Financing Strategies for New Businesses

The Financing Decision: A Framework for Evaluation

When an insurer sells a new policy, it needs cash to pay acquisition costs (like commissions) and to set up the required capital and reserves. The fundamental question is: where does this money come from? The choice is broadly between internal financing (using the company's own resources) and external financing (sourcing funds from outside).

To compare these strategies systematically, actuaries use a set of criteria. The following resource provides a handy mnemonic, FLOSSR, which outlines these criteria. This framework is invaluable for structuring your thinking in an exam context.

With this framework in mind, let's look at the high-level trade-offs between internal and external financing.

As the diagram illustrates, internal financing offers greater autonomy and speed but is limited in scale. External financing can support large-scale growth but comes with costs, conditions, and slower approval processes. Let's examine each in more detail.

Internal Financing

Internal financing is the most straightforward approach: an insurer uses its own accumulated profits (retained earnings) and existing surplus capital to fund new business strain.

• How it works: The profits generated from the existing in-force book of business are retained within the company instead of being paid out to shareholders as dividends. This pool of capital is then used to absorb the initial costs and reserve requirements of new policies.
• Pros:
  • Control: Management retains full autonomy over business decisions without interference from external capital providers.
  • Cost: There are no direct interest payments or fees.
  • Speed: Funds are immediately available.
• Cons:
  • Opportunity Cost: This is the most significant drawback. Capital used to finance new business strain cannot be used for other purposes, such as investing in new technology, expanding into new markets, or returning it to shareholders who expect a certain rate of return.
  • Limited Scale: The amount of new business an insurer can write is constrained by the size of its retained profits and surplus. This can hinder rapid growth.
  • Reduced Resilience: Relying heavily on internal capital can deplete the financial buffers available to withstand unexpected shocks, such as a spike in claims or a market downturn.

Applying the FLOSSR criteria, internal financing scores well on flexibility (the company decides how much to use) and security (the money is already there), but poorly on opportunity cost and can lead to liquidity constraints if growth is too rapid.

External Financing: The Role of Reinsurance

When internal resources are insufficient or the opportunity cost is too high, insurers turn to external financing. While this can include traditional corporate finance options like issuing debt or equity, the most common and specialized tool in the insurance world is reinsurance.

Reinsurance is essentially insurance for insurance companies. A primary insurer (the cedent) transfers a portion of its risks to another company (the reinsurer) in exchange for a portion of the premium. While its primary purpose is risk management, it is also a powerful financing tool.

The following video provides an excellent introduction to why reinsurance is so critical.

As the video explains, by ceding part of a risk, the insurer reduces its liability and the associated capital it must hold. This freeing up of capacity is a direct solution to the new business strain problem. Another key financing benefit comes from reinsurance commission. The reinsurer often pays an upfront commission to the ceding insurer, which helps cover the high initial acquisition costs of the new policy, directly alleviating the strain.

Main Types of Reinsurance

To understand how reinsurance works as a financing tool, it's essential to know the main structures. Reinsurance can be classified by the method of placement and by the structure of risk sharing.

• Facultative Reinsurance: Useful for large, unusual, or high-risk policies that don't fit into the main portfolio. It provides financing on a case-by-case basis.
• Treaty Reinsurance: More efficient for financing large volumes of standard business. The insurer knows it has a certain amount of reinsurance capacity available for the year, which allows for better financial planning.

Once the method is decided, the financial arrangement itself can be structured in two main ways.

• Proportional (Quota Share): The cedent and reinsurer share premiums and losses in an agreed-upon ratio (e.g., 70/30). The reinsurer typically pays an upfront commission that provides direct financing for new business acquisition costs. This is very effective for financing strain.
• Non-proportional (Excess of Loss): The cedent retains all losses up to a certain limit, and the reinsurer covers losses above that. This is less about financing day-to-day strain and more about protecting the insurer's balance sheet from catastrophic events.

Financial Reinsurance

The line between risk transfer and pure financing can become blurred. Financial Reinsurance (FinRe) refers to reinsurance contracts where the primary motivation is financial, rather than the transfer of significant insurance risk. These are highly structured deals designed to help an insurer meet its strategic financial objectives.

As the paper explains, FinRe transactions are a form of sophisticated financing. For example, a reinsurer might provide an upfront cash loan (a "deficit account") that is repaid from the future profits of the block of business. This is more akin to a loan than traditional reinsurance, but it is structured within a reinsurance agreement. These arrangements give insurers greater certainty and allow them to convert uncertain future profits into cash today to fund growth.

Conclusion

Financing new business is a fundamental challenge for insurers, driven by the upfront costs and reserving requirements known as new business strain. The main strategies involve a trade-off between the control and simplicity of internal financing and the scale and capacity offered by external financing.

For insurers, reinsurance is the dominant external financing tool. It operates on a spectrum, from traditional risk-sharing agreements that provide capacity relief and commissions, to highly structured financial reinsurance deals designed explicitly to monetise future profits and manage the balance sheet. The choice of strategy depends on the insurer's risk appetite, growth ambitions, and capital position, and is a critical component of its overall financial management.

Looking ahead, our next module will broaden our perspective to Enterprise Risk Management. The decisions we've discussed today—how much risk to retain, how much to transfer, and at what cost—are core components of a company's overall risk governance framework, which we will begin to explore in the next lesson.

Key Takeaways & Cheatsheet

Here is a summary comparing the main financing strategies using the FLOSSR framework. This is a useful tool for exam revision.