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Agenda

The determinants of capital in the P&C insurance industry Authors: Elena Grubisic , Darrell Leadbetter ARIA Annual Meeting Quebec City, August 6, 2007. Agenda. Why study the determinants of capital? Literature review Data & methodology Results Observations.

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Agenda

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  1. The determinants of capital in the P&C insurance industryAuthors: Elena Grubisic , Darrell LeadbetterARIA Annual MeetingQuebec City, August 6, 2007

  2. Agenda • Why study the determinants of capital? • Literature review • Data & methodology • Results • Observations

  3. Why the determinants of capital? • increasing regulation of capital (allowable ROE) • greater use of capital models • development of risk based regulatory capital • increasing frequency of insolvency • insurance becoming more integrated into capital markets Understanding the determinants of capital is important for the proper application of capital models, regulatory capital, and ERM techniques

  4. Canadian P&C industry • federal or provincial charter • federal or provincial solvency supervision • provincial regulators monitor market conduct • 345 insurance companies • $36 billion in premiums • $111 billion in assets

  5. Federal/provincial supervision Federal (OSFI): 82.9% ($29.8 billion)Provincial: 17.1% ($6.2 billion) Federal: 190 insurers 2 insurers 7 insurers 3 insurers 2 insurers 8 insurers 56 insurers 12 insurers 60 insurers 5 insurers Source: PACICC, based on data from Superintendents of Insurance

  6. More capital in the industry Insurance Risk Ratio (NPW/Equity) Source: based on data from MSA Research

  7. Growing capital & insolvency (Canada) # of insolvencies Insurance Risk Ratio (NPW/Equity) Source: PACICC, based on data from MSA Research

  8. Growing capital & insolvency (U.S.) # of insolvencies Insurance Risk Ratio (NPW/Equity) Source: PACICC, based on data from A.M. Best & III

  9. The role of capital • Central to the operation of an insurance company: • policyholder protection against insolvency • needed to finance future growth • important element of shareholder value • return on capital an important performance measure • protection against uncertainty in liability provisions • protection against catastrophes

  10. Available capital Supervisory ladder of intervention Risk margin Best estimate liability The role of capital “Free” capital Capital requirement Reserves (technical provisions)

  11. Insurance company capital Operational capital minimum capital required to facilitate cash flow and maintain sufficient liquidity to manage current operational liabilities such as salaries, leases and IT maintenance. Risk capital the additional capital a firm requires to cover the financial consequences of its business risks. Signaling/strategic capital capital required to overcome information asymmetries and reassure external stakeholders of the firm’s soundness and capacity to survive catastrophic shocks or pursue other strategic goals such as market share.

  12. Insurance company capital Risk capital Operational capital Signaling/ strategic capital # simulations 99% of scenarios Probability of ruin X % of scenarios capital ($) Source: PACICC & IBC

  13. International trends • higher severity and frequency of catastrophe losses • increased utilization of enterprise risk management by management • recognition of the role of operational risk in insolvency • growing utilization of risk-based capital tests • increased international mobility of capital

  14. Agenda • Why study the determinants of capital? • Literature review • Data & methodology • Results • Observations

  15. Literature review Capital budgeting and allocation Merton and Perold (1993), Cummins and Sommer (1996), Cummins (2000), Myers and Read (2001) Sherris (2006) Determinants of capital Cummins and Nini (2002) Carayannopoulos and Kelly (2005)

  16. Determinants of capital

  17. Capital allocation/budgeting models

  18. Agenda • Why study the determinants of capital? • Literature review • Data & methodology • Results • Observations

  19. Determinants of capitalization The amount of capital an insurance company should hold is expected to depend on: • probability of insolvency • agency costs • product market interactions • strategic opportunities & market signaling • regulatory environment

  20. Data & methodology Tested variables related to: • financial distress • product market • agency costs • signaling/strategic objectives • Similar to Cummins and Nini (2002) & Carayannopoulos and Kelly (2005) Financial data MSA, PACICC, IBC, A.M. Best

  21. Dependent variables Equity capital - longer historical series, data over a full cycle Risk-based capital score (MCT/BAAT) - introduced in 2003, data only for the healthy part of the underwriting cycle.

  22. Independent variables Financial distress: Market risk indicators: CPI, interest rate volatility, TSX volatility Underwriting/insurance risk: ROE, earnings volatility, earthquake exposure, rate regulation, geographic & product concentration, guarantee fund assessments Product market: Long tail risk: commercial writings

  23. Independent variables Agency costs foreign owned mutual company size variables: medium & small group membership (Canadian) Signaling & strategic: M&A activity Financial strength rating stability

  24. Agenda • Why study the determinants of capital? • Literature review • Data & methodology • Results • Observations

  25. Regression results(p-values)

  26. Regression results Related to increased capital holdings: Federal/allProvincial inflation earthquake exposure earnings foreign ownership rate regulation being a mutual company being a member of a group M&A activity commitment to A+ or greater financial strength rating

  27. Regression results Related to decreased capital holdings: Federal/allProvincial geographic concentration rate regulation product concentration guarantee fund assessments being a medium size company M&A activity being a small size company

  28. Regression results Risk-based capital tests: Related to higher MCT/BAAT: inflation interest rate volatility geographic concentration foreign ownership mutual ownership Related to lower MCT/BAAT: group membership

  29. Agenda • Why study the determinants of capital? • Literature review • Data & methodology • Results • Observations

  30. Earnings increase capital Property & Casualty Industry Return on Equity (all companies) (1975 – 2006) Source: IBC

  31. Subject to risk-based capital requirements Cost of capital - practice Leverage: insurance risk ratio Subject to dollar based capital requirements (typically $3 million minimum) Source: PACICC, with data from MSA Research & IBC

  32. Signaling % disagreement between rating agencies Source: Morgan (2002). “Rating Banks: Risk and Uncertainty in an Opaque Industry” American Economic Review, 92:874-888

  33. Observations - regulation Provincial companies, on average, hold less capital Federal companies under a risk-based solvency system hold more capital Supervisory framework: “The objective of assessing Earnings is to understand and assess the quality, quantity and volatility/sustainability of an institution’s earnings and how they contribute to Capital.” Dynamic Capital Adequacy Test (Canadian Institute of Actuaries SOP) “For property and casualty insurers, the actuary would consider threats to capital adequacy under plausible adverse scenarios that include but are not limited to the following risk categories:” “… pricing, government & political action …” Federal solvency framework compensates for capital incentives of provincial rate regulation

  34. Observations - regulation “… given the inherent volatility in this sector, together with the impact of provincial government policies in certain lines of business, and the trend towards more frequent and severe natural disasters, OSFI will continue to monitor the P&C industry closely.” -- OSFI 2006 annual report, pg. 31

  35. Summary • Profitability has a robust but incremental impact on the long run implications of capital • Signaling financial stability and capital for pursuit of growth opportunities are important reasons for holding capital • Capital allocation/budgeting models: • few incorporate factors for operational risks or pursuing strategic opportunities • regulatory environments utilizing such models in setting approved price levels need to consider solvency implications

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