The management of excess capital is a difficult issue for reinsurers. Over-prudent investing can suppress overall performance, but using the cash for share buy-backs or acquisitions could leave them short in a crisis
When it comes to returning excess capital to shareholders, it seems reinsurers are damned if they do and damned if they don’t.
In the lengthy soft market that preceded the September 11 2001 terrorist attacks, equity analysts frequently pilloried reinsurers for hanging on to their surplus money.
Fast forward to 2010, however, and the news in March that German reinsurer Munich Re was planning to buy back up to E1bn ($1.23bn) of stock before its annual general meeting on 20 April 2011 got a mixed response from the investment community.
While some characterised it as prudent capital management, one analyst in particular, Thorsten Wenzel at DZ Bank, opined that given economic uncertainties and the wider insurance industry’s exposure to sovereign debt, now might not be the best time to start reducing capital buffers. He wrote in a research note to clients: “Against this background, we believe Munich Re should keep its excess capital on board for the time being.”
While Wenzel’s response is probably the exception rather than the rule for equity analysts, it highlights the conundrum reinsurers face when deciding when, whether and how much excess capital to return to shareholders. Give back too little, and returns are dampened, potentially triggering a backlash from the investment community and share price reductions. Return too much at the wrong time, and the firm could find itself either taking big capital losses or, worse, being unable to pay policyholders’ claims.
It might be assumed that reinsurance chiefs would err on the side of caution. But the side effects of holding too much capital are unsavoury enough to prevent management from keeping all their excess cash for a rainy, or indeed windy, day.
Excess capital is typically invested, which for the investment risk-averse reinsurance industry generally means government or highly rated corporate bonds. The problem with investing rather than deploying the capital for underwriting is that the returns are starkly worse.
Some estimates suggest that reinsurers can expect a return of around 3% from invested capital, while underwriting, if done well, could net them significantly more.
If a company’s underwriting book is netting it a 10% return on equity, the relatively paltry returns from the investments can drag this number down, making the company’s overall performance look worse.
As a result, reinsurers spend a great deal of time assessing their optimum capital positions. “Deciding how much equity capital to return is proving to be a tricky proposition for reinsurers, in light of uncertain access to post-catastrophe capital on one hand, and too much capacity on the other,” Moody’s senior officer Dominic Simpson says. “Furthermore, they have a number of different stakeholders to pay attention to, be it investors, regulators or rating agencies.”
To avoid such a situation, a reinsurer may be tempted to deploy its excess capital in underwriting. This can lead to disaster, however; if there is already enough capacity in the market, the firm will need to undercut its rivals to put its capital to work, running the risk of making an underwriting loss.
What’s more, holding too much excess capital can make a company look like a takeover target, particularly if the company is listed and its shares are trading below book value, as most reinsurance stocks currently are. One finance executive at a reinsurance company says that such a situation > would effectively give an acquirer the opportunity to buy a lot of excess capital at a discount to its true value. “No company wants to have a lot of excess capital, because it provides someone with a means to buy you,” he comments.
Little surprise, then, that many reinsurers are currently engaging in stock buy-backs or extending existing programmes. Not only is the industry currently generously capitalised – a first quarter packed with catastrophe losses has failed to harden the market – but reinsurers’ current low valuations make buying back stock cheap.
The activity boosts return on equity not only because it is deploying excess capital but also because it is reducing the amount of equity capital in circulation.
“When you are trading below book value, it is pretty much a slam-dunk decision to buy back stock,” the finance executive says.
Munich Re is not the only firm to announce a buy-back recently. PartnerRe, for example, bought back more than three million common shares at a cost of $231m in the first quarter of 2010 and boosted its share repurchase authorisation to eight million shares, of which five million remain to be used.
More recently, on 8 June Bermudian reinsurer Validus Holdings announced it had bought back 12 million shares for $300m in a ‘modified Dutch auction’.
Buying back stock is not the only method of returning capital to shareholders. Firms can opt to pay dividends, as with SCOR’s recent announcement that it would pay E1 per share for the fiscal year of 2009.
They can even engage in mergers and acquisitions, which can help shed excess capital and improve risk management. Purchases that complement rather than duplicate existing capabilities can prove particularly attractive, according to Moody’s senior credit officer Kevin Lee.
“Even if an acquisition complementary to existing business lines didn’t help valuations in the short term, it would provide greater diversification and presumably a greater buffer against shock losses,” he says.
Companies wanting to improve return on investment without depleting their capital base could issue debt and buy back stock with the proceeds. The caveat is that this would boost debt levels. “Generally, issuing debt to buy back stock is not a positive to bondholders,” Lee says.
But, if firms are aiming to win the hearts and minds of the investment community with their capital return programmes, some feel there is little evidence of success so far. “It’s unclear whether buying back shares and M&A activity have boosted price-to-book ratios,” Lee says. “In some cases that hasn’t happened and, going into the hurricane season, we expect companies will take a cautious approach to share buy-backs.”
Playing it safe
Moody’s maintains a negative outlook on the reinsurance sector as a whole, chiefly because it is concerned that reinsurers’ low price-to-book-value ratios raise doubts about their ability to recapitalise if faced with major catastrophe losses.
Nevertheless, it is unlikely that reinsurers will return too much capital ahead of the wind season. Munich Re, for example, said its E1bn buy-back was conditional on a lack of capital markets or underwriting upheavals.
“In the interests of our shareholders, we carefully weigh up the benefit of further buy-backs against the advantages of comfortable capitalisation, also with a view to opportunities for organic and possibly external growth,” a Munich Re spokesman says. “Our aim to return surplus capital to equity holders underlines our determination to maintain strict pricing discipline, and also strict discipline when it comes to any M&A opportunities. We only make Munich Re’s capital and capacity available to the market when and where this makes economic sense.”
The spokesman added that, as at 31 March, Munich Re’s capital buffer was in the low-to-mid single-digit billion euros range, according to rating agency systems.
Rating analysts seem satisfied that reinsurers are being disciplined with their capital management programmes and are not giving back too much too soon. “For the most part, companies have been measured in their share repurchase activities so far,” Lee says. “Even though they have initiated or increased share purchase authorisations, they haven’t bought back all the shares at once.”
AM Best group vice-president of reinsurance ratings John Andre concurs, adding that M&A activity has been reassuringly staid. “Companies are not making grandiose deals that don’t fit their profile,” he says. “M&A in recent years has been sound and well-thought-out, rather than speculative.”
He points out that companies now have an array of tools at their disposal to assess their exposures and capital requirements, such as dynamic financial models, catastrophe models and risk aggregation modelling.
External pressures from rating agencies can also help keep companies’ capital return strategies in check. “They run their ideas and financial plans past us,” AM Best assistant vice-president of reinsurance ratings Peter Dickey says. “We have our own capital model here, which we use in conjunction with companies to make sure they meet our capital requirements.”
It seems that even when reinsurers’ excess capital is burning a hole in their pocket, they’re not inclined to be wreckless. Nevertheless, with an active hurricane season predicted, treading that fine line between achieving good returns and maintaining a secure cushion of capital will remain a challenge. GR