
(See “How Capital, Profit, and Growth Interrelate”, below, for more information)
Problems with Return on Equity
ï‚Ÿ GAAP surplus understates the capital needed by a business.
ï‚Ÿ misunderstood, and not readily available
ï‚Ÿ for Service Businesses, ROE is very high and meaningless.
ï‚Ÿ 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:
ï‚Ÿ Projects which do not pass ROE criteria may pass EVA criteria
ï‚Ÿ find unapparent strategies like reducing the cost of capital.
GROWTH MEASURES
Premium Equivalents (PE’s)
ï‚Ÿ 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.
ï‚Ÿ Each block of business has its own required surplus formula.
ï‚Ÿ 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:
ï‚Ÿ New cases sold
ï‚Ÿ Number of contracts in force
 Number of ees/dep’ts (exposure)
ï‚Ÿ Commissions
DISTORTIONS AND HOW TO ELIMINATE THEM
ï‚Ÿ Reserving
 hard to tell what period caused losses

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

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

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

Solutions:
 Earned Premiums should be adjusted.
ï‚Ÿ Asset Growth
 split growth into true growth (more premiums) and Asset Growth (investment income)
ï‚Ÿ 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
ï‚Ÿ These components cannot be managed separately.
For this section, assume:
ï‚Ÿ No capital gains
ï‚Ÿ no changes in reserve basis
ï‚Ÿ Statutory and GAAP financial statements ar
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

ï‚Ÿ 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.
ï‚Ÿ Let BPi denote the book profit (earnings) earned by the company during year i.
ï‚Ÿ 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:
ï‚Ÿ costs trends high and hard to predict
 Some LOB’s can’t finance their own growth
ï‚Ÿ Earnings often cyclical
ï‚Ÿ Difficult to measure profitability
Recommendations in Budgeting:
ï‚Ÿ Develop a long-term, strategic business plan
ï‚Ÿ Translate into a financial budgeting plan:
 sources of capital
 usage of capital
 hurdle rates for each LOB
ï‚Ÿ 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)
ï‚Ÿ Take corrective action
 e.g. product redesign
ï‚Ÿ Add up all lines of business, to see if the whole operation is self-financing.

Done.

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