CAS Special Interest Seminar: Valuation of Insurance Operations

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CAS Special Interest SeminarValuation of
Insurance Operations

• Valuation Concepts as Used in Internal
  Performance Measurements
• Presented by
• Russel L. Sutter, FCAS
• April 11, 2000
• St. Louis, Missouri

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To Be Discussed

• ? Basics of valuation concepts
• ? Why such concepts should be used internally
• ? How value changes
• ? Framework of an internal valuation model
• ? Interpreting and utilizing model output
• ? Caveats on model usage

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Basics of Valuation Concepts

• Three basic concepts of valuation will be
  discussed
• ? Future cash flows discounted to present
• ? Capital invested has a cost
• ? Current decisions have a value by changing 1

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Why Valuation ConceptsShould Be Used Internally

• ? Investors care more about the future than the
  past
• Yahoo Inc., P/E 657
• Ford Motor, P/E 8
• ? Current income can be heavily influenced by
  past decisions
• ? New lines/products lose money initially
• Net income measures discourage long-term thinking
• ? Best way to measure whether todays decisions
  benefit the company

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Why Valuation ConceptsShould Be Used Internally
(cont.)

• ? New business loses money
• Higher loss ratios on new business are common
• Higher expense to generate new business than to
  maintain existing business
• Valuation concepts necessary to verify that new
  business is adding value

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How Does Value Change

• The value of a LOB or channel can change for
  several reasons(examples all show how decreases
  in value may emerge)
• Reserves can be deficient
• Experience of inforce business can vary from
  expected
• Retention rates lower than planned
• Price levels less than targeted
• Above-expected claims costs or expenses
• New business returns can vary as well
• Same costs but lower price/production
• Higher underlying loss costs

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Framework of a Valuation Model

• Key inputs
• Surplus and required returns by line of business
• Original effective date experience model by LOB

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Framework of a Valuation Model (cont.)

• Key inputs (cont.)
• Corporate Account
• Handles surplus not invested in insurance
  operations
• Encompasses investment and tax functions
• Includes all income/expense items not attributed
  to insurance operations(e.g., excessive
  corporate overhead)

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Framework of a Valuation Model (cont.)
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Framework of a Valuation Model (cont.)
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Framework of a Valuation Model (cont.)

• Consider the following model of an insurers
  business

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Framework of a Valuation Model (cont.)

• The insurers value added analysis for 2001 might
  look as follows

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Framework of a Valuation Model (cont.)

• The insurers value added analysis for 2001 might
  look as follows (cont.)

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Interpreting and Utilizing Model Output

• Run-off of existing business does not add value
  if performance is as expected, despite favorable
  income results
• If a 12 ROR is appropriate, then
• Company should write new business in auto and
  homeowners as much as possible as long as it can
  maintain the loss/expense ratios of that
  business, or risk does not increase
• Company should stop writing new business in
  workers compensation

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Interpreting and Utilizing Model Output (cont.)

• The decision to write new business may be viewed
  in terms of breakeven RORs or worthwhile expense
  investments

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Interpreting and Utilizing Model Output (cont.)

• Impact of changes to performance in 2001 on value
  of existing business

In 2001 only assumed to revert to normal
levels in 2002
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Interpreting and Utilizing Model Output (cont.)

• Value added measurements yield different optimal
  strategies than a net-income measurement

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Caveats of Internal Valuation Models

• In using a valuation model for internal
  performance
• measurements, the following should be considered
• ? Industry value added is 0 on average
• ? Interdependence of LOBs
• a. Does a decision in one line affect another
  performance?
• b. Allocations that shift expenses between LOB
• c. Consider customer segment or channel approach
  instead of LOB
• d. Spread of risk arguments

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Caveats of Internal Valuation Models

• ? Internal vs. external RORs
• a. Market may use a higher ROR for start-up
• ? Single year vs. multi-year decisions
• a. Justifying loss this year based on price hike
  next year
• b. Analogous to timing the market
• ? Sandbagging
• a. Adjustment to reserves with new manager

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Summary

• Value added approach better reflects benefits to
  the organization of managements current
  decisions
• Practical applications, decisions such
• Increasing marketing
• Reinsurance program structure
• Conservation programs
• While perhaps difficult to establish initially,
  successful companies in many industries use
  similar approach today