April, 2010

Having been around product pricing for a long time, I have seen many different approaches to establishing insurer profitability targets for life insurance and annuity products. In most cases, a major measure is an internal rate of return, (IRR), or a similar counterpart, GAAP Return on Equity (ROE), both of which are measured against invested capital. But what is the “right” target profitability level?

Profitability hurdles vary significantly by company, but an approach which makes sense to me is a return hurdle equal to the after-tax risk-free rate plus a margin. The risk-free rate would correspond to a Treasury rate with duration similar to the duration of the product’s liabilities, and the margin would be a figure determined by the insurer, and which reflects financial volatility, and operational and other risks in the product. The margin likely would vary by product and fall into a range of 400-700 bps after-tax. Products with greater risk would require higher returns. Products with no risk should earn the risk-free rate or close to it. Products which generate higher capital needs from the rating agencies or regulators would also face higher, absolute profit hurdles.

Aside from quantifying the “cost” of risk, this approach helps establish a greater focus on risk vs. reward. The return hurdles would vary as risk-free rates change, which, within a range, makes sense (to me). And really, risk/reward is what our business is about, right?

Tim Pfeifer
President