Over the past decade, the U.S. property/casualty insurance industry’s excess capital position has grown dramatically due to slower premium growth, better risk management techniques and significant surplus gains. This assessment is confirmed within A.M. Best’s study of the P/C industry’s capital adequacy at year-end 1999.
This study involved a detailed capital analysis of 996 individual companies and groups that are rated by A.M. Best that represent over 99 percent of the industry’s capital base.
From a solvency perspective, A.M. Best estimates that the domestic P/C insurance industry remains significantly over-capitalized relative to Best’s B+ capital standards. Effectively, the industry’s individual companies and groups could return a total of $180 billion of capital to their stakeholders, which equates to 53 percent of the industry’s 1999 statutory surplus, and still qualify for A.M. Best’s lowest Secure Rating of B+.
From a ratings perspective, Best’s detailed analyses of individual insurers’ balance sheets reveals that over three-quarters of the P/C industry’s organizations maintain “extra” capital totaling $88 billion26 percent of the industry’s 1999 surpluswhen compared against the capital required by A.M. Best to support their respective rating assignments.
Excluding the two capital-rich groupsState Farm and Berkshire Hathawaythe industry still maintains roughly $48 billion in extra capital. Importantly, this $48 billion of “extra” capital already accounts for P/C insurers’ material financial risks identified within Best’s 1999 year-end capital reviews, including: $30 billion of potential losses stemming from insurers’ 100-year catastrophic events; $35 billion of estimated reserve deficiency equating to 10 percent of the industry’s 1999 carried reserves; $25 billion, or 15 percent, decline in insurers’ stock investment values; $ 20 billion of unfunded Asbestos & Environmental (A&E) liabilities.
The industry’s over-capitalization represents a significant capital management challenge and opportunity for most insurers. Best’s capital study may surprise some industry observers that a majority of P/C insurers could return extra capital to their stakeholders without greatly risking a ratings downgradeassuming they exhibit stable operating results. However, for some insurers that are experiencing poor performance in the near-term, it may prove beneficial for them to maintain extra capital to mitigate the threat of a rating downgrade.
Other Study Findings: Less than 8 percent of P/C insurers exhibited “Vulnerable” capital strength at year-end 1999 that fell below Best’s minimum B+ capital standard. Of these “vulnerable” insurers, 90 percent maintained surplus below $25 million. Under Best’s baseline stress test, less than 10 percent of the P/C organizations exhibited an excessive premiums to surplus ratio of 3.0 or morestemming from the convergence of a severe 100-year catastrophe loss, severe reserve development of 30 percent relative to insurer’s unpaid loss and LAE reserves and a 20 percent decline in stock investment values.
Roughly one-half of the P/C insurers rated by A.M. Best maintain capital strength that exceeds the capital standards for Best’s top rating of “A++”; yet only 3 percent are assigned an A++ rating. Only 50 percent of the P/C organizations rated within A.M. Best’s “Excellent” and “Superior” rating categories generated five-year returns on surplus that exceed their estimated cost of capital. Based on 1999’s depressed industry results, only 39 percent of the companies generated returns on surplus that exceed their cost of capital.
The highlights of Best’s research were presented earlier this fall at a conference in Philadelphia sponsored by Aon Corp. and the Wharton School of Business. A copy of the presentation, “Excess Capital: Myth or Reality?” can be accessed on the A.M. Best website at www.ambest.com. A.M. Best will publish its more detailed 1999 study on the Property and Casualty industry’s capital adequacy in January.
2000 & Beyond
The industry’s excess capital position is expected to diminish somewhat in 2000 due to lingering under-priced business, more adverse reserve development, and an overall decline in surplus levels. At the same time, A.M. Best will continue to refine its BCAR capital adequacy model. Within its 2000 capital evaluations, A.M. Best expects to incorporate an explicit credit for multiline diversification, and will be refining reinsurers’ underwriting risk factors to reflect the changing nature of their products.
These model revisions are expected to further temper A.M. Best’s capital requirements for diversified primary insurers and reinsurers going forward. While the current BCAR model remains a powerful tool used in the rating process, A.M. Best is working towards the development of a more dynamic approach to assessing enterprise risk and capital requirements. This initiative includes the development of a Value at Risk model that takes into account emerging as well as traditional risks.
A.M. Best believes VAR provides a valuable dynamic view of an organization’s risks that could complement more static risk-based capital measures in the future.