Assessment of Target Capital for General Insurance Firms

Abstract

Capital and cost of capital form a bridge between the insurance firm and the financial markets. The term capital is used in various ways. In current parlance, economic capital is frequently used to mean capital calculated using a risk-based measure which is independent of the regulatory requirements. In this paper we discuss the concept of target capital, where the firm takes account of three different approaches to risk appetite: regulatory capital plus a buffer; rating agency views; and the views of shareholders, where they make commitments to customers and wish to protect franchise value. We describe how, when blending these views, the firm needs to understand the trade-offs between too high and too low amounts of capital, with reference to the double taxation burden, insurance gearing (leverage of premiums to capital ratio), and the impact of the firm's credit rating on maximising franchise value. We then discuss the main drivers of the cost of capital, which we define as the required total return on the market value of the firm, as determined by reference to the opportunity cost of alternative investments of equivalent risk. We explain that, because the stock market value of the firm is not the same as the capital held inside the firm, the cost of capital derived from external studies cannot be directly applied to internal measures of target return such as return on equity (ROE); it is necessary to translate between the two measures. We separate the risk of the firm between the investment risk and the insurance risk. We describe the frictional costs of investing in an insurance firm, and explain the role of parameter and model risk arising from the uncertainty of the future claim costs of the firm. We describe the findings of two studies of the actual historical stock market returns of United States P&C companies. One of them suggests that applying the Fama-French model produces higher and more accurate cost of capital estimates than the capital asset pricing model (CAPM) method. This is explained by linking the price to book ratio to the costs of financial distress, which are particularly important for general insurance firms, given the influence of insurance strength ratings from the rating agencies. Finally, we attempt to estimate the risk load required in premiums to compensate investors for the elements of cost of capital which we have described, in a way that combines the financial economic approaches to insurance target returns with the traditional actuarial approaches to assessing the risks in the insurance business.

Enterprise Risk Management, Insurer Value Maximisation, and Market Frictions

“…The outstanding claims liability is determined assuming claims are lognormally distributed. The log-normal distribution is commonly used by practitioners to model general insurance liability distributions and is also used in Hitchcox et al [15]. In order to estimate the parameters of the log-normal distribution for each line of business we use the Tillinghast estimate of the coefficient of variation (CV) for outstanding claims liability by line of business from industry data between 1997 and 2001 and the mean outstanding claim liability for each line reported by APRA over this sample period.…”

Enterprise Risk Management, Insurer Value Maximisation, and Market Frictions

“…The log-normal distribution is commonly used by practitioners to model general insurance liability distributions and is also used in Hitchcox et al [15]. In order to estimate the parameters of the log-normal distribution for each line of business we use the Tillinghast estimate of the coefficient of variation (CV) for outstanding claims liability by line of business from industry data between 1997 and 2001 and the mean outstanding claim liability for each line reported by APRA over this sample period.…”

“…As a strategic tool, economic capital impacted pricing policies in 20% of firms and 10% of respondents discontinued unprofitable lines of business based on economic capital. The paper by Hitchcox et al [15] discusses the cost of capital and the impact of frictional costs for a model insurer with an objective of assessing target capital and premium loadings for insurers. Swiss Re [31] also assess the cost of capital for insurers and analyze frictional costs, referred to as the insurance cost of capital.…”

ERM for insurance companies – adding the investor's point of view

“…1 Deciding on the question of how much capital to hold in an insurance company is inextricably linked with the management of risks to franchise value. This topic is dealt with at length in the paper Hitchcox et al (2006), and in this section we present only a summary of the discussion from that paper.…”