Opinion ID: 2073828
Heading Depth: 1
Heading Rank: 3

Heading: allowance for profit

Text: A. The Method of Determining the Profit Allowance. Traditionally, the allowance for profit was 1% of the total premium for compulsory coverages and 5% of the total premium for other coverages. But these figures were likely to be a very misleading indication of the actual profit made by the insurer on a given line of insurance. Because the premium dollars are paid to the insurers early in the policy year and the payment of insurance claims stretches out over several years, the cash flow produces funds that the insurer can invest. See generally Birkinsha, Investment Income and Underwriting Profit: And Never the Twain Shall Meet?, 8 B.C. Ind. & Com. L. Rev. 713 (1967); Comment, Insurance Ratemaking Problems; Administrative Discretion, Investment Income, and Prepaid Expenses, 16 Wayne St. L. Rev. 95 (1969). This income from investment is not directly adverted to in formulating the profit allowance by the traditional method. The Commissioner concluded that the method was the shoddiest component of ratemaking and that the 1% and 5% figures hand solely on threads of imagination unsupported as measures of reasonable profit in either hearing evidence or actuarial literature. The Commissioner proposed a radically different procedure  altogether novel in automobile insurance rate regulation in the Commonwealth  designed to set the profit allowance for a given insurance line in a more realistic fashion. His goal was to adjust the allowance for profit so that it, together with the investment income, would allow the average regulate a rate of return on [shareholders'] invested capital roughly equal to that earned by businesses with similar riskiness in the unregulated, competitive sectors of the economy. The several stages of the Commissioner's procedure follow. (1) A minimum reasonable investment yield is determined for the funds provided by the policyholders and shareholders and available for investment by the insurer. One approach to this end would be to examine and analyze the investment income actually realized by insurers. But the Commissioner, quoting from an earlier decision of his own, noted the multitudinous problems involved in trying to measure actual investment income: insurers pool the cash from several lines of business, so that income cannot easily be attributed to a particular line; and the investment results among real-world insurance companies fluctuate widely from year to year, making difficult the achievement of stable results. Moreover, if a real investment program is examined, complex problems arise in dealing with realized and unrealized gains and with income taxes. Characterizing the problems as a Gordian Knot, the Commissioner chose to slash through it by setting up a hypothetical investment program. He selected as the minimum reasonable investment yield the average yield on Treasury securities of various maturities, each weighted in the averaging in accordance with the cash flow pattern of the line of insurance under consideration. The choice of such a risk-free yield was fair and neutral, according to the Commissioner, for if an insurer pursued an investment policy offering an opportunity for more profit, it did so at the risk of having to absorb losses. (2) A cash flow exhibit is prepared for the line of insurance under examination which discloses how funds become available for investment, and which calculates the amount obtained from investing these funds at the minimum reasonable investment yield. If the premium for the line of insurance is set properly, as the model assumes, then the total premium receipts will exactly equal the payout of the profit allowance, losses, and expenses. [26] The pattern of rapid buildup and gradual release of cash generates investable funds, which are assumed to be invested at the minimum reasonable investment yield. The yield from that investment is divided by the total premium receipts (premium volume) to give what is termed the underwriting investment income as a percentage of premium volume. (3) The return on shareholder-contributed capital is calculated. To the underwriting investment income as a percentage of premium volume (derived in Step 2) is added the profit allowance [27] (which is also expressed as a percentage of premium volume,) giving the total return from underwriting as a percentage of premium volume. Since capital serves as a guaranty fund for payment of claims in the automotive insurance industry, the insurer will monitor and maintain a ration between premium volume, a measure of his loss exposure, and capital. The return from underwriting as a percentage of premium volume is multipled by this ration to give the return from underwriting as a percentage of capital. Next, added to this figure is the return from investing the capital itself at the minimum reasonable investment yield (the return is expressed as a percentage of capital). The total, which represents the pre-tax return on capital, is then multiplied by a tax conversion factor to produce the estimated after-tax return on capital. (4) The rates of return on unregulated industries are gathered and a target rate of return for the insurer is determined. (One of the issues before us is how this determination should be made.) (5) The profit allowance is adjusted so that the total return on capital determined in Step 3 equals the target rate of return derived in Step 4. Essentially the procedure involves an analysis of a hypothetical or model insurance company which writes only the line of insurance under consideration. The various elements of the analysis were considered at both the bodily-injury and property-damage hearings; some were challenged and are discussed below. [28] As it turned out, on the Commissioner's calculations a profit allowance of negative 4% for bodily-injury coverages was found to meet the target rate of return. Because of the investment income made possible by the comparatively slow payout of bodily-injury claims, the amount collected in premiums can be 4% less than the amount absorbed by expenses or paid in claims and still provide those who invest in the insurance company with a reasonable return. For the property-damage coverages, with a much faster payout of claims and hence less underwriting investment income, a positive 5% profit allowance was found necessary to produce the target return. By coincidence a 5% allowance has been traditional in property-damage ratemaking. B. Alleged Errors in the Method. None of the parties to the hearing challenged the Commissioner's general method of setting the profit allowance. [29] Not surprisingly, however, the figures used in applying the method have provoked disagreement. (1) Comparisons with other industries. In the bodily-injury decision the Commissioner took for comparison the rates of return on total capital as reported by Forbes magazine (January 1, 1975) for a recent twelve-month period for 850 of the largest domestic corporations, and, after certain adjustments, he derived a 10% average return on total capital. [30] Because the bodily-injury insurance is a slow pay line, the Commissioner felt that an insurance company engaged in selling such insurance is subject to somewhat greater risk in an inflationary period than the average domestic company, and he therefore adjusted the target rate of return to be used in the profit calculation upward to 11.5%. In the property-damage decision the Commissioner chose the 10% figure as the target, making no such upward adjustment, because the faster payout of property-damage losses made the return less vulnerable to inflation. Did the Commissioner make an appropriate reference to the unregulated sector? The Bureau argues that the proper comparison is not with the return on total capital (debt plus equity), but rather the return on equity alone. And the average return on equity, as derived from Forbes, is in the vicinity of 14%. The Commissioner argued briefly (in the bodily-injury decision) that the Bureau's view would result in a higher total return for a firm with a capital structure consisting only of equity than for a firm with identical total capital but with both debt and equity in the structure, and that this must be unsound because the capital at risk in the two cases is the same. Because insurers seldom issue debt, the Commissioner's view was that setting the target rate by comparison with the return on equity in the unregulated sector would give the insurers an extra return on their capital bases. The Commissioner's reasoning is open to question. The rate of return to an investor in the model insurer should equal what he would expect on an investment of comparable riskiness in the competitive market. See, e.g., New England Tel. & Tel. Co. v. Department of Pub. Util., 360 Mass. 443, 472 (1971), quoting Federal Power Comm'n v. Hope Natural Gas Co., 320 U.S. 591, 603 (1944). See generally V. Brudney & M.A. Chirelstein, Corporate Finance 56-81, 378-380 (1972). And the Commissioner's approach seems suspect because it fails to confront and to consider all the elements of risk of an investment in such an insurer. Among these elements is the risk inherent in the line of insurance itself; some lines will have greater unpredictability and fluctuation of losses than others [31] and an investor in a company which wrote such lines would demand a greater expected return than he would in a company in which the return was more certain. The risk of an investment in an insurer is also affected by the risk that is characteristic of the insurer's internal investment policy. Finally there is risk to the investor associated with the ration which the insurer adopts between premium volume and capital: if the insurer maintains a high ration, then adverse loss or expense experience will consume a greater portion of the capital than it will in the case of an insurer with a low ration; conversely, favorable experience will result in greater return to capital than in a low-ration insurer. See In re Application of Ins. Rating Bd., 63 N.J. 413, 417 (1973). Hence, other things being equal, the high-ration insurer is more risky than a low-ration insurer and the reasonable investor would demand a greater average return from it than from the low-ration insurer. An assessment of these risks, and perhaps others, that characterize the model insurer and a comparison with the risk-return relationship of unregulated enterprises may be thought necessary if the target return of the model insurer is to be properly determined. [32] But even if the Commissioner's view, just criticized, is taken to be weakly supported, we believe a remand to find an appropriate target rate of return is not required. In the course of the property-damage hearings, experts on both sides, testifying on the present subject, all agreed that the target for the model company should be set equal to that of an equity investment of comparable riskiness. The problem, as they saw it, lay in assessing the riskiness of the model corporation. [33] Although the experts felt that prospective shareholders would demand about 15% from an equity investment of average riskiness and that they would demand that much or more from an investment in a real-world liability insurer, they agreed that the model insurers might appropriately pay less. The hypothetical model assumed a premium volume to capital ration of two to one (see note 28 supra ), whereas real insurers are currently writing at a more risky ration of three to one or higher. And the model insurer was to follow a risk-free investment policy, whereas the real insurers typically invest with assumption of risk. Because of the diminished risk of investment in the model insurer, a target return below that of the market generally was justified. In fact, two of the three experts called indicated that 10%  the target chosen, coincidentally, [34] by the Commissioner  was reasonable for the model property-damage insurer. Although the Commissioner characterized the experts' figures as loose estimates and the experts hedged their estimates by saying that more careful analysis would be needed to reach a precise figure, we feel their testimony, in its cumulative effect, provides adequate support for the Commissioner's figure. [35] In reaching this result we are mindful that the Commissioner's approach to the profit allowance is not only novel but complicated, and that somewhat greater imprecision must be tolerated in its initial application than might be acceptable in later years. Turning to the target for the bodily-injury line of insurance (and deferring until (2) below the separate question of the adjustment of 1.5% for the consequences of longer delay in the payment of those claims), we think the basic 10% can be justified here even though there was no expert testimony on bodily injury comparable to that received in respect to property damage. The assumptions concerning the model insurer were identical for both bodily injury and property damage, and so the adjustment of the target return in light of the risk of the internal investment policy and ratio of premium volume to capital would likely be identical for the two coverages. In fact, in the course of the property-damage hearing the experts were asked to comment on bodily-injury decision, and their remarks provide the necessary support we would otherwise expect on remand. (2) Adjustment for risk in the bodily-injury decision. As already suggested, with payment of claims for bodily injury extending over a much longer period than payments for property damage, inflation is a more serious problem increasing the riskiness of the bodily-injury line. The Attorney General argues that the Commissioner's upward adjustment of 1.5% was not adequately supported by the evidence. [36] To the Attorney General's suggestion that there was inadequate record evidence that inflation affects the risk, it is a fair answer that that premise is obvious and may be taken to have been acknowledged by all. As to the amount of the adjustment, we agree with the Commissioner that, while disallowance of any adjustment might be procedurally fair because the Bureau did not come forward on the matter, it would be less than logically fair. Here the judgmental estimate of the Commissioner of the proper adjustment is of the type that can be expected on the initial application of a novel methodology. [37] Crude estimation could not be tolerated in normal circumstances, and we observe that the Commissioner called on future participants in the hearing process to present more formal data and analysis. (3) Deduction of certain expenses from the minimum reasonable investment yield. In the bodily-injury decision the Commissioner allowed a deduction of 0.6% from the weighted average of Treasury securities constituting the minimum reasonable investment yield so as to compensate the insurer for investment expenses and for uninvested cash. In the property-damage decision, on the other hand, the Commissioner found that an insurer following the hypothetical investment policy would be able to invest nearly all its funds and would have minimum investment expenses; thus he concluded that a deduction would be inconsistent with the model and he refused to allow it. The Attorney General argues that the 0.6% deduction in the bodily-injury decision should be disallowed and the Bureau argues that the deduction should have been allowed in the property-damage decision. The results are fully supported by the respective records on which they stand; all witnesses agreed with the need for an adjustment in the bodily-injury hearings and the experts split at the property-damage hearings. We think no correction of either decision is warranted. (4) Claimed deviation of model from reality. Although the Bureau states early in its brief that, at least for purposes of this appeal, it is not challenging the Commissioner's method of calculating the profit allowance (see note 29 supra ), it nonetheless later criticizes the method as a blackboard exercise lacking realism. It points, by way of example, to the fact that the billing and receipt of premiums in 1976 were delayed by tardiness in the issuance of the property-damage decision, making the cash flow exhibit somewhat erroneous, and also to the fact that the investment yields on government securities at the time premium dollars became available for investment have proved to be less than those used in the model. And it says that the omission of the property-damage decision to take account of investment expenses and uninvested cash is a sign of failure to face facts. But the first two problems do not really grow from the model; they rather are the products of disparities that inevitably will exist between a projection of the future and the future as it proves to be. And although, as to the third point, the model may depart from the behavior of real-world companies, it is of the essence of the use of a model that it makes some simplifying assumptions. The model is unrealistic only in the sense that no actual insurer happens to conform its behavior to the assumptions, not in the sense that its assumptions are fanciful or impossible to match in the real world. If under the model there is neither investment expense nor uninvested cash, then the failure of real-world insurers to follow the model must arise from the fact that they find these added expenses are less than the extra profits derived from a more aggressive investment policy. The same observations may be made about other departures by a real insurer from features of the model that are subject to the insurer's control.