An Overview of
Capital Management
for Property/Casualty Insurers
Rick Gorvett, FCAS, MAAA, ARM, FRM, Ph.D.
Actuarial Science Program
University of Illinois at Urbana-Champaign
Casualty Actuarial Society
Washington, DC
July, 2003
Agenda
• “Capital management” and its inclusiveness
• Putting capital management in a financial
services industry context: a look at the
banking world
• The financial theory underlying capital
management
• Discussion of cost of capital
• Capital management for property / casualty
insurance
“Capital
Management”
and its
Inclusiveness
What is Meant by “Capital” and
“Capital Management”
• “Capital” (and surplus)
–
–
–
–
Assets less liabilities
Owners’ equity
Support for (riskiness of) operations
Thus, supports profitability and solvency of firm
• “Capital Management”
– Determine need for and adequacy of capital
– Plans for increasing or releasing capital
– Strategy for efficient use of capital
Types and Measures of Capital
• Statutory
• GAAP
Actual
– Inherently conservative; solvency perspective
– Going concern; income statement orientation
• Risk-based capital
• Economic
– Required capital in order to achieve a
specified solvency standard
Theoretical
– Required capital based on risk attributes and
promulgated charges
Why Do We Care About
Managing Capital?
• Leads to solvency and profitability
• Benefits of solidity and profitability
–
–
–
–
–
–
–
Higher company value
Happy claimholders (policyholders, stockholders,...)
Better ratings
Less unfavorable regulatory treatment
Ability to price products competitively
Customer loyalty
Potentially lower costs
The Problem With Capital
• A certain amount of capital is needed in order to
promote solvency
– Thus, need to be able to raise capital
• But.... If there is too much capital, profitability
(as measured by return on equity) will suffer
– Thus, need to be able to efficiently deploy capital
What Does Capital
Management Entail?
Raising
Capital
Setting
Objectives
Product
Pricing
Capital
Structure
Capital
Management
Asset
Allocation
Financial
Risk Mgt.
Strategic
Planning
Liability
Valuation
Putting
Capital Management
in a
Financial Services Industry
Context:
A Look at the Banking World
Banks: How They Improved
Article: “Renaissance Men,” Economist, 4/15/99
• Banks had tough times in the late 1980s and early
1990s
• Afterward, began taking risk into account more
formally and effectively
• Considered risk-adjusted returns
• They’re still worried about Basle, though....
From the Fed: Bank Capital
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 99-18 (SUP)
July 1, 1999
SUBJECT:Assessing Capital Adequacy in
Relation to Risk at Large Banking
Organizations and Others with Complex Risk
Profiles
From the Fed: Bank Capital (cont.)
“....increasing emphasis on banking organizations' internal
processes for assessing risks and for ensuring that capital,
liquidity, and other financial resources are adequate in
relation to the organizations' overall risk profiles.”
“....one of the most challenging issues faced by bankers and
supervisors is how to integrate the assessment of an
institution's capital adequacy with a comprehensive view
of the risks it faces. Simple ratios - including risk-based
capital ratios - and traditional rules of thumb no longer
suffice in assessing the overall capital adequacy of many
banking organizations, especially large institutions and
others with complex risk profiles such as those
significantly engaged in securitizations or other complex
transfers of risk.”
(continued)
From the Fed: Bank Capital (cont.)
“....this letter directs supervisors and examiners to evaluate
internal capital management processes to judge whether
they meaningfully tie the identification, monitoring, and
evaluation of risk to the determination of the institution's
capital needs.”
“....this letter describes the fundamental elements of a sound
internal capital adequacy analysis - identifying and
measuring all material risks, relating capital to the level of
risk, stating explicit capital adequacy goals with respect to
risk, and assessing conformity to the institution's stated
objectives - as well as the key areas of risk to be
encompassed by such analysis.”
(continued)
From the Fed: Bank Capital (cont.)
“Current industry practice: Most institutions consider
several factors in evaluating their overall capital adequacy:
a comparison of their own capital ratios with regulatory
standards and with those of industry peers; consideration
of identified risk concentrations in credit and other
activities; their current and desired credit agency ratings, if
applicable; and their own historical experiences including
severe adverse events in the institution's past. Some more
sophisticated banks also use risk modeling techniques and
scenario analyses to evaluate risk, but generally have not
yet incorporated such analyses formally into their overall
assessment of capital adequacy.”
(continued)
From the Fed: Bank Capital (cont.)
Fundamental Elements of a Sound Internal Capital Adequacy
Analysis
1) Identifying and measuring all material risks
2) Relating capital to the level of risk
3) Stating explicit capital adequacy goals with respect to risk
4) Assessing conformity to the institution's stated objectives
Composition of Capital
“....it has been the Board's long-standing view that common
equity (that is, common stock and surplus and retained
earnings) should be the dominant component of a
banking organization's capital structure and that
organizations should avoid undue reliance on
noncommon equity capital elements.”
Basle I
• 1988 Basle Accord
• By 1992, banks had to have a capital ratio of
8%
• Capital ratio = {amount of available capital} /
{risk-weighted assets}
• “Risk-weighted assets”
– Only explicitly identifies two types of risks:
(1) credit risk; (2) market risk
– Other risks presumed to be covered implicitly
Basle II
• Ongoing; have issued third Consultative
Document (comments due by 7/31/03)
• New Accord includes three “pillars”: (1) minimum
capital requirements; (2) supervisory review of
capital adequacy; (3) public disclosure
• Pillar 1: proposals to modify definition of riskweighted assets
– Changes to treatment of credit risk
– Explicit treatment of operational risk
The
Financial
Theory
Underlying
Capital
Management
Steps in the Financial Risk
Management (FRM) Process
•
•
•
•
•
•
•
Determine the corporation’s objectives
Identify the risk exposure (e.g., FX risk)
Quantify the exposure (e.g., measure volatility)
Assess the impact (DFA)
Examine financial risk management tools
Select appropriate risk management approach
Implement and monitor program
Finance Theory and
Capital Management
• Why bother to worry about financing or FRM
(or any risk management), in light of the capital
structure irrelevance proposition?
• Modigliani-Miller (1958): if financing does
matter, it must be because of one or more of:
– Tax effects – convex tax function
– Financial distress / bankruptcy costs
– Effects on future investment decisions
Likelihood
Impact of Financial Risk Management
on Cash Flow Volatility
Post-FRM
Pre-FRM
Cash Flow
Derivatives Use Among Insurers
• Activity during 1994
– Cummins, Phillips, Smith (1997)
– 142 P/C insurers (7%) used derivatives in 1994
– Larger companies more likely to use derivatives
than smaller companies
– Most often used contracts for P/C insurers:
• Foreign currency forwards
• Equity options
– Other (FX) activity in 1994 in:
• Foreign currency swaps
• Foreign currency futures
• Foreign currency options
Derivatives Use Among Insurers (cont.)
• Anecdotal evidence from SEC 10-K filings
– Specific mentions re: FX risk include:
• Currency swaps
• Foreign currency forwards
• Asset-liability management
• Sensitivity analysis with respect to
hypothetical changes in exchange rates
• Investments in foreign currencies
• Cash flows from foreign operations, to fund
investments in foreign currencies
Capital Structure - Theory
•
•
•
•
To finance ops., firm can issue debt or equity
“Capital Structure”: firm’s mix of securities
Does this mix selection affect firm value?
Miller & Modigliani said “No” (in perfect
capital markets)
– Firm value is determined by its real assets – value is
independent of capital structure
– Capital structure irrelevant (for fixed investment
decisions, no taxes, no costs of financial distress)
– Allows separation of investment and financing
decisions
Capital Structure - Reality
• Modigliani-Miller Proposition: capital
structure decision is irrelevant to firm value,
under certain “friction-free” assumptions (e.g.,
no taxes)
• But: in reality, there are taxes
• There are also costs associated with financial
distress
Interest Tax Shield
• Tax-deductibility of interest may make some
debt in the capital structure attractive
• Discount the interest tax shield by the rate
demanded by investors holding the debt
• PV (tax shield) = t (rd D) / rd = t D
(assumes debt in perpetuity)
• Value of firm increases by PV (tax shield):
Value of firm = value if all equity-financed
+ PV (tax shield)
Costs of Financial Distress
• However....
• Increasing debt  increasing risk and
increasing likelihood of distress, which has
costs associated with it – e.g.,
– Costs of shareholder – bondholder conflicts
– Costs of potential bankruptcy
– Costs associated with inability to operate optimally
/ efficiently
– Costs associated with bond provisions /
compliance
Sample Debt / Equity Tradeoff
Chart
Firm
Value
PV(costs fin. distress)
PV(tax shield)
Debt / Equity
Ratio
Other Capital Structure Issues
• More on debtholder–shareholder conflicts
– Projects / investments: more risky versus less
risky
– High versus low dividend payouts
– Pack-it-in versus keep-hanging-on
• Financing “pecking order” theory
– Order of preference: (1) internal financing; (2)
issue debt; (3) issue equity
– More profitable / cash flow  don’t need external
– External can send adverse signals
Issuing Securities
• Initial public offerings
– Engage an underwriter(s)
– File SEC registration statement
– Prospectus (“red herring”)
• General cash offers
– Similar steps to those for IPO above
– SEC Rule 415: shelf registration
– Announcement of equity issue: empirically,
small decline in stock price
• Signal to investors
• Puzzle re: long-run underperformance
Issuing Securities (cont.)
• Private placements
– Significant on debt side
– Less costly; flexible
– Counterparty concerns; less liquid
• Costs of security issuance
– Accounting and legal
– Underwriting
• Spread
• Possibility of underpricing securities
Dividends
• Declared by board of directors
• Once declared, an obligation
• Modigliani & Miller: dividend policy is
irrelevant in a world without taxes,
transaction costs, etc.
Types of Dividends
•
•
•
•
Regular cash divs.: expect to maintain
Extra dividend: may not be repeated
Special dividend: unlikely to be repeated
Liquidating dividend:
– When going out of business
– Distribution of assets (“return of capital”)
• Stock dividend: shares of company or
subsidiary
– For company: conserves cash
– For investor: not taxed until sold
Limits on Dividends
• By bondholders
– Covenants prevent the distribution of the firm’s assets
as dividends to stockholders
– Company can’t issue a liquidating dividend if funds
are needed for protection of creditors
• By state law
– Prohibits paying dividend that would make the
company insolvent
– Prohibits paying dividends out of legal capital
Dividend Viewpoints
• Tax effects  low dividend preferable
• Investor preferences  high dividend payouts
• Somewhere in-between are those who subscribe
to the original MM proposition that dividend
policy is irrelevant
Share Repurchase
• Alternative to paying cash dividends
• Often used when
– Company has accumulated lots of cash
– Wants to replace equity with debt
• Methods of repurchase
– Open market
– General tender offer to all or small shareholders
– Direct negotiations with major shareholder
• Repurchased shares seldom de-registered and
canceled
Liquidity Ratios
•
•
•
•
•
•
Indicators of riskiness, financial strength
Short-term “cashability”
More reliable values for liquid assets
Short-term  can become out of date
Possibly seasonal
Ratios:
– Current ratio = current assets / current liabilities
– Quick ratio = (cash + marketable securities +
receivables) / current liabilities
– Cash ratio = (cash + marketable securities) /
current liabilities
Leverage Ratios
• Measures of financial leverage (capital
structure)
• Ratios (other definitions are possible):
– Leverage Ratio = assets / equity
= 1+ (debt/equity)
– Debt ratio = long-term debt /
(long-term debt + equity)
(Here, long-term debt includes value of leases)
– Times interest earned = EBIT / interest expense
(Numerator sometimes includes depreciation)
Market Value Ratios
• Combine accounting (book) and stock
(market) data
• Ratios:
– Price-earnings ratio = stock price / EPS
– Earnings yield = EPS / stock price = 1 / (P/E)
– Market-to-book ratio = stock price /
book value per share
– Dividend yield = dividend per share / stock price
– Tobin’s q = MV of firm / replacement cost
Profitability Ratios
• Measures of profitability and efficiency
• Ratios:
– Sales to total assets (or asset turnover) =
sales / average total assets
– Profit margin = EBIT / sales
– Average collection period =
[(average receivables) / sales] x 365
– Also: ROE, ROA, Payout Ratio
(Note: Usually use averages for snapshot figures
when comparing them with flows)
Other Ratios
• Capital ratios
– E.g., capital / liabilities; capital / assets;
capital / {weighted asset formula}
• NAIC IRIS ratios – e.g.,
– Premium / surplus
– Change in premium writings
– Surplus aid to surplus
International Differences
• United States
– Companies widely held
– Rely largely on financial markets
• Germany
– Cross-holdings of companies; layered ownership
– Greater “reliance” on banking system
• Japan
– “Kiretsu”: network of companies, usually
organized around a major bank
– Most financing from within the group
Debtholders vs. Shareholders
Who’s Interested in What?
Probability
Shareholders
Debtholders
Firm Value
Option Values: Payoff Charts
Payoff
• Call -- long position:
ST
X
• Call -- short position:
X
ST
• Put -- long position:
X
• Put -- short position:
X
ST
ST
Payoff and Profit/Loss Profiles
Long a Call Option
Payoff
Profit/Loss
ST
Call
Premium
X
Black-Scholes
Option Pricing Model
Variables required
1. Underlying stock price
2. Exercise price
3. Time to expiration
4. Volatility of stock price
5. Risk-free interest rate
Black-Scholes Formula
VC = S N(d1) - X e-rt N(d2)
where
d1 = [ln(S/X)+(r+0.5s2)t] / st0.5
d2 = d1 - st0.5
where N( ) = cumulative normal distribution,
S = stock price,
X = exercise price,
r = continuously compounded risk-free interest rate,
t = number of periods until exercise date, and
s = std. dev. per period of continuously
compounded rate of return on the stock
Options & Capital Structure
• Both components of capital structure, equity
and debt can be viewed within the option
(contingent claim) framework
• Thus, we can bring powerful valuation tools
from option / contingent claim theory to
bear on questions of capital structure, firm
value, pricing of insurance policies, etc.
Options & Capital Structure (cont.)
• Equity: residual claim on value of the firm
– Contingent value after other claimholders
– If firm defaults, equityholders put the company
onto the debtholders
– This reflects equityholders’ limited liability
Equity
Payoff
L
Firm Asset
Value
Options & Capital Structure (cont.)
• Debt: claim on firm assets takes priority
relative to equity
– Value contingent upon firm asset value
– Bondholders hold the assets and write a call to
the equityholders
Debt
Payoff
L
Firm Asset
Value
Applying the Option Pricing
Model to Insurance*
Use option pricing to determine the value of each
claim on an insurer’s assets
Policyholders’ Claim = H
Government’s Tax Claim = T
Owners’ Claim = V
* Neil Doherty and James Garven, 1986, “Price Regulation in
Property-Liability Insurance: A Contingent Claims Approach,”
Journal of Finance, December
Option Pricing Model
Applied to Insurance
Stockholder
Value
Taxes
0
Liabilities
Beg. Assets
Terminal Asset Value
Value of Various Claims at the
End Of the Period
• Policyholders’ claim
H1 = MAX{MIN[L,Y1],0}
• Government’s tax claim
T1 = MAX{t[i(Y1-Y0)+P-L],0}
• Owners’ claim
Ve = Y1 - H1 - T1
where:
S0
P
Y0
R
k
Y1
=
=
=
=
=
=
=
Initial equity
Premiums (net of expenses)
Initial assets = S0 + P
Investment rate
Funds generating coefficient
Ending assets
S0 + P + (S0 + kP)R
L
t
i
=
=
=
Losses
Tax rate
Portion of investment income that is taxable
Determine The Value Of These Claims
At The Beginning Of The Period
V(Y1)
=
Market value of asset portfolio
C[A;B]
=
Value of call option with exercise price
of B on asset with value of A
E(L)
=
Expected losses
H0
=
V(Y1) - C[Y0;E(L)]
T0
=
tC[i(Y1 - Y0) + P0;E(L)]
Ve
=
V(Y1) - H0 - T0
=
C[Y0;E(L)] - tC[i(Y1 - Y0) + P0;E(L)]
Use Of Option Pricing To Set
Insurance Premiums
To determine the “fair” premium, the
premium level is determined for which the
owners’ claim is equal to the initial equity.
Thus, the owners receive a “fair” investment
return.
Discussion
of
Cost
of
Capital
Cost of Capital
• Weighted Average Cost of Capital (WACC) = weighted
average of firm’s (after-tax) financing source costs
WACC = rs ws + rp wp + rd (1 – t) wd
where
r = cost, w = weight, t = tax rate, s =
common stock, p = preferred stock, and
d = debt
Cost of Capital
• Cost of capital can be used as a hurdle rate
against which to measure investment decisions.
• Weights are the long-run proportions of the
various financing sources comprising the firm’s
capital structure
• Key is to determine the costs, or rates,
associated with each financing source
– Can use CAPM, APT, etc.
Capital Asset Pricing Model
E(Ri) = Rf + i [E(Rm) - Rf]
where:
E = expected value operator
Ri = return on an asset
Rf = risk free rate
Rm = return on market portfolio
i = Cov(Ri,Rm) / s2(Rm)
= systematic risk
Arbitrage Pricing Model
• The APM is similar to the CAPM with
regard to classifying risk as either
diversifiable or non-diversifiable.
• The APM does not require investors to be
concerned only with market risk.
• The APM allows consideration of any
number of factors to influence the risk of
an investment.
Arbitrage Pricing Model (cont.)
n
Ri = ai +
R
a
b
I
e
i
j
=
=
=
=
=
=
=
b I + e
j = 1 ij j
i
realized rate of return
intercept
sensitivity of return to index
value of index
error term
asset indicator
factor indicator
An Alternative Hurdle Rate
Approach*
• CAPM ignores existing portfolio when
contemplating price / capital needed to support
one more risk
• Add a factor to the CAPM
– Reflects correlation of new risk with existing
portfolio
– Incremental capital to maintain existing target
probability of ruin
* Froot and Stein, “A New Approach to Capital Budgeting for Financial
Institutions,” Journal of Applied Corporate Finance, Summer 1998. Also,
Froot, “A Fundamental Framework for Managing Capital Risk,” in Managing
Capital and Expectations Through Effective Risk Management, Guy Carpenter
Capital
Management
for
Property / Casualty
Insurance
Interesting & Relevant Articles
• The insurer’s capital challenge
– “Capital Punishment,” Economist, 1/16/99
• Alternatives to capital
– “An Earthquake in Insurance,” Economist, 2/26/98
• New risks  new capital needs
– “The New Financiers,” Economist, 9/2/99
• An opportunity for actuaries
– “Capital Cushion Fight, Economist, 6/7/01
• Problems for insurers
– “Poor Cover for a Rainy Day”, Economist, 3/6/03
Canadian Regulation
• “Dynamic Capital Adequacy Testing” (DCAT)
• “(DCAT) is the process of analyzing and projecting the
trends of a company’s capital position given its current
circumstances, its recent past, and its intended business
plan under a variety of future scenarios…. The DCAT
process is to include the running of a base scenario and
several adverse scenarios…”
-- Canadian Institute of Actuaries, Dynamic
Capital Adequacy Testing – Life and
Property and Casualty
Canadian Regulation (cont.)
• “(One possible approach would consist of…) …
‘stress-testing’ of the risk category in question…
Stress-testing means a determination of just how far the
risk factor in question has to be changed in order to
drive the company’s surplus negative during the
forecast period, and then evaluating if that degree of
change is plausible or not. When stochastic models
with reasonable predictability are available, an adverse
scenario would be considered plausible if all remaining
probability in the tail beyond this scenario is in the
range of 1% to 5%.”
-- Ibid
Canadian Regulation (cont.)
• “… the concept of capital adequacy envisioned by
DCAT extends beyond the balance sheet at a specific
date to the continued vitality of the organization…
The principal goal of this process is to help prevent
insolvency by arming the company with the best
information on the course of events that may lead to
capital depletion, and the relative effectiveness of
alternative corrective actions.”
-- Canadian Institute of Actuaries, ibid.
Capital Management for
Insurers – Issues
• Determine the economic (required) capital
• Make adjustments to actual capital position, if
necessary
• “Allocate” capital
• Measure performance relative to capital
• Deploy capital most efficiently
Strategies for Managing
Capital
• If capital is inadequate (i.e., actual < economic)
– Raise new capital
• Internal: retained earnings; realizing capital gains
• External: equity; debt; surplus notes
– Reduce risk level of firm
• Reduce exposures
• Reinsurance
• Strengthen underwriting standards
• Reduce financial risks
Strategies for Managing
Capital (cont.)
• If there is excess capital (i.e., actual > econ.)
– Payout to shareholders
• Increase dividends
• Repurchase shares
– Greater capital investment activity
• New lines or areas of insurance
• Acquisitions
– Increase risk level of firm
Other Issues in Capital Mgt.
• Controlling expenses
• Uncovering “hidden” capital
• Managing dividends
• Managing reinsurance
• Managing asset allocation, buying, and selling
Applying RAROC
• RAROC = Risk-adjusted return on capital
– Emerged from the banking industry
• Reflects expected return on economic capital
• Applied to insurance*
– Aggregate (accounting for correlations) risk
measures and economic capital across all risks
– Reattribute economic capital back to sources of risk
– Measure capital productivity and performance
* Nakada, Shah, Koyuoglu, and Collignon, “P&C RAROC: A Catalyst for
Improved Capital Management in the Property and Casualty Insurance Industry,”
Journal of Risk Finance, Fall 1998