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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.

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The determinants of capital in the P&C insurance industryAuthors: Elena Grubisic , Darrell LeadbetterARIA Annual MeetingQuebec City, August 6, 2007

agenda
Agenda
  • Why study the determinants of capital?
  • Literature review
  • Data & methodology
  • Results
  • Observations
why the determinants of capital
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
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/provincial supervision

Federal (OSFI): 82.9% ($29.8 billion)Provincial: 17.1% ($6.2 billion)

Federal: 190 insurers

2 insurers

7 insurers

3 insurers

2 insurers

8 insurers

56 insurers

12 insurers

60 insurers

5 insurers

Source: PACICC, based on data from Superintendents of Insurance

more capital in the industry
More capital in the industry

Insurance Risk Ratio (NPW/Equity)

Source: based on data from MSA Research

growing capital insolvency canada
Growing capital & insolvency (Canada)

# of insolvencies

Insurance Risk Ratio (NPW/Equity)

Source: PACICC, based on data from MSA Research

growing capital insolvency u s
Growing capital & insolvency (U.S.)

# of insolvencies

Insurance Risk Ratio (NPW/Equity)

Source: PACICC, based on data from A.M. Best & III

the role of capital
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 capital1

Available capital

Supervisory ladder of intervention

Risk margin

Best estimate liability

The role of capital

“Free” capital

Capital requirement

Reserves (technical provisions)

insurance company 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 capital1
Insurance company capital

Risk capital

Operational

capital

Signaling/

strategic capital

# simulations

99% of scenarios

Probability of ruin

X % of scenarios

capital ($)

Source: PACICC & IBC

international trends
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
agenda1
Agenda
  • Why study the determinants of capital?
  • Literature review
  • Data & methodology
  • Results
  • Observations
literature review
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)

agenda2
Agenda
  • Why study the determinants of capital?
  • Literature review
  • Data & methodology
  • Results
  • Observations
determinants of capitalization
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
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
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
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 variables1
Independent variables

Agency costs

foreign owned

mutual company

size variables: medium & small

group membership (Canadian)

Signaling & strategic:

M&A activity

Financial strength rating stability

agenda3
Agenda
  • Why study the determinants of capital?
  • Literature review
  • Data & methodology
  • Results
  • Observations
regression results
Regression results

Related to increased capital holdings:

Federal/allProvincial

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 results1
Regression results

Related to decreased capital holdings:

Federal/allProvincial

geographic concentration rate regulation

product concentration guarantee fund assessments

being a medium size company M&A activity

being a small size company

regression results2
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

agenda4
Agenda
  • Why study the determinants of capital?
  • Literature review
  • Data & methodology
  • Results
  • Observations
earnings increase capital
Earnings increase capital

Property & Casualty Industry Return on Equity (all companies)

(1975 – 2006)

Source: IBC

cost of capital practice

Subject to risk-based capital requirements

Cost of capital - practice

Leverage: insurance risk ratio

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

Source: PACICC, with data from MSA Research & IBC

signaling
Signaling

% disagreement between rating agencies

Source: Morgan (2002). “Rating Banks: Risk and Uncertainty in an Opaque Industry” American Economic Review, 92:874-888

observations regulation
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 regulation1
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
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