Trends in Capital Management For Asian non-life insurance companies

By Verne Baker

Based on Watson Wyatt's experience in carrying out projects across a large number of countries in Asia, we believe that prior to the Global Financial Crisis (GFC), capital management occupied a low level of importance for many non-life insurance companies' management teams.

The introduction of risk based capital in countries such as Singapore and Malaysia has raised greater awareness of the need to manage capital. However, in our assessment, very few companies have paid careful attention to the linking of capital management with investment and reinsurance policy, company strategy, financial performance and setting underwriting targets. These companies are mostly foreign owned or have a foreign majority shareholder.

In this article, Verne Baker looks at the state of capital management in a selection of Asian countries prior to the GFC and considers some possible changes that may occur in the near future as a result of the events of the past couple of years.

What is an optimal level of capital for an insurance company with consideration to risk and return?
In assessing the appropriate range within which the optimal level of capital is believed to lie, a number of factors should be considered. These include:

• regulatory minima
• cost and availability of capital i.e. shareholder requirements for return on capital
• risk appetite of company
• market practice of peer companies
• opinions from rating agencies and market analysts
• company risk profile including considerations of insurance risk, market risk,
  credit risk and operational risk
• future investment plans (for example desire for acquisitions or capital expenditure)
• group capital structure
• the quality of management information
• the responsiveness of management to adverse events or circumstances.

 

From a shareholder's point of view, the company should operate on the minimum level of capital required in order to meet its risk requirements, so that it maximizes returns on capital. Conversely, regulators are more concerned with the fulfillment of policyholders' claims and hence would prefer the company to hold higher levels of capital.

In our merger and acquisition work, we usually cannot carry out a detailed analysis of a company's capital requirements and therefore we instead generally assume that they operate with benchmark levels of capital. Our benchmarks tend to be based on regulatory minimum subject to a reasonable additional buffer and market practice of other similar companies operating in Asia and elsewhere.

For companies primarily writing short tail business with a prudent investment portfolio and risk management process, we often assume a capital to net written premium ratio in the range of 30 percent to 40 percent. Higher ratios are applied for companies with a greater content of commercial business and for those with riskier investment or reinsurance policies.

Based on the latest available industry data, we have plotted the ratio of net assets to net written premiums for the largest ten companies (based on net written premiums) for each of six Asian countries. Some key statistics are shown in Figure 2.

Whilst there are a number of limitations surrounding these statistics (including non-admissibility of certain assets and different accounting and reserving standards that apply) as well as different operating conditions within each market requiring different levels of capital, there are some patterns emerging which we consider to be good indicators of current capital positions:

• A large number of domestic Chinese companies are undercapitalized and practice very poor capital management. As of 31 December 2007, eight out of the top ten companies had a capital to net written premium ratio of less than 35 percent. Whilst motor is the principal class of business in China, some of these companies also write large commercial risk policies with high retentions. Based on our experience, most of the local management teams do not understand the need to manage capital effectively and believe that they can operate their business at levels close to the statutory minimum level. In fact, some companies use quota share reinsurance to shed volumes of gross written premium at the end of the financial year in order to meet the solvency standard.
• In China, the true capital position is likely to be worse than that currently presented in the financial statements, due to under-reserving of policy liabilities. Although actuarial standards appear to be in line with global best practice, it is reportedly common for some actuaries to produce loss reserve estimates that are 'back-solved' from the Company's desired profit results.
• Based on the above comparison, India, Malaysia and Taiwan appear to have reasonable capital levels. However, in the case of India, there are some significant limitations to these numbers to the extent that the current accounting standards are not in line with IFRS . We also have concerns over the quality of the loss reserve estimates for some companies due to
  poor data and management manipulation.
• In Thailand, apart from a small number of companies with very high levels of capital, capital levels are very low. This is of particular concern given that the industry is attempting to introduce a risk based capital framework. While mandatory loss reserving was introduced this year, previously, the involvement of actuaries in setting loss reserves for Thailand companies was relatively rare, and we would expect there to be significant under-reserving in a number of cases.
• At the other end of the scale are the Singaporean companies which, in general, appear to be over-capitalized. The average capital to net written premium ratio was 115 percent for the 10 largest companies. Assuming, for example, that a 15 percent pre-tax return on capital is required by shareholders, our broad calculations indicate that a combined operating ratio of 90 percent or lower would be required to meet such a return for a company with a capital to net written premium ratio of 115 percent. While some Singaporean companies have achieved very good profitability in recent years, such a target appears to be very difficult in the current environment with the volatile investment markets, the problematic motor and workers compensation classes and the reduction in cargo business due to the economic downturn. It should also be noted that in comparison to most other Asian countries, the reserving standards in Singapore are more stringent as outstanding claim and premium liabilities are targeted at the 75 percent probability of adequacy, which includes a provision for adverse deviation (PAD).

 

Post Global Financial Crisis

If we assume that the worst of the crisis is now over and make an assessment based on current evidence, the GFC has hurt non-life insurers but those which have focused on their core businesses and have adopted prudent investment and risk management practices appear to be well placed for recovery.

With such an upheaval over the past couple of years, we would have expected to see heightened interest by insurers and regulators in improving capital management.

We have noted requirements from some regulators for companies to demonstrate their ability to withstand deterministic stress scenarios ('stress tests'). The Chinese regulator, CIRC, has prescribed a set of adverse scenarios as a minimum requirement which companies must satisfy on a monthly basis which include:

• a 10 per cent reduction in premium income
• a 10 per cent deterioration in loss ratios
• a 5 per cent rise of the expense ratio
• a further collapse of the equity market.

 

Bank Negara Malaysia has adopted a similar approach, and the Monetary Authority of Singapore and the Indian Regulatory and Development Authority are currently looking at requesting companies to meet stress tests. There is already such a requirement of life insurers in those countries.

While stress tests are useful for companies to demonstrate their resilience to adverse circumstances, these tests do not automatically provide insight to companies on how they can improve their management of their day-to-day business. Despite this, we believe that many companies' management teams are confusing stress testing with capital management.

We would advocate that every insurance company should have a practical capital model which is a realistic representation of the company. Although a good capital model requires time and resources for development and maintenance, it is a valuable tool from a company's risk management perspective. An internal capital model is the basis for answering the following questions:

• How much capital is needed in order to meet firstly, regulatory requirements and secondly, the company's required risk appetite?
• What are the key risks effecting the organization, what are their implications on capital requirements and potential returns, how can these be effectively managed and how does the company instill within its organization processes for risk identification, quantification, mitigation and monitoring?
• How capital-intensive are particular areas of the business and would the capital be better used elsewhere?
• What is the company's optimal strategic investment strategy based on risk appetite and capital resources, how can investment returns be maximized given the company's risk tolerance and how can investment performance be effectively monitored
  relative to benchmarks?
• What is the company's optimal reinsurance structure, given its risk appetite and desired return, should we decrease cover to increase expected return or increase to reduce capital requirements and risk in order to invest elsewhere?
• How can the company use the tools available for strategic decision making in the company giving regard to implications on risk, return and capital requirements?
• How can the company use the answers to all of the above questions to effectively manage the organization under an Enterprise Risk Management framework?

Finally the process of developing an internal capital model in itself creates an environment for effective risk management due to the considerations, enquiries and analysis that needs to be made.
 

Verne Baker, Head of General Insurance Consulting, Asia Pacific. verne.baker@watsonwyatt.com