The property/casualty reinsurance industry continues to face a capital management crisis. There is too much capital chasing too little risk. As shown in the diagram below, a recent study suggests that up to a third of the capital held by the US property/casualty reinsurance industry is not needed for the industry to maintain an A- or double-A credit rating.
As a result, returns on equity have dropped, with many firms offering returns little better than those available in risk-free Treasury bills. Reinsurer shares have lagged behind those of the broad financial services industry, recording an 11% annual return between 1990 and 1999. By comparison, banks posted a gain of some 16%, according to the S&P industry composites.
None of this is news to most industry participants. But if everyone knows this, then why is no one doing anything about it? This article argues that proper capital management could get the industry out of this situation, but that it will likely not happen without continued consolidation in the industry.
Too much of a good thing
In some ways, it is no surprise that reinsurers find themselves overcapitalized. Reinsurers are in the business of taking on low-frequency, high-severity risks. That means they have to hold significant amounts of capital to maintain solvency in the face of potential large losses. The premiums charged for taking on these risks are priced to earn an appropriate return on this capital.
In most years, however, the large losses do not materialize, and the earnings are either paid out to shareholders or are retained to grow the capital base. Ideally, the amount of earnings retained would be just enough to support the growth of the reinsurer's portfolio of risks. That is, the dividend payout ratio should be equal to the difference between the reinsurers' return on equity (ROE) and the rate of growth of the risk in its business.
The problem in the property/casualty insurance industry is that the dividend payout ratio has not been high enough to make up the difference between ROE and growth in capital requirements. Reinsurers are retaining more capital than they need. As illustrated in the figure overleaf, the US P/C industry has produced a 10.6% ROE over the past five years, but it has only grown new risk-taking opportunities (as measured by premium growth) at a rate of 2.7%. While insurers returned 42.5% of retained earnings to shareholders, they still accumulated significant excess capital during this period. Showing capital levels indexed to 100 in 1995, we see how the industry accumulates more than 20% excess capital during the period from 1995 to 1999.
A reinsurer that finds itself more and more overcapitalised must either accept a reduction in ROE, or try to deploy that capital more effectively in new risk-taking businesses. If the institution grows into its larger capital base by pursuing attractively priced business in areas where it has underwriting expertise, then it can continue to create value for its shareholders. More often than not, however, the reinsurer expands by reducing prices, or by entering businesses that are outside its core underwriting expertise.
Change is possible
The change in commercial banks' approach to capital management during the 1990s points the way for the property/casualty reinsurance industry. During this decade, many banks changed from “capital accumulators” to “capital managers.” They developed internal economic (risk-based) capital models that told them how much capital was needed to support their risks, and developed disciplined processes for keeping only as much capital as was needed to support the natural growth of their business.
Indeed, capital management became one of the cornerstones of the strategic planning process for well-managed financial institutions. Such institutions follow a five-step process:
1. formulate a capital investment plan based on the risk, return, and growth characteristics of the available opportunities;
2. determine a strategic risk transfer plan to eliminate risks that detract from shareholder value;
3. align the capital structure via dividend policy and the issuance or buyback of shares so that the capital is adequate to support the remaining risks;
4. set targets for business unit performance in terms of return on economic capital (RAROC); and
5. measure performance by monitoring RAROC, capital usage and growth against targets.
The property/casualty insurance industry has over the past several years gained access to models that link risk to capital requirements. However, it appears that the accompanying discipline of capital management has been slow to catch on. One possible reason is that the industry tends to change more slowly than the banking industry. However, anecdotal evidence suggests that the real reason lies in a misalignment between what shareholders want and what motivates the ceos that run these companies.
Discussions with ceos and cfos of property/casualty insurers and reinsurers over the past year have uncovered an interesting pattern. While cfos like the idea of capital management, ceos resist the idea as being less important than - and even at odds with - the goals of earnings growth and earnings stability. This brings to light an interesting problem with the capital management philosophy. Shrinking the capital base may improve ROE, but in the short term, it reduces operating profit by reducing investment income. Furthermore, it constrains growth in the capital base to the growth available from profitable risk-taking opportunities.
Shareholders should have a bias toward return on equity, since they have the opportunity to reinvest excess retained earnings elsewhere. However, management has a bias toward growth for two reasons. The first is that many ceos believe (whether correctly or not) that Wall Street expects steady and predictable growth in both top- and bottom-line performance. As such they seem loath to entertain any ideas that would create even a one-time reduction in growth.
Secondly, ceos believe that a larger capital base will serve their companies better in the continuing industry consolidation - the larger the capital base, the more opportunities a firm has to take over other firms, and the fewer threats there are that it will be taken over. This provides management with enough incentive to hang on to its excess capital even at the expense of ROE.
Consolidation facilitates capital management
So shareholders and management are at an impasse. Shareholders would prefer that insurers and reinsurers return excess capital and shrink to a more profitable core; management would rather retain the capital and stay independent.
The key to this problem is continued consolidation. Larger firms can continue to grow their earnings and capital bases by acquiring smaller firms, and then disgorging the excess capital from the acquisition. This allows the acquiring firm to grow and align its capital base at the same time.
This appears to be the approach that industry leaders such as XL Capital have been taking. Over the past several years, XL has grown dramatically through acquisitions and new ventures. In 1998, XL Capital acquired Mid Ocean Limited, a P/C reinsurer, as well as its subsidiary Brockbank. Then in 1999, XL merged with NAC Re and acquired Intercargo, as well as starting a new joint venture called Le Mans Re with partner Les Mutuelles du Mans Assurances Group. Throughout all of this, XL has systematically trimmed back its capital base via share buybacks, most recently $500 million-worth in January 2000.
. . . and vice versa
While consolidation allows firms to grow while reducing excess capital, effective capital management is key to managing the resulting entities. An acquisition-driven strategy forces the ceo to change his or her mindset from that of an operational manager to that of a capital manager, which makes the integration of new entities much simpler. The operational manager ceo must integrate all of the new businesses, reporting and decision-making into the parent company's format. The capital manager ceo only needs to understand two key things: how much capital is required to support the business, and what return on capital the business is expected to generate. There must be centralized control over how the capital and return are calculated, but operational management can be left to the business.
The ceo as capital manager is then left to focus on high-value activities:
In summary, the reinsurance industry's current consolidation may be just what the industry needs to solve its capital problems. It is up to the acquirers to make sure that they don't squander the opportunity to move toward a more efficient capital management regime.
Peter Nakada serves as eRisks vice president of business development, and is responsible for identifying and developing new eRisks products and services, as well as developing and managing eRisks' strategic alliances.
Launched in October 1999 as an e-venture of Oliver, Wyman & Company, a strategic consulting firm dedicated exclusively to the financial services industry, eRisks is the first full-service provider of enterprise risk management information, analytics and consulting services for risk management professionals.