Australian Prudential Regulation Authority

In this paper we develop a model of an insurer incorporating frictional costs of capital and assess and illustrate an optimal capital management strategy. Frictional costs of capital are the additional taxation on profits of shareholders from an insurer’s business over and above those from direct equity investment in financial assets, transaction costs in raising equity capital, moral hazard and adverse selection costs from underwriting insurance risks, agency costs such as management perquisites, as well as the costs of financial distress and insolvency including legal costs and loss of new business opportunities. These costs are deadweight losses to equity investors in an insurer and need to be minimised in order to maximise shareholder returns. Frictional costs of capital do not include the expected return to shareholders, normally regarded as the nominal cost of capital. Fair pricing taking into account risk and optimal capital provides a fair expected rate of return to shareholders. A trade-off exists between the frictional costs of the solvent insurer and the contingent financial distress costs of the insolvent insurer. Higher levels of capital will lower expected financial distress costs but increase other frictional costs such as additional taxation, agency, moral hazard and adverse selection costs. By minimising total expected frictional costs, the model determines the optimal trade-off and the optimal level of insurer capital. The model includes adjustment costs of raising and shedding capital. The paper has implications for the long run sustainability of insurers. The efficient management of the frictional costs of capital should be a focus of the risk management strategy of an insurer and is essential for the long run survival of an insurer