10 February 2009

Published in: Corporate strategy, Capital - models

(Re)insurers face difficult choices on capital

The range of options for bolstering capital has decreased as the credit crunch has intensified. Risk retention vehicles may have a role to play, argue Adrian Richardson and John Reed.

In November 2007, Standard & Poor's published an "Industry Report Card" that examined insurers at the advent of the credit crisis. The report concluded that "the capital adequacy of the sector as a whole is at a cyclical high."

This was indeed welcome news: capital adequacy is vital in allowing (re)insurers to withstand the inherent volatility associated with certain catastrophe exposures. However, it is equally vital (for both the (re)insurer and their cedants) that (re)insurers retain an ability to access the capital markets post-loss to raise substantial capital (at acceptable terms) to rebuild their capital base after a severe and unexpected event (such as a hurricane or series of hurricanes). In other words, access to liquid capital markets can be just as important as current capital adequacy.

Yet, since the S&P report card of 2007, the economic crisis has deepened and that healthy surplus identified by S&P may well have been eroded. In addition, the ease with which (re)insurers could raise significant levels of additional capital in the event of a major market loss may now be questioned. In the short term, this may result in leaner, meaner (re)insurers if it becomes harder to raise capital at attractive terms through mechanisms such as hybrid instruments.

Most (re)insurers have, by convention and necessity, been fairly orthodox in their capitalisation. The "traditional" (re)insurance group may be capitalised as follows:

• debt (borrowing facilities from core lender)
• equity (shareholder funds)
• contingent capital (reinsurance)

However it is possible to argue that, in the decade preceding the current economic crisis, the availability of capital at attractive terms increased through the introduction of new mechanisms, such as hybrid instruments. For the sake of brevity and simplicity, hybrid capital can be defined as debt instruments with some of the loss-absorbing characteristics of traditional equity (such as being long-dated and allowing for a suspension of interest payments). From an accounting perspective, the details of the instrument will determine whether it is classified as debt or equity. It is believed that hybrid instruments accounted for a material amount of the capital raised by (re)insurers in the last decade.

Therefore it is possible to imagine a (re)insurance group capitalized, until very recently, in the following manner:

• senior debt
• hybrid (subordinated) debt
• equity (shareholder funds)
• other forms of "non-indemnification" contingent capital (which dilute equity or must be repaid)
• contingent capital (reinsurance)

Capital structures more complex?

This change in the traditional business model meant that, for those outside the industry, the complexity of (re)insurers' capital structures appeared to grow. For example, as the characteristics of individual hybrid instruments determine how equity-like they actually are (and therefore how well they absorb losses), the lack of "standardisation" meant that a degree of transparency was being lost. However, the key point is that (re)insurers have, in the recent past, been able to bolster their balance sheets through a variety of different instruments. In other words, capital has been readily available at attractive rates, in a variety of forms that correspond to differing (re)insurers' needs.

So what does this all mean? Why is it important that (re)insurers have had access in recent times to a variety of instruments to support (and/or repair) their balance sheets?

The favourable terms available for some of the financial instruments used by (re)insurers may be less readily available. In the short term therefore it may be comparatively difficult for (re)insurers to raise substantial amounts of capital to repair balance sheets in the event of any significant loss activity. This would not present a problem if the insurance industry retains a healthy capital adequacy; however, various losses throughout 2008, such as Hurricanes Ike and Gustav and reserve strengthening against the sub-prime crisis, may have reduced that adequacy level. In other words, there is a strong possibility that the industry's surplus capital has been eroded.

(Re)insurers have, in the recent past, been able to bolster their balance sheets through a variety of different instruments

Even without an additional significant loss event, there are initial indications that the capacity for certain lines of business reduced at 1 January 2009. For example, capacity for catastrophe retro coverage has been reduced in key territories. This may have an impact on those reinsurers who rely on retrocessional catastrophe coverage as a form of contingent capital to support their balance sheets or business strategies.

Added to this erosion of surplus capital and vital retrocessional reinsurance capacity there is the fact that, on the asset side of the balance sheet, many (re)insurer's equity holdings have probably fallen heavily over the past 12 months (the FTSE 100 fell around 32% during 2008).

In a normal market cycle, a rapidly hardening market would be quickly tempered by new investors, and existing insurers, raising capital to take advantage of increasing prices. This, after an initial honeymoon period, rapidly suppresses pricing as the supply of capacity swiftly outstrips demand.

However, in this post-credit crunch market, it is logical to assume that it may be far harder for (re)insurers (and other investors) to raise capital (or traditional debt for that matter) in the immediate future (though there is some evidence that limited appetite remains for "pure" underwriting risk for select lines of business). It may also be fair to assume that shareholders (and/or new investors) themselves may have little surplus with which to invest in any new equity issue.

Should the industry experience any more significant major loss activity in the near future, therefore, it follows that this could usher in a more pronounced hard market as raising additional capital could prove problematic, leaving (re)insurers struggling to repair potentially impaired balance sheets.

Pressure to increase retentions

What does this mean for buyers of commercial insurance?

Firstly, insurance purchasers may well come under pressure to increase their retentions on certain lines of business if prices rise or capacity is withdrawn. If this is the case, it is vital that buyers of insurance understand the full implications of any increased risk retention on their own balance sheets and cash flows. It is therefore important for organisations to have a thorough understanding of their own risk tolerance. Ideally an analysis should be performed not only at group level but also at business-unit or profit-centre level, since the retention capacity and the balance-sheet reactions can be very different, depending on the financial specifics of each entity.

Secondly, buyers of commercial insurance should consider the most efficient means of financing retained risk, particularly if they are required to take on more exposure. Risk retention vehicles, such as captives or cell companies (protected cell companies or incorporated cell companies), may have a role to play and, typically, come to the fore in response to a leaner, meaner insurance market as they may offer advantages over simply financing an increased retention out of existing operating revenues.

It may be far harder for (re)insurers (and other investors) to raise capital (or traditional debt for that matter) in the immediate future (though there is some evidence that limited appetite remains for "pure" underwriting risk for select lines of business)

As an extension of the preceding paragraph, concerns over (re)insurer capitalisation (or their ability to recapitalise in the event of a major loss occurring before the financial markets have had a chance to recover) may well prompt buyers of insurance to "keep their cash where they can see it". In such circumstances, formalising self-insurance arrangements through a risk financing vehicle may well provide more robust risk management controls than simply setting aside funds which are liable to be diverted to alternate uses.

Thirdly, it is possible to imagine that, if capital continues to be eroded, with little investor appetite to replace it, this hard market may last longer than previous upturns. If this is the case, then considering using a risk retention vehicle becomes even more relevant, as the argument traditionally used against them (that their relevance declines in a softening market) is lessened and they can be incorporated in to a long-term readjustment of an organisation's risk financing strategy.

Insurance purchasers would therefore be well advised to consider their current risk financing strategies and have plans in place to respond to this potential shrinkage in capacity and corresponding hardening of terms. To ensure they can respond in an adequate and timely manner insurance buyers should be looking to explore the alternatives to buying traditional commercial insurance now -- so that they are in a position to take control of future risk financing strategy for a potentially prolonged hard-market cycle. As a bare minimum, buyers should (re)consider how much risk they can retain and then address the issue of how this retained risk could be financed most efficiently.

Adrian Richardson is Principal Consultant, Risk Finance, Aon Global Risk Consulting (AGRC), and John Reed, Senior Consultant, Risk Finance, AGRC

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