Holding Sufficient Capital

From Jean-Pierre Berliet

The companies that withstood the crisis and are now poised for continuing success have been disciplined about holding sufficient capital. However, the issue of how much capital an insurance company should hold beyond requirements set by regulators or rating agencies is contentious.

Many insurance executives hold the view that a company with a reputation for using capital productively on behalf of shareholders would be able to raise additional capital rapidly and efficiently, as needed to execute its business strategy. According to this view, a company would be able to hold just as much “solvency” capital as it needs to protect itself over a one year horizon from risks associated with the run off of in-force policies plus one year of new business. In this framework, the capital need is calculated to enable a company to pay off all its liabilities, at a specified confidence level, at the end of the one year period of stress, under the assumption that assets and liabilities are sold into the market at then prevailing “good prices”. If more capital were needed than is held, the company would raise it in the capital market.

Executives with a “going concern” perspective do not agree. They observe first that solvency capital requirements increase with the length of the planning horizon. Then, they correctly point out that, during a crisis, prices at which assets and liabilities can be sold will not be “good times” prices upon which the “solvency” approach is predicated. Asset prices are likely to be lower, perhaps substantially, while liability prices will be higher. As a result, they believe that the “solvency” approach, such as the Solvency II framework adopted by European regulators, understates both the need for and the cost of capital. In addition, these executives remember that, during crises, capital can become too onerous or unavailable in the capital market. They conclude that, under a going concern assumption, a company should hold more capital, as an insurance policy against many risks to its survival that are ignored under a solvency framework.

The recent meltdown of debt markets made it impossible for many banks and insurance companies to shore up their capital positions. It prompted federal authorities to rescue AIG, Fannie Mae and Freddie Mac. The “going concern” view appears to have been vindicated.

Directors and CEOs have a fiduciary obligation to ensure that their companies hold an amount of capital that is appropriate in relation to risks assumed and to their business plan. Determining just how much capital to hold, however, is fraught with difficulties because changes in capital held have complex impacts about which reasonable people can disagree. For example, increasing capital reduces solvency concerns and the strength of a company’s ratings while also reducing financial leverage and the rate of return on capital that is being earned; and conversely.

Since Directors and CEOs have an obligation to act prudently, they need to review the process and analyses used to make capital strategy decisions, including:

  • Economic capital projections, in relation to risks assumed under a going concern assumption, with consideration of strategic risks and potential systemic shocks, to ensure company survival through a collapse of financial markets during which capital cannot be raised or becomes exceedingly onerous
  • Management of relationships with leading investors and financial analysts
  • Development of reinsurance capacity, as a source of “off balance sheet” capital
  • Management of relationships with leading rating agencies and regulators
  • Development of “contingent” capital capacity.

The integration of risk, capital and business strategy is very important to success. Directors and CEOs cannot let actuaries and finance professionals dictate how this is to happen, because they and the risk models they use have been shown to have important blind spots. In their deliberations, Directors and CEOs need to remember that models cannot reflect credibly the impact of strategic risks. Models are bound to “miss the point” because they cannot reflect surprises that occur outside the boundaries of the closed business systems to which they apply.

©Jean-Pierre Berliet   Berliet Associates, LLC (203) 972-0256  jpberliet@att.net

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Explore posts in the same categories: Economic Capital, Financial Crisis, Modeling, Tail Risk, Uncertainty

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