Cpcu 540 Ch.9

Front 1

Overview of capital

Back 1

The finance dept. of an insurer is responsible for ensuring there is enough capital available. Capital funds operation and expansion for insurers.

Capital may have several meanings, a lot of different definitions such as third-party financing, total assets, and net worth.

Front 2

Capital for an insurer

Back 2

Represents the amount of assets from PHs surplus and long-term debt. When an insurance company borrows, the funds borrowed are available for investment until those funds have to be repaid which is why they are included as capital. Can be used for operational needs.

PH's surplus is often used to describe capital for an insurer. Surplus is determined using statutory accounting principals. Used for unexpected upward fluctuations in claims and poor investment results. Capital can be used as an emergency fund for claims the insurer didn't expect.

Front 3

Initial capital for an insurer

Back 3

Initial capital for an insurer provides funds for writing insurance and covering initial losses. Mutual insurer (initial surplus contributed from policyholders). Stock insurer (paid-in capital from original sale of stock).

Additional capital can be generated through borrowing, retained earnings or issuing more stock.

Front 4

Insurers need additional capital:

Back 4

As the amount of insurance written increases (this additional capital is necessary to cover any unexpected losses b/c the more insurance that's written the greater the chance of unexpected losses), also to replenish PH's surplus for reduction in net income caused by policy acquisition costs b/c acquisition costs are expensed immediately, and to support expanded sales and marketing (growth).

Front 5

Investor needs

Back 5

Investors have a need for investment growth. Investors will provide capital if the investment return is expected to exceed the return of alternative investments with similar risk.

Return is often measured by return on equity.

Front 6

Insurer regulator needs

Back 6

Regulators are concerned with the solvency of the insurer (concerned that if a loss occurs the insurer will be able to pay the claim). For regulatory purposes, unlike insurer purposes, long-term debt is not included in an insurer's capital, only assets.

The minimum amount of initial capital required for an insurer is set by insurance company's state of domicile and depends on business organization and types of insurance written.

Front 7

Insurer regulatory minimum capital requirements

Back 7

Minimum capital requirements are too low to serve as benchmarks for sound businesses. They serve only as bare minimums. Just b/c insurer has met minimum level of capital required by regulators doesn't mean the insurer is sound, it just means it's satisfied the bare minimum.

Risk-based capital (RBC) standards were developed by the NAIC. Insurers failing to meet standards may be subject to additional monitoring and review by the state. Not candidate for seizure unless RBC measurements are less than 50% of standard.

Front 8

Internal methods of generating capital

Back 8

Most common way is through business operations, mostly underwriting operations and investment income. Insurers can also generate capital by reevaluating balance sheet values, reducing dividends, and reducing risk.

Front 9

Internal methods of generating capital through business operations: net income and underwriting profits

Back 9

An insurer's capital is increased by net income which adds to capital w/o increasing financial risk associated with taking on more debt b/c it doesn't require borrowing. Income consists of profits from underwriting, income from investments and realized gains.

Increasing underwriting profits is the primary method of generating internal capital.

Underwriting profits are generated through a few different internal methods such as, rate making (setting premium prices), expense control and marketing. External factors that can influence underwriting profits are regulation, competition and inflation.

Front 10

Internal methods of generating capital through business operations: premium income and liability estimation

Back 10

Insurers receive premium income from business operations.

Two most significant liabilities from sale of insurance: unearned premium reserve (insurer receives up-front premium but it's earned over time, reserve is zero at end of policy period). Loss reserve (includes loss adjustment expenses reserves).

When liabilities (reserves) are being estimated that can influence amount of capital b/c surplus represents capital so when liabs are adjusted, surplus is effected which effects capital.

Front 11

Internal methods of generating capital through business operations: investment income and liability insurer returns

Back 11

Investment income is another source of capital. PH's surplus is also increased by unrealized gains on investments. Investments are reported at market value. As value of stocks and bonds fluctuates, so does capital.

Liability insurers generally have a greater rate of return on their investments than the return received by property insurers b/c liability insurers have more long-tail claims so it may take years before their claims are paid out. So liability insurers b/c they have a longer period of time to pay out a claim, will invest in more long term investments which generally have higher returns.

Front 12

Internal methods of generating capital through reevaluation of balance sheet

Back 12

One internal method and insurer can use to meet its capital needs is reevaluation of balance sheet reserves or asset values. Reserves are just estimates so they may be able to be adjusted.

Management is responsible for estimating needed loss and LAE reserves. External factors must be considered. So they can decrease reserves which will lower expenses and therefore increase income and PH's surplus. Liability insurers may discount loss reserves for time value of money which will increases surplus (generally not allowed but for some long tail lines the value of the dollar amount may change over time).

Front 13

Internal methods of generating capital through reevaluation of balance sheet: sale-leaseback transactions

Back 13

Sale-leaseback transactions (selling something you own then renting it back from the person who bought it from you) can be used to increase capital. Insurer has property which has been reported at historical cost (which is lower thus lowering surplus), insurer then sells it at fair market value, that will bring a lot of cash in which will increase assets and therefore surplus which is capital. Insurer then rents asset from purchaser.

Appropriate technique for assets that are normally carried at historical cost on the books. Capital increases will be the difference between the sales price and historical cost.

Front 14

Internal methods of generating capital through reducing dividends

Back 14

Dividends can be reduced or eliminated in an effort to maintain/increase capital. Stock insurer (reduce shareholder dividends but may cause reduction in stock price and loss in investor confidence). Mutual insurer (reduce policy owner dividends but doesn't happen very often due to negative reaction by policyholders).

Front 15

Methods of generating capital: reducing risk (external and internal)

Back 15

Insurer capital is used to cushion risk of loss. An internal method is if risk is lowered, insurer needs less capital. Risk can be reduced by limiting growth or withdrawing from risky lines (stop selling risky lines).

An external way of generating capital through reducing risk is the use of reinsurance. It is the most common method of reducing risk. Transfer of insurance to another insurer through contractual agreement. Does not increase value of insurer's assets.

Front 16

External methods of generating capital

Back 16

Insurers can generate capital externally in the following ways: stock, reorganization, debt, catastrophe bonds and reinsurance.

Front 17

External methods of generating capital: stock

Back 17

Stock insurers can raise capital by issuing stock. Can improve liquidity and solvency b/c there is no risk increase to insurer b/c dividends aren't required to be paid. Mutual insurer must reorganize to issue stock. Issuing stock is more expensive than debt but overall it may be better to issue stock.

An advantage of issuing stock is that financial stress will not be increased b/c lack of dividends is not a default.

Front 18

External methods of generating capital: reorganization

Back 18

Mutual insurance companies seeking external capital may consider a reorganization. Demutualization is the conversion of a mutual company to a stock company.

Disadvantages of demutualization: stock companies will be subject to federal securities laws which are often complex and it can be an expensive and time consuming process.

Front 19

External methods of generating capital through reorganization: full demutualization

Back 19

A full demutualization must be approved by policyholders and the state insurance commissioner. Usually involves surplus distribution to policyholders. Most policyholders receive stock but my receive cash or policy enhancements. Allocation of distribution must be approved by state regulators. Policyholder ownership rights are extinguished but contract rights remain intact. With full demutualization the mutual insurer no loner exists, it fully becomes a stock insurer.

Front 20

External methods of generating capital through reorganization: mutual holding company

Back 20

Another type of demutualization is a mutual holding company conversion where a mutual insurer becomes a stock insurer but it's more complicated than a full demutualization. What happens is the mutual insurer becomes a stock insurer which is then owned by a mutual holding company. So there is a parent (mutual holding company) and subsidiary (stock insurer). Once the transition is complete the mutual holding company can sell stock insurer shares to raise capital.

Policyholder contractual rights remain with stock insurer. Other rights are with holding company. Policyholders receive subscription rights as well.

Front 21

External methods of generating capital: debt and surplus notes

Back 21

Insurers can also issue debt, like bonds, to raise capital. Debt holders have priority claim. Can produce higher ROE b/c when debt is issued it becomes a liability there for is lowers surplus. Surplus is the denominator in the ROE equation so when it is lower the ROE increases

Surplus notes are bonds that have some equity characteristics. Even though it's similar t stock, a mutual insurer can issue them. Unsecured debt with characteristics of both equity and debt. Main way mutual insurers raise equity capital. Even though it really is a bond, for SAP purposes it's not treated as debt, it's treated as surplus (equity) which helps strengthen the RBC ratio. Failure to repay interest isn't considered default. Insurers can purchase surplus notes.

Front 22

External methods of generating capital: catastrophe bonds

Back 22

Another form of debt that can be issued is a catastrophe bond which transfers risk of catastrophe from insurer to bond investors. If the insurance company issues a catastrophe bond the insurance company will be paying interest and will be required to pay the bond at some point however the repayment is reduced or eliminated in the case of a catastrophe. Bond rating is based on likelihood of event. Coupon rates are typically higher than those of investment-grade corporate bonds b/c of additional risk.

Front 23

External methods of generating capital through reinsurance: LPTs

Back 23

Can increase capital through loss portfolio transfer (LPT). LPTs are used to transfer a portfolio of losses from one insurance company to another. The transferring company pays reinsurer some cash amount for that transfer. LPTs are usually used to withdraw from a segment of business rather than raise capital.

Capital from LPT will increases if cash transferred by insurer is less than loss reserves that were on that insurer's balance sheet. Cash paid out is typically based on discounted value of estimated losses however loss reserves are generally undiscounted on financial statements. This typically results in an increase in capital.

Front 24

External methods of generating capital reinsurance: surplus relief through ceding commission

Back 24

Can provide surplus relief. Provides a ceding commission from reinsurer (fee paid by reinsurance company to the original insurer of the policy being ceded to the reinsurer to cover administrative costs). Ceding commission covers policy acquisition expenses of original insurer. Surplus relief is a secondary goal of reinsurance with primary goal being the transfer of insurance risk.

Reinsurance can reduce exposure to risk. Reduced risk results in lower capital need.

Surplu relief = (ceded written premiums - ceded earned premiums) * ceding commission

Front 25

Reasons for shareholder dividends

Back 25

Many financial models indicate the value of a stock is the present value of future dividends plus terminal value. Excluding taxes, cost and uncertainty, there should be no preference between receiving dividends currently and having the earning retained by the insurer to grow. B/c uncertainty is a real life concern a company's dividend policy (whether it will pay out dividends or retain them) becomes critical.

Most insurance companies have a minimum objective of continuing current dividend scale. Most companies don't like to lower dividends b/c that can send a bad signal to the market which can cause the stock price to go down.

Financial managers wanting to increase the market price of the company's stock would likely increase dividend payments.

Front 26

Dividend policy

Back 26

Factors to consider with dividend policy: external sources of capital (if company has access to external sources of capital it may be willing to pay out a dividend), expected return on company investments (if return is lower than the shareholder's expected return then dividends should be paid), investor attitude regarding uncertainty (shareholders often prefer current dividends over higher future returns), tax aspects of dividends (dividends represent taxable income to the shareholders), dividends as an indicator of company performance (increase in dividends usually has a positive effect on the price of a company's stock, companies tend to keep payout ratio within a certain range for dividends).

Front 27

Factors to consider for insurance company dividends

Back 27

Dividends of an insurer are effected by additional factors: income measurement rules (there is no agreement regarding how insurers should measure income for dividend purposes, shareholders receive GAAP stmts, regulators receive SAP stmts, so there is no guidance as to how income should be measured in order to pay out dividends). Regulatory restrictions (dividend payments are restricted by each state). Cash flow (unrealized gains generate income but not cash to pay dividends). Capital structure (insurers can raise cash by issuing debt or equity or expanding). Ownership (mutual companies pay dividends to policyholders, considered an adjustment in the price of insurance).

Front 28

Dividend alternatives

Back 28

As an alternative to dividends an insurer may: Repurchase it's own stock (provides cash to existing shareholders, reduces future dividend payments). Invest funds in alternative opportunities (can offer even greater future returns, can purchase or merge with other companies).