March 20th, 2009

Capital Management: Concluding Thoughts

Posted at 1:00 AM ET

Gary Venter, Managing Director, Instrat®

Balance is among the fundamental ingredients of financial strength. Outside capital, retained earnings, and reinsurance all contribute to a firm’s ability to absorb losses, each in a unique way. At times, these sources may be interchangeable - market conditions may make reinsurance more attractive than raising equity capital, for example. But, no single source universally excludes - or is necessarily preferable to - the others. Success comes from finding the right combination for a particular firm given prevailing market conditions. Some answers are better than others, and “optimal” changes almost constantly.

Finding and keeping pace with optimal capitalization translates to a clear market advantage. But, this requires a salient, ongoing commitment. Capital managers need to evaluate conditions continually, measure alternatives, and take informed action. The return on this form of investment of time and effort comes in the form of a lower weighted average cost of capital (WACC), increased flexibility, and ultimately firm value growth.

Capital, in our industry, is inextricably linked to risk. Capital absorbs losses and generates returns. It is the commodity that carriers seek - and for which they pay. The ability to manage capital effectively translates directly to greater market opportunities, market share capture, and larger returns for shareholders. Thus, the understanding of risk, and how it relates to capital, underlies the benefits of using financial resources judiciously.

The potential for returns, of course, implies that some decisions can result in losses. The market’s reaction to the weakening of an insurer’s or reinsurer’s financial state can be swift and severe. Financial strength equates to a firm’s ability to pay claims, and once this is impaired, a domino effect results, leading to rating downgrades, a higher cost of capital, and (in the extreme) threats to solvency. The ride down is easy to affect; recovery is substantially more difficult.

Attaining a position of financial strength does more than widen margins, demonstrate claims-paying ability, and bolster ratings. It opens an array of strategic alternatives - from investments in new initiatives and ventures to acquisitions-that weaker firms simply do not have the means to consider. Consequently, insurers and reinsurers that manage capital effectively have market - leading positions that also support continued growth, expanding the gap that separates the frontrunners from the middle of the pack. Finding and managing an optimal capitalization does yield returns.

Previous articles in this series:

A Renewed Priority >>

Zero in: Target Capitalization >>

Quantify Capital Risks >>

Strength in Numbers >>

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