III. RISK AND RETURN IN PROPERTY AND LIABILITY INSURANCE MOTIVATION Economic theory has long maintained that a going concern must reward its investors with a return commensurate with the risks inherent in the particular business undertaking. Although many elaborate and technical definitions have been offered for the term "risk," the underlying meaning is generally accepted to be "lack of predictability.” While ruling in the Hope Natural Gas Case, the U.S. Supreme Court stated this fact of economic life as follows: From the investor or company point of view it is important that there 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. Until recently there have been two distinct forms of economic endeavor. The first and most common type is the private enterprise whose product prices are set in more or less competitive markets. The second type is the natural, regulated monopoly, such as telephone companies and power utilities, which are given exclusive geographical jurisdiction by government fiat and whose product prices (or rates) are set by a regulatory body. The basic justification for such regulation is that the regulated industries are characterized by economies of scale with respect to size of market which are so great as to make competition excessively or unacceptably costly. A critical similarity between these two types of industrial organizations is that both raise investment capital from the general public in the national capital markets. The question must be asked, “By what mechanism does each type of organization balance return and risk for its investors?" The forces of supply and demand in the capital market allocate to each private enterprise an amount of capital that balances at the margin prospective risks and returns from the particular economic activity. It is the consumers' marketplace that determines the quantities and prices of the firm's products. In the case of regulated monopolies, the regulatory agencies seek to establish a rate schedule that over time will guarantee a return on invested assets of some specified rate of return, say 6%. In setting the price schedules for regulated industries, the various agencies are required to consider the effect of these rates on the total return of the corporation. This requirement was stated by the U.S. Supreme Court in the Bluefield Waterwork case, as ollows A public utility is entitled to such rates as will permit it to earn a return Another unique form of regulation that various government bodies are attempting today stems from the desire to control final consumer prices of various goods and services. Some have called this type of regulation "consumerism.") Like the utility regulatory gency, the government desires to set the market price of the product. However, unlike the regulatory agency, the total effect of a change in price on the earning abilities of the corporations is usually not considered. Changes in price or rate schedules have immediate effects on the total revenue dream available to the corporation, and both short- and long-term effects on the orporation's ability to service its debt and pay dividends to its stockholders. It would be Pane to assume that one could materially affect the revenue streams without affecting the rate of return a corporation is able to earn. Although final consumer price was the question at issue in the court and regulatory cases mentioned above, attention was directed toward rates of return in regulated industries. Questions of “adequacy." “excessiveness," and "equity" of final price were answered by examination of profit. Profit is the residual that emerges after all expenses have heen deducted from the revenue stream. Under assumptions of profit-maximizing behavior. questions of adequacy, excessiveness, and even equity are evaluated in terms of the rate of retum and risk environment. In studying adequacy and excessiveness of rates of return and risk, the courts and agencies have generally held that the government is not free to change merely the rates of return of the industries whose prices it seeks to establish. Unless the government is willing to make certain guarantees of minimum returns to these new "semiregulated" industries, it will leave the risk environment unchanged, while usually lowering the rate of return by lowering product prices. Such action would result in a marked reduction in the flow of capital to these corporations and a subsequent curtailment of the normal flow of goods and services to the public. It seems clear that regulation of final price is tantamount to regulation of profitability. If, as has been held by the courts, profits and risks are related, then an action which reduces profits without considering risks will result in a reduction of the level of services provided by any industry so regulated. Therefore, to determine the possible effects of proposed changes in rate formation in the property and liability industry, this study first examines the basic question of the relationship of risk and return in American industry. A THEORY OF RISK AND RETURN The objective, in general terms, has been to determine the nature of the relationship between the levels of profitability and the degrees of risk experienced in American industry. Rate of profitability (or return) is relatively easy to measure by any of a number of book value and market value financial statistics. The concept of risk, however, is a more troublesome semantic problem. Risk is basically a subjective phenomenon and not as susceptible to precise or direct measures. What has been done, therefore, was to theorize that certain objectively measurable concepts are related to, and to some extent describe, risk. The next step was to correlate rates of return with these objective risk measures by statistical techniques. The basic unit of concern in this and any risk/return analysis must be the individual corporation. It is within the individual corporation that the balance between expected returns and expected risks is struck. However, this does not imply that the only or best source of information about risk expectations held by entrepreneurs is historical statistics developed on a company-by-company basis. Management forms its risk expectations on the basis of experience, but not solely on the experience of its own firm. Likewise, entrepreneurs considering entry into an industry will assess the general riskiness of the industry by examining the range of corporations active (or previously active) in that industry. It is, therefore, not unreasonable to seek a measure of expected risks within an industry based on historical experiences. To perform the relevant statistical tests, it is necessary to construct a quantitative measure of industry risk (or uncertainty). Before proceeding with a discussion of results it might be well to summarize briefly the basis of our risk measure. When we ask, "What is risk?" the answers usually range over most of the peculiarities that make up a human being and his psychological character. Semantics enter quickly, and quite often the discussion degenerates into the sphere of one's own subjective reactions to stressful situations. In these discussions, however, one is encouraged by a significant number of common threads that emerge as one generally agreed upon element of risk, which we believe is amenable to measurement and quantification in a statistical sense. Uncertainty (or lack of predictability) seems to be the common element; the uncertainty involved in predicting the outcome of an event (i.e., a particular investment) is. in general, what makes the process risky. The greater the uncertainty about final outcome of an event, the greater the risk for those investing in that venture. With this rather simple proposition in mind, consider the two alternative ventures whose possible outcomes are represented in Figure 4 by distribution patterns A and B. One may argue that curve B clearly leads to the broader uncertainty as to what the final outcome will be. It should be noted, however, that this uncertainty is not merely a function of the range (the difference between the highest and lowest possible values). It is also concerned with the frequency of Probability of Occurrence FIGURE 4 Percent of Firms FIGURE 5 B Value of Outcome DISTRIBUTION OF POSSIBLE OUTCOMES OF TWO VENTURES Rates of Return DISTRIBUTION OF RATES OF RETURN EARNED BY FIRMS occurrences at all possible levels of return, and it is, therefore, appropriate to concentrate on the dispersion of possible outcomes about their central, or expected, value as being one of the key elements in the measurement of risk. This measure is the "variance" of rates of return about their expected value. In a similar manner, the riskiness of an industry may be gauged by the lack of predictability of the individual incomes of its members. At any point in time, one may look at the profit performance of individual firms in an industry and obtain some idea of the dispersion or scatter of performance. The configuration of this scatter of performances can be used as a proper and sensitive indicator of risk or uncertainty. Figure 5 illustrates the point. In any one year, the companies that comprise two industries, A and B, may produce the distribution patterns of rate of return on investment shown in the figure. It is obvious from these two distribution curves that the certainty with which one could predict profit levels in Industry A is considerably higher than in Industry B. Put another way, a firm in Industry A (subject to the same competitive forces as most of the other companies in its industry) will have a lower degree of uncertainty in predicting its profit performance than will a firm in Industry B. Thus the configuration of the scatter of profit levels in the industry, taken at a point in time, becomes a manifestation of the risk environment. Looking back at the cross-sectional pattern of dispersions of profit levels in individual years. management can obtain an idea of the typical pattern i.e., a sense of the historical risk environment to which the industry has been subjected. Management bases its risk evaluation and investment decisions on its experience within its own industry. A way of picturing and quantifying an important part of that experience is by considering the scatter of returns earned by firms in that industry. We contend that industries characterized by highly disperse profit distributions will be considered by management and investors as riskier industries than those characterized by compact distributions of profit rates. Stated in this way, such a concept of risk is amenable to fairly straightforward statistical measurement, using well-established and well-understood mathematical relationships. (We consider this an important point in our analysis.) This statistical technique flows naturally from our considerations of the way management perceives risk as well as from the implications of the economist's theory that utility maximizes the behavior. Because this theory of return is essentially a long-term concept, averages have been taken over the period studied (1950-1965) for each industry's annual rate of return and dispersion. In this way the results are not unduly influenced by abnormal years. DEFINITIONS OF RETURN Rates of return can be measured either at book value or at market value. Book value returns relate the yearly income flow as reported on the company's P&L statement to stock balance sheet items, such as total assets. For a company which employed the same level of assets in its operations for an entire year and whose assets were financed solely by common equity, the ideal book rate of return would be: |