1. The determinants of capital in the P&C insurance industry Authors: Elena Grubisic, Darrell Leadbetter ARIA Annual Meeting Quebec City, August 6, 2007

2. Agenda  Why study the determinants of capital?  Literature review  Data & methodology  Results  Observations

3. Why the determinants of capital?  increasing regulation of capital (allowable ROE)  greater use of capital models  development of risk based regulatory capital  increasing frequency of insolvency  insurance becoming more integrated into capital markets Understanding the determinants of capital is important for the proper application of capital models, regulatory capital, and ERM techniques

4. Canadian P&C industry  federal or provincial charter  federal or provincial solvency supervision  provincial regulators monitor market conduct  345 insurance companies  $36 billion in premiums  $111 billion in assets

5. Federal/provincial supervision Federal (OSFI):82.9% ($29.8 billion) Provincial: 17.1% ($6.2 billion) Source: PACICC, based on data from Superintendents of Insurance 8 insurers 7 insurers 12 insurers 3 insurers 60 insurers 56 insurers 5 insurers 2 insurers Federal: 190 insurers

6. More capital in the industry Insurance Risk Ratio (NPW/Equity) Source: based on data from MSA Research

7. Growing capital & insolvency (Canada) # of insolvencies Insurance Risk Ratio (NPW/Equity) Source: PACICC, based on data from MSA Research

8. Growing capital & insolvency (U.S.) Insurance Risk Ratio (NPW/Equity) # of insolvencies Source: PACICC, based on data from A.M. Best & III

9. The role of capital Central to the operation of an insurance company:  policyholder protection against insolvency  needed to finance future growth  important element of shareholder value  return on capital an important performance measure  protection against uncertainty in liability provisions  protection against catastrophes

10. The role of capital Best estimate liability Risk margin Available capital Reserves (technical provisions) Supervisory ladder of intervention Capital requirement “Free” capital

11. Insurance company capital Operational capital minimum capital required to facilitate cash flow and maintain sufficient liquidity to manage current operational liabilities such as salaries, leases and IT maintenance. Risk capital the additional capital a firm requires to cover the financial consequences of its business risks. Signaling/strategic capital capital required to overcome information asymmetries and reassure external stakeholders of the firm’s soundness and capacity to survive catastrophic shocks or pursue other strategic goals such as market share.

12. Insurance company capital Source: PACICC & IBC 99% of scenarios Risk capital Operational capital Probability of ruin X % of scenarios capital ($) # simulations Signaling/ strategic capital

13. International trends  higher severity and frequency of catastrophe losses  increased utilization of enterprise risk management by management  recognition of the role of operational risk in insolvency  growing utilization of risk-based capital tests  increased international mobility of capital

14. Agenda  Why study the determinants of capital?  Literature review  Data & methodology  Results  Observations

15. Literature review Capital budgeting and allocation Merton and Perold (1993), Cummins and Sommer (1996), Cummins (2000), Myers and Read (2001) Sherris (2006) Determinants of capital Cummins and Nini (2002) Carayannopoulos and Kelly (2005)

16. Determinants of capital Cummins and Nini (2002) Carayannopoulos and Kelly (2005) Financial distress  Reinsurance is substitute for capital  Asset risk  Larger insurers hold less capital  Diversification does not reduce capital  Reinsurance is substitute for capital  Larger insurers hold less capital Product market  Commercial policyholders more sensitive to insolvency  Personal lines insurers hold more capital Agency costs  Mutual do not over utilize capital  Long tail lines more leveraged  Information asymmetries reduce capital Signaling/strategic  Support that insurers signal  Insurers with growth opportunities do not hold more capital

17. Capital allocation/budgeting models CAPMFama- French 3/Full value beta Marginal capital allocation Risk Adjusted Return on Capital (RAROC) Value at Risk (VaR) Dynamic Financial Analysis Regulatory Risk Based Tests Approachanalysis of correlations between entity & the market CAPM plus insolvency put option approach probability of default fixed ratios applied to selected accounting positions Risk Components Market riskYes No*Yes Insolvency risk NoYes Operational risk No No* Commentsentity wide, relies on market data entity wide but can be done by line of business, relies on market data applied by line of business adjusts risk based on correlations between lines of business based on volatilities. Not a first principles based approach can include either deterministic or stochastic modeling approaches does not necessarily capture economic role of capital. * these models have variations that incorporate operational risk, which is typically defined as investment risk, which we have defined as market risk. Nevertheless, we believe the capacity for operational risk as currently being discussed in the ERM literature exists.

18. Agenda  Why study the determinants of capital?  Literature review  Data & methodology  Results  Observations

19. Determinants of capitalization The amount of capital an insurance company should hold is expected to depend on:  probability of insolvency  agency costs  product market interactions  strategic opportunities & market signaling  regulatory environment

20. Data & methodology Tested variables related to:  financial distress  product market  agency costs  signaling/strategic objectives Similar to Cummins and Nini (2002) & Carayannopoulos and Kelly (2005) Financial dataMSA, PACICC, IBC, A.M. Best

21. Dependent variables Equity capital - longer historical series, data over a full cycle Risk-based capital score (MCT/BAAT) - introduced in 2003, data only for the healthy part of the underwriting cycle.

22. Independent variables Financial distress : Market risk indicators: CPI, interest rate volatility, TSX volatility Underwriting/insurance risk: ROE, earnings volatility, earthquake exposure, rate regulation, geographic & product concentration, guarantee fund assessments Product market : Long tail risk:commercial writings

23. Independent variables Agency costs foreign owned mutual company size variables: medium & small group membership (Canadian) Signaling & strategic : M&A activity Financial strength rating stability

24. Agenda  Why study the determinants of capital?  Literature review  Data & methodology  Results  Observations

25. Regression results (p-values) All companiesFederalProvincial Financial distress CPI0.0430.2530.172 Interest rate volatility0.5110.5140.886 TSX volatility0.9440.7870.285 earnings/ROE0.0000.0010.701 earnings volatility0.5280.3880.512 exposure to rate regulation0.0000.0010.041 earthquake exposure0.6990.997.014 geographic concentration0.0180.0690.520 product concentration0.0010.0000.840 guarantee fund assessments0.1030.6080.050 Product Market commercial writings0.3950.3500.424 Agency costs foreign owned0.1980.5470.020 mutual company0.0030.0110.354 medium size0.000 0.885 small size0.000 0.379 group membership0.0030.0420.379 Information asymmetry/strategic M&A0.0090.0020.036 financial rating stability0.000 0.299 Adjusted R-squared0.6430.6650.468

26. Regression results Related to increased capital holdings: Federal/allProvincial inflationearthquake exposure earningsforeign ownership rate regulation being a mutual company being a member of a group M&A activity commitment to A+ or greater financial strength rating

27. Regression results Related to decreased capital holdings: Federal/allProvincial geographic concentrationrate regulation product concentrationguarantee fund assessments being a medium size companyM&A activity being a small size company

28. Regression results Risk-based capital tests: Related to higher MCT/BAAT: inflationinterest rate volatility geographic concentrationforeign ownership mutual ownership Related to lower MCT/BAAT: group membership

29. Agenda  Why study the determinants of capital?  Literature review  Data & methodology  Results  Observations

30. Property & Casualty Industry Return on Equity (all companies) (1975 – 2006) Earnings increase capital Source: IBC

31. Cost of capital - practice Source: PACICC, with data from MSA Research & IBC Leverage: insurance risk ratio Subject to risk-based capital requirements Subject to dollar based capital requirements (typically $3 million minimum)

32. Signaling % disagreement between rating agencies Source: Morgan (2002). “Rating Banks: Risk and Uncertainty in an Opaque Industry” American Economic Review, 92:874-888

33. Observations - regulation Provincial companies, on average, hold less capital Federal companies under a risk-based solvency system hold more capital Supervisory framework: “The objective of assessing Earnings is to understand and assess the quality, quantity and volatility/sustainability of an institution’s earnings and how they contribute to Capital.” Dynamic Capital Adequacy Test (Canadian Institute of Actuaries SOP) “For property and casualty insurers, the actuary would consider threats to capital adequacy under plausible adverse scenarios that include but are not limited to the following risk categories:” “… pricing, government & political action …” Federal solvency framework compensates for capital incentives of provincial rate regulation

34. Observations - regulation “… given the inherent volatility in this sector, together with the impact of provincial government policies in certain lines of business, and the trend towards more frequent and severe natural disasters, OSFI will continue to monitor the P&C industry closely.” -- OSFI 2006 annual report, pg. 31

35. Summary Profitability has a robust but incremental impact on the long run implications of capital Signaling financial stability and capital for pursuit of growth opportunities are important reasons for holding capital Capital allocation/budgeting models:  few incorporate factors for operational risks or pursuing strategic opportunities  regulatory environments utilizing such models in setting approved price levels need to consider solvency implications