The changes that are underway will demand the best of us. Indeed, the time is ripe for the development of best practices and for a ”new thinking” that can serve to push companies to become smarter, leaner, and more efficient. It is in this realm that capital management is becoming one of the prevailing top-of-mind topics for insurance executives. The change taking place in the capital management space is hitting life insurers much harder than the P&C sector, although both sectors are feeling the effects of the liquidity crunch. Recent signs of recovery and evidence suggesting a reopening of traditional capital channels notwithstanding, the current environment continues to put pressure on the capital positions of many insurers, as capital bases have been negatively impacted. A number of firms are still looking for ways to bolster statutory surplus – only to find that traditional channels of raising capital have either been significantly reduced or are too expensive.

In spite of this dim picture, some companies are taking charge by embracing strategic capital management solutions that not only answer today’s conundrum, but that put them in the position for improved competitive advantage and longterm profitability.

By strategically assessing a company’s capital adequacy, leading firms are engaging in capital management activities ranging from issuing stock to writing surplus notes and raising capital through alternative sources, such as increased reinsurance and hedging. Many firms are also taking a more holistic approach to managing capital. On the art of perseverance in tough times, Ralph Waldo Emerson once said, “Our greatest glory is not in never failing, but in rising up every time we fail.” And while the financial system itself may have faltered, the insurance industry — which bases its very existence on risk and the unexpected — will pave the way toward a unique competitive advantage on the road ahead by embracing and pursing forwardthinking strategies in the capital management space.

In 2008, both the life and property & casualty (P&C) sectors realized large investment losses that led to significant declines in earnings and surplus – though the life sector fared much worse. With this backdrop, metrics that assess a company’s capital adequacy have taken center stage at a number of insurance companies. On the life side, deterioration in the credit and equity markets adversely affected earnings, liquidity positions and capital levels. Hit by increased investment losses and declines in sales and fee revenues from annuity products, large losses posted by life insurers in 2008 included more than $50 billion in investment losses and a $76.8 billion decrease, or a 24 percent decline, in statutory surplus, down to approximately $250 billion.1 This environment has caused life companies to become vulnerable to downgrades in their financial strength ratings, while a continued weak outlook for variable annuities appears to be in the cards for the near term.

In spite of limited exposure from generally conservative investment portfolios, P&C insurers suffered investment losses as well. Impacted by poor investment performance in 2008, the P&C industry’s weakened profitability was evidenced by $19.6 billion in investment losses; a 90 percent decline in statutory net income; and a $59.4 billion, or 11.3 percent, decline in policyholder’s surplus to $465 billion for FY08. According to A.M. Best: “The second half of 2008 was unprecedented with respect to the dislocation of the financial markets and the significant widening of credit spreads on corporate bonds, causing the industry to report approximately $35.1 billion of realized and unrealized investment losses during the fourth quarter alone.”2 As the result of market volatility, a soft underwriting cycle and reduced sales in a slowly recovering economy, earnings for the P&C industry are projected to remain weak in the near term. This is confirmed by rating analysts who foresee little improvement in yields and a continuation of adverse impact from the soft underwriting cycle.

The changes that are underway will demand the best of us. Indeed, the time is ripe for the development of best practices and for a “new thinking” that can serve to push companies to become smarter, leaner, and more efficient.

NAIC View To better quantify the capital adequacy of a company based on its risk characteristics, the National Association of Insurance Commissioners (NAIC) adopted a measure known as risk-based capital (RBC) in the early 1990s. It is a factor-based approach that applies to the risks of both assets and liabilities. For life insurers, the factors capture risks related to assets, asset/liability mismatch, underwriting risk, credit risk, and some aspects of business risk. The P&C formula includes asset risk, underwriting and reserving risk, credit risk, and some aspects of business risk. The RBC computation also applies a simplistic covariance calculation to multiple risk areas. As life products became increasingly complex and tied to asset accumulations with multiple guarantees, these risks were not captured in the factor based RBC formulas. After several rules-based modifications of the RBC model, the NAIC recently introduced principles-based stochastic models to capture these features in the annuity business. In addition, a standard deterministic scenario still needs to be computed and serves as a floor for the reserves and required capital.

Rating Agency View

Rating agencies generally review a company’s capital adequacy by calculating some variation of the risk-based capital ratio. Moody’s Investor Service (Moody’s) supplements its review of a company’s financial ratios with an assessment of their NAIC risk-based capital ratio. Standard & Poor’s (S&P) calculates its own version of risk-based capital for each company based on its own risk factors, as well as proprietary stress tests. Similarly, A.M. Best calculates a capital adequacy ratio for each company based on factors for investment risk, credit risk and underwriting risk. While rating agencies consider risk-based capital as a directional tool to assess a company’s capital adequacy, they also consider other qualitative parameters like the company’s risk management system, which may impact capital adequacy not captured by these quantitative capital models.

Economic Capital Models

Over the past several years, insurance companies have increasingly been developing economic capital models to supplement the factor-based approach to capital adequacy and to aid in the allocation of capital required to specific products. Economic capital is the amount of capital required to provide a specific level of financial security to a company in relation to the risks assumed. It is a market-consistent economic measurement approach for assessing the value of assets and liabilities. Economic models use probability distributions to determine the level of capital necessary to support unfavorable outcomes. For a given confidence interval and time horizon, stochastic models predict the amount of capital required to support all unfavorable outcomes under that threshold. As a statistical measure, correlations between risks can also be incorporated into the models to assess the amount of required capital.

An important milestone for economic capital has been the European Union’s adoption of Solvency II, which not only will permit, but it will encourage insurers to use internal models to determine their solvency capital. S&P and Moody’s have also broadened their review of companies to supplement static risk-based capital ratios with a review of economic models. In addition, Moody’s has developed its own risk-adjusted capital model that employs Monte Carlo simulations to assess investment, reinsurance, reserve, and underwriting risks for property and casualty companies.

As mentioned above, the NAIC has taken more of piecemeal approach in the use of economic models. The NAIC has focused on modifying its rules-based formulas to develop principle-based models for specific classes of life insurance reserves, such as variable annuities. As the NAIC continues to review the use of principle- based models for specific risks, there is likely to be a further melding of rulebased formulas with principle-based models. Terri Vaughan, CEO of the NAIC, sees the optimal regulatory structure as likely being some combination of internal models that are used as an adjunct to the rulesbased capital requirements.

As shown by the recent market dislocation, an effective regulatory monitoring system must go beyond a reliance on capital models. Ms. Vaughan believes that it is important for regulators to be cognizant of red flags that demand attention – like excessive growth, excessive use of reinsurance, investment strategies outside the norm, entry into new lines of business. History indicates these are potential indicators of future problems. These other aspects of regulatory oversight are at least as important as quantitative capital requirements.

Managing Capital Adequacy Beyond the Model

The recent economic turmoil has highlighted questions about relying too heavily on models for determining capital adequacy. These approximations and assumptions have proven to be problematic in extreme circumstances, as we have experienced in the recent economic situation. The approach needed is one that does not solely focus on capital modeling, but rather focuses on integrating capital management with an insurers’ business planning and risk management system. Insurers should also adopt a mindful approach to balancing regulatory capital, economic capital and the rating agency view of capital. Companies might also wish to think about redefining their risk appetite and whether it makes sense to focus on developing and continuously adjusting capital allocation for products. In addition, a robust capital management framework should place more focus on regulatory capital and the enhancement of regulatory capital forecasting capabilities.

Other Smart Steps in Managing Capital Adequacy

Capital management activities should be designed to fit well within the company’s corporate strategic direction given the level of economic capital required for different risks. A company must plan for its capital needs throughout its product and business life cycles on both a legal entity and company-wide basis. Short-term cash and capital needs must be balanced with longer-term strategic directions. Even during times of market volatility, a welldesigned capital strategic plan allows a company to effectively execute in managing capital.

The company must also consider constraints put on its capital by its different stakeholders. For example, lenders may impose restrictive covenants on the company that impacts their capital decisions.  Proper consideration must also be given to both the current risk-based capital requirements and the direction being taken by regulators in developing a capital adequacy framework for the future. And while maintaining an effective capital strategic plan that considers these varied issues will help companies better manage capital costs and align capital management activities with its overarching corporate objectives, firms are challenged to balance these oftentimes competing priorities.

Widening investment losses, declining returns and a near-dry well of traditional capital channels have limited the availability of fresh capital. As such, savvy insurers are seeking new ways to gain access to liquidity to provide capital support for products with high capital charges. Keeping in mind the wish to regain investor and consumer confidence, stave off further rating downgrades and remain compliant with regulatory standards, insurers are looking at alternative sources of capital through a number of channels, including:

• • Divestiture: Some insurers are selling off non-core businesses, entire blocks of business, or specific assets in an effort to build up capital, pay down debt and fund investment losses. With the illiquidity in the market this can be difficult at an acceptable price. In addition, by divesting now, insurers risk sacrificing the future upside potential of these assets for shortterm capital relief.
• • Securitization: Some companies have securitized some of their assets to enhance capital. Others briefly considered securitization of insurance products but, given the still-tight credit market, have decided against securitization as a viable option.
• • Issuance of stock or debt: With the challenges in the credit market, this option at first appeared not be a workable option, however, it may become a viable alternative in the mid-term future as the markets become more liquid.
• • Hedging techniques: Many large life insurers have historically focused on hedging techniques to reduce the volatility of their GAAP earnings. Today statutory capital volatility has become critically important to ensure sufficient regulatory capital as well as to maintain an insurer’s credit ratings. As a result, hedging strategies that also address statutory capital have gained a lot of impetus in recent times.
• • Reinsurance: Reinsurance is one of the avenues by which insurers might quickly obtain capital. However, few players are offering solutions for the market risks inherent to the embattled life insurance industry’s annuity products. The solutions that some reinsurers offer maybe too expensive to be of real value to assist life insurers in adequately maintaining riskbased capital.
• • Statutory relief measures: The NAIC at its fall national meeting advanced a measure that would allow insurers to expand their use of deferred-tax assets. While the measure faces a final vote at the NAIC’s winter meeting, several states have offered some type of relief in this regard since late 2008 on a state-by-state basis. These include Illinois, Vermont, Connecticut, Indiana, New York, Iowa, Tennessee and Ohio.
• • Structural changes: In order to maximize the use of capital, a number of insurers are looking at their organization and considering alternative structures to ensure the most effective use of capital. In addition, ease of capital flows and maximization of dividends have been key considerations in this effort.
• • Organic capital growth: Insurers are looking at enhancing capital through improvement of their bottom line. Notwithstanding the recent stock market rally, investment yields are expected to be low in the short to medium term. As such, the focus will continue to be on underwriting results. Insurers have already instituted a number of short-term cost reduction measures, however, a trend in developing longer-term sustainable cost management strategies is emerging. Insurers are also developing new products that are more capital efficient and are desirable to their customers.

While the road ahead in the area of capital management is still unsure, signs of better days ahead appear to be imminent. Wise practices insurance companies employ today in managing capital and liquidity are sure to go a long way in offering both immediate and longer-term relief. To be sure, today’s challenging environment may be unique — a road less traveled if you will — yet by thinking creatively about alternative sources of liquidity and aligning capital management activities strategically with the company’s core objectives and goals, that road less traveled becomes a road leading to a unique competitive advantage and position of strength moving ahead.

1 U.S. Life/Health 2008 Financial Results, Best’s Statistical Study, A.M. Best, March 30, 2009

2 2008 Financial Review, U.S. Property/Casualty Industry’s Profit Squeezed on Both Ends, Best’s Statistical Study, A.M. Best, April 13, 2009

3 Best’s Insurance Reports – Property/Casualty, July 21, 2008, page xiv