Capital is without question everyone's concern right now. As Philip Tippin explains, those insurers and reinsurers that reduce their capital requirements will have a competitive advantage.

Capital modelling has been a huge driver of change in the insurance industry over the last few years. In the UK, the Financial Services Authority's (FSA) introduction of the Individual Capital Assessment (ICA) regime has ensured that every company has its own view as to how much capital it needs to support its business to a 99.5% confidence level over 12 months - a view which is then open to challenge by the regulator. And following the 2005 Atlantic hurricane season, the rating agencies stepped up the offensive, requesting increasing amounts of capital from undiversified carriers to achieve the ratings they desired.

Given this, you would perhaps have thought that the industry would have gone to great lengths to make itself capital efficient. Perhaps companies are still adapting to the changes, but to date only a few have made truly bold strides towards a more capital-efficient structure. But the changes are beginning to happen.

Measuring risks

The FSA model considers a number of risks to generate a capital need for a company. Insurance risk, credit risk, market risk, liquidity risk, operational risk and group risk are the main risk categories they highlight. Reducing an operation's exposure to any of these could reduce the overall capital requirement for both that entity and the group as a whole. There is clearly a growing recognition within the industry as to the potential benefits of implementing a risk management framework. A recent KPMG survey, "The agile CEO", identified regulation as being only the fourth highest driver for improving risk and capital management after "more effective use of capital", "improved decision making" and "improving shareholder value".

It is believed that the two single largest contributors to the modelled capital requirements are most often insurance risk and market risk. This is perhaps no great surprise, as the two largest numbers on most insurers' balance sheets are the insurance liabilities and the assets backing them. For companies buying significant reinsurance programmes the credit risk element can get quite large as well. So it would make sense for companies to target these elements in an attempt to reduce their capital needs. For the purpose of this article, we are only going to consider the liability side of the balance sheet. If the size of technical reserves can be managed downwards, then the size of the associated asset risk should reduce as well.

Taking on insurance risk is the main function of any insurance company. The risk applies to new underwriting (the risk that future events will not be as we expect) and to old reserves (the risk that settlements will not occur as we expect). In essence, the larger the amount of business that a company writes, or the larger the liabilities that the company is reserving for, the more capital it is required to hold. So there is an incentive to actively manage the run-off and settlement of old liabilities.

The following is a simplified example to see how much of a difference reducing reserving risk could make to a company. The capital charges are taken from the FSA's Enhanced Capital Requirement calculations by means of illustration. The actual charges do not matter though - the principle holds for most realistic assumptions.

XYZ Re writes $50m of property catastrophe business, and $50m of proportional casualty reinsurance. ABC Re does the same, but also has $150m of property catastrophe reserves and $200m of proportional casualty reserves. They both buy no reinsurance, and hold risk-free investments.

The relevant capital charges are 53% of premiums and 12% of reserves for property catastrophe business, and 14% of both for proportional casualty. On this basis XYZ Re would need capital of $33.5m, and ABC Re $79.5m. This additional capital requirement arises solely because of the "drag" caused by having run-off liabilities on the balance sheet. The cost of servicing this additional capital will depend upon the company's profit target, but even as little as a 10% return requirement would lead to ABC Re needing to operate with a combined ratio nearly 5% lower than XYZ Re - assuming that the underwriting is the only source of profit.

The legacy drag

This is, of course, an oversimplification of reality. The true cost will depend upon the extent to which investment return can be earned on the reserves (a phenomenon returning for US dollar bond portfolios), and diversification of risk, amongst other things. Despite this, evidence from the real world suggests that the conclusion is widely believed. Why else was it so easy to persuade investors to bed down with the new Bermudian start-ups last year, whilst the existing players found the capital harder to come by (but by no means impossible)? Why does having no legacy make you an attractive market to a reinsurance buyer? (Examples would include the "Class of 2001" and Lloyd's, post-Equitas). Ultimately, legacy requires extra capital to support it as the risks are real, capital comes from investors looking for return, and investors can make a more efficient return when there is no legacy - a vicious circle.

So what are the pioneers in the market doing to manage their capital? The answer is "a lot of things". There has been an increasing amount of activity from companies looking to remove old business from their balance sheets through a variety of mechanisms. Some have sold companies and portfolios outright, others have begun the process of entering into a solvent scheme of arrangement for discontinued lines of business. There has been an increase in the use of Part VII transfers to move business around - sometimes within a group to benefit from increased diversification, and also out of a group to get it off the group balance sheet altogether. The first transfer out of Lloyd's has just been sanctioned, providing a new method of achieving finality for Names. And such group restructuring does not just benefit at a capital level. In many cases tax efficiency and regulatory simplification can be achieved at the same time, and the benefits can be significant.

The changes being made are not just structural. More and more, insurers are building up their claims functions in order to proactively manage and settle claims as efficiently as possible. Paying claims faster may cost on investment return, but it saves on legal costs, potential bad faith claims, and unforeseen deteriorations (which have a habit of occurring more often than unforeseen improvements) - it reduces potential operational risks as well as reducing the reserving risk. Across the industry there are signs that the management of capital is slowly becoming embedded in the insurance business.

Indeed, there is little in the way of alternative courses of action. As shown above, if a company can reduce its capital requirement, it can make a return for its investors at much higher combined ratios than when capital encumbered. Given that rates are beginning to come under pressure in many lines of business, an organisation that reduces its capital requirements can gain a real competitive advantage in today's market. The market pioneers are already making their moves - isn't it about time the rest of the industry stopped inflicting capital punishment upon themselves?

- Philip Tippin is a partner at KPMG LLP.