DISCOUNTED CASH FLOW MODELS and

RATE OF RETURN PERSPECTIVES

Russ Bingham
Vice President and Director of Corporate Research
Hartford Financial Services

CANE
March 23, 2000

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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.

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 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

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 “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

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 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

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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

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 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

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 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

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 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.
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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

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 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 11
 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
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 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

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 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

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 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.

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 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
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 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 17
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Simplified Ratemaking Spreadsheet

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