Effect of Including Investment Income in Ratemaking upon Profitability of Non-Life Insurers

Abstract

This paper seeks to determine if underwriting profits by insurance lines written in states which consider investment income in the ratemaking process are significantly different from those in states which do not. Difference in means tests are initially employed in four selected insurance lines to determine whether the mandatory inclusion of investment return has any discernible effect on industry profitability by line. Multiple regression analysis is used on private passenger automobile data to determine the effect on profitability of nine exogenous variables. While five explanatory variables are statistically significant, investment income is not. Controversy over whether investment return (or a portion thereof) earned by insurers should be considered in the determination of the premium rate structure has existed in the property and liability insurance industry since the publication of the McCullough Report in 1947. Insurance company officials historically have resisted the contention that the test of reasonableness for profitability should be the rate of return on equity capital, defined as the sum of investment returns on capital and/or surplus, equity in the unearned premium reserve and underwriting profits. This question simmered until inflationary pressures in the late 1960s and early 1970s forced losses and premiums upward to new levels. In response to public pressure for price relief. an increasing number of regulatory authorities and state legislatures began to advocate the inclusion of investment income in the ratemaking process as a solution to rapidly increasing rate levels. In 1971, the National Association of Insurance Commissioners (NAIC) adopted the Blanks Committee proposal that each insurer be required to allocate investment return by line of business and to the capital and surplus accounts in the insurance expense exhibit of the convention blank. While the official purpose of the proposal is to provide an additional method of solvency surveilance by state authorities, information by line is necessary only in the evaluation of profitability. Consequently, this procedure may be viewed as the first NAIC approved step toward the inclusion of investment income in the ratemaking process. Jerry W. Caswell is a member of the Insurance faculty at Georgia State University. He has published in this Journal and in Business Horizons. Steve C. Goodfellow is in the Department of Risk Management and Insurance at Florida State University. He was a special accounts supervisor, Aetna Insurance Company and an Independent Insurance Agent.