Redeploying Capital.

While insurers are sitting on piles of capital, new competitors are using their cash to redefine the risk market.

The record accumulation of surplus capital brings into question why insurers have not returned excess capital to investors. Are there substantial opportunities that they are pursuing, or plan to pursue, that require vast amounts of capital?

The question of how effectively insurers are putting their cash to work is critical as even more capital flows into the property/casualty industry from nontraditional competitors. By introducing innovative ways to think about and mitigate broader risks, these new entrants have the potential to reshape the risk market.

Building to a Crescendo 

The property/casualty insurance industry has had more capital than what was strictly required to underwrite premiums for more than a decade. But in recent years, the level of overcapacity has grown exponentially.

As a rule of thumb, regulators and rating agencies consider a ratio of two times surplus to premium adequate. In 1985, U.S. property/casualty insurers had an aggregate ratio of 1.9 times surplus to premium and twice as much surplus as required. By 1998, the same ratios had dropped by half, to 0.8 times surplus to premium and equal amounts of surplus and reserves.

During this period the industry moved toward a less volatile mix of lines. Some relatively risky long-tailed lines, such as product liability have shrunk considerably, while less risky, short-tailed lines, such as auto, have grown. Product-liability premiums dropped 25% between 1991 and 1998, according to A.M. Best Co. data. Autoliability premiums increased 32% over the same period. This general shift toward less risky lines implies that on a risk-adjusted basis, the surplus required to support insurers current business could probably be less than what is implied by old guidelines.

U.S. property/casualty insurers in aggregate have about 3.5 times the surplus strictly required to underwrite their current volume and mix of business. (See "Surplus Grows," page 114.) Some companies with significant activities outside the realm of property/casualty insurance contribute disproportionately to this imbalance. Chief among them is Berkshire Hathaway, which has many times the surplus required to underwrite its premiums, but it can be better categorized as an investment fund with substantial insurance operations under its umbrella. Excluding Berkshire Hathaway, property/casualty insurers have about 3.2 times the surplus strictly required to write current premium levels.

Surplus has been growing faster than premium volume for more than a decade. From 1985 to 1998, surplus growth for the industry was 12%, while premium growth was only 6%. Recent years have seen an even more dramatic divergence. Surplus growth for 1995 to 1998 was 13.8%, but net written premium grew at only 2.7%.

Three main economic trends contributed to the greater growth rate for surplus:

* a booming stock market;

* soft prices; and

* increased corporate retention of insurable risk.

Major corporations are taking larger deductibles and using alternative-market mechanisms, such as self-insurance, captive insurance companies and risk-retention groups. A recent Conning & Co. report, "Alternative Markets: An Evolving Mosaic," states that the alternative market now accounts for 34% of total commercial risk protection and 78% of the national market.

Keeping It Close

The record amounts of surplus capital raises an obvious question: If insurers are not returning it to investors, what do they plan to do with it?

The general tendency of companies to hoard cash for a rainy day especially in the face of diminished growth prospects, is well documented. In fact, this tendency made possible many of the leveraged buyouts and hostile takeovers of the late 1980s and early 1990s. To some extent, the financial structure of the insurance industry created impediments to such transactions. Stock companies cannot purchase mutuals outright, and, until recently, federal law has restricted interesting banking/insurance combinations.

Mutuals have little incentive to return capital to owners because policyholder/owners have relatively little power compared with those in stock companies. Companies with ample capital and strong market presence stand to gain enormously during hard markets and periods of strong premium growth, so they have considerable incentives to hold market share during soft markets and keep their powder (excess capital) dry.

As stock companies fight with mutuals to hold and gain market share, they may feel the need to retain excess capital as well. The flexibility it provides them to acquire competitors, introduce new lines of business, invest in noninsurance endeavors and grow quickly when conditions allow is of key strategic importance.

Investment Options

To fully address the question of why capital has remained in the industry, it is important to examine insurers' options for returning and/or redeploying capital. Their alternatives can be split into groups based on balance sheet categories: asset decisions, liability decisions and equity decisions. The asset decisions include taking more investment risk with the excess capital or buying a noninsurance business to broaden product offerings. (See "Capital Options," page 112)

The power of the asset alternatives is compelling. If the entire property/casualty industry had moved an amount equal to one-quarter of its excess surplus from bonds into common stocks for the past 14 years, an additional $80 billion in value would have been realized. (See "Aggressive Investment of Excess Surplus," below).

Regulators and rating agencies perceive stocks as being a less reliable source of funds than bonds. It is certainly true that a bond portfolio matched in duration and size with reserves provides greater certainty that claims and expenses will be paid than a similarly sized stock portfolio. But as insurers become more overcapitalized, they have considerable freedom to invest more aggressively in equities and noninsurance affiliates.

Only recently has there been a substantial shift in this direction, most likely driven by unrealized gains in stock portfolios rather than active management in that direction. Common stocks were roughly 11% to 12% of invested assets from 1984 to 1994. From 1995 to 1998, common stocks grew to constitute 18% of total invested assets. While investment in affiliates has grown, too, this growth has not exceeded that of other parts of insurers' portfolios. Investment in affiliates has remained pegged at 5% to 6% of invested assets since 1984.

At the corporate level, various firms have expanded investments in nonproperty/casualty businesses as well, using excess capital generated by property/casualty insurance operations to expand into mutual fund operations, variable annuities and other products that allow them to leverage their channels to the market more effectively.

Insurers' aggressiveness in portfolio selection has been correlated with their relative level of overcapitalization. Companies with higher ratios of actual surplus to required surplus tend to have more equities and affiliate investments in their portfolio. Naturally, Berkshire Hathaway leads the pack on both dimensions, but several other insurers--such as State Farm, Allianz and American Family Insurance Group--also have taken relatively aggressive positions.

Even given this increase in common stock as a percentage of invested assets, some insurers could be more aggressive. If the industry invested only excess surplus--that portion not strictly required to support current premium and reserve levels--in common stock and affiliates, it could increase equities in its portfolio by $33 billion to $49 billion. In other words, common stock and investment in affiliates would be raised by four to six percentage points in the portfolio mix, to 28% to 30% of invested assets. Each company would have to make its own investment mix decision while comprehensively considering how its business strategy would affect composition and risk on both sides of the balance sheet.

Individual firms have been moving into new, innovative coverages. But overall, the relative increase of personal lines and decline of some high-risk lines, such as product liability, imply a milder risk profile. Mitigating this are increases in deductibles and a more exotic mix of environmental, professional liability and specialty lines in the commercial market.

Recently, some companies have been moving to simply return capital to investors. Allstate, for example, has announced a $2 billion stock buyback program. It remains to be seen if this will spark a trend of stock buybacks substantial enough to reduce the current overcapitalization of the industry.

Capital Arriving

Four emerging trends are attracting even more capital into this market, intensifying the supply of capital problem.

* Regulatory convergence: the weakening of the regulatory barriers between insurance companies, commercial banks, investment banks and professional-service firms. This trend is seen particularly with the actions of Citigroup to combine insurance, investment banking, and commercial banking and with Goldman Sachs and Merrill Lynch establishing units to provide risk products. These and many other companies have moved into the insurance territory without regulatory hindrance.

* Institutional convergence: the co-opting by other financial/professional institutions of the risk adviser role that once belonged solely to the broker and the insurer. The senior management relationships of investment bankers, top commercial bankers and consultants are very real and are focused on helping top executives think about and manage their corporate risk as a strategic initiative to secure competitive advantage.

* Product convergence: the use of noninsurance financial products to manage risk and to use insurance products in new ways to solve nontraditional financing needs. Catastrophe bonds, equity puts, the use of bonds to insure the residual value of assets and the securitization of insurance liabilities are just a few of the initiatives that are blurring the lines between insurance and banking.

* Role convergence: the shifting role of the risk manager within a public or private institution. This includes the elevation of the role and the adoption of these responsibilities by another authority within or outside the company. With the view of institutional risks being a source of capital as well as an exposure, the responsibility is viewed in a very different light today and that responsibility is shifting increasingly to the senior management and to the executivecommittee level.

These trends are producing a different definition of the risk market, and it may well turn into a new industry.

The new capital is not particularly interested in insuring workers' compensation or conventional liability along the traditional coverage lines but may be used to develop new products to manage these exposures. Further, they are demonstrating innovative ways to think about and to mitigate broader risks--the types of risk that can bring an institution to its knees. The new entrants to the--risk market are not simply looking for ways to deliver current products at lower costs or with a slightly better service. Their interest is not in the commodity game but in managing all risks better, possibly shaping a new industry. These companies are coming from all over the globe to serve what is increasingly a global business.

The "Strategic Dominance Map" below illustrates where a selected set of interested participants in the risk market are located. Most have fairly modest book value, with modest returns to shareholders, and they are concerned with this return profile. They are "satisfiers" because they have done excellent work with their regional customers or their product set and have accumulated their capital impressively. Yet they are in that sector with too much capital and too many similar products. This has pinched returns and will continue to do so.

The "nichers" are innovative players who have picked a niche and have done well for their owners. There always will be room for innovators that find a unique niche until the formula is replicated by others and becomes commoditized.

The "expanders" are acquisition minded, believing that size will dominate and provide geographic reach that will be expensive to imitate. The nichers and the expanders are applying their capital with a strong strategic intent, and their capital is not idle.

All the companies in this set are looking at the same customers and trying to find a way to add value. Those that develop the value proposition will employ their capital effectively and will eventually become the founders of a new industry. This does not remove the role or value of those that choose to remain with their traditional products, but a new game is emerging and those who stay out of that game will secure commoditytype returns and will underutilize their capital. They will fall prey to those who have more ambitious ideas on how to use the capital or will be requested to return that capital to its owners.

Jeff Foran is managing director and Gregory W.Finlay is senior consultant at Navigant Consulting.

Capital Options

Property/casualty insurers have a variety of options for returning and/or redeploying capital.

Asset Decisions

* Can we take more investment risk with the excess portion of our capital?

-Increase investments in equities and/or lower-grade corporate bonds?

* Should we purchase or grow a noninsurance business to broaden the product lines we can offer our clients?

Liability Decisions

* Should we take more risk in the mix of P/C products offered in hopes of earning substantial underwriting profits?

-More exotic coverages?

-Increased emphasis on excess/surplus lines?

Equity Decisions

* Can we return capital to investors?

-Share repurchase

-Dividends

-Demutualization