The Capital Race: Maintaining Staying Power

Property and casualty insurers, it appears, have leapt from the frying pan straight into the fire. After several years of depressed pricing but adequate investment returns, the business environment is doing an about-face, with rates finally going in the right direction, but investment returns heading south.

Not only have equity markets been weak (the bear came out of hibernation in mid-2000 and has yet to return to its slumber), but record-low interest rates have also hit bond returns in a bad way. And while the direction that equities will take in the medium-term is anyone’s guess, interest rates will likely stay low for some time to come.

Couple this with very high claims costs (internationally, as a result of 9/11 and a handful of other natural and man made losses, domestically due to the auto line and other sore spots), and it becomes evident that the industry has been hemorrhaging capital as of late.

The end result is that while rates in certain lines are very attractive, many companies either do not have the statutory capital needed to back the assumption of greater risks, or are very close to not having enough. Increased premiums put pressure on the capital ratio for premiums to surplus. In the U.S., a premium to surplus ratio of no more than 2 to 1 is a common “rule-of-thumb acceptable”, while in Canada, it’s 3 to 1. In some parts of Europe, 5 and 6 to 1 are common, while 8 to 1 or higher is common in Bermuda. Many places outside Canada and the U.S., consequently, allow for much higher premium volume with far less backing capital.

Thus, over the last year or so, a great paradox has been created for many property and casualty insurers around the world: just as the cycle is turning for the better, many companies are finding themselves unable to take advantage of the improvement in business terms because of the beating they have taken over the last few years.

INTERNATIONAL SOLVENCY

According to Swiss Re Economic Research in sigma 4/2002, Global non-life insurance is in a time of capacity shortage: “The soft market, the accumulation of major losses, and the decline in equity markets have reduced the industry’s capital base in all major markets. Solvency ratios had already started to decline in 1999 in the U.K. and in most other markets by 2000. The U.S. non-life (p&c) industry’s capital funds declined in 2001 by US$27 billion or 8.5%. In 2001, non-U.S. insurers are estimated to have lost about US$60 billion in capital funds due to losses in their equity portfolios. As a result, worldwide non-life capital decreased by about US$90 billion in 2001. With the current stock market performance, 2002 looks set to be the third consecutive year of capital decline. By August, U.S. insurers’ capital funds were down some US$36 billion due to losses in equity investments. We estimate a loss of G40-50 billion in European insurers’ capital funds in 2002 so far.”

Coming close to failing a given regulator’s solvency test, or failing it outright, can have several possible repercussions for an insurer, ranging from the mild to the catastrophic. First, if a company is close to failing a solvency test, it would have to be very careful about writing new business, to ensure that its surplus is adequate to back the assumption of more risk. It could also force the company to postpone other, non-organic plans to grow, including foregoing acquisitions. It may also require that the company postpone or cancel its dividend payment to shareholder(s).

Failing a solvency test outright may force the company to downsize its book to minimize policy liabilities. This can be done by selling minority stakes or individual portfolios, spinning-off certain operations or placing certain lines into run-off. In serious cases, a company may have to stop writing new business altogether. At the very worst (if a company cannot meet its policy liabilities) the operation could be seized by regulators and a wind-up order eventually issued and a liquidator appointed by the courts.

CANADA: STATUTORILY SPEAKING

P&c insurers in Canada must satisfy regulatory authorities that their assets are sufficient to satisfy their policy liabilities. In this regard, the Office of the Superintendent of Financial Institutions (OSFI) administers the minimum asset test (MAT) for federally regulated insurers.

Compounding the problem that many companies are facing a constraint on their regulatory capital is the fact that the federal regulatory capital requirements are undergoing change. The MAT evaluates capital requirements on a different basis than the new test – minimum capital test (MCT) which will be effective in 2003. Companies have been reporting under both regimes over the past two years as the regulator assesses the impact of the MCT on capital requirements of the industry. There has been some recent concern as to whether the MCT will be the only test applicable in 2003 or whether OSFI will evaluate capital based on both tests.

In an industry letter dated October 17, 2002, OSFI attempted to clarify the issue by stating that it will be recommending that Section-516 of the Insurance Companies Act dealing with asset regulations be revoked at the first available opportunity. The letter observes, “however, such an opportunity is not likely to present itself before the new MCT requirements come into force. With the repeal of the “Assets Regulations”, effective January 1, 2003, Section-516 will only require that balance-sheet assets be at least equal to balance sheet liabilities. As such, Section-516 should not raise any ‘compliance’ concerns on the part of p&c companies.”

While there are some compliance concerns surrounding the change, of perhaps greater relevance for the sake of this article is that some companies currently constrained by capital under the MAT (measured as a percent of excess assets available over assets required) are finding that their MCT (measured as a percent of excess capital available over capital required) results are adequate. As a result, they may be confronted by a situation in which it is necessary to increase capital in the short term until the MCT is implemented.

IBC reports that in 2001, Canadian insurers’ MAT results weakened over the prior year and the number of companies failing the test edged higher. The bureau noted that many factors influence capital adequacy, including investment portfolio valuations, adequacy of premium rates, overall loss experience and development on prior year claims. Regarding investment portfolio valuations, when considering the value of equities as they apply to the MAT, insurers must take the amount by which the market value exceeds the book value (the market value is what buyers are willing to pay at a given time – essentially the bid or ask price – while the book value is the total shareholders’ equity divided by the number of shares outstanding). Therefore, when equity markets are experiencing a bull run, insurers can add to their assets for test purposes, sometimes by a great degree. However, when the markets are being mauled by a bear, the opposite is true. (IBC notes that in 2001, the TSE Composite Index suffered the second-largest percentage decline in its history.)

Regarding development on prior year claims, in 2001 it appears that the well has run dry for positive run-off in Canada. According to IBC, “For the first time in many years, there was negative development on prior year claims [in 2001]. We estimate that insurers pumped $470 million into reserves last year to account for prior year claims. This contrasts with favorable reserve development averaging $550 million a year over the previous six years.” What’s more, IBC in its March 2002 issue of Perspectives, noted that “…58% of companies reported unfavorable development in 2001, compared to fewer than 30% in each of the six prior years.”

ENTER THE REINSURER

There are a number of reinsurance solutions that are designed to address short- term needs as well as any longer term capital needs, such as those mentioned above.

Traditional and finite quota share arrangements have the flexibility to address a variety of n eeds. A quota share arrangement can provide protection against volatility in earnings, provide relief from capital constraints in a variety of forms, and mitigate dependence on a particular line of business. Flexibility is provided through the level of risk transferred, the percentage ceded, the classes of business covered, and the commission structure and commutation provisions. A quota share can be executed with on a retroactive basis (via a transfer of an unearned premium reserve) in order to achieve more immediate capital relief, or on a new and renewal prospective basis to achieve ongoing capital and earnings volatility protection.

A stop loss reinsurance arrangement also provides capital relief and some earnings volatility protection. This is an excess of loss cover applying to losses from the current accident year. Losses in excess of a prescribed level and up to a limit are ceded to a reinsurer.

A loss portfolio transfer (LPT) is a retroactive cover that provides an immediate relief from capital constraints and some protection from earnings volatility. In this case, the reinsurer assumes the insurer’s outstanding losses from prior years with the pricing based on the level of risk assumed, anticipated loss payment patterns and investment returns. Again, flexibility is achieved through the level of risk transfer, commutation provisions and class of business transferred.

While LPTs and finite quota shares are considered to be non-traditional reinsurance solutions, there are newer, more sophisticated non-traditional solutions that are also available to help insurers meet their short and long-term capital requirements. These include “blended covers”, which combine finite and traditional reinsurance solutions, and contingent capital (CC) solutions, which essentially provide an option to raise capital, subject to certain conditions – or triggers – which may be related to such things as natural hazards or financial market risks, among others.

There are many reasons why insurers purchase reinsurance protection: to increase capacity, to smooth results, to spread risk (especially to protect against low frequency/high severity events), and to grow the business in a manageable way. In the current state of the market, one can also add to the list: To help get through the current environment of rapid capital depletion. For many carriers these days, even for the largest global operators, it is not just a matter of their long-term prosperity, but their near-term survival.