October 26th, 2010

Excess Capital Strategies

Posted at 1:00 AM ET

keeling_henry_141x141Henry Keeling, President and CEO of International Operations

The (re)insurance industry is once again facing a familiar challenge: what to do with excess capital? The stretches between major catastrophe events tend to be characterized by robust balance sheets, increased retentions and the ability to absorb risk. Periodically, a loss event occurs, and balance sheet rehabilitation begins. So, despite the occasional shock loss, excess capital is not excessive - rather, it’s the norm. And yet not all carriers have developed effective strategies for making this capital productive.

Solve this problem, and you have the opportunity to attain return on equity (ROE) targets without lowering your base, and to attain outsized growth and capture market share. These outcomes may be achieved through investments in innovation.

What often are called “excess levels of capital” actually represent the normal state of the (re)insurance industry. Typically, capital is abundant, and prior year reserve development and catastrophe activity is within expectations. Advances in risk and capital management have mitigated the impact of large, unexpected insured losses, as evident from the effects of mega-catastrophes over the past 20 years. From Hurricane Andrew, through the 2005 Gulf of Mexico hurricanes, up to the 2008 financial crisis - which hit at the same time as Hurricane Ike - reinsurance rate increases after the loss events decreased in size, suggesting that carriers were able to handle losses more effectively.

Despite the effectiveness of improved risk and capital management practices, times of plenty have been notoriously difficult to exploit. High capital levels often create unfulfilled opportunities for return, leaving (re)insurers to accept lower ROEs, write business that may not be profitable or simply return capital to shareholders - with the last often the preferred approach. The result is accepting that a certain amount of available capital will not be used to generate returns, leading to missed opportunities to fuel profitable growth, capture market share and exploit new, emerging business opportunities.

A solution is needed to fix this situation: one in which capital can be put to work to generate returns. Meanwhile, it seems as though capital on hand is not unrelated to the tools and practices that lead to improved risk management. This is not coincidental, and the reasons underlying it can help solve the excess capital problem, too. The missing component is innovation.

Innovation has led to better catastrophe and capital modeling, improved carrier operations and the development of new solutions that provide access to markets that otherwise would have been closed. Investing in the tools, practices and markets that could redefine growth, and the industry as a whole, will determine the next wave of market leaders in the (re)insurance industry.

Analytics and modeling, new product development and refined forecasting techniques can provide an enduring advantage, something that is difficult to secure in a mature, competitive marketplace. But they require a strategy, investment and commitment to implementation. Look to the future, and identify the opportunities that are at best in their infancy, and you will have a leading edge that the rest of the market will spend years chasing. Innovation today is synonymous with outperformance tomorrow.

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