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

Business Wire

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.