March 19th, 2009

Capital Management: Strength in Numbers

Posted at 1:00 AM ET

Gary Venter, Managing Director, Instrat®

A strong capital position provides access to a plethora of strategic alternatives. It attracts prospective insureds, bolsters ratings, and enables the pursuit of new initiatives. What many insurers and reinsurers may not realize, however, is that the “strength in numbers” associated with a strong capital position is self-reinforcing. Healthy coffers attract insureds … with the implication being a stronger capital position, which attracts more insureds. Investments in growth opportunities (presuming success) follow the same dynamic. Successful initiatives increase a carrier’s capital, enabling greater growth. Thus, fine-tuning capital management practices can lead directly to returns.

Policyholders generally prefer well-capitalized insurers. Remember: the insured’s chief concern is that a carrier will be able to honor claims. This perceived ability will attract premium dollars, and assuming prudent underwriting, new premium dollars translate to profits. Capital, essentially, leads to more capital, as a strong capital position increases prospective and current policyholder comfort.

  1. A strong capital position resonates with prospective insureds
  2. Carrier writes new or more business based on the strength of its capital position
  3. This leads to an increase in premium dollars and (assuming prudent underwriting practices) an increase in earnings
  4. Through retained earnings -and easier access to less expensive capital in general - the company’s capital position becomes even stronger

A strong capital position itself fuels growth, as we’ve just seen, but it also enables growth by other means. The increase in retained earnings - as well as a generally lower cost of capital for debt, equity, and reinsurance - can be committed to the development of new lines of business, operational efficiency initiatives, and other measure that add to the top line and expand margins.

In addition to reinforcing the strong capital position of the insurer or reinsurer, the investments in growth (made from a strong capital position) by a firm that is well-capitalized will likely increase the value of the firm. Capital availability can affect a firm’s performance directly.

Academic research reviewed by Guy Carpenter suggests that:

  • Insureds demand price discounts of 10X to 20X the expected cost of an insurer’s default
  • A 1 percent decrease in capital results in a 1 percent pricing loss
  • A 1 percent increase in the standard deviation of a carrier’s earnings leads to a 0.33 percent decrease in pricing
  • A rating upgrade translates to business growth of 3 percent
  • A rating downgrade, on the other hand, can cause a loss of business ranging from 5 percent to 20 percent

Reinsurance is an important component of financial strength. Perhaps its most important advantage, however, is the ability to accelerate post-loss recovery. Not only will the insurer or reinsurer be able to absorb the loss, it will have an easier time replenishing its balance sheet … and at a lower cost. The rapid replenishment of balance sheets after a mega-catastrophe can result in a salient competitive advantage. While the competition is scrambling for cash and negotiating terms, the recapitalized firm can return its attention to the marketplace-and new client acquisition. Market share increases, and the insurer or reinsurer enters a self-reinforcing growth loop.

This is not to say that there is no limit on how much capital an insurer should hold. There are costs associated with using an insurance company as a place to park capital, such as taxes on profits that may not accrue with other investment vehicles. Thorough capital analysis must include the recognition of strong capital on growth and profit levels, but this has to be balanced with the reflection of the costs of over-capitalization as well.

Sourcing capital is only part of an insurer’s or reinsurer’s capital management effort. Determining how much capital to amass and the best ways to deploy it set the strategic tone for a firm. Quite simply, it’s the gift that keeps on giving.

Previous articles in this series:

A Renewed Priority >>

Zero in: Target Capitalization >>

Quantify Capital Risks >>

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