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CAS Special Interest Seminar: Valuation of Insurance Operations

CAS Special Interest Seminar: Valuation of Insurance Operations. Valuation Concepts as Used in Internal Performance Measurements Presented by: Russel L. Sutter, FCAS April 11, 2000 St. Louis, Missouri. To Be Discussed:.  Basics of valuation concepts

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CAS Special Interest Seminar: Valuation of Insurance Operations

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  1. CAS Special Interest Seminar:Valuation of Insurance Operations Valuation Concepts as Used in Internal Performance Measurements Presented by: Russel L. Sutter, FCAS April 11, 2000 St. Louis, Missouri

  2. 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

  3. 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

  4. 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 today’s decisions benefit the company

  5. 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

  6. 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

  7. Framework of a Valuation Model • Key inputs • Surplus and required returns by line of business • Original effective date experience model by LOB

  8. 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)

  9. Framework of a Valuation Model (cont.)

  10. Framework of a Valuation Model (cont.)

  11. Framework of a Valuation Model (cont.) Consider the following model of an insurer’s business

  12. Framework of a Valuation Model (cont.) The insurer’s value added analysis for 2001 might look as follows

  13. Framework of a Valuation Model (cont.) The insurer’s value added analysis for 2001 might look as follows (cont.)

  14. 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

  15. Interpreting and Utilizing Model Output (cont.) • The decision to write new business may be viewed in terms of breakeven RORs or worthwhile expense investments:

  16. 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

  17. Interpreting and Utilizing Model Output (cont.) • Value added measurements yield different optimal strategies than a net-income measurement

  18. 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

  19. 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

  20. Summary • Value added approach better reflects benefits to the organization of management’s 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

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