March 17th, 2009

Capital Management: Zero in: Target Capitalization

Posted at 1:00 AM ET

Gary Venter, Managing Director, Instrat®

Capitalization means choice, and freedom can be a burden. In selecting the sources from which to acquire capital - and in what proportions - insurers and reinsurers implicitly shape many future decisions. Each type of capital comes with specific advantages and disadvantages, and quirks that can influence a carrier’s strategy. Thus, determining a target capitalization that balances cost, flexibility, and growth potential should be a principal concern for insurance and reinsurance management teams.

Carriers tend to diversify capital sources. In this effort, four major types of capital are typically evaluated:

  • Equity issuances (public and private)
  • Debt issuances (public and private)
  • Retained earnings
  • Reinsurance

In establishing their target capitalizations, insurers and reinsurers are forced to balance the costs and limitations of a particular type of capital against its advantages.

Most insurers and reinsurers prefer equity capital. This source of long-term capital is permanent (i.e., it does not have to be repaid, as debt capital does), and as an asset, it corresponds to a shareholders equity entry on the balance sheet-not a liability. This advantage is not cheap. Public and private equity issuances are usually the most expensive ways to raise capital. Further, the cost of equity capital tends to be highest when you need it most.

Debt issuances are less expensive than equity … but for good reason. Because returns are less uncertain, investors do not expect the profits from debt securities that they do from equities, and they have their principal returned after a fixed period of time-capital is merely rented out to insurers and reinsurers. Thus, this form of capital is transient. The asset entry from the capital infusion has a corresponding liability. Leverage and financial risk are increased … but return on equity (ROE) is, too. Debt can make a smaller amount of equity more productive, but it requires a tradeoff.

In the current economic climate, debt capital is not as easy to acquire as it was in the past. The ongoing financial crisis began in credit markets, which is where the effects continue to be most pronounced.

Retained earnings, unlike equity and debt, have been “acquired” already. This form of capital tends to be less expensive than outside sources, but its availability depends on firm profitability and shareholder expectations of dividends and buybacks. Decisions pertaining to the use of retained earnings usually involve availability rather than cost. While retained earnings may seem like the optimal form of capital for insurers and reinsurers, remember that:

  • Profits may not be predictable, making third-party capital easier to acquire consistently
  • The use of retained earnings may erode surplus
  • There must be sufficient retained earnings available to satisfy the firm’s investment need

There should always be a place for retained earnings in a firm’s target capitalization, but it should be determined carefully.

Often overlooked as a form of capital, reinsurance can be particularly effective. The price of this form of capital does vary; perils, ratings, and risk profiles can influence the cost of reinsurance capital for a particular insurer or reinsurer. The overwhelming advantage of this type of capital, though, is that the terms and forms available are quite flexible. Carriers can get almost exactly what they need quickly and easily. This is especially true when the insurer is hit by a big loss that the reinsurance pays but would otherwise impair capital, further increasing the costs of raising new capital and even the incentives to do so.

More than just another form of capital, reinsurance can make capital from other sources more productive. For example, securing protection via reinsurance can protect earnings, ensuring the availability of retained earnings to fund growth, reducing the chance of having to raise costly new outside capital and ultimately increasing firm value.

When juggling these different forms of capital, each of which has a place on a carrier’s balance sheet, the overall objective should be to maintain a sensible distribution of sources. The exact mix will vary from one firm to the next, but should maximize the productivity of equity, use debt judiciously, and rely on retained earnings only as appropriate. Reinsurance capital should be engaged to manage volatility and secure some predictability.

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