Protecting Your Capital Against Risk

Insurance executives today are inundated with material proclaiming the virtues of building an Enterprise Risk Management (ERM) process. Actuaries, risk managers and other financial professionals are in the market explaining their theory of ERM. Many offer an array of new products and services.

Simply put, ERM is a decision-making process based on principles of risk and reward that spans across all of the firm’s operations. When implemented effectively, ERM ensures appropriate capitalization and provides for controlled risk-taking. It positions the firm to take advantage of attractive business opportunities while at the same time identifying and avoiding unattractive pursuits.

Many of today’s ERM products focus primarily on determining a company’s “Required Economic Capital” (REC). Economic capital is a simple concept: it is the capital of the firm with all assets marked-to-market and liabilities carried at their discounted values. Rather than focusing on how much economic capital a company currently has, most of these models attempt to determine how much capital the firm should have; hence the expression “Required Economic Capital.” Typically, this process involves estimating the amount of economic capital that would be needed to avoid bankruptcy at some high level of confidence.

This approach entails a number of appealing qualities. First, the idea is simple. Large underwriting, investment or operational losses — also known as “tail events” — deplete the capital base of the firm. So it makes sense to establish a capital target based on such events.

Second, the approach recognizes a firm’s capital is needed to support its ongoing operations. The same cannot be said for more traditional capital ratios (e.g. premium-to-surplus ratios) that are based solely on historical figures.

Finally, marking the entire balance sheet to market causes a firm to focus on its true value, rather than looking through a lens that is sometimes distorted because of the use of traditional accounting standards. One need look no further than the recent scandals in the United States surrounding finite reinsurance contracts — many of which were designed solely to smooth earnings without transferring any risk — to understand the importance of using market-based, rather than accounting-based metrics.

REQUIRED CAPITAL

Unfortunately, there are a number of key problems in relying solely on a company’s REC. To understand these problems, it may be helpful to realize the general assumptions underlying this approach to capital setting:

Assumption 1: A firm needs capital solely to avoid insolvency;

Assumption 2: A firm is only worried about one year’s worth of business; and

Assumption 3: A firm only cares about its economic results.

Not surprising, reality is much more complex.

First, most insurance policies, especially casualty coverage and life insurance, offer protection for losses that will not be finalized for many years. As a result, insurance companies must be concerned about maintaining their capital for many years.

Second, largely because of this long-term nature of their policies, insurance companies are among the most closely-watched financial entities. Policyholders, regulators and rating agencies all have a stake in ensuring that these companies maintain enough capital to support their promised payments. What makes the situation even more complicated is the fact that each of these observers has a different idea about how much capital the company should carry.

Finally, there is the matter of what a company’s capital is supposed to help support. Clearly, avoiding insolvency is one of the key goals of having insurance companies hold capital. However, it may be more important for a company to hold capital either to support its rating or to keep the company out of bankruptcy. Although there is a difference between the two, “bankruptcy” and “insolvency” are often used interchangeably. “Insolvency” occurs when a company’s liabilities exceed its assets. “Bankruptcy” occurs when a company is unable to meet its current payment obligations. While insolvent companies usually file for bankruptcy, bankruptcy is more often caused by cash-flow problems.

The natural question to ask at this point is: “So what?”

Specifically, if you agree there are a number of capital constraints facing insurance companies, a more detailed approach is likely to yield different capital requirements than the REC approach. The actual history of bankruptcies is one key indication that this is the case. According to a recent A.M. Best study, only 7% of insolvencies were caused by catastrophic losses; and yet, these are the exact events that tend to dominate most companies’ traditional capital calculations. In reality, the vast majority of insolvencies — nearly 70% — were caused by adverse reserve development, inadequate pricing, rapid growth and/or fraud. Because these problems tend to develop slowly over many years, they often are relatively small contributors to the traditional capital calculations.

So if a company can’t rely on the traditional, simplistic capital models, how should they decide how much capital is appropriate for their business?

In order to answer this question, it would be useful to consider two recent, high-profile collapses: PX Re and Confederation Life.

PX Re was a Bermuda-based reinsurance company that focused on catastrophe coverage in the United States. Like most reinsurers, they had unexpectedly large losses from Hurricanes Katrina, Rita and Wilma in late 2005. While the losses were not big enough to threaten the company’s solvency, they were large enough to threaten the company’s financial strength rating of ‘A.’ The company therefore raised capital from several different sources. Unfortunately, its attempts proved futile: in early 2006, rating agencies lowered PX Re’s rating below ‘A’ because the company had to upwardly revise its estimated losses from the three hurricanes. Very quickly, this led to PX Re’s demise. By August 2006, more than 80% of the company’s policies were cancelled or non-renewed and the company was effectively out of business.

The situation for Confederation Life was very different. At its peak, Confederation Life was one of the five largest life insurance companies in Canada. Like many large insurers, Confederation Life began expanding into many diverse markets in the late 1980s and early ’90s. For example, it moved into banking and spread into the United States. Because these growth options did not turn out to be as profitable as Confederation Life had expected, the company was forced to sink more capital into those operations. Unfortunately, this meant that when their main Canadian Life operations also started heading south, the company quickly ran out of liquidity and was forced into liquidation.

Can we learn from these tales of woe?

First, the risks facing a company are very diverse. Clearly every company needs to worry about the risk of insolvency. Beyond that, though, each company’s risks are quite unique. Therefore, in order to understand the capital ramifications, a company must first understand its unique risks. For example, does one company rely heavily on its rating (e.g. PX Re), or is it more concerned with its liquidity needs (e.g. Confederation Life)?

Once a company understands its unique risks, it must assess the different timeframes that affect its business. Specifically, the company must consider both short-term risks (e.g. catastrophes) and long-term risks (e.g. reserve development).

Finally, the company must consider all the different stakeholders — policyholders, equity analysts, rating agencies — and their unique approaches to assessing the company’s capital adequacy. The result of this process invariably will be a matrix of different capital measures. Only by satisfying all of these different measures, one of which is likely to be the traditional “Required Economic Capital” approach, can the company ensure it is adequately capitalize d.

Companies that incorporate all of these risks into their ERM framework will have a much richer understanding of their potential risks. In addition, they will be better capitalized to weather whatever storms the future may hold.