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The Actuary The magazine of the Institute & Faculty of Actuaries

Managing the money

The effective management of capital is one of the key goals of managers in insurance companies. Indeed, because policyholder-customers are inefficient bearers of insolvency risk, industry regulators subject insurance companies to stringent regulatory capital rules and solvency monitoring requirements. However, because the solvency (risk-based) capital requirements are governed by regulation rather than economic criteria, this can result in a non-optimal allocation and use of insurance capital.

Economic performance measurement
Capital allocation in insurance companies can be used to facilitate the effective measurement of the profitability of various lines of business with varying risk profiles and capital requirements. For example, the matching of the maturity and duration of capital supply (liabilities) and investment (asset) functions is a critical balance sheet management activity that necessitates good accounting/actuarial technology. However, the relation between capital allocation and value maximisation in insurance companies requires managers to measure line of business performance (in terms of generated cashflows or ‘profits’) and to establish whether each business line is exceeding (or at least covering) its economic (opportunity) cost of capital, thereby contributing positively to owners’ wealth.
The link between return and economic capital underpins the economic value added (EVA) concept. (EVA is the registered trademark of the US consulting firm Stern Stewart.) In its simple form:
where NOPAT is net operating profit after tax (adjusted for various accounting items such as research and development costs), k is the weighted average cost of capital (WACC), and CE is capital employed.
The use of EVA is more common in banking than in the insurance sector. This could reflect the preference of managers (in life insurers at least) for actuarial performance measurement tools such as embedded value (EV). In essence, EVA is created in three main ways:
– first, by reducing the cost of capital (eg alleviating market risks);
– second, by increasing NOPAT (eg through generating new business); and
– third, by reducing capital employed (eg by divesting from non-value-adding activities).
As EVA and EV both seek to measure the flow of economic value created from business-in-force, the two concepts should be closely related. Indeed, Robinson suggests that EV is the equivalent of the expected present value of period EVA (discounted at the post-tax WACC (PVd)) and the actuarial value of shareholders’ net assets (SNA) (defined as the excess of total assets over total liabilities plus statutory reserves). Thus:
EV = SNA + PVd (EVA)

Capital management and strategy
Corporate strategy is concerned with generating sufficient funds in time t to invest in assets (projects) that are expected to have a positive net present value in time t+n. Therefore the management of economic capital and its associated aspects of return, risk, and cost should be central to the strategic planning in insurance companies. Such considerations are also likely to be influenced by the form and mix of financing (eg equity, reinsurance, etc) used by managers. Factors such as the availability of financing, managerial expertise, regulatory issues, and tax effects will also be relevant in capital management. However, the overarching strategic issue is that whatever the form and mix of capital employed, it should be allocated optimally to business uses in ways that maximise the value of owners’ economic utility.

Cost of capital
In the insurance industry, economic capital supports the contractual claims of suppliers of finance (policyholders/shareholders) and, as such, it is essential in supporting new business development. Therefore, the cost of capital will be a key issue. Lee and Cummins report that in the US property-liability insurance industry the capital asset pricing model (CAPM) is the most common metric used to derive the cost of capital. The CAPM is defined as:
Rj = Rf + bj (Rm Rf)
where Rj is the expected equity return, Rf is the risk-free rate (assumed to be the short-term return on government bonds), bj is the beta representing the degree to which a firm’s share price volatility reflects that of the market as a whole, and Rm is the expected market return. Betas are computed using historical share price data or taken from published sources such as the London Business School Information Service (LBSFIS). For insurance companies, the value of betas is usually about 1.0 reflecting the risk-return profile of the market as a whole.
One area where the cost of capital is important for insurance companies is in the pricing of risk. For example, to create economic value, underwriters should assign an amount of capital to a particular risk (or risk group) that reflects the cost of capital. Premiums should then be set at a level that generates a (post-tax) return (margin) in excess of the cost of capital. These principles can be used to set targets, evaluate management performance and base compensation plans. Nevertheless, Van Doorn and Briys suggest that in practice many insurers sell products at prices that are below the cost of capital hardly a recipe for maximing owners’ wealth!

Capital allocation
Various techniques have been reported in finance literature to improve the allocation of capital. For example, corporate risk-adjusted performance measures such as the risk-adjusted return on capital (RAROC) and return on risk-adjusted capital (RORAC) are often used in the financial services sector, particularly in banks. The RAROC method assesses a risk adjustment on investment that is assumed to be proportional to the amount of capital at risk. RORAC, on the other hand, involves a risk adjustment on capital at risk that uses a cost of capital normally derived from the CAPM. However, RAROC and RORAC are at best crude measures of the effectiveness of capital usage. For example, they do not take into account diversification or natural hedging. Therefore, their use could result in an overstatement of the cost of business line risk and lead to an inefficient allocation of capital.
Interesting developments using option pricing theory, however, address many of the deficiencies of composite risk measures such as RAROC/RORAC. One such model is that developed by Merton and Perold. Their model accounts for the effect of risk diversification across business lines in multidivisional financial services companies, thereby leading to a more optimal allocation of capital that enhances the transparency of business line profitability. In turn, this enables managers to make operational and strategic decisions that maximise owners’ wealth.

The aim
The overriding aim of capital management in the insurance industry should be the maximisation of owners’ economic interest. Considerations of risk, return and the cost of capital are an integral part of effective economic capital management. The use of sound accounting/actuarial technology is also important, as is an appreciation of the capital management techniques that are reported in the academic finance literature.