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Financial Pricing and Performance Measurement. Sholom Feldblum, Neeza Thandi July 2003. Topics. IRR Pricing Model Profit Measures Parameters and Presentation Cost of Holding Capital. Pricing. DFA Seminar, July 2003. Company. Pricing: Non-Insurance Industries. Net Cash Flow Analysis.
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Financial Pricing and Performance Measurement Sholom Feldblum, Neeza Thandi July 2003
Topics • IRR Pricing Model • Profit Measures • Parameters and Presentation • Cost of Holding Capital
Pricing DFA Seminar, July 2003
Company Pricing:Non-Insurance Industries Net Cash Flow Analysis Cash flow from operations Net Cash Flow Increase in Net Working Capital Capital Investment in Fixed Assets
Pricing: Insurance Industry • Statutory Accounting Rules matter • constrain flow to equityholders • Adaptation of Net Cash Flow Model • applied to P&C
vsAsset Need on Economic Basis PV(future costs) Capital Asset Requirement Required Reserves Surplus Assets: Statutory Accounting requirements Capital Allocation procedure
Determinants of Equity Flows • Asset Flow • U/W Flow • Invest Inc Flow • Tax Flow Increase in Net Working Capital Cash Flow from Operations Equity Flow = Cash Flow from Operations - Incr in Net Working Capital = 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
Target Return on Capital Asset flows U/W flows Investment flows Tax flows (in terms of premium) Equity Flows (in terms of premium) Target Premium Overall Process: Pricing Pricing Model Inputs Parameters Target Combined Ratio
Pricing Model Asset flows U/W flows Investment flows Tax flows Inputs Actual Return on Capital Equity Flows Parameters Application: Retrospective Analysis Mapping from Actual CR to Return on Capital
Profit Measurement DFA Seminar, July 2003
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
-D Capital Equity Flow Net Income Income to Equityholders IRR Acctg System SAP Acctg System Net Incomet = EFCt-1 * IRRon equity flows Net Incomet = Statutory Net Income CCt = Equityflowt - Dividendt CCt = D SAP Surplust Capitalt = sum of CC (from time 0 to time t) Capitalt = Statutory Surplust
Simple Example Target return = 12%;Investment return = 8%; Surplus = 25% of WP (1st year) + 15% of Loss Reserves;
EVA -D Capital Equity Flow Net Income EVAt = Net Incomet - $ cost of capital = Net Incomet - Capitalt-1 * cost of capital
Parameters & Presentation DFA Seminar, July 2003
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 ROC is discretionary Investment Rate of Return is partly discretionary
Sensitivity to Parameters Surplus Assumption: Exogenous requirements determine overall amount of surplus; allocation to line is discretionary
Reserve Valuation Rate • Reserve valuation rate (implicit discounting): 0%, 5%, 10% • IRR target 15% Loss $1,000 paid t=3; expenses $170 paid t=0; invest return = 10%;
Components of Premium PV (Loss + Expenses) PV (Taxes) PhFC
Cost of Holding Capital PV (Loss + Expense) Tax Timing Effect Taxes - CoHC 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: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 • Absolute EVA • Change in EVA • Amortization of EVA • Corresponds to profitability • Corresponds to increase in profitability • Smooths fluctuations in profitability