The world insurance industry is facing a capital shortage.

Mark Lima, a senior vice president at ACE Financial Solutions Ltd., said: “When you think about how much capital has left the industry and how much has come in, there's not nearly enough.”

As a result, even financial controllers of successful insurance and reinsurance companies are facing a challenging time raising enough capital to meet demand.

An analysis of capital constraints sheds some light on why the current insurance market is a gold mine for some and a disaster for others.

As Michael Morrison, chief executive of Allied World Assurance Company, said in a recent interview with The Royal Gazette, the insurance industry dug a hole for itself through underpricing during the last soft market.

The problem was exacerbated for many European reinsurers by bad investments in stocks. Several reinsurers, he hinted, had insufficient reserves.

“You've got downgrades, some companies are not even aware of how bad their results are. Some are probably bust and don't know it.”

Even healthy insurance companies have capital constraints - they need to raise capital even in a hard market with rising premiums. Without certain levels of capital on their balance sheet, the industry regulators will not allow them to continue to write policies or to secure more underwriting business.

Levels of capital are constantly assessed to make sure that insurers have put aside enough reserves to cover their contingent liabilities. Regulators such as the National Association of Insurance Commissioners (NAIC) try to encourage prudence by requiring certain capital adequacy tests of the balance sheet. Policy holders must be protected.

Since large amounts of capital are tied up by these capital adequacy requirements, insurers generally don't like to leverage their balance sheet further with debt and are constantly looking for alternatives.

One option emerging as a popular alternative to debt and common equity offerings on the capital markets appears to be preference shares.

XL Capital Ltd. announced this week that it will raise a total of $250 million by selling 10 million Series B preference ordinary shares at an initial price $25 per share pursuant to XL's currently effective shelf registration statement. Proceeds from the offering will be used for general corporate purposes, inlcuding fusions of capital into operating subsidiaries to support growth. The preference shares will not be exchangeable for or convertible into ordinary shares of XL. The net proceeds from the sale of the preference shares will be used for general corporate purposes.

Everest Re Group, Ltd. and its subsidiaries provide reinsurance in the property, casualty and life segments. It also announced on Tuesday that its indirect subsidiary, Everest Re Capital Trust, in conjunction with Everest Reinsurance Holdings Inc., has priced a public offering of 8 million shares of 7.85 percent Trust Preferred Securities, maturing November 15, 2032, at $25 per Trust Preferred Security, pursuant to its shelf statement.

Stephen Limauro of Everest said there was also some pressure to raise capital in order to maintain ratings. “Even for us who are on a positive outlook from Standard and Poors, it is always prudent to continue raising finance in order to take advantage of opportunities. It's a prudent move to stay ahead of the curve.”

Asked how a trust preferred security differs from other preferred stock, he said: “We create a trust, Everest Re Capital Trust, which is the vehicle for issuing preferred stock. The trust takes the proceeds of the offering and it buys subordinated debt of Everest Re Holdings. This provides a disconnect between the holding company and the shares and can be provided as debt for US tax purposes.”

For primary insurers, one way to improve the capital adequacy situation is to buy reinsurance. The regulators test their levels of premiums versus equity.

Reinsurance helps because it reduces the levels of premiums on the books for capital adequacy purposes.

But because even the reinsurers are cutting back and have capacity problems themselves, at the moment primary insurers cannot necessarily turn to them to take on some of their risk.

Some players, however are coming up with solutions to provide extra capacity.

RenaissanceRe, for example, has been able to provide more reinsurance capacity to its customers because it has raised additional capital through its joint ventures.

In these joint ventures, outside investors provide capital and Renaissance does the underwriting.

Mr. Limauro said the preferred security method was also popular for capital adequacy tests on levels of equity. Certain aspects of the security make it so similar to common stock that the rating agencies regard it as increasing levels of equity.

“S&P will give you credit even though it doesn't raise the common equity.

“Much of the proceeds of this week's preferred security issue will be contributed down to our US operating company which will raise the surplus in that subsidiary.”

At the same time, the fact that the shares offer a fixed dividend makes them attractive to investors leery of falling stock prices while they do not dilute the company's shareholding.

Some insurers have also secured private placements of stock rather than offering shares in the open market.

This week, Bermuda-registered insurer Catlin Westgen Ltd. said it had raised $532 million, mainly from private equity investors in a move to expand its underwriting capacity in what it said were “exceptional” conditions in the insurance market.

Catlin Westgen, which operates through the Lloyd's insurance market and elsewhere, said it raised $482 million in convertible preferred stock and borrowed an additional $50 million in a term loan facility from J.P. Morgan Chase & Co.

The latest tranche of $107 million was raised from Centre Partners Management, Charlesbank Capital Partners and Conning Capital Partners, the firm said. That adds to a $375 million fund-raising that ended in July from four other buyout shops including Capital Z, .P. Morgan Corsair II Partners, Cypress Group and Western General Insurance Ltd., it said.

And last year, Bermuda-registered Arch Capital Group (ACGL) of Bermuda won a $750 million investment from two buyout firms, Warburg Pincus and Hellman & Friedman.

If all else fails, insurers having difficulties raising finance may approach finite risk specialists, such as ACE Financial Solutions International Ltd.

Known as the “rocket scientists” of the insurance industry, they can sometimes come up with alternative solutions where customers have capital issues.

Some of the players in finite risk have withdrawn from the market.

Overseas Partners Re are no long underwriting finite risk type transactions and Scandinavian Re ceased underwriting new business in January this year. However there are other players such as Partner Re and Chubb who are apparently moving in to take on some of this business.

For companies which are in serious difficulties, however many of the avenues for raising capital may have closed off.

As Stephen Limauro, chief financial officer of Everest Re Group puts it: “In the reinsurance industry we see the flight to financial strength, the flight to strength and the flight to quality.”

In other words, the industry is experiencing a polarisation of healthy companies and struggling companies.