REPLY то Norgaard and Schick's "Profitability in the Property and Liability Insurance Industry" and Professor Richard L. Norgaard's testimony before United States Senate, Subcommittee on Antitrust and Monopoly of the Committee on the Judiciary July 9, 1968 ABSTRACT OF: THE ARTHUR D. LITTLE, INC., REPLY TO Norgaard and Schick's "Profitability in the Property and Liability Insurance Industry" come. Arthur D. Little, Inc., completed a comprehensive study of the profitability of the stock property and liability insurance industry-as a part of a general investigation of insurance prices and investment inUsing sound economic and accounting practices which ensured comparability with other industries, ADL measured insurance profitability by including all possible sources of income: operating (underwriting) incomes, interest and dividends received, realized capital gains, and even unrealized capital gains. Adjustments were made to reflect the mixed cash/accrual accounting system employed in this insurance industry. We found no evidence of excessive return in this industry. In fact, when compared to the broad spectrum of American industry and to other financial industries, the insurance industry was found to be underearning. Our conclusions were based not on a sample of companies but on industry-wide data, as well as on several different measures of financial return. Risk/return comparisons were based on a 60-industry, 16-year econometric study which has been published in the academic literature. Our results are diametrically opposed to those reported by Norgaard and Schick. We attribute the differences in results to departures on the part of Norgaard and Schick from sound economic, financial, and accounting theory. Particularly, we find that Norgaard and Schick's analysis has been based on: ● A measure of insurance company profits which vio- • An "apples-and-oranges" comparison of internal with • A misrepresentation and a misinterpretation of Finally, we note that our results and interpretations are much more in keeping with the present happenings in the insurance and financial communities than are their opposites proposed by Norgaard and Schick. We submit that the ultimate test of the validity and value of any economic analysis is its ability to predict and explain real world phenomena. In this regard, the ADL conclusions are substantiated, while the Norgaard and Schick conclusions are invalidated. I. SUMMARY 1 Arthur D. Little, Inc., completed a comprehensive study of the profitability of the stock property and liability insurance industry as a part of a general investigation of insurance prices and investment income. Using sound economic and accounting practices which ensured comparability with other industries, ADL measured insurance profitability by including all possible sources of income: operating (underwriting) incomes, interest and dividends received, realized capital gains, and even unrealized capital gains. Adjustments were made to reflect the mixed cash/accrual accounting system employed in this insurance industry. In fact, We found no evidence of excessive return in this industry. when compared to the broad spectrum of American industry and to other financial industries, the insurance industry was found to be underearning. Our conclusions were based not on a sample of companies but on industry-wide data, as well as on several different measures of financial return. Risk/return comparisons were based on a 60-industry, 16-year econometric study which has been published in the academic literature. This reply discusses the criticisms of ADL's research and the analyses of Professors Richard L. Norgaard and George Schick. Having carefully studied their review, we conclude that the Norgaard and Schick work is devoid of either academic or practical value. As we demonstrate, the principal fallacy of the Norgaard and Schick analysis is its measure of insurance company profits. In both theory and practice their measure departs so radically from rational or useful profit calculations for any industry that their ensuing analyses are totally invalid for this reason alone. The peculiarities of accounting in general, and of insurance accounting in particular, leave some room for differences of opinion in selecting appropriate rate of return measures; however, Norgaard and Schick's measure is outside the realm of reason. Norgaard and Schick's review2 and Professor Norgaard's testimony3 seek to refute the main conclusion of the ADL Report that the risk 1Arthur D. Little, Inc., (ADL) Staff, Prices and Profits in the Property and Liability Insurance Industry (hereinafter cited as ADL Report), Cambridge: Arthur D. Little, Inc., November 1967. 2R.L. Norgaard and G. Schick, "Profitability in the Property and Liability Insurance Industry," a study submitted as part of testimony by R.L. Norgaard before the United States Senate, Subcommittee on Antitrust and Monopoly of the Committee on the Judiciary, July 9, 1968. 3Page references for testimony refer to the Ward and Paul transcript of the hearings before the United States Senate, Subcommittee on Antitrust and Monopoly of the Committee on the Judiciary, July 9, 1968, Senator Philip A. Hart (Chairman) presiding. NS-1 related rates of return of the property and liability insurance industry are below normal. Although Dr. Norgaard stated at the beginning of his testimony, "I have not seen the Arthur D. Little report, as a matter of fact, and would be delighted to see it, too" (p. 363), he nevertheless goes on to say, "I am diametrically opposed to the position taken by the Arthur D. Little report and basically by that taken by the insurance industry" (p. 365). The Norgaard and Schick paper asserts that "major property and liability insurance companies have reaped a high rate of profit" (resumé page), and Dr. Norgaard concludes that "90 out of every 100 companies are doing worse than the insurance companies" (p. 365). The ADL Report reached the opposite conclusion; viz., that 90 out of every 100 companies in the United States are doing better than property and liability insurance firms. Thus, the issue is clear, as Senator Hart observed in summarizing the Norgaard testimony: "As I get it, two people take the same figures and imagine lines being more clearly drawn. I am sure emphasis added) The results of the Norgaard and Schick study are so seriously at variance with the ADL results that, after verifying once more the accuracy of our computations and the validity of our results, we set about to try to understand how the contrary results could have been obtained. Having examined the analyses performed by the reviewers, having discussed them with insurance scholars, and having duplicated their calculations, we believe that our conclusions stand, while those of Norgaard and Schick are wrong. While almost every facet of the Norgaard and Schick report shows some variance from generally accepted academic and professional standards, we found the following three departures from acceptable practice and realism to be the most flagrant; each by itself renders the Norgaard and Schick study worthless: A measure of insurance company profits which • An "apples-and-oranges" comparison of internal • A misrepresentation and a misinterpretation of We appreciate that these are severe allegations. Such severity is warranted because the issues at stake, though technical in nature, have serious implications for the proper interpretation of real world pheSound policy formation demanded the untangling and answering of these questions and the identification of valid criteria for measuring the performance of publicly regulated companies. nomena. NS-3 |