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Financial Pricing and Performance Measurement

This study explores the IRR pricing model, profit measures, parameters, cost of holding capital, and performance measurement in the financial industry.

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Financial Pricing and Performance Measurement

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  1. Financial Pricing and Performance Measurement Sholom Feldblum, Neeza Thandi May 2003

  2. Topics • IRR Pricing Model • Profit Measures • Parameters and Presentation • Cost of Holding Capital

  3. Pricing

  4. 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

  5. Pricing: Insurance Industry • Statutory Accounting Rules matter • constrain flow to equityholders • Adaptation of Net Cash Flow Model • applied to P&C

  6. Illustration: Accounting Constraint

  7. vsAsset Need on Economic Basis PV(future costs) Capital Asset Requirement Required Reserves Surplus Assets: Statutory Accounting requirements Capital Allocation procedure

  8. 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

  9. 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

  10. Use of IRR Model • Determination of profit load for prospective pricing • Retrospective Measurement of Profitability

  11. 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

  12. 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

  13. Profit Measurement

  14. 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

  15. -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

  16. Simple Example Target return = 12%;Investment return = 8%; Surplus = 25% of WP (1st year) + 15% of Loss Reserves;

  17. Accounting System: SAP

  18. Accounting System: IRR

  19. EVA -D Capital Equity Flow Net Income EVAt = Net Incomet - $ cost of capital = Net Incomet - Capitalt-1 * cost of capital

  20. Accounting System: SAP

  21. Accounting System: IRR

  22. Parameters & Presentation

  23. Cost of Capital • Market Benchmark • Return Factor Model (CAPM) • Historical Experience • Risk-Adjusted Discount Rates • Risk-Adjusted Capital

  24. Investment Return: Accounting Issues • Asset allocation: actual vs nominal • Book yields vs New money yields • Valuation of assets • Statutory valuation  portfolio composition

  25. 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

  26. Surplus • Exogenous needs  overall amount of surplus • Endogenous needs  allocation to line/policy

  27. Sensitivity to Parameters Target ROC is discretionary Investment Rate of Return is partly discretionary

  28. Sensitivity to Parameters Surplus Assumption: Exogenous requirements determine overall amount of surplus; allocation to line is discretionary

  29. Cost of Holding Capital

  30. 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%;

  31. Components of Premium PV (Loss + Expenses) PV (Taxes) PhFC

  32. Cost of Holding Capital PV (Loss + Expense) Tax Timing Effect Taxes - CoHC PhFC

  33. 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.

  34. Performance Measurement

  35. 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

  36. 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

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