casualty actuarial society spring meeting may 15 – 18, 2005
TRANSCRIPT
Casualty Actuarial SocietySpring Meeting
May 15 – 18, 2005
The industry's ability to attract The industry's ability to attract capital given historically low capital given historically low ROEs leads us to question: ROEs leads us to question:
Is ROE the right measure for Is ROE the right measure for the insurance industry's the insurance industry's
performance?performance?
by Joan Lamm-Tennant, PhD
Overview
• Macro-Economic View of Capital Flows
• “Accounting – Based” ROE Trends
• If it is not ROE, then what?
• Risk-Adjusted Return on Economic Capital
• Economic Value Added
• Float
Macro Market View
• The demand curve is downward sloping suggesting that price must fall to increase demand for risk transfer
• In equilibrium price and demand intersect to determine price
• At the appropriate level of capacity, price is the “fair” price
PricePV E(L) + Exp
QuantityQ
S
D
P
Basic Laws of Supply and Demand
Macro Market View
• In the short run, net worth may be “shocked” by an extreme event
• The “shock” causes a shift (decline) in capacity
• Prices increases and new capital may flow in
PricePV E(L) + Exp
Quantity
S
P
D
Q*
S
P* Decline inNet Worth
S*
Basic Laws of Supply and Demand
Macro Market View
• Behaviors, not only the financials, may change
• The “shock” may causes an increase in risk aversion therefore an increase in demand
• An increase in demand will exacerbate the price increase
PricePV E(L) + Exp
Quantity
S
P
D
Q*
S
P
S*
Basic Laws of Supply and Demand
S*
D*
P*
Macro Market View
• Higher prices for risk will eventually restore profitability and replenish capital
• Equilibrium is restored at a price of “P”
• The cycle continues to repeat itself and, if fact, may become instantaneous
• Any interference to offset shocks to capital in the short run could be costly in the long run
• Insurance markets are healthy and dynamic!!!
PricePV E(L) + Exp
Quantity
S
P
D
Q*
S
P
S*
Basic Laws of Supply and Demand
S*
D*
P*
6.2%
10.2%
14.2%16.6% 15.6%
12.8%
9.3% 8.4% 8.9%
4.5% 3.9%4.7%
0%
5%
10%
15%
20%
Q4 2001 Q1 2002 Q2 2002 Q3 2002 Q4 2002 Q1 2003 Q2 2003 Q3 2003 Q4 2003 Q1 2004 Q2 2004 Q3 2004
Quarterly Premium Growth Rates
14%
11%13%
16%
19%
22%
25%
31%31%
28%30%
32%33%
28%29%30%32%
30%
27%25%
28%
22%
18%18%17%16%
12%12%10%
12%11%9% 9% 9%
7% 7%5% 4% 4%
2% 2% 2% 1%
0%
10%
20%
30%
40%
Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul - 04 Oct-04 Jan-05
Source: ISO
Source: MarketScout
Rate Increases
$20,492$11,442
$16,437$4,872
$0
$5,000
$10,000
$15,000
$20,000
$25,000
$30,000
2001 2002*
Completed Pending
$25.4 Billion $27.9 Billion
*As of September 13, 2002.
Source: Morgan Stanley, Insurance Information Institute.
14 Pending 38 Pending
40 Completed 33 Completed
Following 9/11 New Capital Entered The Market
Raising by Property / Casualty Insurers Since 9/11 Totals $53.2B
2004 Capital Raising Activity
• The US and Bermuda-based property-casualty insurers raised $12.2 billion of capital directly in the capital markets
• Of the $12.2 billion raised, 60.2% was traditional debt, 26.4% was equity and the remainder was equity-linked and preferred securities
Net Income (AT)
$14,178
$5,840
$19,316
$10,870
$20,598
$24,404
$36,819
$30,773
$21,865$20,559
-$6,970
$9,200
$31,200
38,700
-$10,000
$0
$10,000
$20,000
$30,000
$40,000
$50,000
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
*Sources: A.M. Best, ISO, Insurance Information Institute.(amounts in millions)
1991 to 2004
$0
$50
$100
$150
$200
$250
$300
$350
$400
1975 1978 1981 1984 1987 1990 1993 1996 1999 2002
Industry Surplus
(amounts in billions)Source: A.M. Best and ISO, 2004 Through Third Quarter
Q3 2004
Surplus
June 30, 1999 $341
September 30, 2002 $273
September 30, 2004 $369
December 31, 2004 $394
Overview
• Macro-Economic View of Capital Flows
• “Accounting – Based” ROE Trends
• If it is not ROE, then what?
• Risk-Adjusted Return on Economic Capital
• Economic Value Added
• Float
Period
Historical Statutory ROE by Decade
106.3
107.8
109.2
100.3
Combined Ratio
4.8%5.3%2000 -2004
6.7%8.4%1990s
10.6% 11.5%1980s
7,5% 11.2% 1970s
10 Year T-YieldP/C ROE
Source: A.M. Best Review/Preview
-5%
0%
5%
10%
15%
20%
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003
Return on “Statutory” Equity vs. Cost of Equity
U.S. Property / Casualty Industry (1983 to 2004)
Source: A.M. Best; Conning Forecast; CF&S practice; McKinsey
1983 – 2003
Cost of Equity 11.5%
Accounting ROE 6.5%
2004
Cost of Equity 8.9%
Accounting ROE 10.5%
Difference 1.6%
Return on Equity Cost of Capital
Overview
• Macro-Economic View of Capital Flows
• “Accounting – Based” ROE Trends
• If it is not ROE, then what?
• Risk-Adjusted Return on Economic Capital
• Economic Value Added
• Float
Risk-Adjusted Performance Metrics
• Return on risk-adjusted capital (RORAC) vs. risk-adjusted return on capital (RAROC)
– Dividing expected net income by “economic” capital is technically RORAC, nevertheless the industry convention is to call it RAROC
• Economic value added (EVA)
– Difference between the return on “economic” capital and the cost of capital, where cost of capital is reflective of both capital structure and risk
• Float and Cost of Float
– Arises because premiums are received before losses are paid
– Float may be estimated as
• (Total Invested Assets – Capital – Unassigned Surplus)
– Since premiums tend not to cover losses, insurers run an underwriting loss which is the cost of float
• Cost of float may be negative when the insurer runs an underwriting profit
Profit
Mean
+10% +40%
Risk Tolerance
Acceptable VaR Perhaps
Associated Rating
0%-30%-50%
Economic Capital
RAROC and EVA Require A Measure of Economic Capital
• Economic capital is frequently referred to risk capital
– The amount of capital necessary to cover the risk in our business given our risk tolerance
Float and Cost of FloatU.S. Property and Casualty Industry
3.7%
4.9%5.6%
0.8%
6.5%
10.3%
$200,000
$250,000
$300,000
$350,000
$400,000
$450,000
$500,000
$550,000
$600,000
$650,000
1998 1999 2000 2001 2002 2003
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
Float
Cost of Float
Source: AM Best Aggregates and Averages
Float and Cost of FloatU.S. Commercial Lines Industry
1.8%
3.6%4.3%
4.9%
8.2%
4.2%
$200,000
$220,000
$240,000
$260,000
$280,000
$300,000
$320,000
$340,000
$360,000
1998 1999 2000 2001 2002 2003
-4%
-2%
0%
2%
4%
6%
8%
10%
Float
Cost of Float
Source: AM Best Aggregates and Averages, Commercial Lines Segment
Float and Cost of FloatU.S. Personal Lines Industry
-0.7%
4.1%
5.4%5.8%
11.9%
9.4%
$50,000
$75,000
$100,000
$125,000
$150,000
$175,000
$200,000
$225,000
$250,000
1998 1999 2000 2001 2002 2003
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
Float
Cost of Float
Source: AM Best Aggregates and Averages, Personal Lines Segment
Industry Comparative Cost of Float
-2%
0%
2%
4%
6%
8%
10%
12%
14%
1998 1999 2000 2001 2002 2003
U.S. Property / Casualty Industry
Commercial Lines
Personal Lines
Source: AM Best Aggregates and Averages
The industry's ability to attract capital The industry's ability to attract capital given historically low ROEs leads us to given historically low ROEs leads us to
question: question:
Is ROE the right measure for the insurance Is ROE the right measure for the insurance industry's performance?industry's performance?
Perhaps consider Perhaps consider Risk Adjusted Return on Economic CapitalRisk Adjusted Return on Economic CapitalEconomic Value AddedEconomic Value AddedFloatFloat
Thank You