Liability Insurance Industry Research Articles

Effects of under and Overevaluations in Loss Reserves

It has been suggested that the amount of policyholders' for property and liability insurance companies should be sufficient to cover adverse underwriting results, declines in asset values, and underevaluations of loss reserves. While the first two variables have received considerable study, essentially no data have been collected and analyzed to measure the significance of loss reserve developments. Thus, the primary purpose of this paper will be to study the significance of underevaluations of loss reserves upon policyholders' surplus; to compare the significance of underevaluations of loss reserves with that of unfavorable underwriting results and decreasing asset values; and to examine the interactions among the three variables. The status of policyholders' is one of the key variables in determining financial strength in property and liability insurance companies. Policyholders' relates to financial strength by preserving a solvency. Mayerson states that a company's capital and is its ultimate guarantor of solvency.' Until recently, adequate levels have been measured in the United States on a qualitative basis supplemented by rough rules-of-thumb.2 The recent formations of numerous holding companies have accelerated the need for a more precise measure of adequacy. Through the Dan R. Anderson, Ph.D., is Assistant Professor of Business in the Graduate School of Business at The University of Wisconsin. The author wishes to acknowledge the financial support from the Wisconsin State Insurance Department. This paper was submitted in February, 1971. 1 Allen E. Mayerson, Ensuring the Solvency of Property and Liability Insurance Companies, Insurance, Government, and Social Policy, ed. Spencer L. Kimball and Herbert S. Denenberg (Homewood, Illinois: Richard Irwin, Inc., 1969), p. 181. 2 See Roger Kenney, Fundamentals of Fire and Casualty Insurance Strength, (4th ed.; Dedham, Massachusetts: The Kenney Insurance Studies, 1967). use of the holding company vehicle, excess can be transferred from the insurance firm to the holding company in order to enjoy less stringent investment requirements and hopefully increased profitability. Kip reports that nearly $1.6 billion of capital has been taken from a dozen property and liability companies in the past several years.3 In 1969 alone, $1 billion in left the property and liability insurance industry via this route.4 These transfers present no inherent problems of maintaining solvency, as long as only excess amounts of are transferred. The principal difficulty is that a precise method for determining how much of a is excessive has not been determined. In an attempt to define this problem, the Special Committee on Insurance Holding Companies differentiates between required a d surplus surplus. 3Richard deR. Kip, How To Get Capital Out of the Property Liability Insurance Business, CPCU Annals, Vol. 23, No. 3 (September 1970), p. 244. 4 Jeremy Main, Why Nobody Likes the Insurers, Fortune, Vol. LXXXII, No. 6, (December 1970), p. 119.

Rates of Return in the Nonlife Insurance Industry

Risk-return relationships within the nonlife insurance industry during 1955-1967 are examined in light of the earnings performances of 82 randomly selected stock nonlife insurers. Seven annual measures of return are calculated for each insurer and evaluated using weighted and unweighted earnings bases and alternative temporal methodologies. The study results suggest that returns on capital and surplus were inadequate during the period using either the Plotkin methodology or correlating mean temporal returns and corresponding standard deviations. Other results indicate (1) little significant relationship between insurer size and rate of return, (2) the measurement technique has an important bearing on the risk-return relationship recorded for the nonlife insurance industry, (3) the question of the most appropriate methodology to be used in evaluating industry risk-return relationships remains unresolved, and (4) what is true for aggregate industry behavior need not necessarily hold for the behavior of individual firms within the nonlife insurance industry. There has been a great deal of controversy in recent years regarding the profitability of nonlife insurance companies. Insurers have argued that their earnings have not been commensurate with those of firms within other industries facing similar financial risks. Others have felt that nonlife insurance companies have achieved an adequate return through the years but that this result has failed to be disclosed to the public because of departures from generally accepted accounting principles.1 The one recent study on the subject has been widely criticized for Stephen W. Forbes, Ph.D., is Assistant Professor of Finance at the University of Illinois. The author gratefully acknowledges the assistance of Richard Rudolph, Graduate Research Assistant at the University of Illinois, who gathered the earnings data for this study. The author also wishes to thank Dr. Irving H. Plotkin who provided information regarding the Arthur D. Little methodology. This paper was submitted in October 1970. ' See for example Gilbert B. Friedman, Why Automobile Insurance Keep Going Up, The Atlantic (September, 1969), pp. 58-63 and replies in the January. 1970 issue, pn. 28-29. certain assumed weak conceptual foundations and statistical errors.2 The purpose of this paper is to evaluate alternative measures of return for a sample of firms operating within the nonlife insurance industry during 1955-1967. 2 Prices and Profits in the Property and Liability Insurance Report to the American Insurance Association, Arthur D. Little, Inc., November, 1967. Two recent evaluations of the Little Report include a review by Alfred E. Hofflander and R. Hal Mason in the Journal of Risk and Insurance, XXXV (June, 1968), pp. 293-298 and J. D. Hammond and N. Shilling, A Review Article: The Little Report on Prices and Profits in the Property and Liability Insurance Industry, Journal of Risk and Insurance, XXXVI (March, 1969), pp. 129-145. For a rejoinder to these reviews, see Prices and Profits in the Property and Liability Insurance statements of Dr. David M. Boodman and Dr. Irving H. Plotkin before the Subcommittee on Antitrust and Monopoly Legislation of the Committee on the Judiciary, United States Senate, November 25, 1969. For additional discussions of the pricing and profit issue, see Irving H. Plotkin, Rates of Return in the Property and Liability Insurance Industry, Journal of Risk and Insurance, XXXVI (June, 1969), pp. 173-200 and Comments on the Plotkin Paper by John D. Long on pages 201-216 of the same issue.

Economies of Scale in the Property and Liability Insurance Industry

The extent to which economies of scale exist in the property and liability insurance industry is examined. The analysis centers upon operating expenses and loss or claim costs. The cost effects of principal non-size variables, such as the legal form of organization, type of distribution system used, business mix, and the amount of insurance written in relation to policyholder surplus are also considered. Economies generally exist with operating expenses, and diseconomies exist with loss costs. No evidence of U-shaped cost curves is present. Average costs for operating expenses appear to decline with size and to level out as larger premium volumes are achieved. The notion of economies of scale has long been established in the literature of economics,1 as well as in the minds of entrepeneurs. Although the concept is easily enough accepted, statistical measurement of possible economies must be carried out with caution. reductions or revenue increments which appear to be attributable to large size may in fact be due to other related factors. Scale economies may accrue smoothly over the range of firm size, or there may be jumps in the various cost or revenue functions as firms reach (or surpass) a critical size, permitting markedly different ways of doing business. Further, the firms in the industry may be so heterogeneous that comparisons among firms, even of the same size, The authors are, respectively, Professor of Business, Associate Professor of Quantitative Business Analysis, and Professor of Quantitative Business Analysis in The Pennsylvania State University. This paper was presented at the 1970 Annual Meeting of A.R.I.A. 1The law of increasing return may be worded thus: An increase in labour and capital leads generally to improved organization, which increases the efficiency of labour and capital. A. Marshall, Principles of Economics, Eighth edition, (Macmillan & Company, New York, 1949), p. 318. may be meaningless. Output may be relatively easy to identify for firms producing single homogenous products. It is less so for multiple-product firms. Althougah some studies have analyzed economies of scale in certain industries producing tangible products, few attempts have been made to isolate size effects for any segment of the service industry.2 It is the intent in this paper to analyze the effects of size on costs in the property and liability insurance industry, one of the largest and most important of the service industries.3 One notable exception is a study by the Securities and Exchange Commission of the effects on financing costs of the size of the issuer, Cost of Flotation of Small Issues, 1925-29 and 1935-38, Report of Research and Statistics Section of the Trading and Exchange Division to The Securities and Exchange Commission, May 1940. The study found cost savings exceeding fifty per cent when bond issues were handled by large issuers. See Chart 6, p. 232, Behavior and Price Policy, National Bureau of Economic Research, New York, 1943. For reference to studies of cost functions in manufacturing, electrical generation, distribution, etc., see also pp. 243-261, ibid. 3Premium volume for property and liability insurers amounted to $23.9 billion in 1967, the year selected for the study of size effects.

Profitability in the Property and Liability Insurance Industry

The purpose of this article is to determine how profitable property and liability insurance companies have been over the period 1953-1967. The technique used is based on a risk-return-trend analysis. Four random samples and one selected sample of insurance companies are compared with 622 major industrial corporations through the use of a risk-return-trend indifference plane. It was found that insurance companies earned profits on a par with those earned by the major industrials. Among insurance companies, automobile underwriters did considerably better than multiple-line or fire and allied line underwriters. The data indicated that within the insurance industry there are economies to scale in degree of specialization and size. An important controversy exists over the size of property and liability insurance profits. The industry contends the profits in the past have been subnormal and that rates charged for coverage have been insufficient.1 Critics contend that profits have been at least normal and that any adjustments to increase profits should be reflected in improved utilization of assets. Under most conditions, the question of past profits would be relatively unimportant. In the case of the insurance industry, however, the alleged lack of profits is being used as the rationale for rate inRichard Norgaard, Ph.D., is Professor of Finance at the University of Connecticut. George Schick, Ph.D., is Professor of Quantitative Analysis at the University of Southern California. The authors wish to thank the University of Connecticut Research Foundation for partial financial support. This paper was submitted in November, 1969. This article is based on two reports to the U.S. Senate Anti-Trust & Monopoly Subcommittee. Hearings were held June 3, 1968. The reports were published in The Insurance Industry, U.S. Gov't Printing Office, 1968, Vol. 14. 1 The industry position is best described in Arthur D. Little, Inc. Prices and Profits in the Property and Liability Insurance Industry, A report to the American Insurance Association, 1968. creases. Thus, the study of insurance profits is important because the results can strongly affect consumer prices. The purpose of this article is to present a profit study of the insurance industry centered around a risk-return-trend analysis. The study will show that insurance companies, on the average, are earning normal profits. The article is divided into three parts: (1) reasons why the question of insurance profits has been so difficult to unravel, (2) a theoretical framework for the risk-return-trend analysis, and (3) empirical results. A Basis for Profit Comparison Past studies of inter-corporate profits have been severely restricted because of the difficulty in getting comparable data. This is the direct result of the wide latitude allowed in accounting methods used by individual companies to determine their profits. Since accounts are based on original costs, it is rare that long term assets or even inventory reflect current value. The variations possible in adjusting historical costs, even within an industry, mean that profit comparisons based on book values require tedious reconstruc-

Allocating Sales Effort to Branches

Quantitative allocation models, such as linear programming models, are well suited for planning and controlling sales office operations in the insurance industry. This article surveys some of the problems of branch management and then outlines the structure and results of a programming model developed for the branches of a mutual liability company. The conclusion reports the results obtained, both expected and unexpected. Home office planning for sales growth in the insurance industry is both a simple and a difficult matter. It is simple in that non-renewed policies, or sales losses, oftentimes can be predicted quite accurately. It is difficult because suitably qualified new policyholders must be found to offset those sales losses and produce sales growth. Toward that end, a company may use market research to evaluate new sales territories, sales contests to motivate its local representatives, loss experience records to identify new customer types, and so on. Essentially, the alternatives for securing additional sales revenue are numerous and the probable efficacy of the alternatives may well be difficult to predict. Notwithstanding the complexities of sales planning, this article argues that effective, profitable management science models for sales planning are feasible for the insurance industry. The vehicle for Robert M. Olsen, Ph.D., was Assistant Professor in the School of Business at the University of Kansas when this paper was written. He is now Associate Professor of Marketing in the School of Business Administration and Economics, California State College at Fullerton. Dr. Olsen, whose principal research interest is in applying quantitative techniques to problems in insurance marketing, is currently working on a study of policy cancellations made for the purpose of switching coverage to a competing company. This paper was presented at the A.R.I.A. 1969 Annual Meeting. this argument is a survey of the results of one type of model-known as a block-diagonal programming model '-for the field sales operations of a single-line mutual company in the liability insurance industry. The model itself, however, can be generalized to multiple-line companies or companies represented by independent agents. The emphases of this article are on the problem situation studied and the model's general structure because the author's purpose is to argue for modeling as a general approach to sales planning. Some attention will be given to the construction of the model itself, but the model's description will by no means be

Identifying Merger Targets in the Property and Liability Insurance Industry

THE rapid pace at which property and liability insurance companies were pursued and acquired by conglomerates during 1968 has temporarily abated as conglomerates have lost some of their investor appeal. During this lull, analysts have been assessing the reasons for the large number of mergers and the probability that the remaining companies can escape in the next round of merger activity. The purpose of this article is to examine the 1968 merger movement with respect to property and liability insurance companies to determine characteristics which distinguish acquired from non-acquired companies. The objective of the research is to provide a means for evaluating the vulnerability of companies which are still independent. Although there are many stock property and liability insurance companies, the large companies received most of the attention of the conglomerates during 1968. Of the top 20 companies, seven owning 21 % of the entire industry's assets were acquired during that year by noninsurance companies. If companies which were actively pursued are included, then mergers affected 10 of the top 20 companies, owning 39% of the industry's assets. (Table 2 includes a list of the top 20 companies ranked according to asset size.) Little wonder that the merger activities of the conglomerates causeid great consternation in the industry. What were the factors which made the insurance companies almost irresistible targets for conglomerates?

Rates of Return in the Property and Liability Insurance Industry: A Comparative Analysis

This paper reports on a comprehensive study of the profitability of the P and L insurance industry undertaken as part of a general investigation of insurance prices and investment income. From a socio-economic point of view it compares risk and retums on invested capital with numerous other financial and nonfinancial sectors of the American economy. In measuring retum, all possible sources of income have been considered including unrealized capital gains as well as incomes attributable to the use of mixed cash/accrual accounting systems. risk/return comparisons are based on a 60-industry, 16-year econometric study. conclusions are based not on a sample but on industry aggregates, as well as on several measures of financial retum. No evidence of excessive return was found. These theoretical conclusions are examined against and verified by current industry experience. paper concludes with a plea for responsible academic treatment of this highly political and emotional subject. It urges the shunning of both the shibboleths and traditions of the industry as well as the cries and pressures of the consumerism movement. This paper has as its mission a comparison of the rates of return earned in Irving H. Plotkin, Ph.D., is Senior Economist for Arthur D. Little, Inc. This paper was presented at the 1968 Annual Meeting of A.R.I.A. During 1968, Dr. Plotkin spoke on the general subjects of Risk/Return and of Insurance Prices and Profits at the Executive Committee Meeting of N.A.I.C., Casualty Actuarial Society, British Executives and Press Conference (London), annual meeting of National Association of Independent Insurers, Operations Research Society of America, and the Sloan School Faculty Finance Seminar of M.I.T. Except for minor additions, this paper remains as written for and presented at the August 1968 Annual Meeting of the American Risk and Insurance Association. It draws on over two years of research into the economics of uncertainty. This research was undertaken with the aid of various colleagues in both the Department of Economics of the Massachusetts Institute of Technology and the Management Sciences Division of Arthur D. Little, Inc. present paper is in part based on the following papers and reports: Risk and Return in American Industry: An Econometric Analysis, Arthur D. Little, Inc., Cambridge. Mass.. May 1967. the property and liability insurance industry with the returns earned in numerCompetitive Problems in the Drug Industry; Statement before the Monopoly Subcommittee of the U.S. Senate Select Small Business Committee, Government Printing Office, Washington, D.C., December 19, 1967, pp. 1638-1666 and 1746-1784. Prices and Profits in the Property and Liability Insurance Summary Report, Arthur D. Little, Inc., Cambridge, Mass., November 1967. The Economics of the Property and Liability Insurance Industry, an address to the New York Society of Security Analysts, February 1968, reprinted in Wall Street Transcript, March 4, 1968, pp. 12584-12585. Risk/Return: U.S. Industry Pattern (with Gordon R. Conrad), Harvard Business Review, March-April 1968, pp. 90-99. Editor's Note: Since the publication of the Arthur D. Little Report and the presentation of the Plotkin paper, a number of researchers have presented critiques of this work. Dr. Long's comments appear following this article. Dr. Plotkin is presently preparing rejoinders to other reviewers-particularly Professors Hofflander and Mason and Professors Norgaard and Schick-for publication in subsenuent issues of this lournal.

Comments on the Plotkin Paper

As Dr. Plotkin states in the first paragraph of his paper, the mission is comparison of the rates of return earned in the property and liability insurance industry with the returns earned in numerous other sectors of the American economy. He has indeed presented such a comparison. His paper, which in substance constitutes Part III plus Appendixes A and B of the widely publicized Arthur D. Little, Inc. study,' is a useful addition to the literature. Dr. Plotkin's work in the difficult, generally neglected, and murky area of comparing insurance and non-insurance earnings, is clear in its purpose, embracive in its substance, and straightforward in its methodology. While any serious student of insurance can see problems with the comparative

The Little Report on Prices and Profits in the Property & Liability Insurance Industry

The Little Report on Prices and Profits in the Property & Liability Insurance Industry

Prices and Profits in the Property and Liability Insurance Industry

Prices and Profits in the Property and Liability Insurance Industry