The dramatic collapse of Independent Insurance is the latest in a long line of insurer failures. It is unlikely to be the last – unless insurers can square the circle of providing shareholder value at the same time as ensuring financial stability for their policyholders.

In a report published earlier this year, the rating agency AM Best confirmed that performance, not excess capital, is the key to top credit ratings.

Having assessed the capital adequacy of nearly 1,000 insurers, based on their 1999 year-end capital positions, AM Best concluded that the industry has excess capital, even after accounting for property/casualty insurers' most severe financial risks, led by catastrophe losses, reserve deficiencies and declines in stock values. Consequently, it felt that the industry could return capital to its stakeholders without risking rating downgrades or insolvency.

Too much capital for comfort
AM Best is not alone in its thinking. Many analysts consider insurance companies to have too much capital for their own good. On both sides of the Atlantic, they are said to carry between 50% and 100% more equity than they can use. They have built this up following high investment returns, the relatively low number of catastrophes, and better diversification of risk following cross-border mergers and acquisitions.

To the layman, and particularly to Independent's policyholders, whose policies are now virtually worthless, it is hard to understand how an insurance company can have too much capital. Surely it helps provide greater financial security and enables the insurer to take advantage of new business opportunities as well as adopting a higher risk investment strategy which, over the longer term, will give greater returns?

Vice president of E-risks Peter Nakada says if an insurer grows its capital base by pursuing attractively priced business in areas where it has underwriting expertise, then it can continue to create value for its shareholders. However, the reality is that a combination of too much capital and stagnant demand often leads to underpricing as insurers attempt to bolster market share.

Insurers are also tempted to underwrite classes of business or enter markets about which they have insufficient knowledge. This inevitably leads to eroded profit margins and share prices that lag behind companies in other industries.

Pressure to return
Bryan Joseph, actuarial partner at Pricewaterhousecoopers, notes that the need to achieve better returns has fuelled the recent spate of mergers and acquisitions. He says: "Companies have been consolidating in an attempt to gain economies of scale and reduce some of the capacity in the market."

This is not just confined to the insurance industry or to the UK. Last year, the value of mergers and acquisitions worldwide reached a record £2,100bn. In 1999, in the US, there were 64 acquisitions and 27 mergers in the property/casualty market alone, according to AM Best. The value of merger deals has slowed down in the first six months of this year, but analysts expect an upturn when the stock markets begin to show some signs of sustained recovery.

The jury is still out on whether mergers and acquisitions produce better performance or cost savings. Management consultancy AT Kearney has monitored the insurance industry for 11 years and says it has found no correlation between the size of insurance companies and the levels of growth, profitability or shareholders' returns.

Acquisitions can be costly. Axa had to spend £45.6m to strengthen GRE's reserves which it had bought for £3.4bn in 1999.

Returning capital to the stakeholders usually involves share repurchases or paying higher dividends. Swiss Re bought back $1.3bn (£ 920m) of its shares in 1997 and, consequently, improved the performance of its share price.

Reduce excess capital
Pressure on companies to return capital increases if investment gains reduce. In the US, the excess of investment gains over underwriting losses dwindled by nearly 95% in three years from $75.5bn (£53.6bn) in 1997 to just $4.1bn (£2.92bn) last year. Consequently, US insurers cut dividends to shareholders by 26% in 2000.

US Insurance Services Office president Frank Coyne warns: "Unless returns on capital improve, you might expect pressure on company management to return capital to its owners so they can re-deploy it more advantageously."

The strategy of reducing excess capital only works, however, if companies have accurately assessed the extent of risk to which they are exposed. Clearly, there were failings at Independent, but it is not easy for any insurer to decide how much risk capital it needs to meet unexpected losses.

Insurers must put aside risk capital to cover not only losses in their different lines of business, but also in their stock and bond portfolios. This may account for 70% to 85% of their risk capital. A stock market crash may have a more devastating effect on an insurer's balance sheet than, say, flooding in Europe or an earthquake in California.

Reinsurance can be used to improve the return on capital. Many insurers though, purchase reinsurance for relatively small risks but have insufficient cover for cumulative losses that are big enough to put them out of business.

According to the senior vice president of XL Re, Gregory Hendrick, in Bermuda "almost all companies are reinsuring against the 100-year storm. Only 20% of clients buy higher protection, but practically none cover anything beyond the 250-year event".

Having assessed their risk exposure, insurers need to examine their profitability in accordance with the amount of risk capital each line of business requires. Without this assessment, insurers can unwittingly cross-subsidise underperforming lines of business.

Understand the risk
It is not unusual for a liability portfolio to require a high proportion of an insurer's risk capital but only generate a small return. Without a clear understanding of the basic principles of risk and return, an insurer cannot cherry-pick the most profitable business sectors nor cut prices without serious detriment to its bottom line.

Although premiums are now generally rising, these barely cover the increased cost of reinsurance. With the global movement of capital and alternative risk transfer creaming off the most profitable risk segments, market conditions are likely to remain permanently soft. Some commentators are therefore warning that insurers' prospects for greater profitability may actually be diminishing.

In the US, last year alone saw 31 property/casualty insurers declared insolvent. A further surge in failures is expected this year as the world economy slows and investment returns diminish.

Measuring shareholder value is a complex business. Most consultants now recognise that traditional accounting measures, such as earnings per share and return on capital employed, are an inadequate guide to financial well being and stock market performance. Fund managers are tending now to focus more on ratios involving cash flow. However, as recent events have shown, "cash flow underwriting" is a recipe for disaster.

Companies put a lot of effort into manipulating their image to boost their share price. Policyholders, as well as shareholders, have to be assured that this is more than smoke and mirrors.

The fall of Independent should help to focus insurers' minds on the need to assess and manage their risk capital better. Maximising shareholder value and maintaining financial stability need not be diametrically opposed if the principles of risk and return are properly understood and applied.