Roger Sellek examines the pros and cons of returning capital to shareholders in today’s rapidly softening market.
“Returning capital to shareholders while maintaining access to capital through a contingent capital facility can strike a good balance between shareholder return expectations and rating agency capital requirements
Market conditions in recent years have been highly favourable for P&C insurers. Robust pricing levels, strict terms and conditions and reduced loss frequency, combined with a relatively stable legal, regulatory and investment environment, have produced operating earnings not seen in the industry for several decades.
Couple this favourable environment with two years of below-average insured catastrophe occurrences and the result is a significant appreciation in industry capital. While most companies will undoubtedly report strong financial results for 2007, the challenges associated with navigating the continuously softening insurance market remain plentiful. One such challenge is the need to maintain the right amount of capital, which entails balancing various competing demands and expectations.
Capital management starts with meeting the demands of the owners of the organisation, namely the shareholders. These investors, many of whom recognised the favourable market conditions post-9/11 and injected opportunistic capital, continue to expect an adequate return on their investment. However, rapidly declining rates and broadening terms and conditions at this year’s 1 January renewals, together with the gradual increase in loss frequency and severity in many market segments, has severely constrained the opportunity for profitable growth.
Another means of utilising capital, and thus appeasing shareholders, is through strategic acquisitions. It appears, however, that with the collective health of the industry improving, there is much more interest in being the acquirer than the acquired. In fact, it may take a sizable market disruption before companies agree to sacrifice their autonomy. In light of these difficulties, shareholders are pressing companies to return capital that cannot be put to work.
Another voice in the capital question is the rating agencies. Generally, shareholders and rating agencies have a very different perception of what the appropriate amount of capital should be in an insurance organisation. AM Best views capitalisation (ie risk-adjusted capital) as the cornerstone of every financial strength rating. In view of the importance of capital in assigning a financial strength rating, Best employs conservative assumptions when calculating risk adjusted capital.
Required capital levels, for example, are calibrated to the market cycle. As such, capital requirements increase for those companies that target above-average growth during a soft cycle, as the likelihood of writing underpriced business is increased. In addition, a company’s capital adequacy is stress tested for certain extreme events such as a sharp decline in the stock market, a spike in interest rates, or multiple catastrophic events occurring in a given year.
Enterprise risk management also plays a leading role in determining required capital, as does the operating performance and business profile. These elements combine to form leading indicators of future operating volatility and ultimately, future balance sheet strength. In addition, the review of capital adequacy goes beyond the company’s ability to honour policyholder obligations, and looks at the organisation’s ability to meet its financial obligations to debt holders.
Value of good management
With that said, it may seem out of character for a rating agency to promote the return of capital to shareholders. In cases where excess capital is not apparent, returning capital would likely have a negative effect on a financial strength rating. However, in cases where excess capital truly exists, and management does not expect to deploy that capital for growth or acquisition, returning excess capital to shareholders may be the best course of action. This is particularly true if the alternative is to chase underpriced business, diversify into an area without the requisite expertise or make an imprudent acquisition.
It would be remiss not to mention that in the insurance industry excess capital can disappear rather quickly. The one-two-three knockout punch of hurricanes Katrina, Rita and Wilma in the US in 2005 is a prime example. Because of the risk of a sudden loss of capital faced by all insurers with shock-loss exposure, another important factor in the capital question is financial flexibility. A company’s access to capital is key to determining the required capital level and should be considered when contemplating the return of capital to shareholders.
Some management teams have taken proactive steps toward enhancing their financial flexibility. One popular approach is through contingent capital facilities, which allow companies to pre-set the terms and conditions of future capital raising initiatives. Returning capital to shareholders while maintaining access to capital through a contingent capital facility can strike a good balance between shareholder return expectations and rating agency capital requirements.
Based on the provisions of the facility, AM Best will consider giving qualitative and, in some cases, quantitative credit for contingent capital. It should not be inferred, however, that Best expects a contingent capital facility to go hand-in-hand with all share repurchase programmes – this is simply one of many ways companies can demonstrate their financial flexibility.
Collateralised reinsurance solutions
Considering the recent interest in contingent capital, Best has determined which provisions would likely warrant credit given in our capital model. Generally, more credit is given to facilities that are fully funded; ie the special purpose vehicle (SPV) – or sidecar – holds highly-rated, liquid securities than can be accessed by the sponsor with short notice.
Best also looks favourably upon facilities where the exercise of the put option is mandatory upon the occurrence of a certain event such as a catastrophe loss. If the put option rests with the holding company, more credit is given if the holding company is contractually obligated to downstream the funds to its insurance operating subsidiary. Since limitations are placed on all forms of soft capital, in cases where credit is given in our capital model; the maximum credit allowance is 10% of total adjusted capital.
Also, where credit is given prior to exercising the put option, the securities to be issued pursuant to the contingent capital facility will count toward the financial leverage calculation. Facilities that do not conform to these specifications (ie SPV not fully funded, no mandatory trigger), credit can still be given on a qualitative basis and toward the stress-tested capital requirement. Here, the securities to be issued to the SPV would not count toward the financial leverage calculation until actually issued.
During soft market conditions, when growth and acquisition prospects are slim, returning excess capital to shareholders is often the most prudent course of action. By reviewing management’s strategic business plan, rating agencies are able to evaluate required capital levels on a pro-forma basis, and ensure that projected capitalisation will remain supportive of the financial strength rating.
Roger Sellek is managing director of global financial services at AM Best.