BASIC ECONOMIC THEORY FOR AN INSURER'S RATE

OF RETURN AND FOR ITS REGULATION

BY JOHN S. McGUINNESS
• REVIEW BY WOODY R. BECKMAN

Mr. M c G u i n n e s s has made another fine c o n t r i b u t i o n to the a c t u a r i a l

literature in several respects. First and foremost, he has w e a v e d
insurance c o m p a n y p r o f i t a b i l i t y into the main stream of general
e c o n o m i c theory. In so doing, he has o p e n e d up new a v e n u e s for
research and analysis. Hopefully, this will allow other p r o f e s s i o n a l s
to bring their training and e x p e r t i s e to bear on the d i f f i c u l t
problems o[ insurance company p r o f i t a b i l i t y and rate regulation. In
addition, Mr. McGuinness has set an example w h i c h should be a guide-
line for all actuarial papers w i t h a c o m p r e h e n s i v e literature search
and thorough d o c u m e n t a t i o n of references. This standard will help
improve all papers and improve the content and u s e f u l n e s s of the
a c t u a r i a l literature.

Unfortunately, the paper has been w r i t t e n w i t h a tight time table,

w i t h the u n f o r t u n a t e result that at times the paper is d i f f i c u l t
to follow and the theme of the paper has o c c a s i o n a l d i v e r s i o n s into
non related areas. Sometimes this d i g r e s s i o n lasts only for a
sentence, but sometimes several paragraphs of u n r e l a t e d m a t e r i a l
are included. I hope that additional rewrites of this paper, w i t h
the helpful input of the c o m m i t t e e on review of papers and the
authors' own careful review, w i l l produce a good, c o h e s i v e paper
that will e n c h a n c e the actuarial literature.

A l t h o u g h the paper lists m a n y references, I am c o n c e r n e d that the

m a j o r study of the insurance industry p r o f i t a b i l i t y (The A . D Little
Study of 1967) and the subsequent analyses and d i s c u s s i o n s b e t w e e n
Mr. Plotkin and Mr. B a i l e y has not been u t i l i z e d in this paper.
This study was noted but w i t h o u t substantive u t i l i z a t i o n of the
content.

In the section on kinds of return, the author has d i s e c t e d the return

on investments into three components. T h e o r e t i c a l l y this s e g r e g a t i o n
m i g h t be valid, but there is little j u s t i f i c a t i o n in the p r a c t i c a l
w o r l d for this division. Insurance companies, like any other in-
vestor, select securities based on the total return including interest,
dividends, expected capital gains, and tax consequences. The seg-
regation of this return into components is theoretical and a r b i t r a r y
and ignores the realities of investment strategy. The subject of
investment income is dealt w i t h in other areas of the paper and
implies that rate setting should reflect the actual return on in-
vestments. Because of the d i v e r s i t y of insurance c o m p a n i e s and their
investment strategies, I b e l i e v e it is m o s t i m p o r t a n t to u t i l i z e
a secure rate of return in the ratemaking p r o c e s s and to a l l o w
individual company d e c i s i o n s concerning investment a l t e r n a t i v e s to
he i n d e p e n d e n t of rates. Thus a company that is w i l l i n g to u n d e r t a k e
investment risks can do so w i t h o u t any benefit or d e t r i m e n t to the
policyholder. It is i n a p p r o p r i a t e to reflect an insurance c o m p a n y ' s
investment strategy in e s t a b l i s h i n g rate levels.

--482--
Mr. M c ~ u i n n e s s itemizes six needs for profitability. The first
three are:

A. Protection of net worth from inflation

n. The need rot additional capacity to meet economic growth

C. An adequate return on investment (ROI) to retain and

attract capital

Unfortunately, the author has reverted to an insurance company

e c o n o m i c theory in segregating these three factors. General
e c o n o m i c theory encompasses the same parameters under the caption-
Return o n Investment. The return on investment issue was the
subject of the A.D. Little study which a d d r e s s e d it in great detail
and at great expense, but was unable to resolve the issue. None-
theless, if the long term return on investment is adequate, this
implies both the p r o t e c t i o n of net worth from inflatlon and an
increase in capital n e c e s s a r y to meet e c o n o m i c growth.

The last three needs for p r o f i t a b i l i t y as indicated by the author

relate to the protection of earnings from fluctuations in under-
writing and investments. Again, the author has reverted to an
economic theory for the insurance industry and has b y - p a s s e d a
more general e c o n o m i c theory. In no other industry is there a
guarantee of profits. Because of the social implications of the
insurance business, there should be r e q u i r e m e n t s for insolvency
regulation because of the potential severe impact on the general
population. However, such concerns relate more to long term
o p e r a t i n g results and mis-management, than year to year o p e r a t i n g
losses.

There are two factors w h i c h have not been d i s c u s s e d in this paper

w h i c h play an important role in an,insurers rate of return and
regulatlon.

A. The r e l a t i o n s h i p between p r e m i u m and surplus is a key

index of financial strength that is frequently reviewed
by regulators. This ratio is important in, the d e v e l o p m e n t
of rate of return and insolvency consideratiDns, and should
be w e a v e d into the economic theory.

B. Unlike m o s t industries, the insurance business receives

a large p e r c e n t a g e of its assets w i t h a zero cost of
capital. The insurance reserves produce a source of
additional investment earnings and greatly distqrts the
r e l a t i o n s h i p b e t w e e n return on equity and return on
total assets. This is an area that was d i s c u s s e d in
detail by Mr. Plotkin and Mr. Bailey ten years ago, but
u n f o r t u n a t e l y no resolution has been forthcoming.

--483--
I hope that this paper can serve as a c a t a l y s t for additional
analysis and research into the q u e s t i o n of insurance c o m p a n y
profitability. However, I am not sure that the regulation of
the insurance c o m p a n y can ever be h a n d l e d w i t h i n any e c o n o m i c
theory beuduse of" th(, political and social pressures. In my
opinion, the only sound a p p r o a c h is to d e - r e g u l a t e insuranco
companies and to allow the forces of c o m p e t i t i o n to limit in-
surance c6mpany profits and to provide a r e a s o n a b l y priced
insurance product for the consumer.

--484--