Target Capital for GI
Firms
June 20, 2007
Ian Hinder, FIA – KPMG LLP
Allan Kaufman, FCAS – AMK Consulting Dan Magnolia
1
Working party members
A Hitchcox (Chair) - KILN
I Hinder – KPMG
A Kaufman – AMK Consulting
T Maynard – Lloyd’s
A Smith - Deloitte
M White – Equitas
http://www.actuaries.org.uk/files/pdf/sessional/sm20061127.pdf
2
Three questions
1)How much capital should the firm hold?
2) What rate of return is required?
3) How should the firm assess performance targets?
3
Need to consider a blend of
1)Insurance risk considerations
• “Inside the firm”
• How much capital is needed to back
insurance business
• Premium rates to charge to achieve an
adequate return given risks (volatility)
And…
4
Need to consider a blend of
2) Financial markets views of risk
• “Outside the firm”
• How will this investment affect the risk of my
overall portfolio
• Is the expected return on the shares
sufficient to compensate for the risk
5
1)How much capital should the firm hold?
6
How much capital?
• European MCR – approx 18% premium
Old rules of thumb:
• Short tail & low volatility: 40% premium
• long tail or commercial lines: 60% premium
• London Market/ reinsurance firms: 75% premium
7
Increasing capital…
For
• Better credit rating
– more profitable business
– Discount profit stream at a lower rate –
higher NPV
Against
• Lower leverage – lower ROE
• Increase in double taxation
8
Reducing capital…
For
•
•
More leverage – higher ROE
Reduce in double taxation
Against
• Lower credit rating
– less profitable business
– Discount profit stream at a higher rate –
lower NPV
9
Capital and credit ratings
Table 2.6.
Rating
AAA
AA
A
BBB
BB
B
Hypothetical firm with lognormal CoV of 17.5%
VaR Confidence Level (%)
99.995
99.985
99.966
99.721
99.263
94.036
Capital
839
753
688
514
429
227
% of BBB Capital
163%
146%
134%
100%
83%
44%
VaR percentages based on Fitch’s calibration of Prism
Minimum credit ratings
• AA+ : largest and / or most specialised transactions
• A- : commercial lines, particularly long-tailed / reinsurance
• < A-: customers will leave and market share will decline
10
Old approach…
Profitability versus Security
30%
100.00%
99.95%
25%
99.90%
20%
99.85%
99.80%
15%
99.75%
10%
99.70%
99.65%
5%
99.60%
0%
99.55%
BBB
99.9%
Mean RoE
A
AA
VaR percentile
AAA
11
Capital considerations
12
Franchise value
New thinking
Franchise value = market capitalisation - capital
• Hold capital held to maximise franchise value
13
How much capital?
• Management need to be able to articulate
decision to:
– Regulators
– Shareholders
– Rating agents
• Traditional approach – maximise expected return
subject to acceptable level of risk
• Financial economist – maximise franchise value
• Need consideration of both approaches
14
2) What rate of return is required?
15
Cost of capital
•
•
External studies of Cost of Capital tend to look
at TSR – based on market capitalisation
Market value different to capital in firm
Market value = capital + franchise value
•
•
Cost of capital is not the same as Return on
Equity
Can’t use external cost of capital directly to
set performance targets
16
Cost of capital – external studies
(reproduced from
Swiss Re sigma
No3/2005 Figure 9)
• Increasing volatility has little effect on price / book ratio
• No evidence that cost of capital increases with volatility17
Cost of capital – external studies
(reproduced from
Swiss Re sigma
No3/2005 Figure 6)
• Taking more market risk does not increase franchise value
• Expectation for higher investment returns is countered by
18
increase in target return
Cost of capital estimates
•
Swiss Re sigma No3/2005
•
Two methods used including CAPM
•
2005 - cost of capital 7% to 8% (r=3%; ERP =4%)
19
Cummins and Phillips

Use firm wide beta estimates and fullinformation beta to estimate CoC by line of
business
Favour Fama-French methodology – gives
significantly higher CoC estimates than CAPM
Large variations by line of business

See session C1 at 11am


20
3) Turning cost of capital into performance
targets…
21
Background
1.
An object continues in motion unless acted on
by an outside force.
2.
Have you ever met an object not subject to
outside forces?
3.
Statement #1 useful nonetheless.
22
My Frictionless ObjectA Leveraged Investment Fund
•
•
•
•
•
•
I have capital
I have borrowed funds
I invest in equities, say an S&P index, that has a
9% expected return
My market borrowing costs are 1% over risk
free say 6%=5%+1%
There are no income taxes
What is my expected return?
23
A Leveraged Investment
Fund
•
•
•
•
•
•
Capital
Borrowed Funds
Cost of Borrowed Funds
Expected Earnings on investments
Total return
Total return on capital
2,000
2,000
(120)
360
240
12.0%
24
Frictionless Insurance
Enterprise
Capital
2,000
Borrowed Funds-aka reserves
2,000
Cost of Borrowed funds
x
Expected earnings on investments
360
Total Return
240
Total return % Capital
12%
No constraint on removing capital!!!
Back-solve so cost of borrowed funds is (120) or -6% of reserves.
Implies a 105% UW target, undiscounted, if premium=2,500.
25
Frictionless Insurance
Enterprise
Capital
2,000
2,000
Borrowed Funds-aka reserves
2,000
2,000
Cost of Borrowed funds
x
(120)
Expected earnings on investments
360
360
Total Return
240
240
Total return % Capital
12%
12%
No constraint on removing capital!!!
Back-solve so cost of borrowed funds is (120) or -6% of reserves.
Implies a 105% UW target, undiscounted, if premium=2,500.
26
Frictionless Insurance
Enterprise – No Leverage
Capital
Reserves discounted. No investor return
Cost of Borrowed funds
Expected earnings on investments
Total Return
Total return % Capital
No constraint on removing capital!!!
UW target LR is 100% on discounted basis.
Capital in:
Stocks Bonds
2,000 2,000
0
0
0
0
180
100
180
5%
9%
5%
27
Sources of Insurance
Friction
•
•
•
•
•
Double taxation (A)
Market value > book value (B)
Financial distress cost (C)
Agency risk cost (D)
Regulatory costs (E)
–
•
Plus
We need to consider whether borrowed funds
and reserves have same effect on CoC (F).
28
Base Assumptions
•
•
•
•
•
•
Capital 2,000
Taxes at 30%
Stocks expected to earn 9%
Risk free bonds expected to earn 5%
Premium 2,500 if capital in stock;
Premium 3,000 if capital in bonds
29
A. Income Tax – Capital in
Stock
Premium
Tech Earnings (pre tax)
2,500
X
Earned on Capital
(pre tax)
After Tax Earnings
180
ROC
9%
Frictional Capital Cost
180
Z
30
A. Income Tax – Capital in
Stock
Premium
Tech Earnings (pre tax)
2,500
X
Earned on Capital
(pre tax)
After Tax Earnings
2,500
78
180
180
180
180
(=0.7*158)
ROC
Frictional Capital Cost
% premium/% capital
9%
Z
9%
3.1%/3.9%
(=78/2500)
31
(=78/2000)
Frictional Cost
Tax
This is simply-Friction
From-Tax
Frictional Capital If Capital is
Cost
in Stocks
ROC/.7-ROC
3.9%
UW target implied by the
above
Table 5.3A
3.1%
If Capital is
in Bonds
2.1%
1.4%
32
B. Market Value (Mk:BV=1.5)
Capital in Stocks
Premium
Tech Earnings
Earned on Capital
After Tax Earnings
Return on Market Value
Return on Capital
Frictional Capital Cost
% capital
2,500
X
180
270
9%
13.5%
Z
2,500
205
180
270
9%
13.5%
10.3%
33
Frictional Cost
Franchise Value (Book>Mkt)
This is simply-Friction
From-Franchise
Value
Frictional Capital If Capital is
Cost
in Stocks
ROC*PBV/.7
10.3%
-ROC
UW target implied by the
above
Table 5.4
8.2%
If Capital is
in Bonds
5.7%
3.8%
34
Cost of Financial DistressDescription
1.
2.
3.
Normal avoidance costs– Compliance,
reinsurance, risk management
Expected value of extra costs not included in
#1
“Mortality” or failure risk and other costs that
affect franchise value
35
Scale Based on Survivorship
•
If
0.5% of companies fail,
– Another 0.5% reach market value 0.
– Investor wants 9% from all companies
Then
– The investor needs 10.1% from the survivors
(0.99*10.1%+ .01*-100%=.09)
Thus – Failure rate increases before-the-fact
earnings requirement to meet after-the fact
target
–
•
•
36
Cost of Financial Distress
Scale based on bonds
•
•
•
A-rated bonds have failure rates of 0.2%
Failure typically means 50% loss of value
Therefore expected failure cost = 0.1%
–
•
•
But,
Market spread of A-rated over risk free is 1.0%,
so
Market cost of risk is 0.9% added or 9 times the
expected value!
37
Scale based on bonds
•
What is that 0.9%
– Risk margin?
– Provision for Great Depression type losses
with probability of about 1%?
– Price of systematic risk?
– Agency costs? (we might say adverse
selection)
38
Scale from FF3F Cummins
and Phillips (2005)
•
FF3F fro Phillips and Cummins says financial
distress worth 3% of market value
39
Selected Financial Distress
Cost
•
•
•
•
For our examples we select financial distress
costs composed of-0.5% for expected value of extra costs, not
included in financial projection, plus
2% increase in cost of capital target
(Note – By adjusting the 2%, the model will determine
cost of capital by company rating. Table 5.6)
40
C. Distress Costs
Capital in Stocks
Premium
Tech Earnings
Earned on Capital
After Tax Earnings
Return on Market Value
Return on Capital
Frictional Capital Cost
% capital
2,500
2,500
X-10
300-10=290
180
180
330
330
9+2%
11%
16.5%
16.5%
Z
15.0%
Table 5.5
41
Frictional Cost
Distress
This is simply-
Friction
From--
Frictional Capital If Capital is
Cost
in Stocks
Distress
Costs
(ROC*PBV+
Distressexp )/.7+
Distresscap-ROC
UW target implied by the
above
If Capital is
in Bonds
15.0%
10.5%
12.0%
7.0%
42
Agency Risk
•
•
Fear of investors costs if management actions
favor management to the disadvantage of
investors
Sigma describes this in terms of:
–
–
–
Transparency
Reputation (of management)
Incentives (for management)
43
Scale of Agency Risk Costs
•
•
•
•
Sigma suggests 2% for all risks including
financial distress
Sigma observes variability of UW results of
+16% to -9%
Insurance Linked Securities (ILS) show 1%-2%
charges over expected value
ILS on hurricane after Katrina showed 8%
charge over expected value
44
What Should Reduce Market
Cost of Agency Risk
•
•
•
A long term track record with no operational
changes that need explanation
Results consistent with the business plan, even
if highly variable
Communication the investors believe
45
Selected Agency Cost
•
•
•
Some is already included in the projected results
1.0% that is not included in the results but
would affect the P&L
2.0% that effects franchise value and not the
P&L (i.e., shareholder trust in management)
46
C. Agency Costs
Capital in Stocks
Premium
Tech Earnings
Earned on Capital
After Tax Earnings
Return on Market Value
Return on Capital
Frictional Capital Cost
% capital
Table 5.7-some rounding differences
2,500
2,500
X-10-20
365-10-20=335
180
180
360
360
9+2+1%
12%
18%
18%
Z
18.3%
47
Frictional Cost –
Agency
This is simply-
Friction
From--
Frictional Capital If Capital is
Cost
in Stocks
If Capital is
in Bonds
Distress (ROC*PBV+
+Agency Fricexp )/.7+
Costs
Friccap-ROC
18.0%
13.7%
UW target implied by the
above
14.4%
9.1%
48
Regulatory Costs
•
•
•
Compliance costs
Investment constraints
Limitation on the ability to pay dividends or
otherwise move capital
49
Scale of Regulatory Costs
•
Sigma reports that financial instruments with
reduced liquidity require returns 0.5% higher
50
Selected Regulatory Cost
•
•
No impact on technical earnings, as compliance
and investment constraints are part of the
existing earnings projections
0.5% cost of capital from reduction in liquidity
51
C. Regulatory Costs
Capital in Stocks
Premium
Tech Earnings
Earned on Capital
After Tax Earnings
Return on Market Value
Return on Capital
Frictional Capital Cost
% capital
Table 5.8
2,500
2,500
X-10-20
385-10-20=355
180
180
375
375
9+2+1+
12.5%
0.5%
18.75%
18.75%
Z
19.3%
52
Frictional Cost –
Regulatory
This is simply-
Friction
From--
Frictional Capital If Capital is
Cost
in Stocks
If Capital is
in Bonds
Distress (ROC*PBV+
+Agency Fricexp )/.7+
+Reg
Friccap-ROC
Costs
19.3%
14.7%
UW target implied by the
above
15.4%
9.8%
53
Summary of Targets
Friction
From
Frictional Capital If Capital is
Cost
in Stocks
If Capital is
in Bonds
Tax
ROC/.7-ROC
A. 3.1%
2.1%
+PBV
ROC*PBV/.7
-ROC
B. 10.3%
5.7%
+Other (ROC*PBV+
Frictional Fricexp )/.7+
Costs etc. Friccap-ROC
C. 15.0%
D. 18.0%
E. 19.3%
10.0%
13.7%
14.8%
C=Distress; D=Agency; E=Regulatory
54
Final Thoughts-1
•
•
•
Is ‘zero’ OK after all? If you adjust properly for
all agency costs does remaining ‘insurance risk’
require more return than borrowed funds?
Consistency --The selected frictional cost
charges depend on what has been included in
the earnings projection.
Competition -Policyholders would prefer more
bonds and less stocks. Why do insurers invest in
stocks at all? (Tax issues not reflected here?)
55
Final Thoughts-2
•
•
•
Language - “Frictional costs” as used by
financial economists has implications nearly the
same as “Risk” as actuaries use the word.
Language - Terms like ROC, TSR are
ambiguous
Illustrations - This paper consists of many wild
guesses made to illustrate the issues.
56
Discussion
57
58