The Capital Trap.

Capital Management: Insurers are learning to allocate capital only to businesses where they have a competitive advantage.

Over the past three years, the industry's capital and surplus has increased by nearly one-third, while loss costs in its predominant personal auto and workers' compensation lines have remained stable. Meanwhile, a maturing market, constrained pricing and lack of new products has translated into another year of lackluster premium growth. A.M. Best forecasts that the industry's premium-to-surplus ratio is expected to shrink to 0.9 times at year-end 1999, and could decline further over the next several years.

Based on A.M. Best's capital adequacy model (BCAR), the industry is over-capitalized by $100 billion when compared to the standards of our lowest "Secure" rating level of "B+"--even after accounting for the possible impact of severe catastrophes. Excess capitalization is more common in the personal lines and reinsurance markets, and a greater proportion of mutuals are overcapitalized than stock companies.

Given this excess-capital position, insurers face two pressing questions:

* Where can capital be deployed for an adequate return?

* Can capital models truly create competitive advantage by facilitating strategic and capital allocation decisions?

Roaring 2000s

The property/casualty industry has been a prime beneficiary of today's burgeoning economy, which many signs indicate will continue into the next decade. However, from a core business standpoint, many insurers risk not being able to participate in this ongoing economic expansion. Inefficiencies among markets and companies, lack of differentiation among many insurers and limited growth prospects have challenged insurers to maintain their market positions, let alone deploy excess capital.

In the past five years, many over-capitalized insurers have transformed themselves from underwriters to "virtual" investment companies, as nearly 10% of today's industry participants have more than 50% of their surplus invested in common stocks. Meanwhile, their current business volume has fallen below 50% of surplus.

Inherent Excess

In a growing number of business segments, like reinsurance and large commercial, insurance buyers place a premium on financial security and long-term commitment to the market. This is evidenced in the very large surplus thresholds employed by market leaders as a means to gain advantage in today's "flight-to-quality" trends. It remains to be seen whether there will be any substantial "decapitalization" in these sectors in the near-term, as market leaders maintain excess funds for additional acquisitions.

Excess capital remains in the insurance sector for other reasons as well. Mutual and reciprocal insurers, which currently hold 40% of the industry's surplus, generally do not have the flexibility of stock companies to raise outside capital to fund growth or absorb large losses. They also don't face the same demands for stockholder dividends. For instance, State Farm was better able to handle the shock loss from Hurricane Andrew in 1992 than were publicly traded competitors, such as Allstate, since State Farm retained all of its earnings over the years.

In recent years, though, most insurers have downsized their catastrophe risk to more acceptable, measurable levels, reducing the importance of retaining extraordinary levels of excess capital. Growth-oriented mutual companies such as Nationwide and Liberty Mutual have put their "excess" surplus to use to fund future acquisitions and mutual mergers.

Publicly-traded companies remain under pressure to maintain strong earnings growth, which is a prime reason they seek acquisitions. Many public insurers announced stock repurchase plans in 1999 but few except Allstate made material buybacks. Public insurers also have been reluctant to declare extraordinary dividends and return capital to investors, despite low returns generated by their insurance operations.

In 1999, insurers such as WR. Berkley, Gainsco, Acceptance, Horace Mann and Argonaut announced plans to explore various strategic options to provide better value to shareholders, including possibly selling off various insurance operations. Some chose to maintain their operating autonomy, others chose to restructure their operations, while others are in the midst of selectively selling some assets.

Consolidation trends continue to trail the economic realities of the insurance industry, particularly as entrenched management teams in many organizations are still not held accountable for sub-par performance. Meanwhile, shareholders of public companies have become impatient, punishing under-performing insurers with stock valuations that fall below a company's book value.

More Capital to Come?

Despite the current glut of surplus, investors are ready to deploy additional capital into a property/casualty industry that is certain to undergo structural changes over the next several years. These structural changes will be forced by the price transparency and information made available by the Internet, as well as in response to integrated risk-financing solutions required of mid-to-large businesses. Today's one-off catastrophe-bond issues will lead to broader securitization of insurance products. These developments will make available new funds from the capital markets in the form of contingent capital and reinsurance.

Convergence Ahead

Financial-service deregulation will eventually bring new capital to the risk marketplace. Given today's soft market conditions and low returns in the property/casualty insurance industry, it is unlikely that large financial service players will make near-term widespread cross-sector acquisitions.

While the passage of U.S. financial services reform facilitates cross-sector consolidation, marketing affiliations and joint ventures will remain the prevalent strategy employed in the intermediate-term future. Most of these ventures will likely focus more on distribution than on product development.

A.M. Best expects that financial-service deregulation and technological improvements will hasten insurance consolidation within the over-crowded personal and small commercial segments. In the short-term, investors in publicly traded insurers are voting with their dollars and shunning companies that report reduced profits. Well-positioned mutual insurers, with their more conservative balance sheets, will be able to effect appropriate mergers with other mutuals. Collectively, this consolidation activity will eventually result in a "weeding out" of excess capital--but not for several years.

Unattractive Return On Equity

The property/casualty industry's measures of return on equity, including realized and unrealized stock gains, have kept pace with other financial-service industries in recent years. However, most companies do not maintain large common stock holdings. Further, these total returns have slipped with declining investment yields and less-favorable prior-year development.

Most of the industry has not produced operating returns that are consistent with other sectors, or in line with most company-established targets. Because of differences in liability and capital structures, property/casualty insurers generate lower operating returns on equity compared to noninsurance entities such as banks and diversified financial service organizations.

U.S. capital markets, however, don't recognize those distinctions. This is prompting many in the industry to reduce their overall risk profile and earnings volatility. Nevertheless, weak operating returns and low growth prospects Prevail in today's soft market. This has depressed stock valuations for most public insurers and worsened already unfavorable price-to-earning comparisons against the general markets.

Most property/casualty insurers' returns, excluding unrealized capital gains, trail returns of companies in other financial sectors. The shortfall becomes more pronounced when comparing the industry's median five year after-tax net income returns on surplus of 6%, compared to median returns of other industries of 14% to 18%.

Interestingly, stock and mutual insurers exhibit similar total measures of return on equity (including all capital gains) on a dollar-weighted basis. However, the source of these returns are quite different, as the mutuals' return was 60% comprised of unrealized capital gains, compared to 10% for stock companies. This distinction is seen when comparing recent five-year pre-tax returns relative to premiums: the median mutual insurer produced an after-tax total return of 8.2% (versus 8.5% for stocks); however, on a pretax operating return basis mutuals registered a 5.5% return (versus 9.5% for stocks).

Investors remain skeptical of property/casualty insurers' balance sheets and are underwhelmed with the growth prospects for insurance. These issues are evidenced by stock prices that plummeted in 1999 following poor earnings announcements, including "unexpected" loss reserve surprises.

Acceptable Returns?

The question is, why do companies continue to write business if the price cannot produce an adequate return?

Many policyholder-based companies were founded on the premise that they exist to serve the needs of their insureds, not to maximize investor returns. Mutual companies are obvious examples of this philosophy, but they are not alone. During the liability crisis of the mid-1980s, many reciprocals and even stock companies were created to provide a market for specialty groups such as physicians. As a result, their charters specify that a key objective is to maintain that market. Therefore, they are unlikely to withdraw from the market, regardless of its capacity.

Additionally, mutual insurers in a strong capital position do not face the immediate earnings pressures faced by their stock counterparts. This provides additional flexibility. However, to maintain a strong franchise and market position, they must continue to look for ways to increase the value provided to their customers.

Some forward-thinking CEOs believe that unique opportunities within the insurance market can provide superior returns. These entrepreneurs are creating "virtual" companies, using Internet-based distribution and service models, or insurance-related businesses.

Others believe in the traditional underwriting cycle, hoping for a return to earlier times. However, A.M. Best believes the traditional cycle of hard and soft markets has been replaced with localized mini-cycles, tempering the duration and intensity of rate hardening. The workers' compensation and commercial automobile markets represent segments poised for localized rate hardening.

Optimizing Strategy

Company management is increasingly challenged to justify each business segment on its own merits. Before determining if a return on allocated capital is meeting corporate objectives, the company must first determine the amount of capital to allocate to a business segment or product line. These determinations are rooted in the analysis of risk, internal capabilities, external market factors and growth patterns. Advanced technology and the battle for returns have fostered the growing acceptance of dynamic modeling.

The most sophisticated modeling approach is dynamic financial analysis(DFA). Other modeling approaches are Value at Risk (VAR), and Economic Value Added (EVA). The sophistication of any of these models varies with the level of detail included in the model. These models evaluate the interaction of different simultaneous risks, permitting decision-makers to analyze possible outcomes and the key risk drivers that could be addressed to improve the chance of a favorable outcome.

DFA models were developed within the insurance industry or by those serving the industry. DFA models are based on the actual risk inherent in the asset or liability and attempt to model these integrated risks. The focus and sophistication of these models tends to vary, based on the developing party. Models developed by asset managers tend to focus on asset and investment income areas, while those developed by actuaries focus more on liabilities and underwriting operations. These differences are fading.

These evolving models will play a key role in improving the planning process of the insurance industry. However, A.M. Best continues to focus on the data and assumptions that feed these models, as well as management's ability to execute the plans that might be generated based on these models. Ultimately, the management team will determine the long-term success of a company, but these models and others will provide insight into the risks a company faces and how it can best manage its capital.

Effective Capital Management

Some observers point to rating agency capital models such as A.M. Best's Capital Adequacy Relativity (BCAR) as one reason there is so much capital in the industry. While BCAR can play an important role in AM. Best's rating process, it is simply a tool used to evaluate capital strength, which is only one of three evaluation areas in Best's overall rating determination.

Admittedly, as a rating agency, A.M. Best's evaluation requires more conservative capital levels than that of investors who generally favor greater operating and holding company leverage to boost a company's return on equity. Nevertheless, in the aggregate, the industry's capitalization falls squarely within our second highest rating level of "A+". Nearly 40% of domestic-rated groups maintain capital that exceeds the upper range of A.M. Best's "A++" capital strength standards.

As a result, sheer capital strength, or relative BCAR standing, is less of a rating issue. Divergent performance levels, market risk, business concentration and competitive issues can take on greater importance, particularly at Best's higher rating levels. This balanced ratings approach is consistent with today's marketplace, which is concerned with an insurer's financial stability and market viability.

Ultimately, A.M. Best believes that effective capital management and value creation is found in investing capital in core businesses in which the insurance organization has a specific competency or competitive advantage while having the fortitude to withdraw capital or divest businesses that have little prospect for adequate returns.

Increasingly, insurance companies are utilizing several capital models to evaluate their capital needs, including rating agency requirements. Such companies are allocating capital to their business units based on the risk inherent in their discreet units, with "excess" capital left at the corporate level. In addition, target returns on allocated capital are assigned based on risk and cost of capital considerations.

A.M. Best believes that dynamic capital modeling tools are gaining wider acceptance. They can facilitate an insurer's ability to optimize its business strategy and enhance operating performance by deploying capital towards the best growth prospects. Best-of-breed insurers, which are those with strong balance sheets and sustainable competitive advantages, will clearly leverage and enhance tools such as DFA-type analysis going forward.

                Comparative ROEs for Select Industries (%)
          Property/Casualty Insurance [a]
Year               Total Return           Net lncome/PHS Net lncome/PHS
                  on Surplus [c]          (Average) [d]   (Median) [e]
1994                    5                       6              5
1995                    19                      10             6
1996                    16                      10             5
1997                    23                      13             7
1998                    13                      10             5
1999Est                 7                        7             4
5-yr.Avg.               14                      10             6
          Other Industries [b]
Year          Diversified      Commercial Fortune
             Financial [f]       Banks      500
1994               18              16       14
1995               18              16       14
1996               19              17       14
1997               15              17       14
1998               20              16       13
1999Est            --              --       --
5-yr.Avg.          18              16       14
(a.)Source: A.M.Best.
(b.)Source: III 1999 Fact Book; median return.
(c.)Total after-tax returns (incl.unrealized stock gains) on surplus;
average returns.
(d.)Dollar weighted.
(e.)Median value.
(f.)Financial service enterprise withlarge P/C units.