Treatment of Profit and Contingency Provisions and the Cost of Capital in Property/Casualty Insurance Ratemaking

August 1997

TO: Members of Actuarial Organizations Governed by the Standards of Practice of the Actuarial Standards Board and Other Persons Inter­ested in Profit and Contingency Provisions and the Cost of Capital in Property/Casualty Insurance Ratemaking

FROM: Actuarial Standards Board (ASB)

SUBJ: Actuarial Standard of Practice No. 30

This booklet contains the final version of Actuarial Standard of Practice (ASOP) No. 30, Treatment of Profit and Contingency Provisions and the Cost of Cap­ital in Property/Casualty Insurance Ratemak­ing.

First and Second Exposure Drafts

The first draft of this standard was exposed for review in October 1994, with a com­ment deadline of March 15, 1995. Thirty-one comment letters were received. The second draft of this standard was exposed for review in August 1996, with a comment deadline of December 2, 1996. Ten comment letters were received on the second exposure draft. (For a copy of either exposure draft, please contact the ASB office.) The Task Force on Rate of Return of the ASB’s Casualty Com­mit­tee reviewed and carefully considered all comments received on both exposure drafts. As was the case after the first exposure, the task force revised the second exposure draft after participating in many conference calls and listening to comments made during question-and-answer sessions held at various Casualty Actuarial Society (CAS) meetings.

Substantive Issues

Following the first exposure draft, the task force received a number of comment letters regarding the discussion of rates versus prices. Although several changes were made in the second exposure draft to more clearly indicate that the proposed standard intended only to address the evaluation of costs (i.e., rates), some of the commentators’ letters on the second exposure draft still expressed confusion on this point. In response, the task force further revised several sections to make clear that the standard does not address considerations such as marketing goals, compe­tition, and legal restrictions that may affect price.

In addition to the “rates versus prices” issue, several commentators questioned whether the cost of capital is truly equivalent for stock, mutual, and other insur­ance organizations. After extensive discussion, the task force changed the lan­guage of the standard to focus the practitioner on assessing the cost of capital as an opportunity cost and to recognize that all risk transfers have an opportunity cost. The task force also combined section 3.8 with section 3.2 to indicate that the cost of capital may differ for various capital providers due to their differing risk characteristics, and that such differences play a role in assessing the cost of capital for a specific capital provider. (For a detailed discussion of the comments and the task force’s responses to such, please see Appendix 2 of this standard.)

The task force is grateful to the many individuals who contributed written com­ments or parti­cipated in the numerous discussions of the proposed standard at CAS meetings. The task force believes that the final standard benefitted signifi­cantly from this professional debate.

The ASB voted in July 1997 to adopt the final standard.

Task Force of Rate of Return of the Casualty Committee

Mark Whitman, Chairperson

                      David Appel                                                         Claus S. Metzner

                      Robert A. Bailey                                                  Michael J. Miller

                      Robert P. Butsic                                                  Richard G. Woll

                      Steven G. Lehmann

Casualty Committee of the ASB

Michael A. Lamonica, Chairperson

                      Christopher S. Carlson                                          Karen F. Terry

                      Douglas J. Collins                                                 Margaret W. Tiller

                      Anne Kelly                                                           William J. VonSeggern

                      Steven G. Lehmann                                              Mark Whitman

                      Robert S. Miccolis

Actuarial Standards Board

Richard S. Robertson, Chairperson

                      Phillip N. Ben-Zvi                                                   Roland E. King

                      Harper L. Garrett Jr.                                               Daniel J. McCarthy

                      Patrick J. Grannan                                                Alan J. Stonewall

                      Frank S. Irish                                                       James R. Swenson

Section 1. Purpose, Scope, Cross References, and Effective Date

1.1 Purpose

According to the Statement of Principles Regarding Property and Casualty Insurance Ratemaking (hereafter the Statement of Principles) of the Casualty Actuarial Society, insurance rates should provide for the cost of capital through underwriting profitxand contingency provisions. This stan­dard of practice provides guidance to actuaries in estimating the cost of capital and evaluating underwriting profit and contingency provisions.

1.2 Scope

This standard of practice applies to all property/casualty insurance coverages. This standard also applies to property/casualty risk financing systems, such as self-insurance, that provide similar coverages. References in the standard to risk transfer should be interpreted to include risk financ­ing systems that provide for risk retention in lieu of risk transfer. Further, as is true of the Statement of Principles, this standard is limited to defining a rate as the estimation of future costs and does not address other consid­erations that may affect a price, such as marketing goals, competition, and legal restrictions.

If the actuary departs from the guidance set forth in this standard in order to comply with applicable law (statutes, regulations, and other legally binding authority), or for any other reason the actuary deems appropriate, the actuary should refer to Section 4.

1.3 Cross References

When this standard refers to the provisions of other documents, the reference includes the referenced documents as they may be amended or restated in the future, and any successor to them, by whatever name called. If any amended or restated document differs materially from the originally referenced document, the actuary should consider the guidance in this standard to the extent it is applicable and appropriate.

1.4 Effective Date

This standard will be effective with respect to work per­formed after December 1, 1997.

Section 2. Definitions

The definitions below are defined for use in this actuarial standard of practice.

2.1 Capital

The funds intended to assure payment of obligations from insur­ance contracts, over and above those funds backing the liabilities.

2.2 Contingency Provision

A provision for the expected differences, if any, between the estimated costs and the average actual costs, that cannot be eliminated by changes in other components of the ratemaking process.

2.3 Cost of Capital

The rate of return that capital could be expected to earn in alternative investments of equivalent risk; also known as opportunity cost.

2.4 Insurance Cash Flows

Funds from premiums and miscellaneous (non-investment) income from insurance operations, and payments for losses,  expenses, and policyholder dividends. Associated income taxes are recog­nized when the analysis is on a post-tax basis.

2.5 Insurance Risk

The extent to which the level or timing of actual insurance cash flows is likely to differ from expected insurance cash flows.

2.6 Investment Income

Proceeds (other than the return of principal) derived from the investment of assets, minus investment expenses. Associated in­come taxes are recognized when the analysis is on a post-tax basis.

2.7 Investment Income from Insurance Operations

The income associated with the investment of insurance cash flows. (This is sometimes referred to as investment income on policyholder-supplied funds.)

2.8 Investment Risk

The extent to which the level or timing of actual invest­ment proceeds is likely to differ from what is expected.

2.9 Leverage

A measure of the relative amount of risk to which capital is exposed, typically expressed as the ratio of an exposure measure (such as premium or liabilities) to the capital amount.

2.10 Operating Profit

The sum of underwriting profit, miscellaneous (non-investment) income from insurance operations, and investment income from insurance operations. Associated income taxes are recognized when the analysis is on a post-tax basis.

2.11 Rate

An estimate of the expected value of future costs.

2.12 Total Return

The sum of operating profit and investment income on capital, usually after income taxes, often expressed in percentage terms.

2.13 Underwriting Expenses

All expenses except losses, loss adjustment ex­penses, investment expenses, policyholder dividends, and income taxes.

2.14 Underwriting Profit

Premiums less losses, loss adjustment expenses, underwriting expenses, and policyholder dividends.

2.15 Underwriting Profit Provision

The provision for underwriting profit in the actuarially developed rate, typically expressed as a percentage of the rate.

Section 3. Analysis of Issues and Recommended Practices

3.1 Estimating the Cost of Capital and the Underwriting Profit Provi­sion

Prop­erty/casualty insurance rates should provide for all expected costs, including an appropriate cost of capital associated with the specific risk transfer. This cost of capital can be provided for by estimating that cost and translating it into an underwriting profit provision, after taking leverage and investment income into account. Alternatively, the actuary may develop an underwriting profit provision and test that profit provision for consistency with the cost of capital. The actuary may use any appropriate method, as long as such method is consistent with the considerations in this standard.

For historical and practical reasons, this standard separately discusses the underwriting profit provision, investment income from insurance operations, and investment income on capital. The actuary should keep in mind that evaluation of whether the cost of capital is appropriately recognized does not necessarily require these distinctions.

3.2 Basis for Cost of Capital Estimates

In estimating the cost of capital, the actuary should consider the relationship between risk and return. The methods used for estimating the cost of capital should reflect the risks involved in the risk transfer under consideration. These risks may include insurance, investment, inflation, and regulatory risks, as well as diversi­fication, debt structure, leverage, reinsurance, market structure, and other appropriate aspects of the social, economic, and legal environments.

Thus, the cost of capital is likely to vary from one insurer to another. The actuary should recognize that the capital which is needed to support any risk transfer has an opportunity cost regardless of the source of capital or the structure of the insurer.

3.3 Estimates of Future Costs

Since all components of a rate should be esti­mates of future costs relating to the risk transfer during the prospective period of time to which the rate applies, capital costs, investment income, income taxes, cash flows, and leverage factors used in calculating the profit provision should all be based on expectedfuture values.

3.4 Parameters of the Risk Transfer

The actuary should recognize that the cost of capital associated with an individual risk transfer may vary, based on the specific parameters of the transfer. To the extent that deductibles, dividend or return of premium plans, reinsurance, etc., affect the risk of the insurer, the cost of capital and the amount of capital needed to support the transaction may be affected.

3.5 Investment Income

There are two elements of investment income that the actuary should consider:  investment income from insurance operations and investment income on capital.

The actuary should assess the investment risk, since the amount and cost of capital should reflect investment risk as well as the risk associated with the insurance cash flows. Investment risk addresses the cost of default, reinvestment risk, and other investment uncertainties. Such risks can result in a significantly different yield than the stated yield rate.

Any of several general approaches may be used by the actuary to estimate investment income, as long as the assumptions are reasonable and appropriate. The investment yield rates used should be appropriate for the cash flow patterns associated with the coverages under consideration. If historical balance sheet and cash flow data are used to project investment income, the data should be adjusted to represent future investment income from the associated coverages.

The actuary may use any of a number of methods for recognizing investment income from insurance operations. Two such approaches are as follows:

a. Methods that estimate investment income based on projected insurance cash flows. The insurance cash flows are projected for each future period, and the expected investment yield rate appropriate for each future period is applied to the insurance cash flows for that period. The investment yield rates should be appropriate for the cash flow patterns associated with the coverages under consideration.

b. Methods that apply an expected investment yield rate to assets representing the liabilities for losses, loss adjustment expenses, and unearned premium net of agents’ balances and prepaid expenses. If historic liability-to-premium relation­ships are used, they should be adjusted to reflect expected future relationships between liabili­ties and premiums. The actuary should also consider, for example, the effects of growth, changes in expected loss or expense patterns, and the effect of the delayed receipt of investment income. The investment yield rate selected should represent the expected investment yield for the insurer during the period the rates are expected to be in effect.

3.6 Income Taxes

To the extent income taxes are not included in the expense provision, the actuary should use provisions for expected income taxes that are consistent with the earnings expected from the insurance transaction being evaluated.

3.7 Contingency Provision

The actuary should include a contingency provision if the assumptions used in the ratemaking process produce cost estimates that are not expected to equal average actual costs, and if this difference cannot be eliminated by changes in other components of the ratemaking process.

While the estimated costs are intended to equal the average actual costs over time, differences between the estimated and actual costs of the risk transfer are to be expected in any given year. If a difference persists, the difference should be reflected in the ratemaking calculations as a contingency provision. The contingency provision is not intended to measure the variability of results and, as such, is not expected to be earned as profit.

3.8 Use of Different Bases

The cost of capital can be expressed as a per­centage of capital, a percentage of assets, a percentage of premium, or other appropriate base. The actuary may choose any such appropriate base. Actuaries may use different bases, which can be converted from one to another. Regardless of which base is used to reflect the cost of capital, the actuary should clearly identify the base used and should document the relevant assumptions.

3.9 Accounting Rules for Comparing the Cost of Capital

The accounting rules employed within any model should be internally consistent. When com­paring one industry with another, the actuary should make any necessary adjustments so that cost of capital of industries with different accounting methods can be properly compared.

Section 4. Communications and Disclosures

4.1 Conflict with Law or Regulation

If a law or regulation conflicts with the provisions of this standard, the actuary should develop a rate in accordance with the law or regulation, and disclose any material difference between the rate so developed and the actuarially determined rate to the client or employer.

4.2 Documentation

The actuary should be guided by the provisions of ASOP No. 9, Documentation and Disclosure in Property and Casualty Insurance Ratemaking, Loss Reserving, and Valuations.

4.3 Disclosures

The actuary should include the following, as applicable, in an actuarial communication:

a. in addition to the disclosure covered in section 4.1, the disclosure in ASOP No. 41, Actuarial Communications, section 4.2, if any material assumption or method was prescribed by applicable law (statutes, regulations, and other legally binding authority);

b. the disclosure in ASOP No. 41, section 4.3, if the actuary states reliance on other sources and thereby disclaims responsibility for any material assumption or method selected by a party other than the actuary; and

c. the disclosure in ASOP No. 41, section 4.4, if, in the actuary’s professional judgment, the actuary has otherwise deviated materially from the guidance of this ASOP.

Appendix 1- Background and Current Practices

Note:  This appendix is provided for informational purposes, but is not part of the standard of practice.

Background

Historical Procedures: Until the 1970s, it was common practice to include in rate calculations a standard underwriting profit and contingency provision of 2.5% for workers compensation insurance and 5% for other property/casualty lines of insurance (6% for some property lines). These provisions did not ex­plicitly reflect investment income, since there was general agree­ment at the time that these standard provisions implicitly reflected investment income and insur­ance risk in a reasonable fashion. However, economic and structural changes in the insurance industry over time began to lead to the explicit recognition of in­vestment income in calculating insurance rates.

Historical Issues: A number of issues have historically accompanied the dev­elopment and evaluation of the underwriting profit and contingency provisions: (1) how to measure risk and reflect it in the underwriting profit provision, (2) how or whether to measure any systematic variation from expected costs and reflect it in the contingency provision, (3) which accounting rules should be used to measure insurance returns and to compare them with returns in other industries, (4) how or whether to allocate investment income and capital, and (5) how to relate underwriting profit provisions in rates to the cost of capital.

Role of Capital: Capital plays several roles in an insurance transaction, in­cluding providing the initial investment in physical plant and equipment and providing working capital. How­ever, the primary role is to assure payment of obligations from insurance contracts, over and above those funds backing the liabilities.

Capital has a value and its use entails a cost. The cost is the expected return the capital could earn in alternative investments of equivalent risk. Judicial deci­sions dealing with the cost of capital and profit provisions (see, e.g., Federal Power Commission v. Hope Natural Gas, 320 U.S. 591 (1944)) provide back­ground and definitions for the determination of the cost of capital in a regula­tory setting.

Role of the Underwriting Profit Provision: The underwriting profit provision, together with all other cost and revenue components as defined in section 2.12, provides the risk taker with an expected total return to cover the cost of capital.

Role of the Contingency Provision: A common assumption underlying proper­ty/casualty insurance ratemaking is that the expected costs included in the rate calculations will equal the actual costs over the long run. If not, and the ex­pected difference cannot be explicitly attributed to a specific component of the rate (and thereby eliminated), then this difference is incorporated in the rate­making process by including a contingency provision.

Current Practices

A method commonly used to develop or test the underwriting profit provision in insurance rates is to estimate the cost of capital and translate that cost into an underwriting profit provision. Some methods currently used to estimate the cost of capital, and financial models to relate that cost to the underwriting profit pro­vision, are described below.

Underwriting profit provisions can also be developed using models that do not directly relate the cost of capital to the underwriting profit provision. Some of these models are also described below.

Inclusion of a particular model in this appendix should not be interpreted as an endorsement, but rather a recognition that such a model is used. Some applica­tions of these models may not be consistent with section 3 of this standard.

Estimating the Cost of Capital: Several techniques are used to estimate the cost of capital. These include, but are not limited to, the following:

a. Comparable Earnings Model: The comparable earnings model is used to analyze historical returns on equity for entities or industries of compa­rable risk. The cost of capital is related to the average rate of return over a historical period.

b. Discounted Cash Flow Model: One form of the discounted cash flow (DCF) model, the dividend discount model, is used to analyze the cur­rent prices and dividend levels of publicly traded securities that pay dividends. The cost of capital is cal­culated as the sum of the expect­ed first-year divi­dend yield plus the expect­ed annual growth rate in divi­dends.

b. Risk Premium Model: The risk premium  model is used to analyze the spread in returns for investments of different risk. The cost of capital is estimated as the sum of the expected return on a reference investment plus a margin to reflect relative risk. One widely used form of risk pre­mium analysis is known as the capital  asset pricing model (CAPM), in which the reference security is a risk free Treasury security, and the risk margin is determined using a measure of risk known as beta, defined as the covariance of an investment’s return with returns in capital markets as a whole.

Relating the Cost of Capital to the Underwriting Profit Provision: This section describes various models currently used regarding the relation of the cost of capital to the underwriting profit provision.

1. Models that directly develop an underwriting profit provision are as follows:

a. Net Present Value Model: The net present value (NPV) model is used to discount the estimated net cash flow to the capital pro­vider at a rate equal to the cost of capital. For the purpose of these calculations, net cash flow is defined as the residual amounts of cash that flow to and from the equity account, after all policy obligations are met. The net cash flow reflects the timing of each of the individual cash flows, including the com­mit­ment and release of capital in support of the insurance trans­action. The internal rate of return (IRR) model, a specific appli­cation of the general NPV model, uses an iteration technique to calculate the rate(s) of return that will set the net present value of a risk transfer’s cash inflows and outflows equal to zero.

b. Other Discounting Models: Other discounting models can be used to estimate the present value of the individual cash flows from the insurance transaction. The present value of the premium and miscellaneous (non-investment) income, before profit, is set equal to the present value of the associated losses, expenses, policy­holder dividends, and income taxes. The present values are estimated using appropriate prospec­tive investment yield rates. A margin can be added to the present value of the premium so that the margin plus the expected investment income on capital gen­erate a post-tax return that, when divided by the required capital, equals the cost of capital.

c. Total Financial Needs Model: Total financial needs models are used to develop the underwriting profit provision such that the sum of underwriting profit, miscellaneous (non-investment) in­come, investment income from insurance operations, and invest­ment income on capital, after income taxes, will equal the cost of capital. Each of these components is explicitly quantified.

2. Models that do not directly relate the cost of capital to the underwriting profit provision are as follows:

a. State X Model: The State X model (originally appearing in some Insurance Services Office, Inc. rate filings as the State X method) is used to estimate the investment income from insurance opera­tions. The method does not, in itself, allow for development of the total return or of a profit provision; it is used merely to develop one component of the total rate of return-the estimated investment income from insurance operations.

b. Risk Adjusted Net Present Value Model: The risk adjusted net present value (RANPV) model is used to estimate the risk ad­justed present value of the insurance cash flows. Each of the flows is analyzed for its specific risk, and the otherwise attain­able prospective investment yield rate is adjusted by the risk component prior to calculating the present value. Using the RANPV model, one calculates the premium directly, so that the risk adjusted present value of the premium and miscellaneous (non-investment) income equals the risk adjusted present value of the losses,  expenses, policyholder dividends, and associated in­come taxes. The expected underwriting profit in the premium can be derived from the RANPV model by summing all components using their un­discounted values.

c. Growth Requirement Model: The growth requirement model is used to set the level of retained earnings based on the expected future growth rate of the entity or industry.

d. Additional Models: Other models that do not directly relate the cost of capital to the underwriting profit provision include options pricing models, arbitrage pricing models, models based on ruin theory, models based on utility theory, and shareholder value models.

Developing and Evaluating a Contingency Provision: Contingency provisions have been developed in practice using methods that measure differences be­tween expected and actual costs.

Appendix 2 – Comments on the 1996 Second Exposure Draft and Task Force Responses

The second draft of this standard was exposed for review in August 1996, with a comment deadline of December 2, 1996. Ten comment letters were received and reviewed carefully by the Task Force on Rate of Return of the ASB’s Casualty Committee.

Click here to view Appendix 2 in its entirety.