Best’s Special Report: Risk, Return and Diversification Affect Cost of Capital Through the Cycle

OLDWICK, N.J.–(BUSINESS WIRE)–An insurance company’s ability to access and raise capital and the
potential costs of raising capital, especially during times of stress,
are important considerations in AM Best’s ratings process. In a
new report, AM Best explores the factors that can affect an insurer’s
weighted average cost of capital, which can differ by industry segment.

The Best’s Special Report, titled, “Risk, Return and
Diversification Affect Cost of Capital Through the Cycle,” notes that
the cost of capital is a forward-looking measurement used to determine a
required return on investment. For an overall return to be generated,
the return on invested capital should exceed the cost of capital. A
publicly traded insurer has access to multiple sources of capital:
equity, preferred stock or debt with various forms of subordination.
Although mutual insurers cannot issue stock, they do have access to
capital in the form of surplus notes, lines of credit and debt. The
weighted average cost of capital (WACC) takes into account the sources
as well as the associated costs of raising capital. For each major
insurance segment, the cost of capital peaked during the financial
crisis, attributable to the extreme volatility, when correlations
increased beyond expectation. In the years following the financial
crisis, risk-free rates declined to historical lows owing to
quantitative easing and low interest rates and the cost of capital
dropped correspondingly.

Property/casualty (re)insurance is a cyclical industry, dictated by the
supply of capital. Hard markets are times when the industry earns a
return higher than its cost of capital, as it attracts capital from
investors who want to share in the industry’s profitability. However,
hard markets over time can result in excess capital, intensified
competition and higher pressure on pricing and profitability. Reserve
development also is an important factor, as adverse development can
negatively affect calendar-year performance. Reinsurers have a low cost
of capital, because catastrophe risk is seen as non-correlated with the
capital markets. The report notes that this in part is a reason for the
growth of insurance-linked securities and the growing influx of
third-party capital, which promises a higher yield in a low
interest-rate environment. Still, in 2017-2018, the weighted average
cost of capital for reinsurers increased owing to severe weather
patterns.

The life/annuity segment is more-correlated to the overall business
cycle, and as a result, life/annuity insurers have a higher cost of
capital compared with other insurance segments. During the financial
crisis, life/annuity insurers did not earn returns sufficient to cover
their cost of capital, and in the following years, struggled due to
persistently low interest rates. To minimize spread compression,
companies have traded down the credit scale and increased liquidity
risk. Health insurers’ returns are highly correlated to the cost of
medical care, as measured by the medical Consumer Price Index. Although
morbidity risk is not correlated to market risk, health insurers’
returns depend on their ability to manage medical care services and
commodities.

Insurance companies operate under a variety of structures—mutual,
publicly traded, fraternal, reciprocal and captive—so AM Best’s ratings
approach is not a one-size-fits-all endeavor. AM Best looks at all
relevant factors and may have various benchmarks and expectations
depending on the insurer’s structure and operating model. Ultimately, AM
Best evaluates the financial strength of companies in the context of its
building blocks: balance sheet strength, operating performance, business
profile and enterprise risk management.

To access the full copy of this special report, please visit http://www3.ambest.com/bestweek/purchase.asp?record_code=285830.

AM Best is a global rating agency and information provider with a
unique focus on the insurance industry. Visit www.ambest.com
for more information.

Copyright © 2019 by A.M. Best Rating Services, Inc. and/or its
affiliates. ALL RIGHTS RESERVED.

Contacts

Josie Novak
Associate Analyst
+1 908 439
2200, ext. 5242
josie.novak@ambest.com

Sridhar Manyem
Director, Industry Research and Analytics
+1
908 439 2200, ext. 5612
sridhar.manyem@ambest.com

Christopher Sharkey
Manager, Public Relations
+1
908 439 2200, ext. 5159
christopher.sharkey@ambest.com

Jim Peavy
Director, Public Relations
+1 908
439 2200, ext. 5644
james.peavy@ambest.com