September 9th, 2008

Let ERM Decide When Capital Is Excessive

Posted at 6:26 PM ET

Joan Lamm-Tennant, Global Chief Economist and Risk Strategist

Excess capital is only excessive until you need it. Throughout the year, carriers have struggled to find uses for capital that has not seemed necessary, given the benign loss years that followed the 2005 storm season. Rates are down, retentions are up, and repatriation has been continual. Market conditions have overshadowed analytics in determining carrier behavior. But, aggressive repatriation may have been hasty. Looking to the future, buyback and dividend decisions could benefit from Enterprise Risk Management (ERM).

The basic objective of ERM is straightforward: determine how much capital you need to support the risk on your books (subject to risk tolerance). Quite simply, carriers can use information to take action. Around this concept, ERM offers a framework for identifying opportunities, developing a plan for execution, and measuring the results. Ultimately, there is little magic. Instead, ERM is steeped in traditional business discipline and rigorous capital management techniques.

To date, ERM has been an expense. Carriers have spent heavily on frameworks to identify integrated risks in their portfolios, but they have been less rigorous in applying the results. Consequently, ERM has largely been an investment with no return. There has been no shortage of opportunities to realize the benefits … only a lack of execution. Fortunately, (re)insurers can still turn their ERM expenses into investments, and the easiest application involves the repatriation of capital.

Share buybacks and dividend payments have become increasingly common. By the end of 2007, carriers sent USD2.3 billion back to investors—and that was only from Bermuda! When faced with the challenge of what to do with seemingly excess capital, the natural response has been to return it.

But, what if this excess capital wasn’t excessive?

The last major repatriation occurred in 2005. (Re)insurers were awash in capital that they believed would not be needed. Those in Bermuda, for example, sent nearly USD2.3 billion back to shareholders. Only a few months later, Hurricanes Katrina, Rita, and Wilma struck the Gulf Coast—and carrier balance sheets—with unexpected intensity. Risk-bearers scrambled to refill their coffers. While capital was readily available in 2005, a concern given the state of the financial markets and constraints on liquidity, (re)insurers may have a different experience re-tooling their balance sheet following the next event. Cautious planning would have led to more effective capital management. Retrospectively, the role that ERM could have played is evident.

In the years that followed the 2005 storms, (re)insurers have explored—and invested in—ERM. Frameworks have been adopted, and lessons ostensibly have been learned. Yet, we seem to be reliving 2005. Capital abounds, and repatriation has become the norm. Despite the effort and expense, though, these analytics-based capital management techniques are not being allowed to realize their potential, and carriers are being deprived of ROI.

While (re)insurers have been slow to put their ERM investments to work, rating agency analysts are seeing the possibilities, particularly in regard to the repatriation of capital. Historically, they assumed that carriers would pay dividends or repurchase shares only if they had the capital available to do so. Now, they have become a bit more skeptical. Analysts want to see that capital is excessive before deeming repatriation prudent. In addition to the business imperative for using ERM capabilities, there is now a rating agency implication as well.

So, there are several important reasons to use ERM. Rating agencies are looking for decision justifications, an expense has been made without generating a return and there are direct business benefits from using analytics effectively. Instead of simply reacting to prevailing market conditions, carriers have the opportunity to shape their actions using detailed, reliable, and available information.

The ultimate outcome of an ERM effort should be informed action. For many (re)insurers, the tools are already in place, waiting to be used. But, reactions to market conditions have been permitted to trump the capital management discipline that ERM affords. Future decisions to repatriate, should include ERM considerations. What looks like unproductive capital today may accelerate recovery tomorrow.

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