N.Y. Comp. Codes R. & Regs. tit. 11, Appendices, app 15
APPENDIX
TO REGULATION 70 (11 NYCRR 165)
Discussion of Methodology for Measuring
The Profitability of Property and Liability Insurance Lines
Written in New York State
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APPENDIX
Prior to the enactment of subdivision three of section one hundred seventy-eight of the Insurance Law, as added by Chapter thirteen of the Laws of 1973, the Insurance Department released a report setting forth the Department's position on how insurance profits should be measured,[FN*] and discussed profits and profit measurement in its evaluation of competition in property and liability insurance in New York State.[FN**]
From these studies, the Department concluded that five principles should apply to the measurement of insurance company profits, These principles are:
1. Profitability measurement should include all income, from investments of all kinds as well as from underwriting. Investment income is an essential and important part of any insurance business. The capital used in the business is not tied up in buildings, inventory or equipment, but is invested. Similarly, premium income is usually received in advance before losses occur and well before they are paid. During this interval, the insurance company has the use of the money for investment. A corollary of the principle that investment income must be considered is that all investment income, including unrealized and realized capital gains as well as interest and dividends, must be included.
2. Accounting methods for determining and matching income and expenses should conform as far as possible to those used in other kinds of businesses. The most important application of this principle is that expenses should be written off at the time the related income is earned rather than at the time the expenses are paid, a procedure followed in other businesses. The reason is that the purpose of measuring insurer profits is to make possible some judgment about how high or how low they are, and such a judgment can be made on a valid basis only if the methods are comparable with other businesses.
3. The most useful measure of profitability is the return on - that is profits expressed as a percentage of - equity or net worth. Again, the reason is that comparison of insurance with other businesses is possible only on that basis. Unfortunately, return on equity is one of the most complex of the various profitability measurements, and for that reason return on sales or underwriting return on sales is often used at the operating level for profitability measurement. There is nothing wrong with that device, provided that it is remembered that the results are meaningless standing alone and must be converted into a return on equity before a valid judgment can be expressed as to whether the profit is too high or too low.
4. Profitability measures must include ways of measuring profitability, by line of insurance, by state and by any other relevant characteristic of a market for insurance. It informs us little about the homeowners insurance market in New York to know about nationwide profit levels for all kinds of insurance.
5. Finally, profitability measures are most valid when they are broadly based - in time and volume of insurance - and are least valid when measured over short periods of time or for small volumes of insurance. The reasons are two-fold. First, investment experience, especially when capital gains are considered, as they must be, can vary substantially over time. Secondly, loss experience may also fluctuate widely from time to time and place to place. People do not know when they will suffer losses, and that is why they buy insurance. Insurance companies can use past experience as a guide to the future, and can hope to attract a large and representative sample of customers to even out fluctuations, but the future is never precisely like the past and no group of people is truly random. This principle - that a long-term, broadly-based measure of profits is most valid - conflicts, unfortunately, with the preceding point - that a relevant measure of profits should be limited to the particular market under review. Thus, there is a tension between validity and relevance, between stability and responsiveness, in measuring profits as there is, in fact, in the whole area of insurance pricing.[FN*]
It was against the background of these studies and conclusions that the 1973 profitability measurement legislation was enacted.
Subsequent to the enactment of this legislation, the National Association of Insurance Commissioners (NAIC) adopted a method for measuring insurance company profits on a by line, by state basis. This methodology and the NAIC position paper are attached as Exhibit A.
EXHIBIT A
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It is desirable that profitability measurement methodologies be uniform among the states to the extent possible. Accordingly, the methodologies set forth in this regulation adopt the NAIC principles to the extent that they are consistent with the requirements prescribed by the Legislature in 1973 and the principles that the Insurance Department has concluded should be followed.
However, the NAIC formula differs from these requirements and principles in three important respects:
--it does not measure profits on the basis of net worth;
--it does not include unrealized capital gains or losses; and
--it does not include all realized investment income.
Thus, this regulation modifies the NAIC formula by providing for the computation of profits on the basis of net worth, and by including all realized and unrealized investment income. The New York methodology also differs from the NAIC formula in several other respects (which are appropriately noted later) and utilizes a different format in which underwriting income and investment income are computed separately.
The legislation directing the Superintendent to adopt a profitability measurement regulation implicitly recognizes that profitability measurements over short periods of time and on narrow bases, such as by line and by state, can, of themselves, be very unrepresentative of the total long-run profit picture. The legislation, therefore, directs the Superintendent to make a number or "reasonable and uniform assumptions" in measuring profits. These assumptions, in effect, substitute broad-based industry-wide experience for certain items of a company's actual experience.
EXHIBIT A
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Such assumptions make sense both from the point of view of eliminating unrepresentative developments and of facilitating comparisons between companies. For example, the amount of net worth attributable to a particular line of insurance in a particular state is highly conjectural as was explained in the Department's profitability study. Indeed, such allocations of net worth are of questionable merit because a company's total net worth is indivisible in its support of the company's entire operation. However, allocations of net worth are necessary if meaningful profit determinations are to be made on a by line, by state basis. But even with such allocations, certain profit comparisons between companies can be misleading because rates of profit on net worth in companies with low net worth positions (i.e., high premiums to net worth ratios) might appear quite high in comparison with companies with substantial net worths (i.e., low premiums to net worth ratios). Accordingly, certain inter-company comparisons can be facilitated by assuming that each company has the same amount of surplus behind each dollar of premium it writes for a particular line.
Similar considerations apply to assets available for investment, federal income taxes, and average earnings on insurers' investments, the other items on which the legislature directed the making of reasonable and uniform assumptions.
The Insurance Department recognizes the validity and desirability of this approach. The Department also believes that a full appreciation of insurance company profits requires the use of individual company data as well. Accordingly, the Department's profit measurement regulation requires the reporting of by line, by state profits on two bases: on the basis of the company's own data and on the basis of certain industry-wide experience,
Following is a discussion of the components of the New York profit measurement methodology.
EXHIBIT A
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Underwriting Income
Two substantive differences exist between New York's method and the NAIC's. The first difference is to item 3, the computation of direct loss adjustment expenses. The NAIC format computes this amount on a basis met of reinsurance, whereas the New York methodology provides for computation on a direct basis. The New York Insurance Expense Exhibit will be supplemented for the business of 1974 by the Department requiring the separate reporting of direct losses and direct loss adjustment expenses. In future years this data will be reported on new lines 25 and 26 of the IEE The amount of direct loss adjustment expenses shall not exceed total loss adjustment expenses incurred as reported on IEE Pt. 1 C.1 L.22 increased by L.1c. (total claims adjustment services -- reinsurance ceded), and decreased by L.1b. (total claims adjustment services -- reinsurance assumed).
The second substantive difference is that actual New York direct commission data is used (item 5), rather than national data as used by the NAIC.
The only other difference between the New York and NAIC methodologies in computing underwriting profits is one of format. Th. NAIC formula does not compute underwriting income and investment income separately. The New York methodology does.
Investments
The New York methodology for computing earnings from investments differs in two very important respects from the NAIC formula.
The NAIC formula does not include unrealized capital gains or losses, and does not include all realized investment income. The New York formula, on the other hand, includes all realized and unrealized gains or losses, and all investment income.
EXHIBIT A
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Two reasons have prompted the Insurance Department to include unrealized capital gains or losses in the profit computation.
The first reason for this inclusion is that insurance company profit computations would otherwise be unrealistic because an insurance company's income is to a very large extent dependent upon stock market gains or losses. For example, during a period of market decline the exclusion of unrealized losses could create the erroneous impression that the insurance company was very profitable. An opposite distortion could appear during periods of increasing stock values.
The second reason for including unrealized capital gains or losses is that the inclusion of only realized gains or losses makes the measurement of profits subjective rather than objective. When only realized gains or losses are recognized, a company's management can easily manipulate the profits it reports for the year by engaging in selected year end stock transactions.[FN*]
Thus, the New York profit measurement formula includes all unrealized capital gains or losses on stocks. However, it does not include unrealized capital gains or losses on bonds. Changes in the market value of bond have been excluded because there is a fundamental difference between market value changes in bonds and market value changes in stocks. A stock market value reflects the market's current assessment of the stock's worth. When the value of a stock declines, there is no assurance that it will increase. Likewise, when its value increases, it does not necessarily eventually have to decline.
EXHIBIT A
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On the other hand, a change in the market value of a bond generally does not reflect an assessment of the underlying worth of the bond, but represents instead a premium or discount based on current interest rates. If the issuer of the bond is financially strong, the bond will be redeemed at its full face value upon maturity, regardless of its current market price. Thus, as long as there is no need to sell bonds to meet current obligations, there is no need to recognize changes in the market value of an insurance company's bond portfolio.
The Department's treatment of unrealized gains or losses is consistent with the Department's profitability study which preceded the profit measurement legislation, and is supported by the legislative history of New York's no-fault automobile insurance law. Moreover, this treatment of unrealized items does not conflict with the provisions of other laws which exclude unrealized items for certain purposes, because the purposes underlying such other laws differ from the purpose of the insurance profit measurement law.
Although the New York State Insurance Department firmly believes that unrealized capital gains or losses should be included in profit computations, the Department also recognizes that unrealized gains or losses fluctuate sharply from year to year,[FN*] and that any regulatory use of investment profit data should, therefore, be based upon long term data.
In the profit measurement formula, investment gain is calculated in item 9 and unrealized capital gains or losses in item 10.
EXHIBIT A
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In distributing investment income by line of insurance, the New York Department also differs from the NAIC formula. Under the NAIC formula, the by line investment income is the amount of such income allocated to the line of insurance on Part II of the NAIC Insurance Expense Exhibit. That exhibit gives each insurer full discretion in determining how to allocate this income, and additionally provides for allocating some of it directly to net worth without crediting it to any line of insurance.
Both of these options are improper. The first is improper because, by giving an insurance company discretion as to how to distribute large amounts of income among lines of insurance, it makes it possible for a company to manipulate the profits it reports for a particular line of insurance. This freedom is particularly troublesome in view of the windfall profit provision of New York's new no-fault automobile insurance law. This provision, which was expanded as a consequence of New York's automobile insurance energy crisis legislation [FN*] to include all automobile coverages, provides for the return to policyholders of "excess" profits earned during the first three years of no-fault. If insurance companies had discretion in allocating investment income, companies could attempt to evade the windfall profit law by allocating investment income properly attributable to New York automobile insurance to other lines of insurance.
The second option is improper because it permits insurance companies to omit some income entirely from consideration by allowing it to be credited directly to net worth.
EXHIBIT A
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Neither of these options is permitted by the New York formula. Investment income (including realized and unrealized capital gains or losses) must be allocated to lines of insurance pursuant to § 165.2(d) of this regulation in the proportion that the investable funds for a line of insurance bears to the company's total investable funds for all lines. This allocation method is consistent with the Department's 1972 report on profit measurement.[FN*]It recognizes that some lines of insurance generate more investable funds than other lines of insurance (i.e., they allow the insurance company to retain premiums for a longer period of time before payout than do other lines.)
In addition, the New York methodology requires all investment income (item 11) to be allocated to lines of insurance. In doing this, the New York profit methodology will permit companies to attribute a portion of investment gains to net worth with the balance being attributed to policyholder-supplied funds, making this information available to whoever nay believe it to be important. If a company avails itself of this option, the formula will likewise attribute a portion of unrealized capital gains or losses to net worth. However, although permitting this breakdown, the profit methodology will require the total investment earnings whether attributed to policyholder-supplied funds or to net worth to be allocated to lines of insurance. Although the methods for attributing income between policyholder-supplied funds and net worth may differ, the end results will not be subject to manipulation because both amounts must be allocated to lines of insurance pursuant to the method prescribed in § 165.2(d) of this regulation.
EXHIBIT A
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Income Taxes
Like the allocation of net worth, the allocation of income taxes by line of insurance is highly conjectural, because a company is not taxed separately on its income from each line, but on its total company-wide income. Thus, there is no easy way to allocate a company's actual income taxes to lines of insurance because a company's taxes for a particular year cam be influenced substantially by loss carry-forwards and carry-backs to or from other years' operations, and from a number of other transactions which bear no relation to how much income the company earned in a particular year on a line of insurance in a certain state.
Accordingly, the only useful way for computing a company's income taxes on a by line, by state basis, and for comparing its profits with another's, is to assume that the company had no income or deductions other than those reported in the profit computation.
In the case of underwriting income, for example, the applicable federal income tax rate would be 48 percent for all income above a certain minimal amount. Similarly, the tax rates for the various types of investment income are available and should also be used. A problem is created in this regard, however, because investment income broken down by taxable and non-taxable, and capital gains broken down by long-term and short-term are not readily available. Thus, until this information is available, the next beat approach is to use assumed tax rates for investment income which reflect the overall mix of insurance company investments among taxable and tax exempt items, and long-term and short-term items. This is the approach adopted by the NAIC. For investment gain (item 9), the NAIC uses a tax rate of 20 percent. For unrealized capital gains, the NAIC Profitability and Investment Income in Property and Liability Insurance Subcommittee had recommended a tax rate of 30 percent. These tax rates have been utilized in the New York formula. In addition, the NAIC formula permits a company to adjust these tax rates to reflect "relevant facts." This latter option has been rejected here, because it gives the companies discretion which would be difficult to police and could lead itself to manipulation.
EXHIBIT A
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Net Income on Net Worth
The company's net worth, as calculated in accordance with this regulation, is allocated by line, by state in the same manner that investment income is allocated. Premiums earned divided by the allocated net worth produces the applicable ratio of premiums to surplus. This ratio multiplied by the met income rate of return on premiums earned (item 14) produces the net income rate of return on net worth (item 15).
Using certain industry-wide experience, the industry-wide ratio of premiums to surplus (Table II) should be multiplied by the net income rate of return on premiums earned (item 14) to obtain the net income rate of return on assumed net worth.
Net Income on Assets
The company's total assets (admitted plus non-admitted assets) are allocated by line, by state in proportion to investable funds produced by each line of business. Premiums earned divided by the allocated asset share produces the applicable ratio of premiums to assets. This ratio multiplied by the net income rate of return on premiums earned (item 14) produces the net income rate of return on assets (item 16).
Using certain industry-wide experience, the industry'wide ratio of premiums to assets (Table III) should be multiplied by the net income rate of return on premiums earned (item 14) to obtain the net income rate of return on assumed assets.
EXHIBIT A
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Profitability and Investment
Income in Property and
Liability (A4) Subcommittee
Page 1 of 2
The Profitability and Investment Income in Property and Liability Insurance (A4) Subcommittee met at 2 p.m., December 4, 1973, in Section A of the Las Vegas Hilton Hotel Convention Center, Las Vegas, Nevada. The meeting was recessed at 5 p.m. on December 4 and was reconvened at 4:30 p.m. on December 5.
The Subcommittee received a supplemental report of the Special Task Force on profitability by line and by state.
Following extended discussion - during which it was emphasized that the annual statement remains the only official measure or the items reported there in and in which the importance or the concept of measuring profitability by line and by state was emphasized - a motion was made, seconded and passed to adopt the attached statement on profitability in property and liability insurance by line and by state (Attachment 1).
A motion was made, seconded and passed to adopt the report and the supplemental report (Attachment 2) of the special task force, as modified and amplified by, and to the extent not inconsistent with, the attached statement.
The Subcommittee noted that representatives of insurance trade associations stated that they would produce and submit to the Subcommittee profitability results for the years 1968-1972 in accordance with the standard format in the attachment statement. The Subcommittee expressed appreciation for the opportunity to receive and review such data, although it was emphasized that this should not affect the need and the efforts of the NAIC to develop its own capability to produce financial data.
The special task force was asked to prepare, and to submit for the consideration of the Blanks Subcommittee at the earliest possible time, amendments to the annual statement in accordance with the recommendations in the task force report.
There was no discussion or action in relation to the allocation of net worth among states and lines of insurance.
There being no further business to come before the Subcommittee, the meeting was adjourned.
EXHIBIT A
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EXHIBIT A
Profitability and Investment Income
(A4) Subcommittee Attachment 1 Page 1 of 2
STATEMENT ON PROFITABILITY IN PROPERTY AND
LIABILITY INSURANCE BY STATE AND BY LINE
The National Association of Insurance Commissioners, having adopted in December 1971 a statement of position on financial data in property and liability insurance; having received in June 1973 the report of the Task Force on Profitability By Line and By State; and having received in December 1973 a supplemental report of the Task Force, hereby adopts the attached (Exhibit A) standard format for measuring profitability in property and liability insurance by state and by line of insurance.
This format is adopted in full recognition of the limitations on its use, which include the facts that the results obtained from its use could be extremely misleading and even invalid if applied to the business of one or a few companies over even a long period of time, or if applied to the business of all companies over a period of less than several years, or, especially, if applied to the business of one company for one year. It is also recognized that such results, standing alone, do not provide a basis for determining whether or not competition exists in the insurance economy and that such results, standing alone, do not provide a basis for determining appropriateness of rates.
Such dissemination of profitability data as the NAIC might undertake should not include profitability data by particular companies. It is recognized, however, that individual insurance departments might request (for their own use, including publication by them) the compilation of data on such bases.
The format is adopted provisionally, with the expectation that it should be tested in use and revised, if necessary, on the basis of such testing.
EXHIBIT A
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Profitability and Investment Income
(A4) Subcommittee Attachment 2 Page 1 of 2
PROFITABILITY REPORTING BY LINE AND BY STATE
(A4) SPECIAL TASK FORCE
SUPPLEMENTAL REPORT
Springfield, Illinois
October 1, 1973
I. Profitability Reporting by Line and by State
The Special Task Force met in open session and in executive session at Springfield, Illinois at 1:30 p.m., Monday, October 1, during the Zone 4 NAIC meeting. Written statements and oral presentations were given to the committee by representatives of:
1. American Insurance Association
2. National Association of Independent Insurers
3. Dr. Irving Plotkin, representing AlA and NAII
4. American Mutual Insurance Alliance
5. Insurance Companies of North America
6. Milwaukee Mutual Insurance Company
7. Transamerica Insurance Group
Other written comments and oral statements had been submitted to the Task Force by representatives of several state insurance department.
After careful consideration of the written statements and the oral discussion the Task Force voted to amend its June 1973 report as set forth below and to submit the report as amended as fulfillment of its charge.
1. On page 3 of the Special Task Force Report in (paragraph 6), delete the last three sentences and insert the following: "The controlling consideration at this point is the need to be consistent with the present lines of business shown throughout the annual statement blank. The lines of business should be consolidated as shown below." (Comment: This is a needed editorial change.)
2. On page 3, delete item number (2) under recommendations and on page 4 (at the top of the page), delete the material that is part of recommendations and insert the following:
2) The following lines or combinations be displayed by state:
a. Private passenger auto
b. Commercial auto
c. Homeowner's
d. Farmowner's
e. Commercial multiple peril, Boiler and machinery, Ocean Marine and aircraft
f. Fire, Allied lines, Earthquake, Inland marine, Glass, and Burglary and theft.
[FN*] N.Y.S. Ins. Dept., MEASUREMENT OF PROFITABILITY: PROPERTY AND LIABILITY INSURANCE (1972).
[FN**] N.Y.S. Ins. Dept., COMPETITION IN PROPERTY AND LIABILITY INSURANCE IN NEW YORK STATE (1973), pp. 44-53.
[FN*] Id. Competition report at pp. 45-46.
[FN*] The undesirability of permitting an insurance company's management to control profit results by being able to pick and choose which gains or losses to realize was recently pointed out by the Security and Exchange Commission's Chief Accountant, Mr. John C. Burton. See Proceedings of American Insurance Association May 1973 pp. 40-41.
[FN*] In 1972, for example, property and liability insurance companies licensed in New York State had unrealized investment gains of $2.4 billion, whereas in 1973 they had unrealized losses of $4.2 billion.
[FN*] Chapter 501 of the Laws of 1974.
[FN*] N.Y.S. Ins. Dept., MEASUREMENT OF PROFITABILITY: PROPERTY AND LIABILITY INSURANCE (1972), pp. 15-16.
N.Y. Comp. Codes R. & Regs. tit. 11, Appendices, app 15