DISCOUNTED CASH FLOW MODELS and RATE OF RETURN PERSPECTIVES (FIN - 29 & 30) Russ Bingham Vice President and Director of Corporate Research Hartford Financial Services Seminar on Rate Making San Diego, CA March 9 & 10, 2000

Discounted Cash Flow Models and Rate of Return Perspectives Summary Discounted cash flow is a common approach used to assess financial performance. The purpose of this session will be to review this technique in the broader context of general financial models as applied in insurance. A discussion of the essential “building blocks” upon which models should be constructed will be followed by a review of various rate of return measures that result from them. Specifically, this will compare the policy / accident period to the calendar period view as well as compare the IRR and ROE rate of return calculations. Examples will be presented to demonstrate their fundamental equivalency. The policyholder and shareholder rate of return perspectives will also be reviewed.

Contents “Building Blocks”: The Fundamentals Conceptual Critique of Conventional Accounting Shortcomings of Reported Financials Economic Value Concepts Rate of Return Models: Important Attributes Rate of Return: Parameter Consistency Rate of Return Measures and Their Equivalency The Fundamental Insurance Total Return Model Components of Total Return: Underwriting, Investment & Leverage Aspects of Insurance Total Return Exhibits: Balance Sheet, Income, Cash Flow & Returns

“Building Blocks”: The Fundamentals Balance Sheet, Income and Cash Flow Statements Accounting Valuation: Conventional (statutory or GAAP) and Economic (present value) Development “Triangles” of Marketing / Policy / Accident Period into Calendar Period

Policy (or Accident) / Calendar Period Development Triangles Balance Sheet, Income, Cash Flow Calendar Period Policy Historical Future Total Period 1996 1997 1998 1999 2000 Ultimate Prior X X X X X …... --> Sum 1996 X X X X X …... --> Sum 1997 X X X X …... --> Sum 1998 X X X …... --> Sum 1999 X X …... --> Sum 2000 X …... --> Sum ==== ==== ==== ==== ==== Reported Sum Sum Sum Sum Sum Calendar

General Shortcomings of Reported Financials Missing key elements of total return - absence of market value basis omits important information necessary to more fully judge performance Lacks more relevant current (i.e. policy / accident period) performance focus Biased against longer tail and higher combined ratio business which conceals profitability of commercial to a greater degree than personal lines

Specific Shortcomings of Reported Financials Total Assets are affected by changing and somewhat arbitrary definitions of non-invested assets. (Suggest realignment with only Invested Assets on “left” side, net liabilities and equity on the right.) Income affected by premium earning, deferred acquisition and reserve estimation, all of which can be altered. “Below the line” surplus adjustments, such as unrealized gains, do not flow through “income”. Significant market value adjustments are ignored when Equity is reported - loss reserve adequacy/inadequacy and discount value some invested assets

Economic Value Concepts Economic valuation presents a financial view in which all assets and liabilities are market valued (cash equivalent). Considers the estimated magnitude and timing of future cash flows Focus on performance related to current actions (i.e. policy or accident period) rather than performance related to when reported (i.e. calendar period) Economic income is the change in economic value over a period in time “comprehensive income” perspective (FASB 130) tight balance sheet, income and cash flow linkage no “below the line” adjustments

Conceptual Commentary Reported income and returns (and other financials as well) follow conventional accounting rules which govern the timing of income recognition and are potentially a misleading basis for rating, regulation & financial analysis. Economic rules produce different results. Retained earnings are largely irrelevant to economic accounting Unearned premium reserve is not cash, and thus not economic. Leverage levels involve concessions to the raters and create non-economic based constraints. Economic value is realized either by converting assets and liabilities to market via sale, or over time to “earn” the discount value. ROE calculation - change the formula (income / beginning period contributed surplus). Do not include retained earnings and do not average the equity.

Rate of Return Models: Important Attributes Focus on Cash Flow Inclusion of surplus with flow controlled by specified rules Operating (i.e. policyholder) cash flows maintained separately Economic value with after-tax discounting NPV income formulation (with and without risk adjustment) Development of NPV balance sheet liabilities Policyholder and shareholder rate of return calculations

Rate of Return Models:Reaching a Common Ground - Structural Modifications To Convert Myers-Cohn Into a Rate of Return Model Inclusion of surplus Economic value with after-tax discounting NPV income formulation (with risk adjustment) NPV income formulation (without risk adjustment) Development of NPV balance sheet liabilities Policyholder and shareholder rate of return calculations To Align Internal Rate of Return Model With Both Policyholder and Shareholder Perspectives Separation of operating (i.e. policyholder) cash flows

Rate of Return: Parameter Consistency Dealing with Risk IRR cost of capital based total return NPV risk-adjusted total return equal to risk-free rate NPV total return (without risk-adjustment) equal to cost of capital Beta of Equity versus Beta of Liabilities Surplus Flows Controlling amount required and timing of flows Liability / surplus relationship Multi-period aspect Surplus flow components Surplus contribution and its release Investment income on contributed surplus Release of operating earnings

Rate of Return Measures Income on Investment Conventional Calendar ROE: Income / Average Equity, including Retained Earnings Nominal Ultimate ROE (“steady state” calendar equivalent) Discounted Ultimate ROE (net present value rate of return) Risk-adjusted Ultimate ROE (risk-adjusted NPV rate of return) “ROE like” Underwriting and Operating returns also Cash Flow Internal Rate of Return Basis Shareholder IRR (also Underwriting IRR and Operating IRR) Shareholder (i.e. Investor Perspective) Shareholder Cash Dividend Yield Realized Shareholder Total Return: dividend plus stock price appreciation

Equivalency in Rates of Return For Single Policy - Exhibit 1 (1) IRR (2) Net present value ROE (3) Total policy ultimate nominal ROE (4) Shareholder annual dividend yield realized For Multiple Policy Ongoing (steady state, no growth) - Exhibit 2 (5) IRR (6) Annual nominal ROE while at steady state (income / beginning contributed surplus) (7) Shareholder annual dividend yield realized

The Fundamental Insurance Total Return Model (1) Total Return = Operating Return X Operating Leverage + Investment Rate of Return on Surplus Operating Return = Underwriting Rate of Return + Investment Rate of Return on Policyholder Liability “Float” OR (2) Total Return = Underwriting Return X Operating Leverage + Investment Return X Asset Leverage Operating Leverage = Net Liabilities / Surplus Asset Leverage = Invested Assets / Surplus Insurance Consists of Underwriting, Investment & Financial Leverage

The Components of Insurance Total Return -Underwriting, Investment & Leverage Underwriting Return is the price for the transfer of risk to the company associated with the policyholder related cash flows. When positive the company is being paid for the transfer of risk. When negative the company is incurring a cost to acquire the funds from the policyholder and must depend on the investment spread to generate a profit. Investment Return represents the yield on invested assets (from both policyholder supplied funds and surplus). The spread between the Investment Return applicable to policyholder supplied funds and the Underwriting Return must be positive if the company is to generate a net operating profit from underwriting. Leverage (based on surplus requirements needed to meet specified underwriting, investment and financial risk tolerances) creates a magnifying effect on both return and risk. Total Return reflects the shareholder oriented return, comprised of levered operating return plus the investment return on surplus.

Aspects of Insurance Total Return The Total Rate of Return, as well as the Underwriting and Investment Rates of Return, can be determined on either a cash flow basis, via the Internal Rate of Return (IRR) or as a Return on Equity formed by the ratio of Income to Equity in which the financials are in EITHER Nominal or Present Valued terms The present value rate of return using a risk-adjusted discount rate will equal the risk-free rate, since by definition risk has been eliminated. Leverage is controlled by specifying rules governing the flow of surplus and dividend (distribution of earnings) to maintain a uniform risk profile over the life of the policy Contributed surplus governed by constant liability / surplus ratio Investment income on surplus dividended as earned Operating earnings distributed in proportion to per period liability exposure

Total Return Model Example Total Return = Oper Return X Oper Levg + Invest Rate of Return on Surplus 14.9% = 3.7% X 3.0 + 3.9% not risk-adjusted 6.0% = 0.7% X 3.0 + 3.9% risk-adjusted basis Oper Return = Und Rate of Return + Invest Rate of Return on PH “Float” 3.7% = -0.2% + 3.9% not risk-adjusted 0.7% = -0.2% + 3.9% - 3.0% risk-adjusted basis CAPM Reference Data: Risk-Free interest rate 6.0% 3.9% after-tax Risk Premium 8.9% Equity Beta 1.00 Indicated cost of capital 14.9% Liability Beta -0.52 Indicated risk adjustment 4.6% 3.0% after-tax Indicated risk-adjusted discount rate 1.4% 0.9% after-tax

Simplified Ratemaking Spreadsheet