The Cost of Capital for Insurance Companies

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 have to pay for the capital they use. 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 concept encompasses several important elements. First, the cost of capital is a forward-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. 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, investorswill 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. 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 newtools 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.