The determinants of capital
in the
P&C insurance industry
Authors: Elena Grubisic , Darrell Leadbetter
ARIA Annual Meeting
Quebec City, August 6, 2007
Agenda
 Why study the determinants of capital?
 Literature review
 Data & methodology
 Results
 Observations
Why the determinants of capital?
 increasing regulation of capital (allowable ROE)
 greater use of capital models
 development of risk based regulatory capital
 increasing frequency of insolvency
 insurance becoming more integrated into capital
markets
Understanding the determinants of capital is important
for the proper application of capital models, regulatory
capital, and ERM techniques
Canadian P&C industry
 federal or provincial charter
 federal or provincial solvency supervision
 provincial regulators monitor market conduct
 345 insurance companies
 $36 billion in premiums
 $111 billion in assets
Federal/provincial supervision
Federal (OSFI):
82.9% ($29.8 billion)
Provincial:
17.1% ($6.2 billion)
Federal: 190 insurers
2
insurers
7
insurers
8
insurers
3
insurers
12
insurers
60
insurers
56
insurers
2
insurers
5
insurers
Source: PACICC, based on data from Superintendents of Insurance
More capital in the industry
Insurance Risk Ratio (NPW/Equity)
3
Canada
US
2.5
Canada (provincial)
2
1.5
1
0.5
0
1975
1980
1985
1990
1995
2000
2005
Source: based on data from MSA Research
Growing capital & insolvency (Canada)
# of insolvencies
Insurance Risk Ratio (NPW/Equity)
8
3
6
insolvency
leverage
2
4
1
2
0
0
1975
1980
1985
1990
1995
2000
2005
Source: PACICC, based on data from MSA Research
Growing capital & insolvency (U.S.)
# of insolvencies
Insurance Risk Ratio (NPW/Equity)
60
3
50
40
2
30
insolvency
leverage
20
1
10
0
0
1975
1980
1985
1990
1995
2000
2005
Source: PACICC, based on data from A.M. Best & III
The role of capital
Central to the operation of an insurance company:
 policyholder protection against insolvency
 needed to finance future growth
 important element of shareholder value
 return on capital an important performance measure
 protection against uncertainty in liability provisions
 protection against catastrophes
The role of capital
“Free” capital
Available
capital
Capital
requirement
Risk margin
Best estimate
liability
Reserves
(technical
provisions)
Supervisory
ladder of
intervention
Insurance company capital
Operational capital
minimum capital required to facilitate cash flow and maintain
sufficient liquidity to manage current operational liabilities such as
salaries, leases and IT maintenance.
Risk capital
the additional capital a firm requires to cover the financial
consequences of its business risks.
Signaling/strategic capital
capital required to overcome information asymmetries and reassure
external stakeholders of the firm’s soundness and capacity to
survive catastrophic shocks or pursue other strategic goals such as
market share.
Insurance company capital
Risk capital
# simulations
Operational
capital
Signaling/
strategic capital
99% of scenarios
Probability of ruin
X % of scenarios
capital ($)
Source: PACICC & IBC
International trends
 higher severity and frequency of catastrophe losses
 increased utilization of enterprise risk management
by management
 recognition of the role of operational risk in
insolvency
 growing utilization of risk-based capital tests
 increased international mobility of capital
Agenda
 Why study the determinants of capital?
 Literature review
 Data & methodology
 Results
 Observations
Literature review
Capital budgeting and allocation
Merton and Perold (1993),
Cummins and Sommer (1996),
Cummins (2000),
Myers and Read (2001)
Sherris (2006)
Determinants of capital
Cummins and Nini (2002)
Carayannopoulos and Kelly (2005)
Determinants of capital
Cummins and Nini
(2002)
Carayannopoulos
and Kelly (2005)
Financial distress
 Reinsurance is substitute for
capital
 Asset risk
 Larger insurers hold less capital
 Diversification does not reduce
capital
 Reinsurance is substitute for
capital
 Larger insurers hold less
capital
Product market
 Commercial policyholders more
sensitive to insolvency
 Personal lines insurers hold
more capital
Agency costs
 Mutual do not over utilize capital
 Long tail lines more leveraged
 Information asymmetries reduce
capital
Signaling/strategic
 Support that insurers signal
 Insurers with growth opportunities
do not hold more capital
Capital allocation/budgeting models
Approach
CAPM
FamaFrench
3/Full
value beta
Marginal
capital
allocation
Risk
Adjusted
Return on
Capital
(RAROC)
Value at
Risk (VaR)
Dynamic
Financial
Analysis
Regulatory
Risk Based
Tests
analysis of
correlations
between
entity & the
market
CAPM
plus
insolvency
put option
approach
insolvency put
option
approach
probability of
default
probability of
default
fixed ratios
applied to
selected
accounting
positions
Risk Components
Market risk
Yes
Yes
Yes
Yes
No*
Yes
Yes
Insolvency
risk
No
Yes
Yes
Yes
Yes
Yes
Yes
Operational
risk
No
No
No
No*
No*
No*
No*
Comments
entity wide,
relies on
market data
entity wide
but can be
done by
line of
business,
relies on
market
data
applied by
line of
business
adjusts risk
based on
correlations
between lines
of business
based on
volatilities.
Not a first
principles
based
approach
can include
either
deterministic or
stochastic
modeling
approaches
does not
necessarily
capture
economic role
of capital.
* these models have variations that incorporate operational risk, which is typically defined as investment risk, which we have defined as market risk. Nevertheless, we
believe the capacity for operational risk as currently being discussed in the ERM literature exists.
Agenda
 Why study the determinants of capital?
 Literature review
 Data & methodology
 Results
 Observations
Determinants of capitalization
The amount of capital an insurance company should hold is
expected to depend on:
 probability of insolvency
 agency costs
 product market interactions
 strategic opportunities & market signaling
 regulatory environment
Data & methodology
Tested variables related to:
 financial distress
 product market
 agency costs
 signaling/strategic objectives
Similar to Cummins and Nini (2002) & Carayannopoulos
and Kelly (2005)
Financial data
MSA, PACICC, IBC, A.M. Best
Dependent variables
Equity capital
- longer historical series, data over a full cycle
Risk-based capital score (MCT/BAAT)
- introduced in 2003, data only for the healthy part of
the underwriting cycle.
Independent variables
Financial distress:
Market risk indicators:
CPI, interest rate volatility, TSX
volatility
Underwriting/insurance risk: ROE, earnings volatility, earthquake
exposure, rate regulation, geographic
& product concentration, guarantee
fund assessments
Product market:
Long tail risk:
commercial writings
Independent variables
Agency costs
foreign owned
mutual company
size variables: medium & small
group membership (Canadian)
Signaling & strategic:
M&A activity
Financial strength rating stability
Agenda
 Why study the determinants of capital?
 Literature review
 Data & methodology
 Results
 Observations
Regression results (p-values)
All companies
Federal
Provincial
CPI
0.043
0.253
0.172
Interest rate volatility
0.511
0.514
0.886
TSX volatility
0.944
0.787
0.285
earnings/ROE
0.000
0.001
0.701
earnings volatility
0.528
0.388
0.512
exposure to rate regulation
0.000
0.001
0.041
earthquake exposure
0.699
0.997
.014
geographic concentration
0.018
0.069
0.520
product concentration
0.001
0.000
0.840
guarantee fund assessments
0.103
0.608
0.050
commercial writings
0.395
0.350
0.424
Financial distress
Product Market
Agency costs
foreign owned
0.198
0.547
0.020
mutual company
0.003
0.011
0.354
medium size
0.000
0.000
0.885
small size
0.000
0.000
0.379
group membership
0.003
0.042
0.379
M&A
0.009
0.002
0.036
financial rating stability
0.000
0.000
0.299
Adjusted R-squared
0.643
0.665
0.468
Information asymmetry/strategic
Regression results
Related to increased capital holdings:
Federal/all
Provincial
inflation
earthquake exposure
earnings
foreign ownership
rate regulation
being a mutual company
being a member of a group
M&A activity
commitment to A+ or
greater financial strength rating
Regression results
Related to decreased capital holdings:
Federal/all
Provincial
geographic concentration
rate regulation
product concentration
guarantee fund assessments
being a medium size company
M&A activity
being a small size company
Regression results
Risk-based capital tests:
Related to higher MCT/BAAT:
inflation
interest rate volatility
geographic concentration
foreign ownership
mutual ownership
Related to lower MCT/BAAT:
group membership
Agenda
 Why study the determinants of capital?
 Literature review
 Data & methodology
 Results
 Observations
Earnings increase capital
Property & Casualty Industry Return on Equity (all companies)
(1975 – 2006)
25%
20%
15%
10%
5%
0%
-5%
-10%
capital growth
ROE
-15%
-20%
1975
1980
1985
1990
1995
2000
2005
Source: IBC
Cost of capital - practice
Leverage: insurance risk ratio
3
Subject to dollar based capital requirements
(typically $3 million minimum)
provincial
federal
2
1
Subject to risk-based capital requirements
0
1999
2000
2001
2002
2003
2004
2005
2006
Signaling
% disagreement between rating agencies
100%
75%
50%
25%
0%
Insurance
Mining
Trade
Banks
Transp.
Services
Manuf.
Utilities
Other
finance
Source: Morgan (2002). “Rating Banks: Risk and Uncertainty in an Opaque Industry” American Economic Review, 92:874-888
Observations - regulation
Provincial companies, on average, hold less capital
Federal companies under a risk-based solvency system hold
more capital
Supervisory framework:
“The objective of assessing Earnings is to understand and assess the
quality, quantity and volatility/sustainability of an institution’s earnings
and how they contribute to Capital.”
Dynamic Capital Adequacy Test (Canadian Institute of Actuaries SOP)
“For property and casualty insurers, the actuary would consider threats to
capital adequacy under plausible adverse scenarios that include but are not
limited to the following risk categories:” “… pricing, government &
political action …”
Federal solvency framework compensates for capital incentives
of provincial rate regulation
Observations - regulation
“… given the inherent volatility in this sector,
together with the impact of provincial
government policies in certain lines of business,
and the trend towards more frequent and severe
natural disasters, OSFI will continue to monitor
the P&C industry closely.”
-- OSFI 2006 annual report, pg. 31
Summary
Profitability has a robust but incremental impact on the long run
implications of capital
Signaling financial stability and capital for pursuit of growth
opportunities are important reasons for holding capital
Capital allocation/budgeting models:
 few incorporate factors for operational risks or pursuing
strategic opportunities
 regulatory environments utilizing such models in setting
approved price levels need to consider solvency
implications