Return on Equity - the efficient frontier

Insurers’ earnings are under downward pressure from competitive price reductions and ongoing low yields from investment portfolios. To survive, they are reducing costs and improving efficiency. This cannot just be limited to operating expenses, but must also include cost of capital.

When returns are under pressure, investment market value expectations can still be delivered through the active management of an insurer’s capital base. In terms of returns on equity (RoE), this means looking at the ‘E’ as well as the ‘R’. Traditionally, active capital management has included using 3rd party reinsurance capital to support risk, either proportionally or non-proportionally. Each can have an impact on both the ‘R’ and the ‘E’ of the insurer’s RoE and so the use of each will affect where the insurer sits on their own unique RoE efficient frontier.

The following diagram illustrates this efficient frontier for an insurer and plots the position of different approaches to capitalising the insurer’s risk in terms of the insurer’s RoE versus the risk of diminishing shareholder equity.

Efficient capital portfolio

Modelling shows the capital mix giving the lowest RoE is where the dominant source of capital is the insurer’s shareholders’ equity; the ‘E’ is at its largest, suppressing the RoE. With little use of cheaper insurance linked 3rd party capital, the risk to shareholders’ equity is marked.

At the other extreme, the scenario giving the highest RoE is one where the insurer’s shareholders’ equity is geared the most, and therefore at its thinnest. RoE may consequently be high, but the risk to shareholders’ equity is as well.

Most insurers seek to position themselves somewhere between the two to optimise the RoE vs risk to equity in accordance with the expectations of their shareholders. The tools available to insurers have expanded beyond simple equity vs reinsurance and include debt and hybrid debt (typically as an equity substitute) and for natural catastrophe risk, ILS (typically used as a reinsurance substitute). Both these tools, and new alternative asset structures, help underlying sophisticated investors target insurance risk as a new asset class.

Vario was established to increase the options to insurers looking to optimise capital in a post-Solvency II environment.