Moving toward economic capital: diversification of risks could reduce the capital insurers are required to hold.

When more sophisticated risk measures were first introduced, they led to the recognition of greater risks through increased capital requirements. Think early fixed annuities and, more recently, variable annuities. While it often took regulators and rating agencies some time to catch up, market expectations adjusted quickly, and capital desired by management and investors usually rose in unison.

As these economic-capital methods have been extended to more products and risks, it appears that required capital can be reduced significantly from rating agency requirements. Mostly, this has come from recognizing the substantial benefits of the diversification of risks across varied products, risks and markets.

The potential to free up all this capital to support expansion of the business is a huge benefit. But what happens when rating agencies have yet to agree that these new capital levels provide adequate protection for policyholders? Or investors have yet to agree on the implications of lower capitalization on the price of committed capital? Will the next big mispricing problem the industry faces be the adoption of diversified capital measures for pricing before rating agencies have bought into the lower levels of capital and before investors have repriced their capital in recognition of their higher level of risk?

Consider product prices. EC-based pricing is likely to emerge well in advance of changes to third-party capital requirements. And using current costs of capital, this will show acceptable profits at significantly lower price points.

With rating agency capital still required, an EC-based pricing exercise will remove the additional capital's carrying cost from product prices--unless its cost is adjusted to recognize the greater level of risk being assumed by investors. But are companies increasing hurdle rates as pricing methods begin to recognize diversification benefits?

Today's market prices for capital are based on rating agency levels. If companies move to adopt significantly reduced capital levels and continue to use prices for less risky rating agency capital, investor demands for taking on the greater risk will not be captured. EC pricing before rating agencies have agreed to weaker standards and before investors have repriced the capital provided at this higher level of risk seems like a dangerous way to demonstrate product profitability.

Many will say this is a short-term problem, as rating agencies will adopt diversified economic capital levels. Or that current capitalization levels are so high that risk is not significantly increased by moving to lower EC capital levels. Perhaps. But reductions to current capital requirements will come slowly and the temptation to price on an economic basis to justify lower prices will be strong.

I hope the industry is not so smitten by the possibility of reduced capital requirements that it fails to see that providers of that capital will reprice its cost if it is put at greater risk. Companies should carefully consider what there is about improved risk measures that allows them to reduce capital, prices and earnings and still meet investors' return demands.

Robert W. Stein, a Best's Review columnist, is global vice chairman of Global Financial Services for Ernst & Young. He may be reached at [e-mail]