DISCOUNTED CASH FLOW MODELS and RATE OF RETURN PERSPECTIVES (FIN - 29

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DISCOUNTED CASH FLOW MODELS and RATE OF RETURN
PERSPECTIVES(FIN - 29 30)

• Russ Bingham
• Vice President and Director of Corporate
  Research Hartford Financial Services
• Seminar on Rate Making
• San Diego, CA
• March 9 10, 2000

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Discounted Cash Flow Models and Rate of Return
Perspectives Summary

• Discounted cash flow is a common approach used
  to assess financial performance. The purpose of
  this session will be to review this technique in
  the broader context of general financial models
  as applied in insurance. A discussion of the
  essential building blocks upon which models
  should be constructed will be followed by a
  review of various rate of return measures that
  result from them. Specifically, this will
  compare the policy / accident period to the
  calendar period view as well as compare the IRR
  and ROE rate of return calculations. Examples
  will be presented to demonstrate their
  fundamental equivalency. The policyholder and
  shareholder rate of return perspectives will also
  be reviewed.

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Contents

• Building Blocks The Fundamentals
• Conceptual Critique of Conventional Accounting
• Shortcomings of Reported Financials
• Economic Value Concepts
• Rate of Return Models Important Attributes
• Rate of Return Parameter Consistency
• Rate of Return Measures and Their Equivalency
• The Fundamental Insurance Total Return Model
• Components of Total Return Underwriting,
  Investment Leverage
• Aspects of Insurance Total Return
• Exhibits Balance Sheet, Income, Cash Flow
  Returns

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Building Blocks The Fundamentals

• Balance Sheet, Income and Cash Flow Statements
• Accounting Valuation Conventional (statutory or
  GAAP) and Economic (present value)
• Development Triangles of Marketing / Policy /
  Accident Period into Calendar Period

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Policy (or Accident) / Calendar Period
Development Triangles

Balance Sheet, Income,
Cash Flow Calendar Period Policy
Historical Future Total Period
1996 1997 1998 1999 2000 Ultimate
Prior X X X X X ... --gt
Sum 1996 X X X X X ...
--gt Sum 1997 X X X X
... --gt Sum 1998 X X X
... --gt Sum 1999 X X ...
--gt Sum 2000 X ... --gt
Sum
Reported Sum Sum Sum Sum Sum
Calendar
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General Shortcomings of Reported Financials

• Missing key elements of total return - absence of
  market value basis omits important information
  necessary to more fully judge performance
• Lacks more relevant current (i.e. policy /
  accident period) performance focus
• Biased against longer tail and higher combined
  ratio business which conceals profitability of
  commercial to a greater degree than personal lines

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Specific Shortcomings of Reported Financials

• Total Assets are affected by changing and
  somewhat arbitrary definitions of non-invested
  assets. (Suggest realignment with only Invested
  Assets on left side, net liabilities and equity
  on the right.)
• Income affected by premium earning, deferred
  acquisition and reserve estimation, all of which
  can be altered.
• Below the line surplus adjustments, such as
  unrealized gains, do not flow through income.
• Significant market value adjustments are ignored
  when Equity is reported -
• loss reserve adequacy/inadequacy and discount
  value
• some invested assets

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Economic Value Concepts

• Economic valuation presents a financial view in
  which all assets and liabilities are market
  valued (cash equivalent).
• Considers the estimated magnitude and timing of
  future cash flows
• Focus on performance related to current actions
  (i.e. policy or accident period) rather than
  performance related to when reported (i.e.
  calendar period)
• Economic income is the change in economic value
  over a period in time
• comprehensive income perspective (FASB 130)
• tight balance sheet, income and cash flow linkage
• no below the line adjustments

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Conceptual Commentary

• Reported income and returns (and other financials
  as well) follow conventional accounting rules
  which govern the timing of income recognition and
  are potentially a misleading basis for rating,
  regulation financial analysis. Economic rules
  produce different results.
• Retained earnings are largely irrelevant to
  economic accounting
• Unearned premium reserve is not cash, and thus
  not economic.
• Leverage levels involve concessions to the raters
  and create non-economic based constraints.
• Economic value is realized either by converting
  assets and liabilities to market via sale, or
  over time to earn the discount value.
• ROE calculation - change the formula (income /
  beginning period contributed surplus). Do not
  include retained earnings and do not average the
  equity.

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Rate of Return Models Important Attributes

• Focus on Cash Flow
• Inclusion of surplus with flow controlled by
  specified rules
• Operating (i.e. policyholder) cash flows
  maintained separately
• Economic value with after-tax discounting
• NPV income formulation (with and without risk
  adjustment)
• Development of NPV balance sheet liabilities
• Policyholder and shareholder rate of return
  calculations

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Rate of Return ModelsReaching a Common Ground -
Structural Modifications

• To Convert Myers-Cohn Into a Rate of Return Model
  
• Inclusion of surplus
• Economic value with after-tax discounting
• NPV income formulation (with risk adjustment)
• NPV income formulation (without risk adjustment)
• Development of NPV balance sheet liabilities
• Policyholder and shareholder rate of return
  calculations
• To Align Internal Rate of Return Model With Both
  Policyholder and Shareholder Perspectives
• Separation of operating (i.e. policyholder) cash
  flows
• Policyholder and shareholder rate of return
  calculations

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Rate of Return Parameter Consistency

• Dealing with Risk
• IRR cost of capital based total return
• NPV risk-adjusted total return equal to risk-free
  rate
• NPV total return (without risk-adjustment) equal
  to cost of capital
• Beta of Equity versus Beta of Liabilities
• Surplus Flows
• Controlling amount required and timing of flows
• Liability / surplus relationship
• Multi-period aspect
• Surplus flow components
• Surplus contribution and its release
• Investment income on contributed surplus
• Release of operating earnings

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Rate of Return Measures

• Income on Investment
• Conventional Calendar ROE Income / Average
  Equity, including Retained Earnings
• Nominal Ultimate ROE (steady state calendar
  equivalent)
• Discounted Ultimate ROE (net present value rate
  of return)
• Risk-adjusted Ultimate ROE (risk-adjusted NPV
  rate of return)
• ROE like Underwriting and Operating returns
  also
• Cash Flow Internal Rate of Return Basis
• Shareholder IRR (also Underwriting IRR and
  Operating IRR)
• Shareholder (i.e. Investor Perspective)
• Shareholder Cash Dividend Yield Realized
• Shareholder Total Return dividend plus stock
  price appreciation

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Equivalency in Rates of Return

• For Single Policy - Exhibit 1
• (1) IRR
• (2) Net present value ROE
• (3) Total policy ultimate nominal ROE
• (4) Shareholder annual dividend yield realized
• For Multiple Policy Ongoing (steady state, no
  growth) - Exhibit 2
• (5) IRR
• (6) Annual nominal ROE while at steady state
  (income / beginning contributed surplus)
• (7) Shareholder annual dividend yield realized

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The Fundamental InsuranceTotal Return Model

• (1) Total Return Operating Return X Operating
  Leverage
• Investment Rate of Return on Surplus
• Operating Return Underwriting Rate of Return
• Investment Rate of Return on
• Policyholder Liability Float
• OR
• (2) Total Return Underwriting Return X
  Operating Leverage
• Investment Return X Asset Leverage
• Operating Leverage Net Liabilities / Surplus
• Asset Leverage Invested Assets / Surplus
  
• Insurance Consists of Underwriting, Investment
  Financial Leverage

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The Components of Insurance Total Return
-Underwriting, Investment Leverage

• Underwriting Return is the price for the transfer
  of risk to the company associated with the
  policyholder related cash flows. When positive
  the company is being paid for the transfer of
  risk. When negative the company is incurring a
  cost to acquire the funds from the policyholder
  and must depend on the investment spread to
  generate a profit.
• Investment Return represents the yield on
  invested assets (from both policyholder supplied
  funds and surplus). The spread between the
  Investment Return applicable to policyholder
  supplied funds and the Underwriting Return must
  be positive if the company is to generate a net
  operating profit from underwriting.
• Leverage (based on surplus requirements needed to
  meet specified underwriting, investment and
  financial risk tolerances) creates a magnifying
  effect on both return and risk.
• Total Return reflects the shareholder oriented
  return, comprised of levered operating return
  plus the investment return on surplus.

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Aspects of Insurance Total Return

• The Total Rate of Return, as well as the
  Underwriting and Investment Rates of Return, can
  be determined on either
• a cash flow basis, via the Internal Rate of
  Return (IRR) or
• as a Return on Equity formed by the ratio of
  Income to Equity in which the financials are in
  EITHER Nominal or Present Valued terms
• The present value rate of return using a
  risk-adjusted discount rate will equal the
  risk-free rate, since by definition risk has been
  eliminated.
• Leverage is controlled by specifying rules
  governing the flow of surplus and dividend
  (distribution of earnings) to maintain a uniform
  risk profile over the life of the policy
• Contributed surplus governed by constant
  liability / surplus ratio
• Investment income on surplus dividended as earned
• Operating earnings distributed in proportion to
  per period liability exposure

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Total Return Model Example

• Total Return Oper Return X Oper Levg Invest
  Rate of Return on Surplus
• 14.9 3.7 X 3.0 3.9
  not risk-adjusted
• 6.0 0.7 X 3.0 3.9
  risk-adjusted basis
• Oper Return Und Rate of Return Invest Rate of
  Return on PH Float
• 3.7 -0.2 3.9
  not risk-adjusted
• 0.7 -0.2 3.9
  - 3.0 risk-adjusted basis
• CAPM Reference Data
• Risk-Free interest rate 6.0 3.9 after-tax
• Risk Premium 8.9
• Equity Beta 1.00
• Indicated cost of capital 14.9
• Liability Beta -0.52
• Indicated risk adjustment 4.6 3.0
  after-tax
• Indicated risk-adjusted discount
  rate 1.4 0.9 after-tax

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Simplified Ratemaking Spreadsheet