The determinants of capital

in the

P&C insurance industryAuthors: 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)

Source: PACICC, based on data from Superintendents of Insurance

8 insurers

7 insurers

12 insurers

3 insurers

60 insurers

56 insurers 5

insurers

2 insurers

2 insurers

Federal: 190 insurers

More capital in the industryInsurance Risk Ratio (NPW/Equity)

0

0.5

1

1.5

2

2.5

3

1975 1980 1985 1990 1995 2000 2005

Canada

US

Canada (provincial)

Source: based on data from MSA Research

Growing capital & insolvency (Canada)

0

2

4

6

8

1975 1980 1985 1990 1995 2000 2005

0

1

2

3

insolvency

leverage

# of insolvencies Insurance Risk Ratio (NPW/Equity)

Source: PACICC, based on data from MSA Research

Growing capital & insolvency (U.S.)

Insurance Risk Ratio (NPW/Equity)

0

10

20

30

40

50

60

1975 1980 1985 1990 1995 2000 2005

0

1

2

3

insolvency

leverage

# of insolvencies

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

Best estimate liability

Risk margin

Available capital

Reserves (technical provisions)

Supervisory ladder of interventionCapital

requirement

“Free” capital

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

Source: PACICC & IBC

99% of scenarios

Risk capitalOperational capital

Probability of ruinX % of scenarios

capital ($)

# simulationsSignaling/strategic capital

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

CAPM Fama-French 3/Full value beta

Marginal capital allocation

Risk Adjusted Return on Capital (RAROC)

Value at Risk (VaR)

Dynamic Financial Analysis

Regulatory Risk Based Tests

Approach 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

Financial distress

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

Product Market

commercial writings 0.395 0.350 0.424

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

Information asymmetry/strategic

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

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

Property & Casualty Industry Return on Equity (all companies)

(1975 – 2006)

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

1975 1980 1985 1990 1995 2000 2005

capital growth

ROE

Earnings increase capital

Source: IBC

Cost of capital - practice

Source: PACICC, with data from MSA Research & IBC

0

1

2

3

1999 2000 2001 2002 2003 2004 2005 2006

provincialfederal

Leverage: insurance risk ratio

Subject to risk-based capital requirements

Subject to dollar based capital requirements (typically $3 million minimum)

Signaling

0%

25%

50%

75%

100%

Insurance Mining Trade Banks Transp. Services Manuf. Utilities Otherfinance

% disagreement between rating agencies

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