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The rates of return earned in the Canadian general insurance industry

University of British Columbia

Since the introduction of the Little Report which looked at the relationship between prices and profits in the property and liability insurance industry, there has been extensive discussion in the Journal of Risk and Insurance and elsewhere on the important issue of calculating the profitability of property and liability insurance companies. Much of this discussion has centered on defining the appropriate measures of risk and return in order to determine the insurance industry's profitability relative to that of other industrial groups. It is generally agreed that such inter-industry comparisons must be set within a risk-return framework. However, the emphasis placed on the conceptual problems of defining and measuring risk has resulted in a good deal of arbitrariness in, calculating rates of return. To be specific, none of the studies published in the Journal of Risk and Insurance employ the same rate of return measure. These variations arise in part from the differing approaches adopted in arriving at a comparative measure, but they also reflect an attempt to develop a more precise method of measurement. This study investigates the underlying difficulties that are associated with these previous studies. It is felt that many of these difficulties can be circumvented by analyzing the rate of return that is earned within the insurance industry, ignoring a comparison of returns with other industries. This allows the risk dimension to be dropped from the analysis. In arriving at a accurate measurement procedure, it is explained that profit should be related to net worth rather than total assets, investable funds, or some other measure. The reason is that the return on net worth considers only those funds which management has under its control for alternative indirectly as the difference between total assets and liabilities at one point in time. However, there are several adjustments that must be made to the statutory asset and liability figures before they can be used. Assets, which consist primarily of financial assets, should be valued at market prices, because market values are a more realistic valuation of assets at a point in time than book values. Non-admitted assets should also be included in the total asset figure. Liabilities require subtracting a realistic value of the "equity" from the unearned premium reserve. Care must also be taken not to classify such items as unauthorized reinsurance reserves, investment and contingency reserves, etc. as liabilities because they are really a part of the net worth of the company. It is then explained how an accurate calculation of the return on net worth can actually be made. In this area, special consideration must be given to the quarterly payment of dividends, the payment of income taxes, any additional capital that is raised during the time period, and to tax or tax credits relating to any unrealized profits or losses that are to be included in the return measure. A brief explanation of how the population and sample were chosen is presented along with other various empirical procedures that were followed. This study then presents the results of the empirical work. Several rates of return were calculated including the rate of return before and after tax for the industry as well as for three generally defined size classes of the industry. The latter was done to determine if there are any economies of scale in operation. The rate of return was then defined to originate from three sources. These sources are investment income, mainly consisting of rents, interest and dividends received, underwriting profit, and other or residual income mainly comprised of unrealized capital gains or losses. The 'tax shield effect relating to the difference between underwriting profits calculated on a statutory basis and on an incurred basis was also determined. On the other hand, the tax shield effect associated with unrealized capital gains and losses was not calculated because no capital gains tax were evident in Canada during the time period studied. Finally some conclusions are presented along with mention of further study and research that could be undertaken in light of the results of this study. The general conclusions are that the insurance industry return during this period was not excessive. It was also concluded that after a certain volume of insurance business is reached, some economies of scale seem to exist. Finally, investment income (rents, interest, and dividends received) accounted for most of the industry rate of return before taxes because underwriting and residual income (unrealized capital gains and losses were generally within the - 1 percent to + 1 percent range on net worth during the time period of the study.

Text

2011-03-14

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http://hdl.handle.net/2429/32438

Business Administration

University of British Columbia

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