For comparisons, other commonly used, but for our analysis less meaningful, measures of book return are considered. They are: B' is objectionable because it considers neither the totality of assets invested in the enterprise nor the totality of return. B" is a misleading measure when comparing industries with different degrees of leverage. In selecting the measure of return, there are basic reasons for not being concerned with the debt/equity financing mix that a firm's management may use to finance its investments. Among these reasons are the following: - 1. Society's view of optimal resource allocation If physical 2. Underlying source of risk - It is not suggested that management disregard trying to optimize its debt/equity ratio (a task which Modigliani/Miller say is impossible). Instead, it is suggested that in evaluating the underlying cause of financial as well as operating risks which is the nonpredictability of earnings flow management should concentrate on total investment and total earnings. Financial, or leverage risk arises due to this underlying uncertainty. - - As has been shown adequately many times, the only proper criterion for making marginal investment decisions is the effect of the investment on the total risk and return position of the company. Marginal decisions do not become profitable if financed one way and unprofitable if financed another way, except in a most myopic sense. -5 IV. ADJUSTMENTS FOR THE INSURANCE INDUSTRY It is important to note that this analysis involved both financial and industrial corporations. It was necessary to make comparisons between corporations whose assets are carried at historic cost and those (notably property and liability insurance companies) whose assets are carried at current (or market) value. To maintain comparability in the book rate of return ratios, all changes in asset values (e.g., unrealized capital gains) were included as income-type items for those industries keeping their books at current value. Thus, for property and liability insurance, the book rate of return (B) is developed below as the sum of net underwriting profit, interest and dividends received, realized capital gains, less taxes paid, plus unrealized capital gains, all divided by the sum of policyholders' surplus and unearned premium and loss reserves. It should be noted that this return has been constructed for purposes of comparisons with other industries. This in no way implies that such a definition of return is valid for other purposes. The analyses described in the Prices and Profits Report are based on comparisons with industrial corporations. Financial statements for these corporations were collected by Standard & Poor's and, after adjustment for inter-company comparability, were reported on its COMPUSTAT tape. To extend the analyses to financial corporations, two problems must be resolved. First, there existed no COMPUSTAT tape or similar source of historical information about financial industries. Second, the accounting conventions used by the several financial industries vary among themselves and differ considerably from the general conventions used by industrial corporations. By focusing primarily on the property and liability insurance industry, these two problems are overcome. Accounting conventions used in property and liability insurance reporting produce a current (or market) value balance sheet and a mixed cash/accrual income statement. As an aid in comparing the property and liability industry with industrial corporations, a model balance sheet and income statement have been constructed and are presented in Exhibit 1. Each item is either a basic observation available from primary sources (e.g., Cash 10 10) or is derived from basic items (e.g., Stocks 50 = 30+ 40). = 4 3,4 An analysis of the mixed cash/accrual accounting system of the property and liability industry shows that its effect is to understate the total rate of return by less than 10 percent (not percentage points) in typical cases. (See Appendix B of the Prices and Profits Report.) Because of these differences in account conventions, direct (non-ratio) comparisons are difficult. There is, however, a way to construct a rate of return for insurers similar to the industrial measure discussed previously. If the balance sheet is taken at current value (as reported on convention statements), we have (using Exhibit 1): Total Assets (market) Current Liabilities = 90 which is equivalent to: Total Investable Funds (market) · = 180 + 130 = 199 = This measure is analogous to an industrial company's Total Capitalization. The income flow can be evaluated before or after unrealized capital gains: Net Income Before Unrealized Capital Gains 340 = N35 N45 Net Income Plus Unrealized Capital Gains 360 N4 The all inclusive income measure, "Net Income Plus Unrealized Capital Gains," should be related to "Total Investable Funds (at market)." In short: for insurance companies we have: and liability insurance companies are unlike any industrial company. The ratio is, however, comparable from the efficiency and alternative earnings standards set forth in this study. It may even overstate the property and liability return when compared to the other industries. That is, the same quantity--unrealized capital gains--is added to both the numerator and denominator of the fraction. If the rate of return, B, is less than unity and the average unrealized capital gains are positive, then the value of the new fraction will be increased. Therefore, when comparing in this manner the insurance industry's internal return valued at market with industries valued at cost, the insurance measure is relatively overstated. 5 These symbols are used in the Exhibits. 6 See the Appendix for an extended discussion of this distortion. -7 We may now summarize the components of the rates of return presented in the Exhibits in terms of the items found in Exhibit 1: The income figure we concentrate upon is the all inclusive N4 measure. It is composed of: All the insurance data reported in the Exhibits were derived from Best's Aggregates and Averages, Property-Liability editions for the years 1956-1968. Best's divides the industry into four types of company groups: stocks, mutuals, reciprocal, and Lloyds. 7 For each group it publishes annually "Grand Totals" of balance sheet and income statement items. The A.M. Best organization is recognized as the authoritative source of insurance data. They describe their efforts in obtaining their data as follows: "We have spared neither time nor expense in our effort to make In general, our rate of return calculations were made directly from the figures reported in Best's for the Grand Totals of each industry segment. However, a problem arose for the mutual Grand Totals for the years 1955 through 1965. In these years, Best's Grand Totals included more companies in the balance sheet items than in the accounts showing premium distribution, underwriting income, investment income, and policyholders' For a description of each type of insurer, see Chapter 58 "Structure of the Business", by A.D. Goerlich in Property and Liability Insurance Handbook, Long and Gregg editors, Richard D. Irwin, Inc. Homewood, Ill., 1965. surplus. The additional companies reported in the balance sheet items were five to seven perpetual mutuals. In order to calculate the rates of return ratios of income items to balance sheet items, it was necessary to have a consistent data base. Therefore, the balance sheet values for the perpetual mutuals were subtracted out of the Grand Totals for the mutual segment in each year. For the years 1966 and 1967 this adjustment was not necessary since the perpetual mutuals had not been included by Best's in the mutual's grand total balance sheet accounts. 8 According to Long and Gregg, op. cit., perpetual mutuals have policies which are issued in perpetuity in exchange for one advance premium. The capital of the company is comprised of the total of these payments. Perpetual mutuals do not report premium distribution, underwriting income, investment income, or policyholders' surplus because of their special method of obtaining capital. -9 |