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particular business undertaking. . . . In short, if an enterprise is to attract capital, it must offer prospective investors, especially equity investors, an expected return high enough to compensate for any risks (lack of predictability) that might accompany this expectation."

This statement would lead the unwary to believe that the study would be based on the rate of return on stockholders' equity, i.e., policyholders' surplus. A study of other material released by the A.I.A. would reinforce this belief. However, this is not the case.

The four and four-tenths per cent of return so widely quoted is the rate of return on total investable funds, including loss reserves and unearned premium reserves. These reserve items are not risk capital in any sense.

The study does, to be sure, develop a figure for the rate of return on policyholders' surplus. It appears in only one inconspicuous place in the Summary Report, at the bottom of Column N4/D1 of Table 3, on page 24 of the report. That rate of return is nine per cent.

This rate of return is slightly too high because it ignores potential income taxes on unrealized capital gains and it ignores the equity in the unearned premium reserve. The rate of return after these adjustments probably would be about eight per cent.

The Arthur D. Little organization defends their choice of return on the basis that:

"The total rate of return (N4/D2) is the only measure which evaluates overall economic earnings on the totality of economic resources employed. From society's viewpoint this is the critical measure of whether resources are being over- or under-applied to an economic activity. Society is not interested in the financial structure of particular companies. Whether assets are offset by debt instruments or common stocks plays no part in determining their value to the economy as a whole." (emphasis in original)

This appears to be good economic theory, but it is not likely to be accepted by financial analysts as a basis for evaluating an equity investment. The A.D.L. study, which started out to determine the ability of insurers to compete for risk capital has ended as a research study in social economic theory. Unfortunately, the change in goals may escape the superficial reader. It apparently was not detected by the A.I.A., if one may judge by their news releases.

It is true that the rates of return for other industries were calculated on the basis of the sum of equity and debt capital. However, the resulting rates of return are not comparable. The other firms must use a large part of the earnings on debt capital to pay interest to their bondholders, thereby reducing the part of that return which inures to stockholders. Insurers make no such payments on reserves. To illustrate the importance of this difference, compare the results for two hypothetical firms. Firm A is an insurer with total investable assets divided equally between policyholders' surplus and reserves. Firm B is an industrial firm with capital divided equally between equity and debt. Both firms earn a rate of return of eight per cent on total investable funds, but B must pay six per cent interest to bondholders. Under these assumptions stockholders of A would realize a return of sixteen per cent, while stockholders of B would realize a return of only ten per cent. Stockholders of the insurer would earn sixty per cent (not percentage points) more than the stockholders of the industrial firm, although both firms earned the same rate of return on total investable assets. At the proper rate of return, approximately eight per cent, A.D.L. and the A.I.A. could have made a good case for their position that insurers cannot earn enough to compete with other industries in the capital market. By using the lower fictitious rate of return they have created considerable doubt as to the credibility of the study and may have prejudiced their case beyond repair.

In summary, this reviewer would like to evaluate separately the theory behind the A.D.L. study and the report of that study. It is his belief that the basic A.D.L. approach, other than the choice of the rate of return, is a sound method of comparing risk and return among industries. In the author's view the report, because of its faulty choice of rate of return, probably will cause greater financial harm than benefit to all branches of the property and liability insurance industry.

INFORMATION SUPPLIED BY IRVING PLOTKIN OF ARTHUR D. LITTLE, INC.

Reply to Robert A. Bailey "A Review of the Little Report on Rates of
Return in the Property and Liability Insurance Industry"*

Irving H. Plotkin

Arthur D. Little, Inc.

NOTE

This draft of my reply is based on a corrected version of Mr. Bailey's original paper. His changes were made after several telephone conversations with me, and I have not as yet seen the latest version of his paper. While I believe I understand the substitutions he intends to make, I am handicapped in replying to his paper by not actually having them in front of me at the time of writing my review. Accordingly, I apologize if I misquote Mr. Bailey and reserve the right to amend this review when I have studied the final version of his paper. I complement Mr. Bailey on his willingness to delete without hesitation his earlier inaccurate quotations from and references to

the ADL study.

*Presented at the November 16-18, 1969 Meetings of the Casualty Actuary Society at Atlanta, Georgia.

1. INTRODUCTION

We are pleased to have this opportunity to reply to Mr. Bailey's well

*

written review of Arthur D. Little, Inc.'s recent study of property and liability insurance. Mr. Bailey raises several methological questions in financial and welfare economics. We will address each of these questions in turn. While we disagree with several of the conclusions Mr. Bailey reaches with respect to economic methodology, we do not disagree with what is, perhaps, the primary, practical (non-theoretical) conclusion of the Bailey review. We agree that it is both interesting and useful to compare properly measured and adjusted return on net worth for stockholder owned insurance companies to the return on net worth experienced in other economic endeavors having similar

risk characteristics.

Rates of Return in the Property and Liability Insurance Industry:

1955-1967,

June 1969. Copies are available from the National Association of Independent Insurers, Chicago, Illinois.

11. BAILEY ON RATE MAKING

Before turning to Mr. Bailey's criticisms of the ADL report, we feel it

is important to note the contribution Mr. Bailey's review has made to the growing discussion of the role of investment income in rate making. The issue Mr. Bai ey addresses involves the inclusion or exclusion of investment income in the formulation of premium rates. ADL has not taken a position as to whether rates should be lowered by the direct inclusion of investment income in rate making formulas. However, Mr. Bailey appears to take a definite stand on this critical issue. In his review of current insurance practices, Mr. Bailey demonstrates that insurance premiums are lowered by the income generated through the company's investment of unearned premiums and loss reserves. He also discusses a return due to delayed loss payments.

I am not an actuary and frankly admit I do not completely follow Mr. Bailey's point with respect to the time value of loss payments. However, I believe I understand his point with respect to lower premiums due to prepayments. Further, I accept Mr. Bailey's observations about the rate making process because, as the chief actuary of a major state's insurance bureau, he is in a much better position to understand current rate making policies. Although Mr. Bailey's fellow actuaries may wish to argue these points with him, I feel it is best for the purpose of discussing his review to accept them as stated. The following

is intended merely to clarify the position I believe Mr. Bailey is advancing.

Mr. Bailey observes, "The policyholders do receive a return on the funds they advance to an insurance company. They receive several returns. One return is lower rates" (p.4). He indicates these returns correspond to " investment income from the assets that back up the reserves for unearned premiums

...

the

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