36 - Capital Management Flashcards
What does Capital management of a financial benefit provider involve?
ie “Define Capital management”
- Ensuring sufficient solvency and cashflow to meet - existing liabilities and future growth aspirations (under all reasonably foreseeable circumstances)
- Maximising the reported profits (return on capital)
Give the capital needs of individuals.
- Provide a cushion against unexpected events
2. Save for the future
Give the capital needs of a company
- Deal with the financial consequences of adverse events
- Provide a cushion against fluctuating trade volumes
- Business expansion
- Finance stock and work in progress
- Obtain premises, hire staff, purchase equipment - start-up capital
What characteristics of the business of financial service providers requires that they have more extensive needs for capital management?
The long-term nature of financial services products and the associated uncertainty.
Give the extended capital needs of a financial service provider.
- Meet benefits before sufficient premiums/contributions are received
- Meet development expenses
- Hold a cushion against unexpected events
- Meet statutory/solvency requirements - fund new business strain, reflect risk
- Invest more freely - mismatching
- Sell products with guarantees
- Demonstrate financial strength to attract business
- Smooth reported profits
- Achieve strategic aims
Give the capital needs of the State.
- Support fluctuations in the balance of payments and economic cycle
- Timing differences in income and outgo.
How are the State’s capital needs different to that of the individual or company?
The state has unique avenues to raise finance:
- Taxation
- Borrowing
- Printing money
What type of reserves does the State normally hold?
Gold and foreign currency
Give the unique way of raising finance open to a Mutual insurer as an alternative to raising equity.
Subordinated debt: ranked after all other debt and the guaranteed policyholder benefits.
What are the capital management tools available to providers?
- Reinsurance
- FinRe
- Securitisation - SPV
- Subordinated debt
- Equity capital
- Banking products
- Derivatives
- Internal restructuring.
What two factors influence the effectiveness of any of the capital management tools available to providers.
The regulatory and tax environments that the company operates in.
Explain how FinRe can be beneficial?
FinRe exploits some form of regulatory arbitrage in order to manage the capital, solvency or tax position of a provider more efficiently
List the banking instruments available to providers as capital management tools.
- Liquidity facilities
- Contingent capital
- Senior unsecured financing
- Derivatives
What are the methods of internal restructuring available to financial providers as forms of capital management.
- Merging funds
- Changing assets (to admissible ones, to matched assets)
- Weakening the valuation basis (improves reported solvency)
- Surplus distribution deferred
- Retaining profits (don’t pay dividends)
Describe the methods open to a Life insurance company that has seen a steady drop in free assets in the most recent period
- Reduce the level of new business or close to new business
- Seek assistance from a reinsurer
- Change investment strategy
- Change the type of business written to be more capital efficient
- Defer profit distribution
- One-off measure to boost the level of capital
What pros/cons come with reducing or closing to new business for an insurance company?
Pros
1. Will reduce new business strain - reducing initial expenses and sales commissions and the need to establish cautious levels of regulatory capital
Cons
- This may cause long-run diseconomies of scale
- Foregoes potential future profits
- Fewer policies so volatile experience
How does Reinsurance boost the capital position of an Insurance company?
- May reduce regulatory capital requirements - reduces volatility of claims
- Reinsurance commission can help reduce new business strain (source of capital)
- Financial reinsurance could improve the solvency position - loans from the reinsurer that are contingent on future profits
- Depends on the regulatory regime
Describe how changing the Investment strategy can help improve the capital position of an insurance company
- Less volatile asset classes can reduce the total level of assets needed to back liabilities
- Reduce mismatching reserve by seeking out a more matched position to liabilities
- May be able to increase the discount rate used to value liabilities to improve solvency position ie reduce liabilities
- Could use derivatives to reduce market risk
How can an insurance company change its business sold (or designs) to be more capital efficient?
- Reducing the level of guarantees under business sold
- Selling unit-linked versions of contracts
- Structure contracts with high initial charges or variable charges - usually with unit-linked contracts
What does an insurance company need to consider when Deferring Profit Distribution
- Reducing regular bonuses for with-profit business - aim to pay more terminal bonuses
- Need to consider TCF
- Can hold back dividends - may upset shareholders
What one-off measures are available for an insurance company to boost the level of capital?
Could raise capital through:
- A rights issue (shares)
- Securitisation of a block of business/future profits
- Issue of subordinated debt
- Banking products such as contingent capital
Explain how Securitisation works
Securitisation involves converting an illiquid asset into a tradable instrument (eg future profits or mortgages)
Each of these could be securitised into tradable instruments (eg bonds), in order to raise capital
There is typically risk transfer as the repayments on the bonds are made only if, for example, the future profits emerge or mortgage repayments are made
What are the pros and cons of Securitisation
- Converts a bundle of assets into a structured financial instrument which is negotiable - so it offers:
- A way to raise money, linked directly to the cashflow receipts anticipated in the futures
3, An alternative source of finance to issuing normal secured/unsecured bonds
- Passes risk in the assets to 3rd party - reducing capital requirements
- A way of effectively selling exposure to what may otherwise be an unmarketable pool of assets
How does Subordinated debt improve solvency position?
- Ranks below p/hs
- No need to show on liability side of balance sheet
- Increases assets without changing liability
What are Liquidity facilities?
This is same as Overdraft
Provide short term financing to rapidly growing businesses
What is Contingent capital?
Capital is provided (by banks), as it was required following a deterioration of experience
What is Senior unsecured financing?
Finance/capital obtained by the parent company from banks, and distributed to subsidiaries
How can Derivatives be used to Manage risk/capital?
Derivatives can be used to:
- Hedge (reduce risk) thus capital
- Speculate (increase risk) to improve returns
