Unit 6 - Strategically Managing Capital

Business Operations

Primary sources of internal capital ; produces revenue through net income or unrealized capital gains ; generate funds from premiums received when selling policies

Unrealized Capital Gain

The profit not yet earned on a held asset when it exceeds its original purchase price but has not been sold

Net Income

Underwriting profit and investment income and gains ; funds can be generated from insurance operations that can then be invested ; investment income and realized capital gains

Gains on stocks and bonds

Carried at market value ; unrealized capital gains directly increase policyholders’ surplus ; gains not counted as income

Unearned Premium Reserve

An insurer liability representing the amount of premiums received that are not yet earned ; premiums can only be earned as the period unfolds ; proportionate to premium in case it must be returned during a mid-term cancellation ; zero when premium is fully earned

Loss Reserve

In financial statements, a liability on an insurer’s balance sheet that shows the estimate amount that will be required to settle claims that have occurred but have not yet been paid

Assets and Liabilities on the balance sheet

May provide an additional source of capital

Valuation of los reserves

Cannot be done precisely, so it is reviewed for reasonableness ; a small adjustment may have a significant impact on policyholders’ surplus and business activities ; reductions will reduce loss expenses in the year the adjustment is made and increase net income and policyholders’ surplus

Discounting loss reserves

Directly increases policyholders’ surplus ; not allowed in statutory accounting ; explicitly permitted or approved by regulators for long-tail lines

Sell and Leasback

Used to increase capital ; owner sells the asset at fair market value to another party, then leases it back from the new owner ; can be useful in reducing liabilities by selling heavily mortgaged properties

Dividend Policy Decision Factors

Access to external sources of capital, expected rate of return on investment opportunities, dividends as an indicator of the company’s prospective performance, tax considerations, and investor attitude toward uncertainty

Access to external sources of capital

It usually costs more to generate capital from external sources, i.e. borrowing or issuing stock, compared to just retaining profits

Expected rate of return on investment opportunities

If it is lower than what is available to stockholders, management should consider using its free cash to pay dividends

Dividends as an indicator of the company’s prospective performance

A popular reason for increasing cash dividend payments us due to the belief that higher dividends will crease higher market prices for the shares because it reflects management’s optimism regarding company performance ; reducing dividends may be perceived as a negative signal that should lead to a reduction in share value

Tax considerations

Shareholders are taxed on dividends when they are declared ; if dividends are foregone and instead invested, the stockholder is not immediately taxed and should receive a benefit in the form of increased stock value

Investor attitude toward uncertainty

Shareholders might prefer current dividends over potentially higher future returns because uncertainty increases with the length of the planning horizon

Ways to reduce risk

Reduce the need for capital (limit expansion or reduce the amount of business written), refrain from writing or withdraw from riskier segments of business (long-tail liability lines or property in hurricane-prone areas), or attempt to manage the effect of social inflation on long-tail claims

Long-Tail Claim

A claim that is characterized by an extended delay between the claim’s triggering event and the reporting of the event to the insurer

Equity Capital

The money insurers raise from investors in exchange for stock in the company ; more expensive than issuing long-term debt

Benefit of equity capital

Does not increase financial stress because failing to pay dividends is not considered a default

Long-Term Debt

Either in the form of bonds or surplus notes ; external source of capital

Bond

Type of long-term debt ; the issuer (insurer) pays a set annual rate of interest and repays the borrowed sum on a specified date ; liability is shown on the statutory balance sheet as borrowed money

Surplus Notes

Function like bonds ; main method for mutual insurers because they cannot issue stock ; classified as policyholders’ surplus on statutory balance sheet

Reinsurance

The transfer of insurance risk from one insurer to another through a contractual agreement under which one insurer (the reinsurer) agrees, in return for a reinsurance premium, to indemnify another insurer (the primary insurer) for some or all of the financial consequences of certain loss exposures covered by the primary’s insurance policies

Loss Portfolio Transfer (LPT)

An insurer sells some of its policies to a reinsurer, also taking over the loss reserves to pay the policies ; the insurer transfers the risk and removes the associated liabilities ; used most often to withdraw from a segment of business than as a source of business

Surplus relief

Statutory accounting requires all expenses associated with the sale of a policy to be recognized when the policy is sold ; results in temporary surplus reduction ; insurer receive a commission in a reinsurance contract that offsets this temporary reduction

Reduced exposure to risk (reinsurance)

Renting additional capital from reinsurers ; helps avoid maintaining capital for potentially serious but unlikely losses

Securitization of Risk

The use of securities or financial instruments (stocks, bonds, commodities, financial futures) to finance an insurer’s exposure to catastrophic loss

Insurance-Linked Securities (ILS)

Issued by insurers ; transfers some of the risk that’s been absorbed by issuing policies ; typica;;y used for catastrophe risks

Securitization Process

Insurer pays cash into special purpose vehicle (SPV) ; SPV sells ILS to investors ; SPV retains the principal from sales until either the loss threshold is met (SPV will reimburse qualifying losses) or the security expires (principal is returned to investors) ; loss threshold is determinedby actual losses or index of insured losses by a group of insurers

Special Purpose Vehicles (SPV)

A facility established for the purpose of purchasing income-producing assets from an organization, holding title to them, and then using those assets to collateralize securities that will be sold to investors

Catastrophe Bonds

A type of insurance-linked security that is specifically designed to transfer insurable catastrophe risk to investors ; usually three year maturity, but often rolled over

Catastrophe bond process

Issued by SPV’s owned by large reinsurers, insurers, or large corporations to act as intermediaries ; transfer the risk directly to the investor in the bond

Catastrophe bond rating

Often rated by an agency ; rated based on its probability of default resulting from the occurrence of its triggering event and the accompanying loss of interest and/or principal ; probability is determined using catastrophe models ; many are below investment grade and therefore pay a higher interest rate (to compensate for the additional risk being assumed)

Amount of capital an insurer needs

Depends on the size of writing, the type of business being written, and the types of assets held

Risk-Based Capital (RBC)

Amount of capital an insurer needs to support its operations, given the insurer’s risk characteristics ; requirements consider underwriting risk, asset risk, credit risk, and reserve risk ; correlate to the risks assumed by that insurer

Underwriting Risk

A measure of the loss volatility of the types of insurance sold by an insurer

Credit Risk

The risk that customers or other creditors will fail to make promised payments as they come due

RBC Minimum

200%

RBC Model Law

Insurance regulators can take action before an insurer becomes too financially weak to be rehabilitated

RBC Formula

Provides an objective test of an insurer’s solvency and matches regulatory action to the level of solvency concern

Company Action Level

First level of regulatory intervention ; insurer must submit a comprehensive financial plan identifying factors that caused the problem and proposing corrective action ; 150% - 200% of the minimum RBC amount

RBC formula benefit for insurers

Can perform complex by mechanical calculation themselves to know whether they will come under regulatory scrutiny

RBC formula benefit for state regulators

Regulatory intervention is not arbitrary or motivated by political factors

RBC formula benefit for policyholders

Greater security that potential financial security of their insurers will be addressed by either the company or regulators

RBC Formula adjustment

Using covariance ; adjusts the sum of the capital requirements, so they do not need to be added together

Asset Risk

A decrese in asset value will reduce policyholders’ surplus ; considers investments in subsidiaries, fixed income assets (bonds and loans), equity assets (common and preferred stock) ; riskier assets need more capita ; multiply the NAIC value by a factor in the RBC booklet

Credit Risk

Most significant is the chance that one or more of the insurer’s reinsurers won’t be able to pay amounts due under reinsurance agreements ; interest, dividends, federal income tax recoverables, real estate income due and accrued, etc.

200% or more of the minimum RBC amount

No Action Required level ; no action required from either the insurer or regulator

100% - 150% of the minimum RBC amount

Regulatory Action Level ; the regulator is required to conduct an examination or analysis as deemed necessary ; the insurer is required to file a comprehensive financial plan with the state regulator

70% - 100% of the minimum RBC amount

Authorized Control Level ; the regulator may place the insurer under regulatory control but is not required to do so

70% or lower of the minimum RBC amount

Mandatory Control Level ; the insurance regulator is required to place the insurer under regulatory control

Action an insurer can take if they are having difficulty meeting the RBC minimum

Reduce its risk exposures or increase capital

NAIC Risk Management and Own Risk and Solvency Assessment (ORSA)

A model act requiring a risk and solvency self-assessment by insurers with a focus on ERM-related planning and processes ; promotes ERM principles, advocates financial soundness, and challenges insurers to effectively manage their risks and prospectively determine capital adequacy

ORSA Basics

Requires insurers to assess their current and probable future solvency by aligning capital adequacy with its risks, risk appetite, and current and future business planes ; ensure multiyear plans are achieved with managed risk and sufficient capital ; principles based ; provides help and facilitation ; each report is unique ; has requirements but allows discretion on amount of details

Summary Report

Requirement of ORSA ; when an insurer’s annual premium surpasses certain thresholds ; a commissioner may require it if an insurer appears to be in a deteriorating condition

Risk Management Framework

Section of ORSA ; describes insurer’s risk management policy ; the types and amount of risk it can and must take to achieve objectives ; list of risk categories, description of how its managed, policies for claims, underwriting, details on how the risk appetite aligns with risk management strategy

Assessment of Risk Exposure

Section of ORSA ; quantitative assessment of risk exposures ; in normal and stressed situations, considering operational, credit, cash flow, and market conditions ; encouraged to determine the level of stress for each risk that could cause failure, given their current capital ; description of the model process and calibrations

Prospective Solvency Assessment

Section of ORSA ; uses findings to determine the level of capital necessary to manage and maintain the insurer’s current business and future business for two to five years ; should demonstrate that they have the financial capacity to achieve its financial plans