36 - Capital Management

Question 1

What does Capital management of a financial benefit provider involve?
ie “Define Capital management”

Answer 1

1. Ensuring sufficient solvency and cashflow to meet - existing liabilities and future growth aspirations (under all reasonably foreseeable circumstances)
2. Maximising the reported profits (return on capital)

Question 2

Give the capital needs of individuals.

Answer 2

1. Provide a cushion against unexpected events

2. Save for the future

Question 3

Give the capital needs of a company

Answer 3

1. Deal with the financial consequences of adverse events
2. Provide a cushion against fluctuating trade volumes
3. Business expansion
4. Finance stock and work in progress
5. Obtain premises, hire staff, purchase equipment - start-up capital

Question 4

What characteristics of the business of financial service providers requires that they have more extensive needs for capital management?

Answer 4

The long-term nature of financial services products and the associated uncertainty.

Question 5

Give the extended capital needs of a financial service provider.

Answer 5

1. Meet benefits before sufficient premiums/contributions are received
2. Meet development expenses
3. Hold a cushion against unexpected events
4. Meet statutory/solvency requirements - fund new business strain, reflect risk
5. Invest more freely - mismatching
6. Sell products with guarantees
7. Demonstrate financial strength to attract business
8. Smooth reported profits
9. Achieve strategic aims

Question 6

Give the capital needs of the State.

Answer 6

1. Support fluctuations in the balance of payments and economic cycle
2. Timing differences in income and outgo.

Question 7

How are the State’s capital needs different to that of the individual or company?

Answer 7

The state has unique avenues to raise finance:

1. Taxation
2. Borrowing
3. Printing money

Question 8

What type of reserves does the State normally hold?

Answer 8

Gold and foreign currency

Question 9

Give the unique way of raising finance open to a Mutual insurer as an alternative to raising equity.

Answer 9

Subordinated debt: ranked after all other debt and the guaranteed policyholder benefits.

Question 10

What are the capital management tools available to providers?

Answer 10

1. Reinsurance
2. FinRe
3. Securitisation - SPV
4. Subordinated debt
5. Equity capital
6. Banking products
7. Derivatives
8. Internal restructuring.

Question 11

What two factors influence the effectiveness of any of the capital management tools available to providers.

Answer 11

The regulatory and tax environments that the company operates in.

Question 12

Explain how FinRe can be beneficial?

Answer 12

FinRe exploits some form of regulatory arbitrage in order to manage the capital, solvency or tax position of a provider more efficiently

Question 13

List the banking instruments available to providers as capital management tools.

Answer 13

1. Liquidity facilities
2. Contingent capital
3. Senior unsecured financing
4. Derivatives

Question 14

What are the methods of internal restructuring available to financial providers as forms of capital management.

Answer 14

1. Merging funds
2. Changing assets (to admissible ones, to matched assets)
3. Weakening the valuation basis (improves reported solvency)
4. Surplus distribution deferred
5. Retaining profits (don’t pay dividends)

Question 15

Describe the methods open to a Life insurance company that has seen a steady drop in free assets in the most recent period

Answer 15

1. Reduce the level of new business or close to new business
2. Seek assistance from a reinsurer
3. Change investment strategy
4. Change the type of business written to be more capital efficient
5. Defer profit distribution
6. One-off measure to boost the level of capital

Question 16

What pros/cons come with reducing or closing to new business for an insurance company?

Answer 16

Pros
1. Will reduce new business strain - reducing initial expenses and sales commissions and the need to establish cautious levels of regulatory capital

Cons

1. This may cause long-run diseconomies of scale
2. Foregoes potential future profits
3. Fewer policies so volatile experience

Question 17

How does Reinsurance boost the capital position of an Insurance company?

Answer 17

1. May reduce regulatory capital requirements - reduces volatility of claims
2. Reinsurance commission can help reduce new business strain (source of capital)
3. Financial reinsurance could improve the solvency position - loans from the reinsurer that are contingent on future profits
4. Depends on the regulatory regime

Question 18

Describe how changing the Investment strategy can help improve the capital position of an insurance company

Answer 18

1. Less volatile asset classes can reduce the total level of assets needed to back liabilities
2. Reduce mismatching reserve by seeking out a more matched position to liabilities
3. May be able to increase the discount rate used to value liabilities to improve solvency position ie reduce liabilities
4. Could use derivatives to reduce market risk

Question 19

How can an insurance company change its business sold (or designs) to be more capital efficient?

Answer 19

1. Reducing the level of guarantees under business sold
2. Selling unit-linked versions of contracts
3. Structure contracts with high initial charges or variable charges - usually with unit-linked contracts

Question 20

What does an insurance company need to consider when Deferring Profit Distribution

Answer 20

1. Reducing regular bonuses for with-profit business - aim to pay more terminal bonuses
2. Need to consider TCF
3. Can hold back dividends - may upset shareholders

Question 21

What one-off measures are available for an insurance company to boost the level of capital?

Answer 21

Could raise capital through:

1. A rights issue (shares)
2. Securitisation of a block of business/future profits
3. Issue of subordinated debt
4. Banking products such as contingent capital

Question 22

Explain how Securitisation works

Answer 22

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

Question 23

What are the pros and cons of Securitisation

Answer 23

1. Converts a bundle of assets into a structured financial instrument which is negotiable - so it offers:
2. 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

4. Passes risk in the assets to 3rd party - reducing capital requirements
5. A way of effectively selling exposure to what may otherwise be an unmarketable pool of assets

Question 24

How does Subordinated debt improve solvency position?

Answer 24

1. Ranks below p/hs
2. No need to show on liability side of balance sheet
3. Increases assets without changing liability

Question 25

What are Liquidity facilities?

Answer 25

This is same as Overdraft

Provide short term financing to rapidly growing businesses

Question 26

What is Contingent capital?

Answer 26

Capital is provided (by banks), as it was required following a deterioration of experience

Question 27

What is Senior unsecured financing?

Answer 27

Finance/capital obtained by the parent company from banks, and distributed to subsidiaries

Question 28

How can Derivatives be used to Manage risk/capital?

Answer 28

Derivatives can be used to:

1. Hedge (reduce risk) thus capital
2. Speculate (increase risk) to improve returns