Sean Mooney, Chief Economist
Despite the ambiguity pervading financial and reinsurance markets, it is clear that systemic risk has increased. Unprecedented chaos in financial markets left investors more risk-averse than they were at the end of the summer. They are demanding greater returns on the capital they put at risk. A closer look at the economic conditions underlying the marketplace, however, suggests that an increase of 1 percent to 3 percent is warranted for catastrophe covers, which should result in a minor impact at the January 1, 2009 renewal. Other factors, including the impact of the global recession on premiums and claims, the collapse in equity values, a rising distrust of modeled results arising out of Hurricane Ike, increased demand by cedents seeking to preserve their diminished capital, and diminished supply of reinsurance capacity, are likely to have a much greater impact on rates.
Increase in Systemic Risk from the Global Credit Crisis
For most financial firms, the world became a riskier place in the middle of September, as the global credit crisis grew into a full financial catastrophe. Credit markets became even more difficult to navigate than they had been over the previous 18 months, and the contagion spread to equities, leaving no corner of the global financial market untouched.
Managing the Cost of Capital
Capital is normally broken down into two main elements: debt and equity. A company’s overall cost of capital is then calculated as a weighted average of the costs of capital from each of these two sources.
Focusing first on debt, we need to review the increase in risk spreads that occurred for debt instruments following the events of September 15, 2008. To control for variation from different maturities, an internal study by Guy Carpenter focused on ten year maturities. Two factors influenced this choice. First, very short-term instruments are heavily influenced by monetary policy and risk spreads reflect this influence. At the other end of the scale, several factors can influence securities with much longer maturities, including projections of long-term inflation and economic growth. Consequently, they may not provide clear signals on the size of the expansion in risk premium.
The spreads of 10-year corporate bonds relative to U.S. Treasury bonds with the same maturities suggest that the increase in the risk premium following September 15, 2008, was around 100 basis points (bps), within a range of 50 bps to 150 bps. The difference between corporate and U.S. Treasury bond yields may reflect other factors, not just a change in the risk premium. For example, sales by a foreign government of U.S. Treasury securities could cause their yields to increase-with little impact on corporate bonds. However, it appears clear from the data that the dominant factor behind the widening risk premium was the perceived increase in systemic risk.
Turning to the equity cost of capital, given the collapse in equity prices in 2008, it would be tempting to extrapolate an increased cost of equity capital from an increase in the Earning/ Price (E/P) ratio (i.e., the inverse of the Price/Earnings ratio). However, this year’s 40 percent decrease in equity values suggests a significant jump in equity risk premiums, putting the result at odds with changes in the bond market. Most likely, the E/P ratio’s rise represents to a combination of overvaluation at the start of 2008 and undervaluation following September 15, 2008.
The Capital Asset Pricing Model (CAPM) offers a more realistic sense of the increased equity risk premiums at present.
E(r) = Risk free rate + β [E(rm) – Risk free rate]
- E(r) is the expected return on an asset
- Risk free rate is the return from an asset with no risk, typically a government bond
- β is the coefficient for correlation between the market risk and the asset
- E(rm) is the Expected Return on the market portfolio.
We make the assumption that the only variable that changes in the formula as a result of increased systemic risk is E(rm). Next, we assume that the change in this variable is about equal to the change in the risk premium for bonds, because the many of the increased risks facing a corporate bond holder, such as widespread corporate defaults, are similar in nature to those facing an investor holding the market portfolio of equities.
Following Cummins and Philips, we use a β of 0.8. Given the change in the E(rm) of 100 basis points, the increased cost of equity capital would be 80 basis points. If we confine the analysis to reinsurers, we can us β for the S&P 400 Reinsurance Index, which is 1.05. This refinement has no material impact on the results.
Ultimately, this approach results in a projection of an increase in the risk premium for equities of 80 basis points.
Some reinsurers argue that they have an increased cost of capital because, given the ongoing financial catastrophe, they risk not being able to recapitalize following a meg-catastrophe. This is a serious concern, particularly with the general upward shift in systemic risk. It is likely to lose its force, though, once credit markets begin to thaw.
Implied Increase in Reinsurance Cost
Given that reinsurers may encounter an increased cost of capital of about 100 basis points, the final question is how much extra premium needs to be charged to cover this additional cost.
Guy Carpenter’s databases allow for an in-depth review of reinsurance programs in terms of Rate on Line (ROL), limit size and probability distribution of loss data, ultimately generating an implied return on equity (ROE) for each program. For the purpose of this exercise, we reversed the process. We started by increasing the implied rate of return by 100 basis points, and then calculated the increase in the premium that would be needed to cover this added capital cost. On a pre-tax basis, we found that the projected increased cost of capital would lead to a 1.5 percent increase in reinsurance premiums. Post-tax, at the U.S. tax rate of 35 percent, the increase would be about 2 percent.
A reinsurer has a combined ratio of 95 percent. Premiums are USD100 million, and loss and expenses total USD95 million. If we assume a Premium/Surplus ratio of 1:1, then surplus is USD100 million, and the ROE is 5 percent. If the cost of capital goes up a full percentage point, the reinsurer needs to attain an ROE of 6 percent. It can achieve this by increasing premiums to USD101 million. Hence, an increase of 1 percent in premiums will result in a 20 percent increase in the rate of return-from 5 percent to 6 percent.
While reinsurers will want to base their pricing on their cost of capital, they are under no mandate to price in the short term at rates that reach this threshold. If current pricing is well above their cost of capital, they will not need to raise rates.
Finally, it should be noted that this analysis is restricted to the systemic increase in risk arising from the credit crisis of 2008. Other factors likely to influence renewal rates at January 1, 2009 include the impact of the global recession on premiums and claims, the demand/supply imbalance between cedents and reinsurers, increased property catastrophe losses, cost pressures on cedents, an increased distrust of modeled results arising out of Hurricane Ike, and the collapse in global equity values.
Estimating the Cost of Equity Capital for Property-Liability Insurers,” The Journal of Risk and Insurance 2005, Volume 73, No. 3.
- Christopher Klein, Managing Director and Global Head of Business Intelligence