An Overview of Capital Management for Property/Casualty Insurers

1. An Overview ofCapital Managementfor 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

2. 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 / casualtyinsurance

3. “CapitalManagement”and itsInclusiveness

4. 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

5. Types and Measures of Capital • Statutory • Inherently conservative; solvency perspective • GAAP • Going concern; income statement orientation • Risk-based capital • Required capital based on risk attributes and promulgated charges • Economic • Required capital in order to achieve a specified solvency standard Actual Theoretical

6. 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

7. 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

8. What Does Capital Management Entail? Capital Structure Raising Capital Financial Risk Mgt. Setting Objectives Capital Management Strategic Planning Product Pricing Liability Valuation Asset Allocation

9. PuttingCapital Managementin aFinancial Services Industry Context:A Look at the Banking World

10. Banks: How They Improved “After the near-death experience of the late 1980s and early 1990s, banks began to invest where the rewards for investing were not just higher but also better in relation to the amount of risk they were taking—in other words, they started looking at risk-adjusted returns. This meant that they began to jettison businesses that were insufficiently profitable.” “What worries banks most, however, is not that their fees might drop, but that their main business—lending, which still accounts for most of their revenues—would come a cropper. That is where most of their capital is at risk. And that is why their favourite gripe is about the bankers at Basle.” - “Renaissance Men,” Economist, 4/15/99

11. From the Fed: Bank Capital BOARD OF GOVERNORSOF THEFEDERAL RESERVE SYSTEMDIVISION OF BANKINGSUPERVISION 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

12. 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)

13. 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)

14. 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)

15. 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.”

16. 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

17. 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 risk-weighted assets • Changes to treatment of credit risk • Explicit treatment of operational risk

18. TheFinancialTheoryUnderlyingCapitalManagement

19. 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

20. Finance Theory andCapital 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

21. Post-FRM Pre-FRM

22. 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

23. 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

24. 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

25. 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

26. 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)

27. 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

28. Sample Debt / Equity Tradeoff Chart Firm Value PV(costs fin. distress) PV(tax shield) Debt / Equity Ratio

29. 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

30. 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

31. 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

32. Dividends • Declared by board of directors • Once declared, an obligation • Modigliani & Miller: dividend policy is irrelevant in a world without taxes, transaction costs, etc.

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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)

39. 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

40. 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)

41. 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

42. 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

43. Debtholders vs. ShareholdersWho’s Interested in What? Probability Shareholders Debtholders Firm Value

44. Option Values: Payoff Charts Payoff • Call -- long position: • Call -- short position: • Put -- long position: • Put -- short position: ST X X ST ST X X ST

45. Payoff and Profit/Loss ProfilesLong a Call Option Payoff Profit/Loss ST Call Premium X

46. Black-ScholesOption 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

47. 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

48. 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.

49. 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 Firm Asset Value L

50. 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 Firm Asset Value L