To improve returns to shareholders, chief executives of insurance companies around the world use a variety of techniques, including mergers and acquisitions, programs for improving the performance of core businesses, and schemes to promote investor relations. Although most insurers are massively overcapitalized, the repertoire doesn’t include capital management, which senior executives appear to regard as largely a matter for actuaries and accountants.

This state of mind has a number of causes. In the first place, the actuarial and financial sides of insurance companies don’t communicate well. Moreover, formidable analytic and computational difficulties confront any company that attempts to determine not only how much capital is required to cover the risk from its different business lines but also the actual return on capital. Regulation too has played a part: until recently, even if companies tried to manage their businesses and capital aggressively, they were frustrated by the rules governing insurance markets, particularly in Europe.

But deregulation, threats of acquisition, tougher competition, and eroding margins make it increasingly important to give shareholders competitive returns—and also supply the pressure that could transform capital management into a powerful tool for creating value. Advances in analytics and computing power address the complexities of the task, while new financial instruments can change the risk embedded in portfolios and thus their capital requirements. In addition, capital management doesn’t require companies either to lay off employees or to undertake burdensome reorganizations.

Insurance companies that have taken the leap and begun to manage capital comprehensively have achieved exceptional results. The prominent reinsurer Swiss Re, for example, has significantly improved the performance of its shares by shaping its business mix and returning capital to shareholders. When the company bought back $1.3 billion worth of its shares in 1997, market analysts noted that active management of its risk portfolio had permitted it to redeploy capital in this way. The Scandinavian insurer Storebrand has used the insights from an integrated understanding of its risk capital needs to adapt its capital allocation and pricing and to assess more accurately the capital synergies in cross-border merger-and-acquisition deals. Chubb cut its reinsurance spending to 10 percent (from 25 percent) of premiums and increased its use of capital by raising the self-insurance level for individual losses to $25 million (from $5 million), a move presumably driven by a better understanding of the true risk capital needed. And a major Swiss insurer defined a portfolio of strategic thrusts based on value while also considering the implications for capital—measures that helped the company double its bottom line and raise its share price by more than 50 percent.

Indeed, when insurance companies realistically assess the genuine risk their business units carry, most of them will probably find that they have surplus capital reserves, which can then be redeployed for maximum returns. The rational allocation of risk capital and risk-adjusted performance targets for business units can serve as the foundation of a new model of governance.

How insurance companies can estimate the capital they need, the levers they can pull to manage their capital, the levers they can pull to manage their capital, and the actions required to act on those levers are essential to maximizing the companies’ capital and value.

Understanding risks and returns

On both sides of the Atlantic, insurance companies carry from 50 to 100 percent more equity than they use. High investment returns over many years, the relatively low number of natural or industrial catastrophes requiring big payouts, and better diversification of risk as a result of cross-border mergers and acquisitions have all contributed to this buildup.

But how can insurance companies have too much capital? Wouldn’t excess capital permit them to write more business or to take more risks? The answer would be yes if insurers knew how much extra capital they had and could add more value by taking advantage of profitable new business opportunities. In reality, the combination of too much capital and stagnant demand in the property-and-casualty business has cut prices. The profit margins of insurance companies are eroding quickly, and their shares lag behind those of companies in other industries. (See boxed insert, "Economic profit.")

Bringing value-at-risk to insurance

For insurance companies, the challenge is to bring the risks generated by a wide variety of insurance businesses (life, catastrophe, property and casualty, and investments) under one roof and to measure these risks consistently. What does an earthquake in Japan have to do with a car accident in Poland, a windstorm in Northern Europe with a stock market crash in Asia, and longevity in developed countries with changes in the interest rate of Brazil’s government bonds? The answer is the need for capital, the common denominator of all risk. How much capital—that is, equity—should a company put aside against unexpected losses? By measuring risk in terms of capital required in unfavorable situations, insurance companies can make the whole spectrum of risks comparable.

Mastering the skills needed to do so represents a challenge similar to that faced by banks, which must understand and manage widely different kinds of risks, from financial market positions to credit exposures. Banks therefore developed a concept, known as value-at-risk, that increases the transparency of market and, more recently, credit risks. Just as banks must hold equity capital, insurance companies must put aside risk capital to cover not only losses in their different lines of business (such as life, and property and casualty) but also in their stock and bond portfolios.

A simplified balance sheet can illustrate these ideas (Exhibit 1). On its right-hand side, insurance companies list their equity capital and reserves for future claims payments; on the left, their investments. Equity capital offsets investment losses and unexpected claims liabilities. To calculate the actual amount of capital required for that purpose, a company estimates the difference between its expected results and the worst possible results (stemming from asset and liability losses) over a period of, say, one year. The amount needed to cover that loss is the company’s risk capital.

Once an insurer knows how much capital it requires to back up its total level of risk, it can determine how close its available equity comes to meeting its needs (Exhibit 2). The results of this exercise can be surprising. For one thing, only 15 to 30 percent of the risk capital is generally set aside for insurance underwriting risks; the remainder covers potential investment losses. In addition, many if not most companies will discover that they carry more equity capital than they need and that it is time to think about ways of using their shareholders’ capital more productively.

Linking risk capital to returns

The next important task is to link the risk capital a company requires to the returns its businesses generate. Each business should have a return in line with the risk it brings to a company’s book. Exhibit 3 shows the returns of individual businesses, the risk capital they require, and the return on that risk capital. Fortified with this knowledge, an insurer can identify which businesses are promising and which are not.

Even so, it is not enough to compile reports on risk capital and risk-adjusted returns for each line of business or each channel. Before an insurer can manage its capital for maximum shareholder value, it must see the combined impact on net profit and capital needs and value of its underwriting and investment activities, its growth and performance targets, its asset allocations, and its reinsurance policies. So the next step in managing capital for value dynamically is to assess the implications of risk and return for the company’s financials over time: the net profit in the income statement and the risk capital on the balance sheet.

Putting capital to work

Once insurance companies have devised a comprehensive approach to their capital and balance-sheet management, they can improve their use of capital in four ways: allocating assets more productively, optimizing reinsurance programs, buying back shares, and changing their mix of businesses.

Allocating assets

Adjusting the duration and currency mix of the bond portfolio and its share of the total investment portfolio can have an enormous impact on a company’s level of risk and thus generate a superior risk-adjusted return. Possible modifications include structuring the investment portfolio so that returns correspond to the cash flow patterns of a company’s liabilities and making equity portfolios more diverse by increasing holdings of foreign stocks.

Such actions can increase a company’s asset returns by more than 50 basis points (or half a percentage point), which translates into a 2 percent increase in return on equity. Insurance companies might well take more risk with their assets if they have excess capital and difficulty putting it to work (for example, German insurers facing huge tax liabilities if they pay back equity) but cannot enlarge their businesses.

Reinsurance programs

Insurers obtain reinsurance to cover themselves against large unexpected underwriting losses and therefore to even out their earnings. They pay for it by giving up shares of the premium. In the case of the European property-and-casualty industry, this involves some 10 to 15 percent of premiums, or as much as $40 billion a year. After claims and commissions received back from reinsurers are deducted, the cost for the German property-and-casualty insurance industry, for example, has averaged 3.5 percent of premiums over the past ten years. Is this a reasonable price for the ensuing reduction in risk?

Many insurers, though covered against relatively small risks that diversification alone could handle, don’t have enough coverage against cumulative losses that are big enough to put them out of business. These insurers could improve their return on capital by increasing their levels of self-insurance and by purchasing nontraditional reinsurance protection—for example, protection for the bottom-line result of the whole business. They could also improve their combined ratio (claims and expenses as a percentage of premiums) by 1 to 3 percent if they looked at their current reinsurance strategies in an integrated way.

Buying back shares

Many insurance companies will still have too much capital even after adjusting their asset mixes and reinsurance strategies to increase their use of it. Without growth or an acquisitions program, the surplus can be diminished only by returning capital to shareholders in the form of share repurchases or higher dividends.

Insurers that pay back excess capital not only show that they understand their level of risk and care about creating value but also escape pressure to write unprofitable business. On the industry level, the effect should be to raise trading multiples (market-to-book ratios, for example) and thus to help support acquisition programs or fend off hostile takeovers. As governments remove regulatory constraints on repurchasing shares—something that has started to happen in France, Germany, and the United Kingdom—the level of such transactions will probably surge.

Changing the business mix

Finally, companies can improve their returns and capital structures by examining the current profitability of their business units as reckoned by the amount of risk capital each requires. Many companies unwittingly use hard-earned returns to subsidize underperforming lines of business. One casualty insurance portfolio we saw generated about 15 percent of the company’s return but required 40 percent of the risk capital, thereby producing a risk-adjusted return on capital that was no less obscure to senior managers than it was unsatisfactory for shareholders.

Once a company understands the risks and returns of all its business lines and the nature of its portfolio as a whole, it can distinguish promising lines from also-rans, which it can restructure (market conditions permitting) so that they befit a portfolio organized on the principle of risk-adjusted returns.

Insurers must introduce a planning procedure that allocates capital to all business units, sets targets for returns on that capital, and monitors the returns on a risk-adjusted basis to sustain performance. Under this regime, poorly performing lines have to raise their operating profits or wither away. Profitable lines will receive more capital, in effect giving them higher growth targets that can be translated into front-line operational targets.

In this way, companies can expect to gain an edge in the game of maximizing shareholder value. At first, they will improve their performance by using their capital more effectively. When the new approach has been applied across the board, they will be able to cut prices and to cherry-pick the most profitable business segments. The laggards, meanwhile, can expect lower margins, less business, and, if they persist in their outmoded ways, eventual loss of independence.