New York Codes, Rules and Regulations › Title 11 - INSURANCE › Appendices › Appendix 15

Current through Register Vol. 46, No. 28, July 10, 2024
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
A-2
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
A-6
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
A-9
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
A-10
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
A-14
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.
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EXHIBIT A
A-16
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.
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EXHIBIT A
A-18
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.
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[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.