An Overview of Capital Management for PropertyCasualty Insurers

1
An Overview ofCapital Managementfor
Property/Casualty Insurers

• Rick Gorvett, FCAS, MAAA, ARM, FRM, Ph.D.
• Actuarial Science Program
• University of Illinois at Urbana-Champaign
• Casualty Actuarial Society
• Washington, DC
• July, 2003

2
Agenda

• Capital management and its inclusiveness
• Putting capital management in a financial
  services industry context a look at the banking
  world
• The financial theory underlying capital
  management
• Discussion of cost of capital
• Capital management for property / casualty
  insurance

3
CapitalManagementand itsInclusiveness
4
What is Meant by Capital and Capital
Management

• Capital (and surplus)
• Assets less liabilities
• Owners equity
• Support for (riskiness of) operations
• Thus, supports profitability and solvency of firm
• Capital Management
• Determine need for and adequacy of capital
• Plans for increasing or releasing capital
• Strategy for efficient use of capital

5
Types and Measures of Capital

• Statutory
• Inherently conservative solvency perspective
• GAAP
• Going concern income statement orientation
• Risk-based capital
• Required capital based on risk attributes and
  promulgated charges
• Economic
• Required capital in order to achieve a specified
  solvency standard

Actual
Theoretical
6
Why Do We Care About Managing Capital?

• Leads to solvency and profitability
• Benefits of solidity and profitability
• Higher company value
• Happy claimholders (policyholders,
  stockholders,...)
• Better ratings
• Less unfavorable regulatory treatment
• Ability to price products competitively
• Customer loyalty
• Potentially lower costs

7
The Problem With Capital

• A certain amount of capital is needed in order to
  promote solvency
• Thus, need to be able to raise capital
• But.... If there is too much capital,
  profitability (as measured by return on equity)
  will suffer
• Thus, need to be able to efficiently deploy
  capital

8
What Does Capital Management Entail?
Capital Structure
Financial Risk Mgt.
Raising Capital
Capital Management
Setting Objectives
Strategic Planning
Liability Valuation
Product Pricing
Asset Allocation
9
PuttingCapital Managementin aFinancial
Services Industry ContextA Look at the Banking
World
10
Banks How They Improved

• Article Renaissance Men, Economist, 4/15/99
• Banks had tough times in the late 1980s and early
  1990s
• Afterward, began taking risk into account more
  formally and effectively
• Considered risk-adjusted returns
• Theyre still worried about Basle, though....

11
From the Fed Bank Capital

• BOARD OF GOVERNORSOF THEFEDERAL RESERVE
  SYSTEMDIVISION OF BANKINGSUPERVISION AND
  REGULATION
• SR 99-18 (SUP)
• July 1, 1999
• SUBJECTAssessing Capital Adequacy in Relation to
  Risk at Large Banking Organizations and Others
  with Complex Risk Profiles

12
From the Fed Bank Capital (cont.)

• ....increasing emphasis on banking
  organizations' internal processes for assessing
  risks and for ensuring that capital, liquidity,
  and other financial resources are adequate in
  relation to the organizations' overall risk
  profiles.
• ....one of the most challenging issues faced by
  bankers and supervisors is how to integrate the
  assessment of an institution's capital adequacy
  with a comprehensive view of the risks it faces. 
  Simple ratios - including risk-based capital
  ratios - and traditional rules of thumb no longer
  suffice in assessing the overall capital adequacy
  of many banking organizations, especially large
  institutions and others with complex risk
  profiles such as those significantly engaged in
  securitizations or other complex transfers of
  risk.
• (continued)

13
From the Fed Bank Capital (cont.)

• ....this letter directs supervisors and
  examiners to evaluate internal capital management
  processes to judge whether they meaningfully tie
  the identification, monitoring, and evaluation of
  risk to the determination of the institution's
  capital needs.
• ....this letter describes the fundamental
  elements of a sound internal capital adequacy
  analysis - identifying and measuring all material
  risks, relating capital to the level of risk,
  stating explicit capital adequacy goals with
  respect to risk, and assessing conformity to the
  institution's stated objectives - as well as the
  key areas of risk to be encompassed by such
  analysis.
• (continued)

14
From the Fed Bank Capital (cont.)

• Current industry practice   Most institutions
  consider several factors in evaluating their
  overall capital adequacy a comparison of their
  own capital ratios with regulatory standards and
  with those of industry peers consideration of
  identified risk concentrations in credit and
  other activities their current and desired
  credit agency ratings, if applicable and their
  own historical experiences including severe
  adverse events in the institution's past.  Some
  more sophisticated banks also use risk modeling
  techniques and scenario analyses to evaluate
  risk, but generally have not yet incorporated
  such analyses formally into their overall
  assessment of capital adequacy.
• (continued)

15
From the Fed Bank Capital (cont.)

• Fundamental Elements of a Sound Internal Capital
  Adequacy Analysis
• 1) Identifying and measuring all material risks
• 2) Relating capital to the level of risk
• 3) Stating explicit capital adequacy goals with
  respect to risk
• 4) Assessing conformity to the institution's
  stated objectives
• Composition of Capital
• ....it has been the Board's long-standing view
  that common equity (that is, common stock and
  surplus and retained earnings) should be the
  dominant component of a banking organization's
  capital structure and that organizations should
  avoid undue reliance on noncommon equity capital
  elements.

16
Basle I

• 1988 Basle Accord
• By 1992, banks had to have a capital ratio of 8
• Capital ratio amount of available capital /
  risk-weighted assets
• Risk-weighted assets
• Only explicitly identifies two types of risks
  (1) credit risk (2) market risk
• Other risks presumed to be covered implicitly

17
Basle II

• Ongoing have issued third Consultative Document
  (comments due by 7/31/03)
• New Accord includes three pillars (1) minimum
  capital requirements (2) supervisory review of
  capital adequacy (3) public disclosure
• Pillar 1 proposals to modify definition of
  risk-weighted assets
• Changes to treatment of credit risk
• Explicit treatment of operational risk

18
TheFinancialTheoryUnderlyingCapitalManagement
19
Steps in the Financial Risk Management (FRM)
Process

• Determine the corporations objectives
• Identify the risk exposure (e.g., FX risk)
• Quantify the exposure (e.g., measure volatility)
• Assess the impact (DFA)
• Examine financial risk management tools
• Select appropriate risk management approach
• Implement and monitor program

20
Finance Theory andCapital Management

• Why bother to worry about financing or FRM (or
  any risk management), in light of the capital
  structure irrelevance proposition?
• Modigliani-Miller (1958) if financing does
  matter, it must be because of one or more of
• Tax effects convex tax function
• Financial distress / bankruptcy costs
• Effects on future investment decisions

21
Post-FRM
Pre-FRM
22
Derivatives Use Among Insurers

• Activity during 1994
• Cummins, Phillips, Smith (1997)
• 142 P/C insurers (7) used derivatives in 1994
• Larger companies more likely to use derivatives
  than smaller companies
• Most often used contracts for P/C insurers
• Foreign currency forwards
• Equity options
• Other (FX) activity in 1994 in
• Foreign currency swaps
• Foreign currency futures
• Foreign currency options

23
Derivatives Use Among Insurers (cont.)

• Anecdotal evidence from SEC 10-K filings
• Specific mentions re FX risk include
• Currency swaps
• Foreign currency forwards
• Asset-liability management
• Sensitivity analysis with respect to hypothetical
  changes in exchange rates
• Investments in foreign currencies
• Cash flows from foreign operations, to fund
  investments in foreign currencies

24
Capital Structure - Theory

• To finance ops., firm can issue debt or equity
• Capital Structure firms mix of securities
• Does this mix selection affect firm value?
• Miller Modigliani said No (in perfect capital
  markets)
• Firm value is determined by its real assets
  value is independent of capital structure
• Capital structure irrelevant (for fixed
  investment decisions, no taxes, no costs of
  financial distress)
• Allows separation of investment and financing
  decisions

25
Capital Structure - Reality

• Modigliani-Miller Proposition capital structure
  decision is irrelevant to firm value, under
  certain friction-free assumptions (e.g., no
  taxes)
• But in reality, there are taxes
• There are also costs associated with financial
  distress

26
Interest Tax Shield

• Tax-deductibility of interest may make some debt
  in the capital structure attractive
• Discount the interest tax shield by the rate
  demanded by investors holding the debt
• PV (tax shield) t (rd D) / rd t D
• (assumes debt in perpetuity)
• Value of firm increases by PV (tax shield)
• Value of firm value if all equity-financed
• PV (tax shield)

27
Costs of Financial Distress

• However....
• Increasing debt ? increasing risk and increasing
  likelihood of distress, which has costs
  associated with it e.g.,
• Costs of shareholder bondholder conflicts
• Costs of potential bankruptcy
• Costs associated with inability to operate
  optimally / efficiently
• Costs associated with bond provisions / compliance

28
Sample Debt / Equity Tradeoff Chart
Firm Value
PV(costs fin. distress)
PV(tax shield)
Debt / Equity Ratio
29
Other Capital Structure Issues

• More on debtholdershareholder conflicts
• Projects / investments more risky versus less
  risky
• High versus low dividend payouts
• Pack-it-in versus keep-hanging-on
• Financing pecking order theory
• Order of preference (1) internal financing
  (2) issue debt (3) issue equity
• More profitable / cash flow ? dont need external
• External can send adverse signals

30
Issuing Securities

• Initial public offerings
• Engage an underwriter(s)
• File SEC registration statement
• Prospectus (red herring)
• General cash offers
• Similar steps to those for IPO above
• SEC Rule 415 shelf registration
• Announcement of equity issue empirically, small
  decline in stock price
• Signal to investors
• Puzzle re long-run underperformance

31
Issuing Securities (cont.)

• Private placements
• Significant on debt side
• Less costly flexible
• Counterparty concerns less liquid
• Costs of security issuance
• Accounting and legal
• Underwriting
• Spread
• Possibility of underpricing securities

32
Dividends

• Declared by board of directors
• Once declared, an obligation
• Modigliani Miller dividend policy is
  irrelevant in a world without taxes, transaction
  costs, etc.

33
Types of Dividends

• Regular cash divs. expect to maintain
• Extra dividend may not be repeated
• Special dividend unlikely to be repeated
• Liquidating dividend
• When going out of business
• Distribution of assets (return of capital)
• Stock dividend shares of company or subsidiary
• For company conserves cash
• For investor not taxed until sold

34
Limits on Dividends

• By bondholders
• Covenants prevent the distribution of the firms
  assets as dividends to stockholders
• Company cant issue a liquidating dividend if
  funds are needed for protection of creditors
• By state law
• Prohibits paying dividend that would make the
  company insolvent
• Prohibits paying dividends out of legal capital

35
Dividend Viewpoints

• Tax effects ? low dividend preferable
• Investor preferences ? high dividend payouts
• Somewhere in-between are those who subscribe to
  the original MM proposition that dividend policy
  is irrelevant

36
Share Repurchase

• Alternative to paying cash dividends
• Often used when
• Company has accumulated lots of cash
• Wants to replace equity with debt
• Methods of repurchase
• Open market
• General tender offer to all or small shareholders
• Direct negotiations with major shareholder
• Repurchased shares seldom de-registered and
  canceled

37
Liquidity Ratios

• Indicators of riskiness, financial strength
• Short-term cashability
• More reliable values for liquid assets
• Short-term ? can become out of date
• Possibly seasonal
• Ratios
• Current ratio current assets / current
  liabilities
• Quick ratio (cash marketable securities
• receivables) / current liabilities
• Cash ratio (cash marketable securities) /
• current liabilities

38
Leverage Ratios

• Measures of financial leverage (capital
  structure)
• Ratios (other definitions are possible)
• Leverage Ratio assets / equity
• 1 (debt/equity)
• Debt ratio long-term debt /
• (long-term debt equity)
• (Here, long-term debt includes value of leases)
• Times interest earned EBIT / interest expense
• (Numerator sometimes includes depreciation)

39
Market Value Ratios

• Combine accounting (book) and stock (market) data
• Ratios
• Price-earnings ratio stock price / EPS
• Earnings yield EPS / stock price 1 / (P/E)
• Market-to-book ratio stock price /
• book value per share
• Dividend yield dividend per share / stock price
• Tobins q MV of firm / replacement cost

40
Profitability Ratios

• Measures of profitability and efficiency
• Ratios
• Sales to total assets (or asset turnover)
• sales / average total assets
• Profit margin EBIT / sales
• Average collection period
• (average receivables) / sales x 365
• Also ROE, ROA, Payout Ratio
• (Note Usually use averages for snapshot figures
  when comparing them with flows)

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Other Ratios

• Capital ratios
• E.g., capital / liabilities capital / assets
  capital / weighted asset formula
• NAIC IRIS ratios e.g.,
• Premium / surplus
• Change in premium writings
• Surplus aid to surplus

42
International Differences

• United States
• Companies widely held
• Rely largely on financial markets
• Germany
• Cross-holdings of companies layered ownership
• Greater reliance on banking system
• Japan
• Kiretsu network of companies, usually
  organized around a major bank
• Most financing from within the group

43
Debtholders vs. ShareholdersWhos Interested in
What?
Probability
Shareholders
Debtholders
Firm Value
44
Option Values Payoff Charts
Payoff

• Call -- long position
• Call -- short position
• Put -- long position
• Put -- short position

ST
X
X
ST
ST
X
X
ST
45
Payoff and Profit/Loss ProfilesLong a Call Option
Payoff
Profit/Loss
ST
Call Premium
X
46
Black-ScholesOption Pricing Model

• Variables required
• 1. Underlying stock price
• 2. Exercise price
• 3. Time to expiration
• 4. Volatility of stock price
• 5. Risk-free interest rate

47
Black-Scholes Formula

• VC S N(d1) - X e-rt N(d2)
• where
• d1 ln(S/X)(r0.5s2)t / st0.5
• d2 d1 - st0.5
• where N( ) cumulative normal distribution,
• S stock price,
• X exercise price,
• r continuously compounded risk-free interest
  rate,
• t number of periods until exercise date, and
• s std. dev. per period of continuously
• compounded rate of return on the stock

48
Options Capital Structure

• Both components of capital structure, equity and
  debt can be viewed within the option (contingent
  claim) framework
• Thus, we can bring powerful valuation tools from
  option / contingent claim theory to bear on
  questions of capital structure, firm value,
  pricing of insurance policies, etc.

49
Options Capital Structure (cont.)

• Equity residual claim on value of the firm
• Contingent value after other claimholders
• If firm defaults, equityholders put the company
  onto the debtholders
• This reflects equityholders limited liability

Equity Payoff
Firm Asset Value
L
50
Options Capital Structure (cont.)

• Debt claim on firm assets takes priority
  relative to equity
• Value contingent upon firm asset value
• Bondholders hold the assets and write a call to
  the equityholders

Debt Payoff
Firm Asset Value
L
51
Applying the Option Pricing Model to Insurance

• Use option pricing to determine the value of each
  claim on an insurers assets
• Policyholders Claim H
• Governments Tax Claim T
• Owners Claim V
• Neil Doherty and James Garven, 1986, Price
  Regulation in Property-Liability Insurance A
  Contingent Claims Approach, Journal of Finance,
  December

52
Option Pricing Model Applied to Insurance
Stockholder Value
Taxes
0
Liabilities
Beg. Assets
Terminal Asset Value
53
Value of Various Claims at the End Of the Period

• Policyholders claim
• H1 MAXMINL,Y1,0
• Governments tax claim
• T1 MAXti(Y1-Y0)P-L,0
• Owners claim
• Ve Y1 - H1 - T1

54
where

• S0 Initial equity
• P Premiums (net of expenses)
• Y0 Initial assets S0 P
• R Investment rate
• k Funds generating coefficient
• Y1 Ending assets
• S0 P (S0 kP)R
• L Losses
• t Tax rate
• i Portion of investment income that is taxable

55
Determine The Value Of These Claims At The
Beginning Of The Period

• V(Y1) Market value of asset portfolio
• CAB Value of call option with exercise
  price of B on asset with value of A
• E(L) Expected losses
• H0 V(Y1) - CY0E(L)
• T0 tCi(Y1 - Y0) P0E(L)
• Ve V(Y1) - H0 - T0
• CY0E(L) - tCi(Y1 - Y0) P0E(L)

56
Use Of Option Pricing To Set Insurance Premiums

• To determine the fair premium, the premium
  level is determined for which the owners claim
  is equal to the initial equity. Thus, the owners
  receive a fair investment return.

57
DiscussionofCostofCapital
58
Cost of Capital

• Weighted Average Cost of Capital (WACC)
  weighted average of firms (after-tax) financing
  source costs
• WACC rs ws rp wp rd (1 t) wd
• where r cost, w weight, t tax rate, s
• common stock, p preferred stock, and
• d debt

59
Cost of Capital

• Cost of capital can be used as a hurdle rate
  against which to measure investment decisions.
• Weights are the long-run proportions of the
  various financing sources comprising the firms
  capital structure
• Key is to determine the costs, or rates,
  associated with each financing source
• Can use CAPM, APT, etc.

60
Capital Asset Pricing Model
E(Ri) Rf ?i E(Rm) - Rf
where E expected value operator Ri
return on an asset Rf risk free rate Rm
return on market portfolio ?i Cov(Ri,Rm) /
?2(Rm) systematic risk
61
Arbitrage Pricing Model

• The APM is similar to the CAPM with regard to
  classifying risk as either diversifiable or
  non-diversifiable.
• The APM does not require investors to be
  concerned only with market risk.
• The APM allows consideration of any number of
  factors to influence the risk of an investment.

62
Arbitrage Pricing Model (cont.)
Ri ai bijIj ei
R realized rate of return a intercept b sens
itivity of return to index I value of
index e error term i asset indicator j facto
r indicator
63
An Alternative Hurdle Rate Approach

• CAPM ignores existing portfolio when
  contemplating price / capital needed to support
  one more risk
• Add a factor to the CAPM
• Reflects correlation of new risk with existing
  portfolio
• Incremental capital to maintain existing target
  probability of ruin

Froot and Stein, A New Approach to Capital
Budgeting for Financial Institutions,
Journal of Applied Corporate Finance, Summer
1998. Also, Froot, A Fundamental Framework
for Managing Capital Risk, in Managing
Capital and Expectations Through Effective Risk
Management, Guy Carpenter
64
CapitalManagementforProperty /
CasualtyInsurance
65
Interesting Relevant Articles

• The insurers capital challenge
• Capital Punishment, Economist, 1/16/99
• Alternatives to capital
• An Earthquake in Insurance, Economist, 2/26/98
• New risks ? new capital needs
• The New Financiers, Economist, 9/2/99
• An opportunity for actuaries
• Capital Cushion Fight, Economist, 6/7/01
• Problems for insurers
• Poor Cover for a Rainy Day, Economist, 3/6/03

66
Canadian Regulation

• Dynamic Capital Adequacy Testing (DCAT)
• (DCAT) is the process of analyzing and
  projecting the trends of a companys capital
  position given its current circumstances, its
  recent past, and its intended business plan under
  a variety of future scenarios. The DCAT process
  is to include the running of a base scenario and
  several adverse scenarios
• -- Canadian Institute of Actuaries, Dynamic
• Capital Adequacy Testing Life and
• Property and Casualty

67
Canadian Regulation (cont.)

• (One possible approach would consist of)
  stress-testing of the risk category in
  question Stress-testing means a determination
  of just how far the risk factor in question has
  to be changed in order to drive the companys
  surplus negative during the forecast period, and
  then evaluating if that degree of change is
  plausible or not. When stochastic models with
  reasonable predictability are available, an
  adverse scenario would be considered plausible if
  all remaining probability in the tail beyond this
  scenario is in the range of 1 to 5.
• -- Ibid

68
Canadian Regulation (cont.)

• the concept of capital adequacy envisioned by
  DCAT extends beyond the balance sheet at a
  specific date to the continued vitality of the
  organization The principal goal of this
  process is to help prevent insolvency by arming
  the company with the best information on the
  course of events that may lead to capital
  depletion, and the relative effectiveness of
  alternative corrective actions.
• -- Canadian Institute of Actuaries, ibid.

69
Capital Management for Insurers Issues

• Determine the economic (required) capital
• Make adjustments to actual capital position, if
  necessary
• Allocate capital
• Measure performance relative to capital
• Deploy capital most efficiently

70
Strategies for Managing Capital

• If capital is inadequate (i.e., actual lt
  economic)
• Raise new capital
• Internal retained earnings realizing capital
  gains
• External equity debt surplus notes
• Reduce risk level of firm
• Reduce exposures
• Reinsurance
• Strengthen underwriting standards
• Reduce financial risks

71
Strategies for Managing Capital (cont.)

• If there is excess capital (i.e., actual gt econ.)
• Payout to shareholders
• Increase dividends
• Repurchase shares
• Greater capital investment activity
• New lines or areas of insurance
• Acquisitions
• Increase risk level of firm

72
Other Issues in Capital Mgt.

• Controlling expenses
• Uncovering hidden capital
• Managing dividends
• Managing reinsurance
• Managing asset allocation, buying, and selling

73
Applying RAROC

• RAROC Risk-adjusted return on capital
• Emerged from the banking industry
• Reflects expected return on economic capital
• Applied to insurance
• Aggregate (accounting for correlations) risk
  measures and economic capital across all risks
• Reattribute economic capital back to sources of
  risk
• Measure capital productivity and performance

Nakada, Shah, Koyuoglu, and Collignon, PC
RAROC A Catalyst for Improved Capital
Management in the Property and Casualty Insurance
Industry, Journal of Risk Finance, Fall 1998
74
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