The Ethical Issues Forum: The Case of the High Return

The Ethical Issues Forum: The Case of the High Return

Editor's Note: This article is part of a series written by members of the CAS Committee on Professionalism Education (COPE) and the Actuarial Board of Counseling and Discipline (ABCD). The opinions expressed by readers and authors are for discussion purposes only and should not be used to prejudge the disposition of any actual case or modify published professional standards as they may apply in real-life situations.

Volatile Insurance Company (Volatile) is a monoline, single-state insurer that only writes specialty commercial automobile liability policies with high limits. This specialty program is comprised of log trucks and long haul trucking. The public service commission (PSC) requires these vehicles to carry liability insurance with a minimum limit of $1 million. Volatile does not purchase reinsurance for this program. The total volume of insurance industry log trucks and long haul trucking business in this state is $10 million.

Volatile is filing for a 57 percent rate increase with the state insurance department on their $3 million book of business. Volatile has calculated their profit and contingency provision by subtracting investment income from an overall cost of capital. The cost of capital used in the filing is 25 percent. As stated in the filing by Volatile's actuary: "Since Volatile is unaware of any other insurance company in our unique situation, it was necessary to use my 30 years of actuarial/insurance company operations and professional judgment to select the overall cost of capital in this case."

The prior Volatile filing, which underlies the current rates, was based on a 12 percent cost of capital assumption. This prior filing was completed by Volatile's vice president of marketing prior to the establishment of the company's actuarial department.

The state insurance commissioner has disapproved the rate filing on the grounds that the 25 percent cost of capital is considerably higher than the overall insurance industry's return on equity of approximately 12 percent.
Point

Volatile disagrees with the decision, with the assertion that their book of business is more volatile than the insurance industry in aggregate and as a result needs to achieve a higher return to attract investors. Volatile contends that this increased volatility is a result of the small volume of specialty vehicles in the state and the high limits required by the PSC.

Several sections of ASOP #30, Treatment of Profit and Contingency Provisions in Property/Casualty Insurance Ratemaking, have been called into question by Volatile's actions. Section 3.1, "Estimating the Cost of Capital and the Underwriting Profit Provision," states that "insurance rates should provide for all expected costs, including an appropriate cost of capital associated with the specific risk transfer." Further, under Section 3.2, "Basis for Cost of Capital Estimates," states, "In estimating the cost of capital, the actuary should consider the relationship between risk and return." Finally, Section 3.4, "Parameters of the Risk Transfer," requires the actuary to "recognize that the cost of capital associated with an individual risk transfer may vary, based on the specific parameters of the transfer."

The nature of Volatile's book of business (high severity, limited diversification) clearly subjects its surplus to more significant risk of loss than its average counterparts. While the Insurance Commissioner's target may prove reasonable over the long-term for the industry in aggregate, capital investment decisions require recognition of the specific risk and return relationships afforded by each opportunity. The capital marketplace will generally require a "premium" to offset the potential impairment to Volatile's surplus and their investment.

Further, true rate of return regulation is better served by competitive market pressures.
Counterpoint

The 57 percent rate increase, which is primarily a result of the increase in the cost of capital assumption from 12 percent to 25 percent, could have a potentially severe impact on the commercial trucking business in this state. The result could reasonably expect to drive a number of commercial trucking companies out of business (along with the associated jobs) or at least result in a number of operations leaving the state. Due to the economic issues, a change of this magnitude should, at a minimum, be incorporated into the ratemaking process over a number of years.

In addition, the 25 percent cost of capital assumption has not been justified in this filing. ASOP #30 requires that "the actuary should consider the relationship between risk and return." This issue was not directly addressed in this filing. The professional judgment of the actuary alone does not provide sufficient justification for the selected cost of capital. While ASOP #30 does not endorse any particular methods, Appendix 1 recognizes three models used in current practice (that is, Comparable Earnings Model, Discounted Cash Flow Model and Risk Premium Model). When using these or other models, the Actuary needs to follow the documentation requirements in ASOP #9, Documentation and Disclosure in Property and Casualty Insurance Ratemaking, Loss Reserving, and Valuations.

In addition to justification of cost of capital under their current situation, there are several ways that Volatile could reduce their risk; reinsurance is one way. ASOP #30, section 3.2, "Basis for Cost of Capital Estimates," states:

"In estimating the cost of capital, the actuary should consider the relationship between risk and return. The methods used for estimating the cost of capital should reflect the risks involved in the risk transfer under consideration. These risks may include insurance, investment, inflation, and regulatory risks, as well as diversification, debt structure, leverage, reinsurance, market structure...."

Volatile should be asked to reassess their cost of capital given a reduction in volatility that could be achieved through a reasonable reinsurance program. Insureds should not be required to pay artificially high premiums if the company decides to retain abnormally high levels of risk.