Discounted return, measuring profitability and setting targets

Abstract

The Hargord Insurance Group employs a total return approach in ratemaking and performunce measurement. This article describes the discounted return methodology used by the Hartford in measuring profit and setting prices based on a target return. Determination of total income involves the consideration of the time value of money in conjunction with the investment period related to key cash flows. The paramount importance of meeting policyholder liabilities precipitates certain investment principles aimed at reducing risk. Liabilities are fully funded with fixed income assets invested at a “risk-free” treasury murket rate where maturities match the uverage duration of liabilities. Benchmark surplus, dictated by the consideration of funding and solvency, is introduced as a base for measuring return. The benchmark surplus will differ from the actual surplus of a company depending on past results, dividend pay>out policy, and debtiequity capital management policy. A methodology is suggested for determining benchmark rates of return for state regulatory purposes, consistent with the management of solvency risk. The benchmark return will difSer from actual total return, which is based on reported income and surplus. In this context, the risks and rewards of investment and capital management policies are borne entirely by the owners of the company and reflected in the total company return. MEASURING PROFITABILITY AND SETTING TARGETS 125 The benchmark return is suggested for use in ratemaking and regulation since i) it includes income from all sources, 2) it incorporates investment principles which enhance the protection of policyholder funds, and 3) it measures return against a surplus “standurd” not inj!uenced by noninsurance driven capital management practices.