Which capital structure maximizes the shareholder value of an insurance com- pany, given the regulatory, accounting and rating constraints?

Which capital structure maximizes the
shareholder value of an insurance com-
pany, given the regulatory, accounting and
rating constraints?



Diplomarbeit
in

Corporate Finance

am

Institut für schweizerisches Bankwesen
der Universität Zürich


bei

PROF. DR. MICHEL ANTOINE HABIB



Verfasser:
FABIAN ACKERMANN










Abgabedatum: 01.04.2007

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Which Capital Structure Maximizes the Shareholder Value of an Insurance Company
Executive Summary
I. Problem Definition
There is an intensive pressure on insurance companies to optimize their capital structure. As
in other industries, value creation is one of the most important challenges of an insurance
company. Shareholder value has been a buzzword since the publication of the famous work
“Creating Shareholder Value” from Rappaport, A. (1986). A method to increase this share-
holder value is the optimization of the capital structure. However, insurance companies are
partly limited in increasing the shareholder value since the growth in this industry is rather
low.1 Thus, capital structure optimization gains even more importance for insurance compa-
nies.

This thesis will detect the optimal capital structure of an insurance company under the indus-
try specific constraints given by regulators and rating agencies. Hybrid capital is an elaborate
instrument up to a specific limit, since many hybrid instruments are within those constraints.

The critical question of how to optimize the capital structure has been widely discussed for a
half a century, and different solutions have been presented. Recently, hybrid capital was in-
cluded in this debate due to its various advantages. It is the aim of this thesis to verify the
benefits of hybrid capital for an optimal capital structure and to apply the findings in the in-
surance sector, proven with the practical example of Bâloise Holding. The strong regulation
of the insurance sector has significant influence on the optimization discussion, but rating
aspects and - to a lesser part - accounting principles, also play also an important role in this
subject.

II. Proceeding
The core of this thesis is the practical realization of the capital structure optimization with the
help of the example of Bâloise Holding. To reach this aim, a theoretical basis is essential. As
an introduction, the classification of the whole theory in corporate finance will be presented
(chapter two). A broad discussion of general capital structure theories and the specific appli-
cability to the insurance industry will follow (chapter three). A second part of the theory con-
cerns hybrid capital, which will present the characteristics of hybrid capital, give some exam-
ples of particular instruments and their contribution to an optimal capital structure, and finally

1 Compare with chapter 5.3.2. Analysis of the Industry
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Which Capital Structure Maximizes the Shareholder Value of an Insurance Company
empirical evidence about the usage in the insurance industry (chapter four). Additionally, the
treatment of hybrid capital in regulation, accounting and rating aspects will be reviewed in
depth for the case of Swiss insurers. To connect theory and practice, an interview with an
investment banker about hybrid capital is attached in the appendix (8.1. Interview).
Equipped with these theoretical and empirical findings, the practical implementation will be
carried out using the example of Bâloise Holding (chapter five). There will be a special focus
on the insurance framework and the allowability of hybrid capital. The optimization itself
was executed with the help of an excel model,2 thus, giving one the possibility to perform
sensitivity analyses by adjusting the parameters of the model.

III. Results and Evaluation
The Excel model is not merely a tool that can be used for arbitrary calculations. It can be
used to assess the optimal capital structure of the firm. In reality, there is no model that calcu-
lates the optimal capital structure, since the situation is too complex to be captured in a model
with a single output. An example is the solvency ratio: If this ratio falls below a certain level,
the regulator can run-off the business of the company. This liquidation risk must be balanced
against other benefits, but it cannot be captured in a single number. Thus, an optimal capital
structure does not exist. There is rather a range of favorable capital structures that are more
advantageous than others. With the excel model, it is possible to compute different capital
structures with different financial instruments and observe the effects on the shareholder val-
ue and finally discuss the advantages and disadvantages.
A hybrid instrument has obvious benefits in the case of Bâloise Holding compared with debt
and equity, since equity is more expensive and debt is not allowable as risk bearing capital.
The replacement of equity with hybrid capital in the capital structure of Bâloise Holding
leads to an increased shareholder value keeping the risk of bankruptcy constant. Up to a spe-
cific limit, even the important solvency ratios can be held constant. Additionally, share buy-
back is an option, since growth opportunities in the insurance sector are rather seldom, but
free cash flow is high.

Capital structure optimization is not trivial. However, in the case of Bâloise Holding, there
seems to be optimization potential and different possibilities should be discussed and
weighed against each other.

2 Bâloise_Holding_Optimal_Capital_Structure.xls
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Which Capital Structure Maximizes the Shareholder Value of an Insurance Company
In practice, implementing the optimal capital structure involves additional complications that
are not completely captured by theory. For instance, while there obviously is a potential tax
benefit, it is not easy to determine it in the case of Bâloise Holding, since the different sub-
sidiaries have different tax rates. Other aspects such as financial flexibility also have to be
discussed by management and the advisory board.


III

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