March 16th, 2009

Capital Management: A Renewed Priority

Posted at 1:00 AM ET

Gary Venter, Managing Director, Instrat®

The continuing meltdown in global financial markets has underscored the importance of prudent capital management. As the financial catastrophe is still unfolding, its full implications remain ambiguous. But, in the near term, the situation is forcing insurers and reinsurers to take a second look at how they are capitalized-and how fresh capital would be sourced in a post-loss environment.

Capital, doubtless, is what keeps our industry moving. It enables the assumption of risk … and the generation of revenue. At its most fundamental, though, capital translates to the ability to absorb losses. In the event of a claim, cash ensures that contractual obligations can be met. The challenge, of course, comes from determining just how much is enough. Thin capitalization imperils a carrier’s ability to pay, and over-capitalization drags down return on equity (ROE). If a carrier has cash on hand, it should be made as productive as possible. Thus, an insurer’s or reinsurer’s target capitalization is intended to provide enough capital to meet expected losses without sacrificing productivity (and returns).

Ultimately, a carrier’s goal is to have sufficient capital on hand not only to cover expected losses but to fuel steady earnings growth and reach target ROE levels. The risk measures, regulatory requirements, and other rules regarding capital levels really exist to ensure that claims can be paid, and insurers and reinsurers extend these tools to help them reach profit objectives. In the event of a routine loss or a market-changing shock, customers, regulators, and carriers just want to be confident that obligations will be met. And, regardless of market conditions, shareholders want to know that the management team is making the decisions most likely to push the stock price higher.

Over the next five days, we’ll take a look at the basic issues surrounding capital management - from sourcing to deployment strategies and metrics. While market conditions shape the daily decisions of risk-bearers, some principles can be applied regardless of risk-transfer pricing, the rate of investment return, and the immediate cost of capital. Applying these general thoughts to the decisions to be made at present can make a company’s capital more productive.

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