Transcript Handout 4 - Casualty Actuarial Society

Casualty Actuarial Society
Spring Meeting
May 15 – 18, 2005
The industry's ability to attract
capital given historically low ROEs
leads us to question:
Is ROE the right measure for the
insurance industry's 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
Basic Laws of Supply and Demand
Price
PV E(L) + Exp
S
• 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
P
• At the appropriate level of capacity,
price is the “fair” price
D
Q
Quantity
Macro Market View
Basic Laws of Supply and Demand
Price
• In the short run, net worth may be
“shocked” by an extreme event
S*
PV E(L) + Exp
S
Decline in
Net Worth
P*
P
D
Q*
Quantity
• The “shock” causes a shift (decline)
in capacity
• Prices increases and new capital
may flow in
Macro Market View
Basic Laws of Supply and Demand
Price
• Behaviors, not only the financials,
may change
S*
PV E(L) + Exp
P*
S
P
P
D*
D
Q*
Quantity
• The “shock” may causes an
increase in risk aversion therefore
an increase in demand
• An increase in demand will
exacerbate the price increase
Macro Market View
Basic Laws of Supply and Demand
Price
S*
PV E(L) + Exp
P*
S
• Higher prices for risk will eventually
restore profitability and replenish
capital
• Equilibrium is restored at a price of “P”
P
P
D*
D
Q*
Quantity
• 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!!!
Quarterly Premium Growth Rates
20%
16.6%
14.2%
15%
15.6%
12.8%
10.2%
10%
9.3%
8.9%
8.4%
6.2%
4.7%
3.9%
Q2 2004
Q3 2004
4.5%
5%
0%
Q4 2001
Q1 2002
Q2 2002
Q3 2002
Q4 2002
Q1 2003
Q2 2003
Q3 2003
Q4 2003
Q1 2004
Source: ISO
Rate Increases
40%
3 1%3 1%
30%
25%
33%
32%
32%
30%
30%
30%
29%
28%
28%
28%
27%
25%
22%
22%
19 %
20%
18 %18 %
16 %
14 %
17 %
16 %
13 %
12 %12 %
11%
12 %
10 %
10%
11%
9% 9% 9%
7% 7%
5%
4% 4%
2% 2% 2%
1%
0%
Jul-01
Oct-01
Source: MarketScout
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
Following 9/11 New Capital Entered The Market
Raising by Property / Casualty Insurers Since 9/11 Totals $53.2B
$30,000
$25.4 Billion
$27.9 Billion
$25,000
$4,872
$20,000
14 Pending
$16,437
38 Pending
$15,000
$10,000
$20,492
$5,000
40 Completed
$11,442
$0
2001
2002*
Completed
*As of September 13, 2002.
Source: Morgan Stanley, Insurance Information Institute.
Pending
33 Completed
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)
1991 to 2004
$50,000
$40,000
38,700
$36,819
$31,200
$30,773
$30,000
$24,404
$20,000
$21,865
$20,598
$19,316
$20,559
$14,178
$10,870
$10,000
$9,200
$5,840
$0
-$6,970
-$10,000
1991
1992
1993
1994
1995
1996
*Sources: A.M. Best, ISO, Insurance Information Institute.
(amounts in millions)
1997
1998
1999
2000
2001
2002
2003
2004
Industry Surplus
Surplus
June 30, 1999
$341
September 30, 2002
$273
$400
September 30, 2004
$369
$350
December 31, 2004
$394
$300
$250
$200
$150
$100
$50
$0
1975
1978
1981
1984
1987
Source: A.M. Best and ISO, 2004 Through Third Quarter
(amounts in billions)
1990
1993
1996
1999
2002
Q3 2004
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
Historical Statutory ROE by Decade
Period
P/C ROE
Combined
Ratio
10 Year
T-Yield
1970s
11.2%
100.3
7,5%
1980s
11.5%
109.2
10.6%
1990s
8.4%
107.8
6.7%
2000 -2004
5.3%
106.3
4.8%
Source: A.M. Best Review/Preview
Return on “Statutory” Equity vs. Cost of Equity
U.S. Property / Casualty Industry (1983 to 2004)
2004
1983 – 2003
20%
Cost of Equity
Accounting ROE
Cost of Equity
11.5%
8.9%
Accounting ROE
6.5%
Difference
15%
10.5%
1.6%
10%
5%
Return on Equity
Cost of Capital
0%
-5%
1983
1985
1987
1989
1991
Source: A.M. Best; Conning Forecast; CF&S practice; McKinsey
1993
1995
1997
1999
2001
2003
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
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
Profit
Mean
Risk Tolerance
Acceptable VaR
Perhaps
Associated
Rating
-50%
-30%
0% +10%
Economic Capital
+40%
Float and Cost of Float
U.S. Property and Casualty Industry
$650,000
12%
10.3%
Float
Cost of Float
$600,000
10%
$550,000
8%
6.5%
$500,000
5.6%
6%
4.9%
$450,000
3.7%
4%
$400,000
0.8%
$350,000
2%
0%
$300,000
$250,000
-2%
$200,000
-4%
1998
1999
Source: AM Best Aggregates and Averages
2000
2001
2002
2003
Float and Cost of Float
U.S. Commercial Lines Industry
$360,000
10%
Float
Cost of Float
$340,000
8.2%
8%
$320,000
6%
4.9%
$300,000
4.3%
4.2%
3.6%
4%
$280,000
1.8%
2%
$260,000
0%
$240,000
$220,000
-2%
$200,000
-4%
1998
1999
2000
2001
Source: AM Best Aggregates and Averages, Commercial Lines Segment
2002
2003
Float and Cost of Float
U.S. Personal Lines Industry
$250,000
14%
11.9%
Float
Cost of Float
$225,000
12%
9.4%
10%
$200,000
8%
$175,000
5.8%
5.4%
$150,000
6%
4.1%
4%
$125,000
2%
$100,000
-0.7%
0%
$75,000
-2%
$50,000
-4%
1998
1999
2000
2001
Source: AM Best Aggregates and Averages, Personal Lines Segment
2002
2003
Industry Comparative Cost of Float
U.S. Property / Casualty Industry
14%
Commercial Lines
Personal Lines
12%
10%
8%
6%
4%
2%
0%
-2%
1998
1999
Source: AM Best Aggregates and Averages
2000
2001
2002
2003
The industry's ability to attract capital given
historically low ROEs leads us to question:
Is ROE the right measure for the insurance
industry's performance?
Perhaps consider
Risk Adjusted Return on Economic Capital
Economic Value Added
Float
Thank You