Discounted Cash Flow
Content
DISCOUNTED CASH FLOW MODELS and RATE OF RETURN PERSPECTIVES
Russ Bingham Vice President and Director of Corporate Research Hartford Financial Services
CANE March 23, 2000 1 1
Discounted Cash Flow Models and Rate of Return Perspectives Summary Discounted cash flow is a common approach used to assess financial performance. The purpose of this session will be to review this technique in the broader context of general
financial
models
as
applied
in
insurance.
A
discussion of the essential \u201cbuilding blocks\u201d upon which models should be constructed will be followed by a review Examples will be presented their fundamental of various to ratedemonstrate of return measures that result equivalency. from them. The policyholder and shareholder rate ofperiod return Specifically, this will compare the policy / accident to perspectives also be reviewed. the calendar will period view as well as compare the IRR and ROE rate of return calculations.
2 2
Contents q q q q q q q q q
\u201c Building Blocks\u201d: The Fundamentals Building Blocks\u201d: The Fundamentals \u201c ConceptualCritique Critique ofofConventional Conceptual ConventionalAccounting Accounting ShortcomingsofofReported ReportedFinancials Financials Shortcomings Economic Value Concepts Economic Value Concepts Rateof of Return Return Models: Important Rate Important Attributes Attributes Rateof of Return: Return: Parameter Rate Parameter Consistency Consistency Rateof of Return Return Measures Measures and and Their Their Equivalency Rate Equivalency The Fundamental Insurance Total Return Model The Fundamental Insurance Total ComponentsofofTotal Total Return: Return: Underwriting, Components Underwriting, Investment Investment &&Leverage Leverage
q
AspectsofofInsurance InsuranceTotal Total Return Return Aspects
q
Exhibits: Balance Balance Sheet, Sheet,Income, Income,Cash CashFlow Flow&& Returns Returns Exhibits: 3 3
“ Building Building Blocks”: Blocks”: The TheFundamentals Fundamentals q
q
q
BalanceSheet, Sheet,Income Incomeand andCash CashFlow FlowStatements Statements Balance Accounting Valuation: Valuation: Conventional Conventional (statutory (statutory or Accounting or GAAP) and Economic (present value) Development“Triangles” “Triangles” of of Marketing Marketing //Policy Development Policy/ / Accident Period into Calendar Period
4
Policy (or Accident) / Calendar Period Development Triangles Balance Sheet, Income, Cash Flow Policy Period Prior 1996 1997 1998
Historical 1996 X X
1997 X X X
Calendar Period 1998 X X X X
1999 2000 Reported
==== Sum
==== Sum
==== Sum
1999 X X X X
Future
Total
2000 Ultimate X …... --> Sum X …... --> Sum X …... --> Sum X …... --> Sum
X
X X
==== Sum
==== Sum
…... --> --> Sum Sum …...
Calendar
5
General Shortcomings of Reported Financials q
Missing key key elements elementsofoftotal total return return -- absence of market market value Missing absence of value basis omits important information necessary to more fully judge performance
q
q
Lacks more more relevant relevant current current (i.e. policy // accident Lacks (i.e. policy accident period) period) performance focus Biasedagainst againstlonger longertail tail and and higher higher combined combined ratio ratio business Biased business which conceals profitability of commercial to a greater degree than personal lines
6
Specific Shortcomings of Reported Financials q
q
q
Total Assets Assets are are affected affected by by changing changing and and somewhat somewhat arbitrary arbitrary Total definitions of non-invested assets. (Suggest realignment with only Invested Assets on “left” side, net liabilities and equity on the right.) Income affected affected by by premium premium earning, earning, deferred deferred acquisition acquisition and Income and reserve estimation, all of which can be altered. such as as unrealized gains, do do Below the theline” line”surplus surplusadjustments, adjustments, such unrealized gains, ““Below not flow through “income”.
q
Significant market market value value adjustments adjustments are are ignored ignored when when Equity Equity isis Significant reported q loss lossreserve reserveadequacy/inadequacy adequacy/inadequacy and and discount discount value value q some someinvested investedassets assets 7
Economic Value Concepts q
q
q
q
Economic valuation valuation presents presentsaa financial financial view view in in which all assets Economic assets and liabilities are market valued (cash equivalent). Considersthe theestimated estimatedmagnitude magnitudeand andtiming timingof of future future cash flows Considers cash flows Focus on on performance performance related related to to current current actions actions (i.e. (i.e. policy policy or Focus o accident period) rather than performance related to when reported (i.e. calendar period)
r
Economicincome incomeisisthe thechange changeinineconomic economicvalue valueover overaaperiod periodinin Economic time q q q
(FASB 130) comprehensiveincome” income”perspective perspective (FASB 130) ““comprehensive tight balance balance sheet, sheet,income incomeand andcash cashflow flowlinkage linkage tight no “below “below the line” no line” adjustments adjustments 8
Conceptual Commentary q
q
Reported income income and and returns returns (and (and other other financials financials as as well) Reported follow conventional accounting rules which govern the timing of income recognition and are potentially a misleading basis for rating, regulation & financial analysis. Economic rules produce different results. Retainedearnings earningsare arelargely largelyirrelevant irrelevant to to economic economic accounting accounting Retained
q
Unearnedpremium premium reserve reserveisisnot not cash, cash,and andthus thusnot not economic. economic. Unearned
q
Leverage levels levelsinvolve involveconcessions concessions ratersand andcreate create Leverage to tothetheraters non-economic based constraints.
q
Economic value value isis realized realized either either by by converting converting assets assets and and Economic
q
liabilities to market via sale, or over time to “earn” the discount value. ROE calculation calculation -- change change the the formula formula (income ROE (income / beginning period contributed surplus). Do not include retained earnings and do not average the equity. 9
Rate of Return Models: Important Attributes q
q
Focuson onCash CashFlow Flow Focus Inclusion of surplus with flow controlled by specified rules Inclusion of surplus with flow controlled by specified rules
q
Operating (i.e. (i.e. policyholder) policyholder) cash cash flows flows maintained maintained separately separately Operating
q
Economicvalue valuewith with after-tax after-tax discounting discounting Economic
q
NPV income income formulation formulation (with NPV (with and and without withoutrisk riskadjustment) adjustment)
q
DevelopmentofofNPV NPVbalance balancesheet sheetliabilities liabilities Development
q
Policyholder and and shareholder shareholderrate rate of of return return calculations Policyholder calculations 10
Rate of Return: Parameter Consistency q
Dealingwith with Risk Dealing q q q
q
IRR cost cost of of capital total return IRR capital based based total return NPV risk-adjusted total return equal to risk-free rate NPV risk-adjusted total return equal to risk-free rate NPV total total return to cost of of NPV return (without (withoutrisk-adjustment) risk-adjustment)equal equal to cost capital
Beta of of Equity Equity versus Beta ofofLiabilities Beta versus Beta Liabilities Surplus Flows Flows Surplus Controlling amount of of flows q Controlling amount required requiredand andtiming timing flows q
– Liability Liability // surplus surplusrelationship relationship – Multi-period Multi-periodaspect aspect q
Surplus flow flow components components Surplus – Surplus release Surplus contribution contributionand anditsits release surplus – Investment Investmentincome incomeon oncontributed contributed surplus – Release Releaseof ofoperating operatingearnings earnings 11
Rate of Return Measures Income on Investment q
q q q q
Conventional Calendar Calendar ROE: ROE: Income Income // Average Average Equity, Equity, including Conventional including Retained Earnings Nominal Ultimate Ultimate ROE (“steady Nominal (“steady state” state” calendar calendar equivalent) equivalent) DiscountedUltimate Ultimate ROE ROE (net (net present present value value rate rate of of return) Discounted return)
Risk-adjusted Ultimate ROE (risk-adjusted NPV rate of return) Risk-adjusted Ultimate ROE (risk-adjusted NPV rate of return) Operating returns alsoalso ROE like” like”Underwriting Underwritingand and Operating returns ““ROE
Cash Flow Internal Rate of Return Basis q
ShareholderIRR IRR (also (also Underwriting Underwriting IRR Shareholder IRRand andOperating OperatingIRR) IRR)
Shareholder (i.e. Investor Perspective) q q
ShareholderCash CashDividend DividendYield Yield Realized Realized Shareholder ShareholderTotal Total Return: Return: dividend plus Shareholder plus stock stock price price appreciation appreciation 12
Equivalency in Rates of Return For Single Policy - Exhibit 1 q (1) IRR (1) IRR q (2) (2) Net Net present present value value ROE ROE q
(3) Total Total policy policy ultimate (3) ultimate nominal nominalROE ROE
q
(4) Shareholder Shareholderannual annual dividend dividend yield yield realized (4) realized
For Multiple Policy Ongoing (steady state, no growth) - Exhibit 2 q
(5) IRR IRR (5)
q
(6) Annualcontributed nominal ROE while (6) Annual nominal ROE while at atsteady steady state state (income (income // beginning surplus)
q
(7) Shareholder Shareholderannual annual dividend dividend yield yield realized (7) realized
13
The Fundamental Insurance Total Return Model (1) Total Return = Operating Return X Operating Leverage + Investment Rate of Return on Surplus Operating Return = Underwriting Rate of Return + Investment Rate of Return on Policyholder Liability “Float” OR (2) Total Return = Underwriting Return X Operating Leverage + Investment Return X Asset Leverage Operating Leverage = Net Liabilities / Surplus Asset Leverage = Invested Assets / Surplus Insurance Consists of Underwritin Investment & Financial Leverage Underwriting, g, Investment & Financial Leverage 14
The Components of Insurance Total Return -Underwriting, Investment & Leverage q
the company Underwritin gReturn Return is the the price pricefor forthe thetransfer transferofofrisk risktoto the company Underwriting associated with the policyholder related cash flows. When positive the company is being paid for the transfer of risk. When negative the company is incurring a cost to acquire the funds from the policyholde and must depend on the investment spread to generate a profit.
q
r r
represents the Investment Return Return represents the yield yield on on invested investedassets assets(from (fromboth both Investment policyholder supplied funds and surplus). The spread between the Investment Return applicable to policyholder supplied funds and the Underwriting Return must be positive if the company is to generate a net ne operating profit from underwriting.
q
t
needed to to meet specifie Levera ge (based (basedon onsurplus surplusrequirements requirements needed meet specified Leverage d
underwriting, investment and and financial magnifying effect on both return risk. risk tolerances) creates a q
Total Return Return Total
reflects o o reflects the the shareholder shareholder oriented orientedreturn, return,comprised comprised levered operating return plus the investment return on surplus.
ff
15
Aspects of Insurance Total Return q
The Total Total Rate Rate of Return, as The as well as as the the Underwriting Underwriting and and Investment Rates of Return, can be determined on either q q
q
q
cashflow flow basis, basis,via via the the Internal Internal Rate aa cash Rate of of Return Return(IRR) (IRR)oror as aa Return Return on on Equity Equity formed of of Income to to Equity in in as formedbybythetheratio ratio Income Equity which the financials are in EITHER Nominal or Present Valued terms
The present present value value rate rate of of return return using The using aa risk-adjusted risk-adjusted discount discount rate will equal the risk-free rate, since by definition risk has been eliminated. Leverageisis controlled controlled by by specifying specifying rules rules governing governing the the flow flow of Leverage surplus and dividend (distribution of earnings) to maintain a uniform risk profile over the life of the policy q
q q
Contributed surplus governed liability / /surplus Contributed governed by constant constant liability surplusratio ratio Investment income incomeon onsurplus surplus dividended dividended as asearned earned Investment Operating earnings earnings distributed distributed in proportion Operating proportion toto per per period periodliability liability exposure
16
Total Return Model Example Total Return = Oper Return X Oper Levg + Invest Rate of Return on Surplus 14.9% = 3.7% X 3.0 + 3.9% not risk-adjusted 6.0% = 0.7% X 3.0 + 3.9% risk-adjusted basis Oper Return = Und Rate of Return + Invest Rate of Return on PH “Float” 3.7% = -0.2% + 3.9% 0.7% = -0.2% + 3.9% - 3.0% CAPM Reference Data: Risk-Free interest rate
6.0%
Risk Premium Equity Beta Indicated cost of capital Liability Beta
not risk-adjusted risk-adjusted basis
3.9% after-tax
8.9% 1.00
14.9%
-0.52
Indicated risk adjustment Indicated risk-adjusted discount rate
4.6% 1.4%
3.0% after-tax 0.9% after-tax
17
18
19
Simplified Ratemaking Spreadsheet
Russ Bingham Vice President and Director of Corporate Research Hartford Financial Services
CANE March 23, 2000 1 1
Discounted Cash Flow Models and Rate of Return Perspectives Summary Discounted cash flow is a common approach used to assess financial performance. The purpose of this session will be to review this technique in the broader context of general
financial
models
as
applied
in
insurance.
A
discussion of the essential \u201cbuilding blocks\u201d upon which models should be constructed will be followed by a review Examples will be presented their fundamental of various to ratedemonstrate of return measures that result equivalency. from them. The policyholder and shareholder rate ofperiod return Specifically, this will compare the policy / accident to perspectives also be reviewed. the calendar will period view as well as compare the IRR and ROE rate of return calculations.
2 2
Contents q q q q q q q q q
\u201c Building Blocks\u201d: The Fundamentals Building Blocks\u201d: The Fundamentals \u201c ConceptualCritique Critique ofofConventional Conceptual ConventionalAccounting Accounting ShortcomingsofofReported ReportedFinancials Financials Shortcomings Economic Value Concepts Economic Value Concepts Rateof of Return Return Models: Important Rate Important Attributes Attributes Rateof of Return: Return: Parameter Rate Parameter Consistency Consistency Rateof of Return Return Measures Measures and and Their Their Equivalency Rate Equivalency The Fundamental Insurance Total Return Model The Fundamental Insurance Total ComponentsofofTotal Total Return: Return: Underwriting, Components Underwriting, Investment Investment &&Leverage Leverage
q
AspectsofofInsurance InsuranceTotal Total Return Return Aspects
q
Exhibits: Balance Balance Sheet, Sheet,Income, Income,Cash CashFlow Flow&& Returns Returns Exhibits: 3 3
“ Building Building Blocks”: Blocks”: The TheFundamentals Fundamentals q
q
q
BalanceSheet, Sheet,Income Incomeand andCash CashFlow FlowStatements Statements Balance Accounting Valuation: Valuation: Conventional Conventional (statutory (statutory or Accounting or GAAP) and Economic (present value) Development“Triangles” “Triangles” of of Marketing Marketing //Policy Development Policy/ / Accident Period into Calendar Period
4
Policy (or Accident) / Calendar Period Development Triangles Balance Sheet, Income, Cash Flow Policy Period Prior 1996 1997 1998
Historical 1996 X X
1997 X X X
Calendar Period 1998 X X X X
1999 2000 Reported
==== Sum
==== Sum
==== Sum
1999 X X X X
Future
Total
2000 Ultimate X …... --> Sum X …... --> Sum X …... --> Sum X …... --> Sum
X
X X
==== Sum
==== Sum
…... --> --> Sum Sum …...
Calendar
5
General Shortcomings of Reported Financials q
Missing key key elements elementsofoftotal total return return -- absence of market market value Missing absence of value basis omits important information necessary to more fully judge performance
q
q
Lacks more more relevant relevant current current (i.e. policy // accident Lacks (i.e. policy accident period) period) performance focus Biasedagainst againstlonger longertail tail and and higher higher combined combined ratio ratio business Biased business which conceals profitability of commercial to a greater degree than personal lines
6
Specific Shortcomings of Reported Financials q
q
q
Total Assets Assets are are affected affected by by changing changing and and somewhat somewhat arbitrary arbitrary Total definitions of non-invested assets. (Suggest realignment with only Invested Assets on “left” side, net liabilities and equity on the right.) Income affected affected by by premium premium earning, earning, deferred deferred acquisition acquisition and Income and reserve estimation, all of which can be altered. such as as unrealized gains, do do Below the theline” line”surplus surplusadjustments, adjustments, such unrealized gains, ““Below not flow through “income”.
q
Significant market market value value adjustments adjustments are are ignored ignored when when Equity Equity isis Significant reported q loss lossreserve reserveadequacy/inadequacy adequacy/inadequacy and and discount discount value value q some someinvested investedassets assets 7
Economic Value Concepts q
q
q
q
Economic valuation valuation presents presentsaa financial financial view view in in which all assets Economic assets and liabilities are market valued (cash equivalent). Considersthe theestimated estimatedmagnitude magnitudeand andtiming timingof of future future cash flows Considers cash flows Focus on on performance performance related related to to current current actions actions (i.e. (i.e. policy policy or Focus o accident period) rather than performance related to when reported (i.e. calendar period)
r
Economicincome incomeisisthe thechange changeinineconomic economicvalue valueover overaaperiod periodinin Economic time q q q
(FASB 130) comprehensiveincome” income”perspective perspective (FASB 130) ““comprehensive tight balance balance sheet, sheet,income incomeand andcash cashflow flowlinkage linkage tight no “below “below the line” no line” adjustments adjustments 8
Conceptual Commentary q
q
Reported income income and and returns returns (and (and other other financials financials as as well) Reported follow conventional accounting rules which govern the timing of income recognition and are potentially a misleading basis for rating, regulation & financial analysis. Economic rules produce different results. Retainedearnings earningsare arelargely largelyirrelevant irrelevant to to economic economic accounting accounting Retained
q
Unearnedpremium premium reserve reserveisisnot not cash, cash,and andthus thusnot not economic. economic. Unearned
q
Leverage levels levelsinvolve involveconcessions concessions ratersand andcreate create Leverage to tothetheraters non-economic based constraints.
q
Economic value value isis realized realized either either by by converting converting assets assets and and Economic
q
liabilities to market via sale, or over time to “earn” the discount value. ROE calculation calculation -- change change the the formula formula (income ROE (income / beginning period contributed surplus). Do not include retained earnings and do not average the equity. 9
Rate of Return Models: Important Attributes q
q
Focuson onCash CashFlow Flow Focus Inclusion of surplus with flow controlled by specified rules Inclusion of surplus with flow controlled by specified rules
q
Operating (i.e. (i.e. policyholder) policyholder) cash cash flows flows maintained maintained separately separately Operating
q
Economicvalue valuewith with after-tax after-tax discounting discounting Economic
q
NPV income income formulation formulation (with NPV (with and and without withoutrisk riskadjustment) adjustment)
q
DevelopmentofofNPV NPVbalance balancesheet sheetliabilities liabilities Development
q
Policyholder and and shareholder shareholderrate rate of of return return calculations Policyholder calculations 10
Rate of Return: Parameter Consistency q
Dealingwith with Risk Dealing q q q
q
IRR cost cost of of capital total return IRR capital based based total return NPV risk-adjusted total return equal to risk-free rate NPV risk-adjusted total return equal to risk-free rate NPV total total return to cost of of NPV return (without (withoutrisk-adjustment) risk-adjustment)equal equal to cost capital
Beta of of Equity Equity versus Beta ofofLiabilities Beta versus Beta Liabilities Surplus Flows Flows Surplus Controlling amount of of flows q Controlling amount required requiredand andtiming timing flows q
– Liability Liability // surplus surplusrelationship relationship – Multi-period Multi-periodaspect aspect q
Surplus flow flow components components Surplus – Surplus release Surplus contribution contributionand anditsits release surplus – Investment Investmentincome incomeon oncontributed contributed surplus – Release Releaseof ofoperating operatingearnings earnings 11
Rate of Return Measures Income on Investment q
q q q q
Conventional Calendar Calendar ROE: ROE: Income Income // Average Average Equity, Equity, including Conventional including Retained Earnings Nominal Ultimate Ultimate ROE (“steady Nominal (“steady state” state” calendar calendar equivalent) equivalent) DiscountedUltimate Ultimate ROE ROE (net (net present present value value rate rate of of return) Discounted return)
Risk-adjusted Ultimate ROE (risk-adjusted NPV rate of return) Risk-adjusted Ultimate ROE (risk-adjusted NPV rate of return) Operating returns alsoalso ROE like” like”Underwriting Underwritingand and Operating returns ““ROE
Cash Flow Internal Rate of Return Basis q
ShareholderIRR IRR (also (also Underwriting Underwriting IRR Shareholder IRRand andOperating OperatingIRR) IRR)
Shareholder (i.e. Investor Perspective) q q
ShareholderCash CashDividend DividendYield Yield Realized Realized Shareholder ShareholderTotal Total Return: Return: dividend plus Shareholder plus stock stock price price appreciation appreciation 12
Equivalency in Rates of Return For Single Policy - Exhibit 1 q (1) IRR (1) IRR q (2) (2) Net Net present present value value ROE ROE q
(3) Total Total policy policy ultimate (3) ultimate nominal nominalROE ROE
q
(4) Shareholder Shareholderannual annual dividend dividend yield yield realized (4) realized
For Multiple Policy Ongoing (steady state, no growth) - Exhibit 2 q
(5) IRR IRR (5)
q
(6) Annualcontributed nominal ROE while (6) Annual nominal ROE while at atsteady steady state state (income (income // beginning surplus)
q
(7) Shareholder Shareholderannual annual dividend dividend yield yield realized (7) realized
13
The Fundamental Insurance Total Return Model (1) Total Return = Operating Return X Operating Leverage + Investment Rate of Return on Surplus Operating Return = Underwriting Rate of Return + Investment Rate of Return on Policyholder Liability “Float” OR (2) Total Return = Underwriting Return X Operating Leverage + Investment Return X Asset Leverage Operating Leverage = Net Liabilities / Surplus Asset Leverage = Invested Assets / Surplus Insurance Consists of Underwritin Investment & Financial Leverage Underwriting, g, Investment & Financial Leverage 14
The Components of Insurance Total Return -Underwriting, Investment & Leverage q
the company Underwritin gReturn Return is the the price pricefor forthe thetransfer transferofofrisk risktoto the company Underwriting associated with the policyholder related cash flows. When positive the company is being paid for the transfer of risk. When negative the company is incurring a cost to acquire the funds from the policyholde and must depend on the investment spread to generate a profit.
q
r r
represents the Investment Return Return represents the yield yield on on invested investedassets assets(from (fromboth both Investment policyholder supplied funds and surplus). The spread between the Investment Return applicable to policyholder supplied funds and the Underwriting Return must be positive if the company is to generate a net ne operating profit from underwriting.
q
t
needed to to meet specifie Levera ge (based (basedon onsurplus surplusrequirements requirements needed meet specified Leverage d
underwriting, investment and and financial magnifying effect on both return risk. risk tolerances) creates a q
Total Return Return Total
reflects o o reflects the the shareholder shareholder oriented orientedreturn, return,comprised comprised levered operating return plus the investment return on surplus.
ff
15
Aspects of Insurance Total Return q
The Total Total Rate Rate of Return, as The as well as as the the Underwriting Underwriting and and Investment Rates of Return, can be determined on either q q
q
q
cashflow flow basis, basis,via via the the Internal Internal Rate aa cash Rate of of Return Return(IRR) (IRR)oror as aa Return Return on on Equity Equity formed of of Income to to Equity in in as formedbybythetheratio ratio Income Equity which the financials are in EITHER Nominal or Present Valued terms
The present present value value rate rate of of return return using The using aa risk-adjusted risk-adjusted discount discount rate will equal the risk-free rate, since by definition risk has been eliminated. Leverageisis controlled controlled by by specifying specifying rules rules governing governing the the flow flow of Leverage surplus and dividend (distribution of earnings) to maintain a uniform risk profile over the life of the policy q
q q
Contributed surplus governed liability / /surplus Contributed governed by constant constant liability surplusratio ratio Investment income incomeon onsurplus surplus dividended dividended as asearned earned Investment Operating earnings earnings distributed distributed in proportion Operating proportion toto per per period periodliability liability exposure
16
Total Return Model Example Total Return = Oper Return X Oper Levg + Invest Rate of Return on Surplus 14.9% = 3.7% X 3.0 + 3.9% not risk-adjusted 6.0% = 0.7% X 3.0 + 3.9% risk-adjusted basis Oper Return = Und Rate of Return + Invest Rate of Return on PH “Float” 3.7% = -0.2% + 3.9% 0.7% = -0.2% + 3.9% - 3.0% CAPM Reference Data: Risk-Free interest rate
6.0%
Risk Premium Equity Beta Indicated cost of capital Liability Beta
not risk-adjusted risk-adjusted basis
3.9% after-tax
8.9% 1.00
14.9%
-0.52
Indicated risk adjustment Indicated risk-adjusted discount rate
4.6% 1.4%
3.0% after-tax 0.9% after-tax
17
18
19
Simplified Ratemaking Spreadsheet
