The Cost of Capital for Insurance Companies

The Geneva Papers on Risk and Insurance Vol. 25 No. 1 (January 2000) 4±24

by Walter KielholzÃ

1. Summary A unique characteristic of the insurance industry is that its product is basically a promise. Unlike a physical product or even some other service, customers pay premiums for a promise that they will be compensated in case of an adverse event. In order to demonstrate that they can keep this promise, customers and public of®cials require insurers to show that they have suf®cient ®nancial resources. Insurers need to supply their own capital to support their promise. Insurer capital comes from investors which means there is a cost associated with it. The cost of this capital is the expected rate of return insurers haveto pay for the capital theyuse. The cost of capital is a well-established economic concept. Very often the terms ``the cost of capital'', ``fair rate of return'', or ``opportunity cost of capital'' are used synonymously. The conceptencompasses severalimportant elements.First,the costofcapitalis aforward-looking concept: it is the return investors demand in order to be induced to invest the funds. Second, the cost of capital is determined in capital markets and includes the notion of opportunity costs. Investors face an ever-growing array of opportunities from which to choose and the cost of capital or expected return must compensate for other foregone opportunities. Finally, the cost of capital is dependent on risk: higher risk investments require higher returns to attract capital. This paper explores several dimensions of the cost of capital for insurance companies. It presents cost of capital estimates from the past 20 years for ®ve major insurance markets: the United States, the United Kingdom, France, Germany, and Switzerland. Separate estimates are provided for the life and non-life business segments. Generally, the cost of capital has declined for insurers in these markets. Most of the decline is attributed to the secular decline in nominal interest rates in most of the major developed economies. Based on beta estimates from the capital asset pricing model, changes in the inherent riskiness of insurance have varied by country and by line of business. The riskiness of insurance appears to have increased in the U.K. and Switzerland while declining in France and Germany. The picture is mixed in the U.S.: non-life business appears less risky while life insurance appears riskier. Implications for understanding the changing cost of capital in insurance are discussed. Notably, newer models and information technology have emerged that purport to make risk assessment and the ef®cient use of capital easier. Historically, it has been quite dif®cult to understand the contribution of individual business activities to the overall risk of an insurance enterprise. These new tools in combination with advances in corporate ®nance theory provide a framework for allocating risk capital to these individual business activities. This in turn will allow insurance managers to deploy their capital more ef®ciently and optimize its use across lines of business.

Ã Chief Executive Of®cer, Swiss Re, Zurich.

# 2000 The International Association for the Study of Insurance Economics. Published by Blackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UK. THE COST OF CAPITAL FOR INSURANCE COMPANIES 5

The combination of empirical cost of capital estimates and the newer risk assessment and capital allocation tools are discussed in the context of the important trends affecting the global insurance markets. Globalization of capital markets, deregulation of insurance markets, and consolidation have important implications for the cost of capital and its ef®cient use. Insurers need no longer raise and deploy capital in local markets. Potentially, capital can be raised from worldwide capital markets, which may lower its cost. At the same time, investors will demand greater transparency about insurance activities which will increase costs. Finally, viewed as a levered investment vehicle, insurers continue to seek scale advantages in asset management. Lower cost of capital and more ef®ciently managed ®rms will have competitive advantages in the changing market landscape. This is especially critical in the developed countries of the world where insurance is a mature industry with top-line growth not expected to be dramatic.

2. The cost of capital: what is it and why is it important? For ®nancial services and the insurance industry in particular, capital is as important to production as it is for the manufacturing industry. In contrast to manufacturing, capital is not invested in tangible assets such as plant or machinery; instead it is invested in liquid assets like bonds or stocks. The insurance business is based on a promise and capital guarantees that future funds will be available in the case that some contractually speci®ed event occurs, in which insurance losses might exceed the premiums. Modern views about the business of insurance have been heavily in¯uenced by theories of corporate ®nance, optimal capital structure, and the ef®cient use of capital. While insurance itself is about risk selection, underwriting, loss control, and claims management, capital funds are required to produce this business. An insurer raises capital which permits it to write an insurance policy. With its own capital plus the funds from insurance premiums, insurers must pay out claims from the insurance policies and the associated business expenses. Yet there are important time lags between the raising of capital, collection of premiums, and payment of losses and expenses. Insurers exploit these time lags and invest both their investors' capital and the insurance premiums until the claim and expense payments are required. In effect, insurance is a leveraged investment vehicle. As such, decisions about how much and what type of capital to raise, investment allocation decisions, asset management strategies, and types of insurance to offer all involve decisions about capital allocation and risk-adjusted returns. The cost of capital is the rate of return insurers have to pay for the equity they use.1 The rate of return demanded depends on demand and supply of capital in general and the risk the business is involved in. A company that does not pay the rate of return demanded, will come under pressure from capital markets. There is the risk that stock prices decrease to such an extent that the company becomes a takeover target for competitors, or that the management, which is not able to provide the return requested, will be removed. The cost of capital is a well-established economic concept.2 Very often the terms ``the

1 For simplicity, this discussion focuses mainly on the use and cost of equity. While insurers do use debt ®nancing, it is typically a small proportion of the total capital structure. 2 A useful de®nition is: ``The cost of capital is the minimum rate of return necessary to attract capital to an investment. It can be de®ned as the expected rate of return prevailing in capital markets on investments of corresponding risks.'' (Kolbe, Lawrence, Read and Hall, The Cost of Capital. Cambridge, MA: Charles River Associates, 1984)

# 2000 The International Association for the Study of Insurance Economics. 6 KIELHOLZ cost of capital'',``fair rate of return'',or ``opportunity cost of capital''are used synonymously. The concept encompasses several important elements. First, the cost of capital is a forward- looking concept: it is the return investors demand if they are to be induced to invest their funds. Second, the cost of capital is determined in capital markets and includes the notion of opportunity costs. Investors face an ever-growing array of opportunities from which to choose, and the cost of capital or expected return must compensate for other foregone opportunities. Finally, the cost of capital is dependent on risk: higher risk investments require higher returns to attract capital.3 The cost of capital is thus important both from the perspective of investors and of insurance managers. Investors are concerned about their risk-adjusted expected returns; managers are similarly concerned and seek to deploy the capital ef®ciently in the production of insurance. To get the most out of an insurer's capital base, managers must weigh the costs and bene®ts of raising and holding capital. The bene®ts of a strong capital base are clear. The primary bene®t, of course, is security. An insurance company's capital base is the company's buffer against unexpected claims or ®nancial losses. Regulatory authorities, rating agencies and policyholders have all taken a heightened interest in the ®nancial strength of insurers after a signi®cant rise in the number of insolvencies in the 1980s and 1990s.4 Shareholders, too, bene®t from maintaining a buffer to survive through the bad times. Nearly all insurers have a market value signi®cantly above the value of the company's net assets. This premium, known as franchise value, represents the value built up in the company's brand and the ability of the company to continue to make pro®ts in the future. Insolvency would put this franchise value at risk. By holding capital, however, insurers also incur costs due to taxation and transaction costs.5 Managing capital effectively involves making decisions about the trade-off between these costs and the return from taking risks. Insurers have increasingly improved their decision-making in recent years by including the opportunity cost of capital in the performance measures used to set incentives for management. By doing so, insurers elicit decisions from management that more closely re¯ect the interests of shareholders. To implement these performance measures insurers need, however, a quantitative measure of those costs. The remainder of this paper discusses measures for estimating the cost of capital for insurance companies in ®ve major markets: the United States, the United Kingdom, France, Germany, and Switzerland. After a discussion of the cost of capital estimates in section 2,

3 The cost of capital also has well-established judicial foundations. For example in the United States, there are two important U.S. Supreme Court cases (Blue®eld Water Works and Improvement Company v. Public Service Commission of West Virginia (1923) 262 US 679, 692±693 and Federal Power Commission v. Hope Natural Gas (1944) 320 US 591, 603) that address this concept for regulated industries. These cases codify the above economic principles. Speci®cally, these court rulings articulate the basic standards under which regulated industries must operate. First, the rate of return to investors should equal that which can be expected to be earned by investors in businesses of similar risk. Second, the rate of return must be suf®cient to ensure the continued attraction of capital. The last criterion is especially important given the nature of the insurance business, where bene®t payouts may occur years after the policy inception and premium payment has been made. 4 According to A.M. Best, ``Insolvency: Will Historic Trends Return?'' Special Report, February 1999, nearly two-thirds of all insolvencies (in the U.S.) in the past 30 years took place between 1984 and 1993 and have averaged 41 per year. 5 These transaction costs include the fees paid to investment banks for issuing equity and also agency costs, which are discussed in section 5.

# 2000 The International Association for the Study of Insurance Economics. THE COST OF CAPITAL FOR INSURANCE COMPANIES 7 section 3 examines the business of insurance and implications for earning the cost of capital. Section 4 discusses how to improve capital productivity; section 5 looks at ways in which insurers can manage their equity capital costs, while the ®nal section offers conclusions and addresses areas for future research.

3. Measuring the cost of capital for insurance companies This section discusses some common techniques for estimating the cost of capital for insurance companies. It also presents some practical problems with the techniques, and ®nally estimates of the cost of capital are presented. Cost of capital estimates are presented separately for the United States for the time period 1981±1998 and for the United Kingdom, Germany, France and England for 1978±1998. Among the interesting implications from the empirical work is that, for all ®ve countries investigated, the cost of capital for both diversi®ed insurance companies and non-life companies has declined over the past several years. With the exception of the U.S., the cost of capital has also declined in the 1990s for life insurers. The decline in the cost of capital is driven mostly by the secular downward trend in nominal market interest rates. Measures of insurer market volatility and riskiness (so-called beta) have also declined slightly, contributing to the lower cost of capital.

Techniques for estimating the cost of capital: CAPM It is widely agreed in the academic literature and by practitioners, that techniques to measure the cost of capital have to rely on market data. Such market information re¯ects investors' views on the risk and return characteristics of different investments.6 The most widely used and simplest technique for estimating the cost of capital is the capital asset pricing model (CAPM). The intuition is straightforward. The cost of capital is really a measure of the opportunity cost of capital. Given the myriad investment opportunities facing investors, the cost of capital represents the price, or expected return, a ®rm must offer to induce investors to make funds available. Implicit in this is the notion that investors consider the relative riskiness of the investment opportunity and demand higher expected returns for riskier investments. Stated differently, investors demand an equity risk premium for investing in insurance companies. Investors can always choose to invest in ± at least in most of the developed world ± virtually risk-free government bonds. That is, investors could purchase short-term government bonds and by holding them to maturity be virtually guaranteed of interest payments and return of principal (of course investors would still face in¯ation risk). If they are to invest in riskier activities, such as the stock of an insurance company, investors will require a higher expected return than what is available on risk-free government bonds. Indeed, investors will demand an expected premium commensurate with the perceived risk of the investment.

6 An alternative to using market data would be to use accounting data. These procedures are generally considered seriously ¯awed since they are not prospective and do not necessarily re¯ect the current and future possible returns that can be earned in the market (see Fisher and McGowan, ``On the Misuse of Accounting Rates of Return to Infer Monopoly Pro®ts'', American Economic Review, March 1983). Accounting book values will re¯ect things like the choice of depreciation schedules, the historical mix of business, and the company's growth rate. For insurers this potential distortion is exacerbated by the long-tail nature of some lines of business.

# 2000 The International Association for the Study of Insurance Economics. 8 KIELHOLZ

This simple notion is captured quite elegantly in the CAPM formula. While there is more sophisticated theory and mathematics underlying CAPM, the simple formula is:

k rf â(rm À rf ) or

k rf ârp where: k cost of capital

rf risk-free rate of return

rm return on market equities â beta or volatility measure

rp difference between the risk free rate and return on equities, or the equity risk premium: As mentioned above, government bonds are typically used as the risk-free rate, and the market return on equities is typically measured by a benchmark market index such as the S&P500 in the United States. Beta is a measure of the systematic or non-diversi®able risk from owning a particular stock, and mathematically is derived from a regression analysis of how a change in the market index affects the returns of the individual stock. For example, a beta of 1.1 means that a 10 per cent change in the market index will give rise to an 11 per cent change in the stock. This holds for both positive and negative changes. Thus a beta greater than 1 implies the stock is more volatile than the market; conversely, a beta less than 1 implies the stock is less volatile than the market.7

Techniques for estimating cost of capital: discounted cash ¯ow analysis An alternative to the CAPM for measuring the costs of capital is a discounted cash ¯ow analysis (DCF). DCF is based on the notion that the price an investor is willing to pay for an

7 In order to estimate a CAPM cost of capital, an estimate of the equity risk premium is required. There is considerable debate about this within both academic and investment banking communities. There is debate over the data to use in the analysis and the method of estimation. Some argue that equity risk premiums need to be looked at over long periods of time. The logic is that long time periods capture the most varied market conditions. For example, one common source of the equity risk premium in the United States is Ibbotson and Associates. Ibbotson uses data from 1926 to the present and argues that this time period contains expansions, recessions, a depression, and stagnant times and is therefore suitable for contemplating possible future market conditions. Others argue that the world and ®nancial markets have experienced fundamental changes over that time period, and that what happened in the 1920s has little to no relevance on likely future conditions. There is also debate about how to use the data in calculating the risk premium. Ibbotson argues that the best estimate of likely excess returns is the simple arithmetic average over the longest available time period, i.e. the best estimate acrossa distributionoflikelyoutcomes is the average. Others arguethat compound returns arewhat matter toinvestors. For example, a 50 per cent decrease followed by a 100 per cent increase yields a 0 per cent return on a compound or geometric mean basis. The arithmetic average would imply a 25 per cent return. (See Welch, ``Views of Financial Economists on the Equity Premium and Other Issues'', UCLA: Anderson Finance Working Paper 10-98, May 1998.)

# 2000 The International Association for the Study of Insurance Economics. THE COST OF CAPITAL FOR INSURANCE COMPANIES 9 asset should equal the present value of all future cash ¯ows. For a stock, this means that the price an investor is willing to pay (P0) should equal the sum of the discounted future dividend payments. This may be represented as: 2 3 P0 DIV1=(1 r) DIV2=(1 r) DIV3=(1 r) ... where r is the discount rate that causes the future payments from the investment to equal the price an investor is willing to pay. Stated differently, r is the required rate of return or cost of capital. Notice that similar to the CAPM, the DCF model uses market data on expected future returns. This equation can be transformed into the following expression to solve for the cost of capital:

r DIV1=P0 g where g is the annual growth rate of dividends. Thus to estimate the DCF cost of capital all one needs is the current stock price, information on next year's target dividend rate and the expected growth in dividends. Dividend growth rates are available from ®nancial analysts or may be generated by extrapolating from historical dividend and earnings growth. Similar to the equity risk premium debate in using the CAPM, there are many different methods for estimating this important DCF parameter. There is no consensus as to the best approach. Even given the unresolved operational issues about the CAPM and DCF, it is still quite interesting to observe differences in the cost of capital for insurers across lines of business, country and time. Differences between the CAPM and DCF are also interesting to note. As argued already, as a major input into the production of insurance, capital costs are vitally important to the owners and managers of insurance companies.

Cost of capital estimates for insurers in the U.S., the U.K., Switzerland, Germany and France Tables 1 and 2 show estimates of the cost of capital for the U.S. and European insurance industries, respectively. Separate cost of capital estimates are shown for life insurers, property casualty insurers, and diversi®ed insurers.8 The cost of capital for U.S. insurers has been between 12 and 17 per cent during the 1990s. Diversi®ed and property casualty carriers have experienced greater ¯uctuations than life insurers, with the cost of capital declining signi®cantly over this period. The present cost of capital for those segments is in the range of 12 to 13 per cent. This is comparable to the cost of capital during 1986±1988. Life insurers have experienced a relatively consistent cost of capital during the 1990s of about 14 per cent. The DCF models produce similar results, although the DCF cost of capital estimates are usually a little lower than the CAPM cost of capital. CAPM cost of capital estimates for the U.K., Switzerland, France and Germany are shown in Table 2. Although based on a slightly different variant of the CAPM used for calculating the U.S. ®gures, the overall picture in Europe is consistent with the ®ndings in the U.S., particularly for non-life insurers. The cost of capital has fallen steadily throughout the 1990s. In contrast to the U.S., this has also been the case for life insurers. The U.K. has the

8 Figures from 1981 to 1990 are from Cummins and Lamm-Tenant, ``Capital Structure and the Cost of Capital in the Property-Casualty Insurance Industry'', Journal of Risk and Insurance.

# 2000 The International Association for the Study of Insurance Economics. # 10 00TeItrainlAscainfrteSuyo nuac Economics. Insurance of Study the for Association International The 2000

Table 1: U.S. insurance industry cost of capital estimates Diversi®ed insurance companiesÃ Non-life Life

Average cost Average cost Average cost U.S. DCF CAPM of capital DCF CAPM of capital DCF CAPM of capital 1981 19.31 21.64 20.48 n/a n/a n/a n/a n/a n/a 1982 16.67 17.38 17.03 n/a n/a n/a n/a n/a n/a 1983 15.01 15.73 15.37 n/a n/a n/a n/a n/a n/a 1984 12.75 16.66 14.71 n/a n/a n/a n/a n/a n/a 1985 11.93 14.79 13.36 n/a n/a n/a n/a n/a n/a 1986 13.95 13.61 13.78 n/a n/a n/a n/a n/a n/a 1987 11.94 12.95 12.45 n/a n/a n/a n/a n/a n/a 1988 14.66 13.85 14.26 n/a n/a n/a n/a n/a n/a 1989 15.19 16.09 15.64 n/a n/a n/a n/a n/a n/a 1990 16.41 n/a n/a n/a n/a n/a n/a n/a n/a 1991 16.38 15.76 16.07 17.42 14.97 16.20 1992 15.66 14.54 15.10 17.80 13.60 15.70 14.15 14.23 14.19 1993 10.98 14.08 12.53 15.60 12.52 14.06 15.16 13.45 14.31 1994 11.22 14.77 13.00 14.47 13.33 13.90 15.03 14.55 14.79 1995 13.06 15.76 14.41 13.45 14.16 13.81 14.78 15.84 15.31 1996 13.32 14.43 13.88 12.86 13.79 13.33 14.22 15.41 14.82 1997 13.54 14.74 14.14 11.67 13.82 12.75 15.47 15.50 15.49 1998 10.95 13.53 12.24 13.67 12.69 13.18 14.21 13.79 14.00

Ã1981±1990 ``Diversi®ed'' CAPM and DCF estimates include both diversi®ed and non-life companies. KIELHOLZ H OTO AIA O NUAC COMPANIES INSURANCE FOR CAPITAL OF COST THE

Table 2: Insurance industry cost of capital estimates for select European countries Cost of capital U.K. Switzerland France Germany

Non-life Life Non-life Life Non-life Life Non-life Life

1978 12.68 14.13 4.50 n/a 13.75 13.75 6.41 5.51 1979 18.94 20.85 3.00 n/a 10.06 10.06 7.17 6.09 1980 23.94 24.77 8.82 n/a 14.25 14.25 11.95 11.56 1981 22.10 22.81 9.70 n/a 11.31 11.31 12.51 11.93 1982 22.34 22.79 13.51 n/a 21.53 21.53 13.99 14.17 1983 16.61 16.95 7.16 n/a 29.49 29.49 9.70 10.07

# 1984 15.31 15.05 8.22 n/a 17.90 17.90 10.28 10.07 00TeItrainlAscainfrteSuyo nuac Economics. Insurance of Study the for Association International The 2000 1985 15.69 15.06 9.48 n/a 15.59 15.59 10.68 9.16 1986 17.52 17.21 9.35 n/a 18.30 18.30 10.66 7.87 1987 17.47 17.12 9.28 n/a 15.77 15.77 11.08 8.48 1988 14.85 14.79 7.48 n/a 14.80 14.80 9.54 7.83 1989 18.98 18.96 9.34 n/a 14.62 14.62 11.48 9.98 1990 21.22 21.31 14.03 n/a 17.52 17.59 14.19 12.92 1991 20.25 20.31 13.56 n/a 15.93 16.08 14.78 14.44 1992 17.52 17.38 13.00 n/a 16.11 16.41 14.85 15.14 1993 14.48 13.91 11.66 n/a 16.76 17.29 13.96 14.32 1994 13.09 12.37 9.49 8.20 11.50 12.32 10.93 11.40 1995 14.60 13.51 9.10 7.44 11.66 12.31 10.05 10.88 1996 14.73 13.29 6.49 4.81 10.60 11.14 8.39 9.29 1997 14.19 13.13 6.69 4.96 8.69 8.51 7.92 8.28 1998 15.23 13.74 6.85 6.06 8.43 8.54 8.81 7.81 11 12 KIELHOLZ highest cost of capital estimate across all the countries investigated. Swiss insurers appear to have lower capital costs than insurers in the other countries. Three things may cause changes in the CAPM cost of capital: changes in riskiness or beta; changes in the risk-free rate; or changes in the equity risk premium. To investigate this further two sets of analyses are shown. Table 3 contains average betas for all countries from 1978 to 1998 (1981 to 1998 for the U.S.). Figures 1 to 5 show the cost of capital estimates for each country plotted against the risk-free rate. Changes over time in the betas vary by country and sometimes by line of business. In the U.K., non-life betas have increased signi®cantly since the early 1990s and are the highest of any of the countries studied. The non-life beta has increased from 1.01 in 1990 to 1.28 in 1998. Interestingly, betas for U.K. life insurers increased between 1990 and 1997 but appear to have declined in 1998. Betas for both life and non-life insurers have increased to what appear to be historically high levels in Switzerland. Betas in France and Germany have declined. The picture in the U.S. is mixed: diversi®ed and non-life betas have declined, whereas life betas appear to have increased. There may be a number of explanations for the apparent changes in the betas. Although not investigated in detail, the following three points may be relevant.9 First, the late 1980s and early 1990s were a time when the perceived riskiness of insurance may have increased. Speci®c events include: deceptive sales practices in the U.K. and to a lesser extent in the U.S.; the collapse of Lloyd's; several notable natural catastrophes (hurricanes Hugo, Iniki and Andrew, and the Northridge earthquake). All these events when combined may have caused investors to lose con®dence in insurers in some markets. Of course, we did not investigate differences by insurer nor did we explicitly control for changing ®nancial and economic conditions. Second, there is also a statistical/measurement issue: the betas are of course only estimates of true riskiness. We did not explore the estimated standard errors or con®dence intervals. It is expected that betas might change over time although research from the 1970s ®nds that the relative rankings of betas tend to be fairly stable over time. Finally, at least for the U.S., the pattern of CAPM cost of capital estimates is consistent with that derived from an alternative theoretical structure, the discounted cash ¯ow model. It is important to note that all the betas (and cost of capital estimates) are ``intra-country'' in the sense that individual country stock market indices were used as the benchmark market index. One might argue, given the globalization of capital markets and consolidation within the insurance industry over the past couple of years, that it might be more appropriate to calculate betas using some weighted average of the individual country market indices. This probably lowers both the betas and the equity risk premium, which would lower the cost of capital estimates shown. The ®gures show an important part of the cost of capital story for the insurance industry. As expected, the cost of capital estimates track very closely with the yields on risk-free securities. Nominal interest rates are at historical 20-year lows in all ®ve countries. This is clearly the dominant factor in the lower insurance industry cost of capital over the past couple of years. The differences in the cost of capital between countries to a large extent re¯ect differences in the risk-free rate. The country with the lowest cost of capital is Switzerland, with short-term interest rates of 1.5 per cent, whereas the cost of capital and risk-free rates in the U.S. and U.K. were three to four percentage points higher.

9 These areas are beyond the scope of the current paper and are topics for further research.

# 2000 The International Association for the Study of Insurance Economics. H OTO AIA O NUAC COMPANIES INSURANCE FOR CAPITAL OF COST THE

Table 3: Average betas by country and year U.K. Switzerland FranceÃÃ Germany U.S.

Non-life Life Non-life Life Non-life Life Non-life Life Diversi®edÃ Non-Life Life

1978 0.99 1.23 0.61 n/a n/a n/a 0.83 0.63 n/a n/a n/a 1979 1.02 1.29 0.58 n/a n/a n/a 0.83 0.59 n/a n/a n/a 1980 1.18 1.32 0.60 n/a n/a n/a 0.74 0.65 n/a n/a n/a 1981 1.20 1.32 0.83 n/a n/a n/a 0.75 0.62 0.96 n/a n/a 1982 1.10 1.17 0.86 n/a 0.98 0.98 0.78 0.82 0.95 n/a n/a 1983 1.02 1.07 0.78 n/a 0.90 0.90 0.84 0.92 0.94 n/a n/a 1984 0.99 0.95 0.89 n/a 0.90 0.90 0.97 0.92 0.95 n/a n/a 1985 0.95 0.84 0.96 n/a 0.97 0.97 1.14 0.80 0.96 n/a n/a #

00TeItrainlAscainfrteSuyo nuac Economics. Insurance of Study the for Association International The 2000 1986 0.94 0.89 1.06 n/a 1.01 1.01 1.30 0.68 1.01 n/a n/a 1987 1.05 0.99 1.06 n/a 1.03 1.03 1.37 0.79 1.04 n/a n/a 1988 0.99 0.98 0.92 n/a 1.17 1.17 1.36 0.98 1.04 n/a n/a 1989 0.98 0.97 0.92 n/a 1.20 1.20 1.36 1.02 1.02 n/a n/a 1990 1.01 1.03 0.98 n/a 1.23 1.24 1.31 1.02 1.01 n/a n/a 1991 1.04 1.05 0.97 n/a 1.16 1.19 1.23 1.15 1.08 0.98 n/a 1992 1.10 1.07 0.97 n/a 1.17 1.23 1.18 1.24 1.09 0.97 1.05 1993 1.25 1.15 1.14 n/a 1.05 1.16 1.17 1.25 1.18 0.98 1.10 1994 1.29 1.17 1.10 0.84 1.04 1.20 1.12 1.23 1.16 0.97 1.13 1995 1.34 1.16 0.98 0.65 1.13 1.26 1.08 1.26 1.17 0.97 1.18 1996 1.38 1.14 0.95 0.61 1.13 1.23 1.03 1.23 1.01 0.93 1.13 1997 1.29 1.12 0.98 0.63 1.06 1.03 1.06 1.15 1.01 0.90 1.10 1998 1.28 1.04 1.08 0.92 0.96 0.98 1.16 0.93 1.05 0.95 1.08

Ã1981±1990 ``Diversi®ed'' estimates include both diversi®ed and non-life companies. ÃÃFrance betas start in October 1982. 13 14 KIELHOLZ

19781979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Non-life insurers Life insurers Risk-free rate of return

Figure 1: Cost of capital for French insurers

14 12

2 0

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Non-life insurers Life insurers Risk-free rate of return Figure 2: Cost of capital for German insurers

# 2000 The International Association for the Study of Insurance Economics. THE COST OF CAPITAL FOR INSURANCE COMPANIES 15

16 14 12 10 8

4 2 0

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Non-life insurers Life insurers Risk-free rate of return

Figure 3: Cost of capital for Swiss insurers

1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Non-life insurers Life insurers Risk-free rate of return

Figure 4: Cost of capital for U.K. insurers

# 2000 The International Association for the Study of Insurance Economics. 16 KIELHOLZ

1981 1983 1985 1987 1989 1991 1993 1995 1997

Diversified insurance companies Life insurance companies Non-life insurance companies Short-term Treasury (three-month)

Figure 5: Cost of capital for U.S. insurers

For the U.K. and Switzerland the decline in interest rates masks what appears to be, based on the beta analysis, an increase in volatility and hence riskiness for insurers. Insurance markets in the other countries do not appear any riskier, therefore the cost of capital for insurers relative to the overall market has not changed materially. Of course there could also have been changes in the equity risk premium over the past 20 years. Indeed, based on the Ibbotson approach (see note 7), the equity risk premium based on short-term treasury bills has actually increased in the U.S. from 8.4 per cent in 1991 to 9.2 per cent in 1998. This has been caused by the signi®cant run-up in the equity markets during 1995±1998. This makes the decline in the cost of capital all the more notable. In contrast to the Ibbotson approach, analysts who argue for using shorter time horizons and the geometric (or compound return) mean in calculating the equity risk premium would currently use a ®gure of approximately 3 per cent in the U.S., which is a decline from 5 per cent earlier in the decade.10 As compared to the approach shown, instead of an overall industry cost of capital of 13.24 per cent for the U.S. (calculated as the straight average of the three industry segments), the cost of capital would be about 7.8 per cent. Under this alternative methodology the overall U.S. insurance industry cost of capital in 1991 would have been about 13.5 per cent. Clearly if the equity risk premium has declined, as some argue, then the decline in the cost of capital for the insurance would be even more acute. (Note that in Europe we use the JP Morgan historical equity risk premium, which is 6 per cent for the U.K., 5 per cent for France and Switzerland, and 4.5 per cent for Germany.)

10 The Economist, ``Finance and Economics: Choosing the Right Mixture'', 27 February 1999 and JP Morgan data on equity risk premium.

# 2000 The International Association for the Study of Insurance Economics. THE COST OF CAPITAL FOR INSURANCE COMPANIES 17

It is important to stress that this paper and discussion pertain only to the equity cost of capital. We have not considered the impact of debt ®nancing which is generally cheaper than equity ®nancing. Many analysts look at the weighted average cost of capital that considers both equity and debt ®nancing. Generally, though, stock insurers use equity ®nancing to raise funds. For example, on average in the U.S. the capital structure of the insurance industry is 10 to 15 per cent debt and 85 to 90 per cent equity. Further, it is often insurance holding companies which may use debt ®nancing to raise capital and then make a downstream equity investment in the insurance operating company. There are, of course, other possible equity investments for the holding company to make, and so these investments are constrained to seek market rates of return. There are some well-known problems with cost of capital estimates that are worth mentioning. Since the CAPM and DCF are based on market data on the overall ®rm and industry activities, they capture more than the risk and return relationship solely for insurance operations. This is especially the case for diversi®ed insurers which engage in broader ®nancial services activities. In addition, the estimates presented here pertain formally only to publicly traded stock companies; the mutual form of ownership is not considered.11 CAPM has also come under attack by more recent research in the academic community. Options pricing models are now preferred on theoretical grounds. Yet these newer models present practical estimation problems; consequently the CAPM and DCF models are still relied on as reasonable approaches by practitioners. Their simplicity and ease of calculation remain strong virtues.

4. How to earn the costs of capital: business conditions as important drivers In this section U.S.-GAAP ®gures are used to show the pro®t drivers in insurance and the extent to which they have contributed to pro®ts in the last few years. Figure 6 shows a breakdown of the insurance process and pro®tability for U.S. property-casualty stock insurers over the time period 1993±1997. Although it is based on accounting ®gures and does not show the real economic pro®ts, this ®gure highlights several important features regarding the business of insurance. The upper right part of the tree diagram contains information on insurance underwriting results. Between 1993 and 1997, U.S. non-life stock insurers paid out 76.9 per cent of premium as bene®ts to policyholders, 28.3 per cent of premium in expenses to run the business, and 0.6 per cent in dividends to policyholders. This resulted in a combined ratio before investment income of À6.4 per cent. The investment earnings of insurers are shown in the lower right portion of Figure 6. Insurers earned a 6.8 per cent return on their invested assets, but since for every dollar of premium insurers have $2.76 of assets, relative to the premium received insurers earned total investment earnings of 18.8 per cent. Combining this with the 6.4 per cent underwriting loss, insurers earned 12.6 per cent in net income before taxes. With an effective tax rate of 20.2 per cent, insurer after-tax earnings were 9.9 per cent. Insurance is a leveraged business: for every dollar of investors' capital and surplus, insurers wrote $1.24 in premium. Thus the total industry-wide return relative to the equity of

11 From time to time, especially in public policy and regulatory proceedings, there are discussions about whether the cost of capital is a relevant concept for mutual companies. Clearly there are also measurement issues. These issues are beyond the scope of the present paper.

# 2000 The International Association for the Study of Insurance Economics. 18 KIELHOLZ

LLAE 76.9% UWRES NPE NPW NIAT TAX- NIBT Ϫ6.4% EXP 28.3% NPW ϭϫ()1ϪRATE NPW NPW 9.9% 20.2% 12.4% PHD 0.6% ROE NPW 12.1% OTHER NPW NIR AVG SURPLUS 6.8% NIR INVEST ASSETS 124.3% NPW 18.8% INVEST ASSETS 275.5% NPW

Figure 6: 1993±1997 pro®tability breakdown for U.S. p/c stock insurers

the industry was 12.1 per cent over this time period. Stated differently, for every dollar an investor provided to the insurance industry over this period, insurers made a 12.1 per cent return. Broadly speaking, there are ®ve factors that affect the book performance, or capital ef®ciency, of an insurer. These are: (1) underwriting performance (losses and expenses, which are affected by claims modelling, underwriting selection, claims management, overhead, and product pricing); (2) investment performance, which is a function of asset allocation and asset management; (3) asset leverage; (4) tax strategies; and (5) solvency or premium-to-surplus leverage. To put it simply, an insurer can increase the return on equity by increasing insurance earnings (lower losses and expenses relative to premium), increase investment returns; increase asset leverage, reduce taxes, or increase solvency leverage. The next few paragraphs discuss each of these in the context of current market trends and conditions. Given current market conditions, there may be reason to suspect that it will be dif®cult for many insurers to signi®cantly improve their net after-tax income, or the numerator in the return on equity calculation. Looking ®rst at insurance underwriting, the present market is quite competitive. Premium rates have not risen over the past few years, and for some lines of businesses have actually declined. Fortunately, at least until recently, loss cost in¯ation was also moderate. In some markets, however, evidence is emerging which suggests that medical in¯ation and liability costs may be rising. The expectation is that loss and combined ratios will rise in the near future. Insurers could also reduce their underwriting expenses. Indeed, this is one of the driving forces behind the recent remarkable mergers and acquisition activity. The economies of scale mantra is often mentioned when an acquisition is announced. So long as everything else remains the same this will directly result in higher income; there may also be a solvency leverage effect. Insurer size also plays a role in asset leverage. Typically, older and larger insurers have more assets to manage relative to premiums than newer or smaller insurers. Again this is one of the motivations behind the mergers and acquisition trend. Insurers have also released a

# 2000 The International Association for the Study of Insurance Economics. THE COST OF CAPITAL FOR INSURANCE COMPANIES 19 signi®cant amount of reserves over the past few years as claims in¯ation was lower than anticipated. This effectively lowers the amount of invested assets. Potentially offsetting this, however, is the likelihood that investment returns will be lower than they have been over the past few years. Signi®cant gains in equity markets plus historically low interest rates have been good to all investors including insurers. With the majority of their investments in ®xed income securities, insurers have pro®ted from the low interest rates. They have also pro®ted from high levels of realized capital gains. During the 1993±1997 time period in the U.S., 1.2 per cent of the 6.8 per cent return on assets may be attributable to realized capital gains. Likely lower investment returns could be offset in part by a shift in asset allocation strategies. Of course there are often regulatory restrictions which constrain an insurer's investment portfolio. There may be other costs associated with such a strategy too. To the extent that investors view a shift towards equities in an insurer's portfolio as taking on more risk, they will presumably bid up the beta and the cost of capital. Insurers could also take on more leverage by increasing the premium-to-surplus ratio. Yet,on an overall basis, just the opposite is occurring. While the ®ve-year average premium- to-surplus ratio in the U.S. was 124.3 per cent, in 1997 the ®gure was 107 per cent. This ®gure may now be under 100 per cent in 1999 for the U.S. Similar trends are observed in other countries. One problem is that insurance is a mature industry; top-line or new product growth has lagged behind economic growth in the U.S. and is roughly equal to, or grows slightly faster than, economic growth in the other countries. Also, the recent capital market performance has signi®cantly increased the value of insurer surplus. By historical standards, relative to insurance premiums, the insurance industry has more capital than ever. Taken together, these factors suggest that insurers are facing return pressures in the near future. Insurers could of course reduce the amount of equity on their books by returning it to investors through share buy-back programmes. Some insurers have used this approach; in the U.S., non-life insurers are estimated to have bought back more than $10 billion in shares between 1996 and 1998. This is less than 3 per cent of total U.S. non-life capital and surplus which does not appear to have signi®cantly affected the overall industry balance sheet.

5. Incorporating the cost of capital in risk-pricing and decision-making Insurers can incorporate the cost of capital into their daily business by using measures of economic pro®t to price risk and to set incentives for management. Traditional measures of accounting pro®t do not take into account the cost of capital that an insurer employs despite the fact that capital costs constitute approximately 20 per cent of the total costs facing a typical non-life insurer. Measures of economic pro®t, on the other hand, explicitly take into account the opportunity cost of the capital that an insurer uses. An insurer makes economic pro®t only if its earnings exceed the opportunity cost of the capital it employs. This is a relatively simple notion, but one that has important consequences for the way insurers do business. Only by targeting economic pro®t as a decision metric can insurers maximize shareholder value. Other benchmarks, like earnings or return on equity, may result in poor decision-making. The notion of economic pro®t has been used extensively to evaluate the investment opportunities of industrials for decades. Its application in insurance has always been troublesome, however. Unlike in manufacturing, where it is relatively easy to identify the capital costs of an individual investment (i.e. it is easier to estimate the costs of a piece of machinery), it is fairly dif®cult to identify the capital costs of an individual risk or a line of business. The capital costs of an insurer depend on its entire portfolio of risks, not on individual risks. The major development of recent years is the emergence of risk-based capital

# 2000 The International Association for the Study of Insurance Economics. 20 KIELHOLZ requirements and the evolution of risk-measurement tools, such as value-at-risk and dynamic ®nancial models, that allow capital to be allocated to individual risks or at least risk segments. These developments make it possible to judge the impact of a risk class on the capital costs of an entire company. This innovation is now revolutionizing the way that insurers do business by making the use of economic pro®t measures possible. Insurers can improve their capital ef®ciency by incorporating measures of economic pro®t at multiple levels of decision-making. At the lowest level of decision-making, economic pro®t can be incorporated in the pricing of risk. Different risks require different amounts of capital. Larger, more risky, transactions require larger amounts of capital. Risks which are uncorrelated or negatively correlated with the current portfolio of risks will improve the diversi®cation of the portfolio and might even reduce the overall capital needed to support the business. To properly price a risk, underwriters must assign an appropriate amount of capital to the risk; a return on this capital equal to the company's opportunity cost of capital must be included in the price of the contract. Doing so will ensure that the company is only underwriting value-creating business. Insurers can also use measures of economic pro®t to set incentives for managers. Incentive systems reward the performance of managers based upon measures of the economic pro®t that their units produce for the company. Managers can improve the performance of their unit in severalways. They can increase the volume of business they write or obtain higher margins. They can also decrease their capital costs by minimizing the amount of capital their units utilize and by reducing the cost of that capital. It is by managing these margins properly that insurers can realize the value creation potential of their business. Such an incentive system is particularly important because it enables insurers to decentralize decision-making. This is only possible because economic pro®t metrics align the incentives of managers with the preferences of shareholders. Decentralized decision-making can dramatically improve the ef®ciency of an insurer by putting the power to make decisions in the hands of the line managers who are in the best position to make those decisions. Measures of economic pro®t can also be used at the highest level of decision-making, as an aid to developing informed business strategies. These quantitative tools, such as value- based management, are aimed at managing the value of a company: identifying value- destroying activities and value-creation opportunities so that scarce resources can be channelled to their most productive use. Economic pro®t tools can also be used to evaluate the value-creating potential of merger and acquisition opportunities.

6. Managing the cost of capital The development of economic pro®t measures has placed new emphasis on the importance of capital costs in insurance. As previously discussed, mechanically in the CAPM world, there are three factors that in¯uence the cost of capital: (1) the risk-free rate; (2) beta; and (3) the equity risk premium. Yetthere are several other factors that are important and warrant a discussion.

Solvency risk/diversi®cation In the CAPM world, risk managers have an easy job. Since the cost of capital in the CAPM model is only affected by systematic risk, which is by de®nition undiversi®able, there is no point in maintaining a diversi®ed book of business. The CAPM model is an over-

# 2000 The International Association for the Study of Insurance Economics. THE COST OF CAPITAL FOR INSURANCE COMPANIES 21 simpli®ed version of reality, however. For one thing, it does not consider the risk of insolvency or even ®nancial distress. Avoiding insolvency is, of course, the reason for holding capital to begin with. Insurers with a high probability of insolvency put their franchise value at risk. These insurers must pay a premium to shareholders to compensate for this risk. Insurers with a high risk of insolvency therefore face a higher cost of capital. Insurers have two options for managing their risk of insolvency. Insurers can minimize solvency risk by holding more capital, but holding more capital incurs more capital costs. A second option for insurers to minimize their risk of insolvency is to maintain a diversi®ed book of risks. By holding a diversi®ed book of business, insurers can operate with less capital and still maintain a low risk of insolvency. In this sense, risk diversi®cation is a substitute for capital. A company with a diversi®ed book of risks will have lower capital costs and will therefore have a competitive advantage over less diversi®ed competition. Effective diversi®cation, especially for low frequency, high severity risks, requires that a company write business in a broad range of risks and also over a wide geographic region. This in turn requires a large scale and a global scope. Alternatively, insurers can outsource their diversi®cation by transferring risks to reinsurers who specialize in risk diversi®cation. This allows insurers to focus their operations on the lines of business and regions in which they are most competitive. Transferring risks directly to securities markets to tap the immense diversi®cation ability of investors also holds great potential, though this potential is still largely unrealized.

Tax costs Taxation of corporate pro®ts also increases the opportunity cost of capital for insurers. To make positive economic pro®ts, an insurer must have suf®cient after-tax earnings to compensate shareholders for the use of their capital. So insurers in high-tax countries will have higher costs of capital than insurers in low tax countries. Since underwriting pro®ts are rare in insurance these days, most of the income that insurers generate is from investments. Because insurers hold so many investments, it is common to think of them as a combined risk management and investment company. The truth is, though, from a tax point of view, that insurers are poor investment funds. This is due to double taxation of income from capital. Investment income from an insurer'scapital base is taxed twice, ®rst as income for the insurer and second as income for the shareholder. An investment fund, on the other hand, pays no taxes on investment income. Investment income is passed directly to shareholders where it is taxed only once. Insurers can manage their tax burden in a number of ways. First, they can simply hold less capital. Of course, they must balance the tax cost of capital against the solvency bene®ts of a strong capital base. Holding excess capital makes no sense from a tax point of view. Contingent capital solutions are a good way to keep capital off the balance sheet of insurers for tax purposes. Securitization is also a promising technique for reducing double taxation of income from capital. This is because the assets backing a securitized risk are held directly by shareholders and so avoid taxation on the insurer's books. Contingent capital solutions and securitization also reduce the need to hold capital and thus may reduce an insurer'saggregate capital costs. Insurers can also reduce their tax burden to a certain extent by holding more assets that are taxed at a lower rate and by postponing realization of capital gains. However, these measures create costs of their own in the form of reduced asset portfolio ¯exibility. Finally, from a tax point of view, location matters. Tax rates on capital differ widely from

# 2000 The International Association for the Study of Insurance Economics. 22 KIELHOLZ country to country, with European countries having, in general, the highest rates of capital taxation in the world. Options to transfer capital income to low-tax countries are limited because insurers are licensed and regulated in the country they do business in and transfer- pricing regulations prevent the wholesale transfer of income across countries. Insurers do, however, have several options, notably reinsurance and captive subsidiaries, for outsourcing their capital requirements to companies located in low-tax countries.

Transaction costs Another factor affecting an insurer's opportunity cost of capital is the transaction costs incurred in accessing ®nancial markets. These transaction costs arise primarily from what are termed, in the academic literature, agency costs. Agency costs occur because of intranspar- encies in an insurer's book of business. Investors are not fully informed about the risks an insurer takes on its books and so they must trust the management of the company to make proper decisions regarding risk/return trade-offs. Investors then take a risk that the managers of a company will make bad decisions. Because of this lack of transparency, an investor's perception of the risk of investing in a company is usually higher than the actual risk being taken by the company. Companies must pay a premium on their capital to compensate investors for this extra uncertainty. In addition to management compensation programmes discussed earlier, one way to reduce agency costs is to increase the information ¯ow to investors. The cost of this information transfer can be onerous, however, and for a complex business like insurance, it is inevitable that some uncertainty will remain on the part of investors. Several institutions have arisen in ®nancial markets that improve the information ¯ow from companies to investors. Rating agencies play an important role in this regard since they effectively monitor the balance sheets of companies for investors. Investment banks also maintain large research functions that provide investment research free of charge to investors. This service is offered primarily to improve the information base available to investors for the securities that the bank is bringing to market. The reputation of an insurer is also an important factor affecting the agency costs of an insurer. Companies that have an established reputation of making good decisions gain the con®dence of investors and so may pay a lower premium for their perceived risk. The cost of providing transparency to investors can be substantial, particularly for small companies who have not yet established a reputation in the market. For these companies, it is often better to seek alternative sources of capital. Reinsurers play an important role in this regard. Reinsurers can usually evaluate an insurer's book of business more easily than investors can. By raising capital through a reinsurer rather than directly tapping capital markets, insurers can bene®t from the reputation and scale of a well-established reinsurer. In this way, reinsurers play the role of intermediary, very much as banks do for companies that are not well enough established to go directly to capital markets for their funds.

Regulation Regulation also impacts the capital costs of an insurer. Regulatory institutions usually impose capital requirements on an insurance company to make sure that the insurer is able to honour its commitments. Risk-based capital requirements have signi®cantly improved the capital ef®ciency of regulation by more closely matching capital to the risk. However, since these rules need to be simple and regulators are mostly concerned about solvency and the

# 2000 The International Association for the Study of Insurance Economics. THE COST OF CAPITAL FOR INSURANCE COMPANIES 23 welfare of policyholders, capital requirements normally exceed economic needs. This in turn imposes additional capital costs; usually the extra capital does not earn after-tax returns re¯ecting the cost of capital, especially when there are additional restrictions on investing. Insurers have some ¯exibility in managing regulatory capital requirements. As with taxes, regulation differs by location. When regulations require that more capital be held than is economically justi®ed, risks can be transferred to locations with requirements that more closely re¯ect economic requirements. This can be accomplished through vehicles such as reinsurance and captives. Securitization also holds promise in this respect. Restrictive capital requirements in banking, in fact, have been one of the major factors driving the growth of the asset-backed securities market.

7. Conclusion and areas of further research Managing volatility is critical to the ef®cient use of capital for insurers. Traditionally, insurers have attempted this through diversi®cation across lines of business, geographic exposures, or across companies in an insurance group. Yet understanding the risk-adjusted cost of capital for each business activity is important for ef®cient capital allocation. In order to properly assess whether an activity adds or destroys value, capital must be allocated to individual business activities in relation to risk. Misallocation occurs if too little or too much capital is provided to an activity on a risk-adjusted basis. Stated differently, shareholder wealth is maximized if the marginal productivity of risk-adjusted capital is the same across all business activities. Otherwise an insurer can improve pro®tability simply by moving capital to more productive activities and reducing the capital needed to support the less productive activities. These theoretical concepts have very practical applications for an insurer. First, insurers need tools for measuring the cost of capital and understanding the volatility and risk of their business lines. These tools should include an understanding of the impact of economic and market conditions on the volatility of lines of business. Scenarios about future liability and asset performance must be consistent with macroeconomic factors and insurance market conditions. And importantly, the interactions of assets and liabilities must be understood and speci®ed accurately by the risk assessment tools. The newer class of models, such as value- based management and dynamic ®nancial analysis, seek to do this. The joint and interrelated behaviour of assets and liabilities is one of the important distinctions for the business of insurance. With the continued globalization of capital markets, insurers face a growing array of issues with respect to the ef®cient allocation of capital. For example, decisions about where to raise capital are extremely important. A listing on the New YorkStock Exchange might make sense for some European insurers. Potentially this offers investors an investment vehicle with lower systematic risk; it may be uncorrelated (or not highly correlated) with the overall market index. This would imply a lower beta and a lower cost of capital. There may be offsetting costs, however, in terms of the demand for greater transparency about the insurers' books: U.S.- GAAP accounting ®gures are required for listing on the stock exchange. The cost of capital and its ef®cient use also have important implications for the consolidation/mergers and acquisition trends currently driving the insurance market. There is wide belief, although very little concrete research to support it, that larger insurers are more ef®cient both in terms of the expenses required to produce insurance and in asset management. Insurers who create value and produce positive economic returns, that is returns which exceed the cost of capital, have a signi®cant competitive advantage and will continue to look

# 2000 The International Association for the Study of Insurance Economics. 24 KIELHOLZ for opportunities to acquire less ef®cient companies. Lower costs of capital will allow these more ef®cient insurers to ®nance their acquisitions through stock purchases. Deregulation will also have an important effect on the cost of capital and its deployment in insurance. Insurers need not raise and deploy funds on a local basis; funds can now be raised where it is most ef®cient (where volatility is lower for investors) and deployed where the risk- adjusted returns are most attractive. Insurers who understand their cost of capital better and employ techniques and incentives to ef®ciently use their funds will have a signi®cant advantage as the full effects of deregulation unfold. Throughout this paper a number of issues have been raised that have been beyond the scope of this review. Additional research is required to better understand the implications of the global ®nancial markets on the cost of capital for insurers. The implied cost of capital and capital ef®ciency for mutuals needs further analysis. More sophisticated cost of capital measurement tools such as multi-factor beta models or options pricing models need more work to make them more accessible to practitioners. Finally, while it is theoretically compelling, the experience with VBM and DFA models needs to be closely monitored. As with any model trying to forecast the future, even if based on sophisticated simulation techniques, there still remains signi®cant uncertainty. While only the test of time and experience with these models will provide further insight into this uncertainty, they are clearly steps in the right direction for helping insurance managers understand their capital costs and capital productivity. Newer concepts such as contingent equity solutions and securitizations are also quite promising. They potentially offer vehicles for reducing the amount of capital an insurer needs to keep on its balance sheet, effectively lowering aggregate capital costs.

# 2000 The International Association for the Study of Insurance Economics.