Capital Needs of an Insurance Company

Capital Needs of an Insurance Company

There are two historical trends on capital needs and risk, tracing back to the work of two Italian researchers in the late 1950s. Franco Modigliani (with Merton Miller) argued that risk management that costs something in expected earnings is not worthwhile. One of their assumptions was that a firm that gets into financial difficulty can always refinance at the market cost of capital. Bruno de Finetti made the opposite assumption, namely that no financing would be possible. He started the actuarial theory of risk.

The Modigliani-Miller ideas did not seem to describe firm behavior, and eventually economists worked out alternative theories. One key figure there was Ken Froot, whom I worked with for a time when he was a consultant to Guy Carpenter on risk and capital needs relating to reinsurance. He took a middle ground, namely that refinancing would be possible for a distressed firm, but at a high rate. To avoid this, some risk reduction could be worthwhile, even if it cost something in expected earnings. Firm value would be enhanced. Empirical work found that this theory matched firm behavior, but mainly for firms that had regular ongoing financing needs.

Meanwhile the theory of risk advanced, mostly in European actuarial work, and incorporated dynamic programming for optimizing capital, following the approach of Richard Bellman. A recent branch of this theory is determining how much a firm should pay in dividends. Mostly that ends up with a threshold test, essentially paying out any accumulation above the capital need. That theory too has run into empirical obstacles. In practice, firms try to pay consistent dividends over time, and are punished by the market when they drop them. Also insurers often hold more capital than regulators require. An interesting attempt to face up to these anomalies is the 2016 paper “A note on realistic dividends in actuarial surplus models” by some colleagues at UNSW, Benjamin Avanzi, Vincent Tu, and Bernard Wong. See

They review some changes that could be made to ruin theory to conform to firm behavior, but are more raising the issues. One thing they look at but then dismiss is agency theory. They cite one fairly old article that does not think it works. But it is the basis of a lot of capital theory papers that came out of Wharton and other places more recently. Agency theory is not about insurance agents, but is the idea that when investors provide funds for others (who act as their “agents”) to manage, there are a number of potential conflicts that can arise.

One relationship is between shareholders and management. Depending on compensation arrangements, management can take too much of either a short-term or long-term view. A good balance can be found where bonuses depend to some degree on both horizons. A more relevant agency conflict here is shareholders and debtholders. There is an incentive for shareholders to over-leverage with a lot of debt, then initiate high-risk strategies that could make a huge amount of money or go broke. They are risking mostly the debtholders’ money, but would get most of the gain and little of the loss.  If that is not their plan, then they need to give debtholders some indication of that. Keeping the leverage low would be such a signal, and hopefully would keep debt costs down. Agency theory is basically about this kind of signaling.

Risk management is a similar signal. It can keep down the cost of debt, but also risky firms seem to have to pay higher salaries, and an uncertainty premium to suppliers. So risk management can actually reduce costs.

Insurers have one more wrinkle: their debtholders are their customers. Premium and loss reserves are all obligations to policyholders, and are most of the liabilities of insurance companies. This magnifies the agency issues. Maintaining a high surplus is a signal to the policyholders that the insurer will be able to meet its obligations. There is empirical evidence that highly capitalized and highly rated insurers can charge higher risk premiums as a result. This would explain why some insurers maintain higher capital levels than regulators require.

One possible way to explain the share-price penalty that arises from cutting dividends may be to consider the share price as the market expectation of the value of future earnings. The market may regard accounting as too flexible to be relied on entirely, and see dividends as a truer reflection of financial prospects. Thus a company that cuts its dividend would be viewed as having problems, no matter what the accounting says.

These are fairly standard explanations from an economic viewpoint, but haven’t been much present in ruin theory. Finding a way to build them in might help reconcile the actuarial and economic approaches.