1 DISCOUNTED CASH FLOW MODELS (MIS-45&46) Seminar on Ratemaking Nashville, TNRuss Bingham March 11-12, 1999Hartford Financial Services

2 Contents l “Building Blocks”: The Fundamentals l Rate of Return Models: Reaching a Common Ground l Dealing with Accounting Conventions: Economics Rule l Equivalency in Rates of Return: Do it “Right” and all Models can be Reconciled l The Fundamental Insurance Total Return Model l The Components of Total Return: Underwriting, Investment & Leverage Underwriting, Investment & Leverage l Equivalency in Rates of Return l Aspects of Insurance Total Return l Exhibits: Balance Sheet, Income, Cash Flow & Returns

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

4 Policy (or Accident) / Calendar Period Development Triangles Balance Sheet, Income, Cash Flow Calendar Period Policy HistoricalFuture Total Period Ultimate Prior X X X X X …... --> Sum 1995 X X X X X …... --> Sum 1996 X X X X …... --> Sum 1997 X X X …... --> Sum 1998 X X …... --> Sum 1999 X …... --> Sum ==== ================ Reported Sum Sum Sum Sum Sum Calendar

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

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

7 Dealing With Accounting Conventions: Economics Rule l Retained earnings l Not relevant to economic accounting l Unearned premium reserve l If it’s not cash, it’s not economic l Reported income and returns (and other financials as well) l Potentially misleading basis for rating, regulation & financial analysis l Leverage constraints l Concessions to the raters, non-economic constraints l Realizing economic value l Economic value realization takes time, unless liabilities are “sold” l ROE calculation - l Change the formula (income / beginning period contributed surplus) –Do not include retained earnings –Do not average the equity

8 Equivalency in Rates of Return: Do it “Right” and All Models Can Be Reconciled l For Single Policy l (1) IRR l (2) Net present value ROE l (3) Total policy ultimate nominal ROE l (4) Shareholder annual dividend yield realized l For Multiple Policy Ongoing (steady state, no growth) l (5) IRR l (6) Annual nominal ROE while at steady state (income / beginning contributed surplus) l (7) Shareholder annual dividend yield realized

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

10 The Components of Insurance Total Return Underwriting, Investment & Leverage l 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. l 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. l The Risk / Return tradeoff applicable to both underwriting and investment are such that, generally, returns and risk increase or decrease in tandem. l Leverage creates a magnifying effect on both return and risk

11 Aspects of Insurance Total Return l The Total Rate of Return, as well as the Underwriting and Investment Rates of Return, can be determined on either l a cash flow basis, via the Internal Rate of Return (IRR) or l 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 l 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. l 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 l Contributed surplus governed by constant liability / surplus ratio l Investment income on surplus dividended as earned l Operating earnings distributed in proportion to per period liability exposure

12 Total Return Model Example Total Return = Oper Return X Oper Levg + Invest Rate of Return on Surplus Total Return = Oper Return X Oper Levg + Invest Rate of Return on Surplus 14.9% = 3.7% X % not risk-adjusted 14.9% = 3.7% X % not risk-adjusted 6.0% = 0.7% X % risk-adjusted basis 6.0% = 0.7% X % risk-adjusted basis Oper Return = Und Rate of Return + Invest Rate of Return on PH “Float” Oper Return = Und Rate of Return + Invest Rate of Return on PH “Float” 3.7% = -0.2% + 3.9% not risk-adjusted 3.7% = -0.2% + 3.9% not risk-adjusted 0.7% = -0.2% + 3.9% - 3.0% risk-adjusted basis 0.7% = -0.2% + 3.9% - 3.0% risk-adjusted basis CAPM Reference Data: CAPM Reference Data: Risk-Free interest rate6.0%3.9% after-tax Risk-Free interest rate6.0%3.9% after-tax Risk Premium8.9% Risk Premium8.9% Equity Beta1.00 Equity Beta1.00 Indicated cost of capital14.9% Indicated cost of capital14.9% Liability Beta-0.52 Liability Beta-0.52 Indicated risk adjustment4.6%3.0% after-tax Indicated risk adjustment4.6%3.0% after-tax Indicated risk-adjusted discount rate1.4%0.9% after-tax Indicated risk-adjusted discount rate1.4%0.9% after-tax

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15 Simplified Ratemaking Spreadsheet