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Capital For Rent, Cheap

by Donald F. Mango

Project investment models from corporate finance assume a capital owner invests in a "project," which then returns that capital, plus any profits, to the owner over time. Net present value, ROE or IRR can then be calculated, and the attractiveness of the investment proposition assessed. We will call this a capital transfer model, since the capital is transferred to the project managers, putting it under their control for their own uses.

Imputed Capital Transfer

The transfer model is well suited to a manufacturing business model. Actuarial research has applied capital transfer models to insurance for pricing and planning. The insurance capital transfer model presumes that the capital owner transfers imputed required capital to the various portfolio segments (e.g., contracts, lines of business), which then return it over time.

There are practical problems with implementation and interpretation of insurance capital transfer models. First, the imputed required capital transactions between the company and the portfolio segments are completely theoretical. The only capital transfers that do occur are actual transfers—reserve increases, which are permanent.

Second, the imputation is in fact a mis-imputation. Imputed means "attributed to." Imputed capital flows are the presumed cause of the changes in calculated required capital amounts over time. Required capital is typically calculated based on key balances (for example, written premiums, reserves). The calculated required capital changes over time not because required capital flows into or out of some required capital account, but because the underlying balances themselves change. For example, if a product segment's loss reserves decrease as claims are paid, the calculated required capital would also decrease.

On a more philosophical note, the transfer model separates and distributes capital. Separating capital is at odds with a critical fact of insurance: every policy could lay claim to potentially all the company's assets. The transfer model is unable to reflect this fundamental reality.

Space Available at the Capital Hotel

Why have we spent so much effort on the transfer model? The exact reasons may never be known, but a key reason may be that capital flows are required inputs to insurance capital transfer models. You literally cannot use a capital transfer model without assuming capital is transferred, even if the transfer is only in theory.

Can we evaluate the insurance investment proposition without capital transfer? Instead of transfer, have we considered capital rental—occupation over time, something like a hotel? Maybe the insurance investment proposition for the capital provider is more like a sticky, long-term investment in a large fixed asset.

The financial instruments backing promises to pay may be liquid investments, but a well-run insurance franchise is not. There are licenses, production channels, marketplace reputation, client relationships, pricing models, internal databases, and intellectual assets in actuarial, underwriting, claims, and finance. These critical elements all take time to develop, and cost money to maintain.

Hotels rent their space (capacity) for occupation over periods of time, for which they are paid fees. Similarly, insurers could be thought to rent a portion of their finite supply of underwriting capacity to blocks of policies. The longer those policies stay on the books, the longer they occupy capacity—reserves generate required capital, hence take up space that could be used to write future new business. Policies therefore must cover the opportunity cost of the capacity they use, both amount and duration.

The hotel model shows the dual modes of insurance company capital usage. A product line performing per plan is "benignly occupying space"—staying, then leaving the room intact. On the other hand, a product whose results deteriorate "damages its room," by using up (consuming) the capital rather than merely renting it. Similar parallels exist in physics, with potential and kinetic energy. In banking, there is the issuance of a letter of credit, which creates a potential exposure to the bank that may turn into an actual cash call.

The rental model even handles the claim of any policy to potentially use all the company assets. Massive losses are like conflagration through the hotel—wreaking damage well beyond your own room. A catastrophic loss from one segment can impair the viability of other segments or the franchise as a whole. Transfer models cannot account for this fundamental reality.

Consider This

From a philosophical perspective, the hotel model includes rather than divides. Thinking of the capital hotel changes the focus from slicing the pie via allocation, to simultaneous, competing usage of a common capital pool. This leads to healthy peer pressure among product proponents, and a sense of a single, shared, intertwined corporate fate. It is worthy of our consideration as a valuable alternative perspective.

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