36. Capital management Flashcards
What does capital management involve?
Capital management involves:
- Ensuring the provider has sufficient solvency and liquidity
- To meet existing liabilities and future growth aspirations
- In all reasonably foreseeable circumstances.
- As well as maximising the reported profits of the provider.
Why do individuals need capital
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- Cushion against unexpected events e.g. car repairs
- Overcome timing differences between income and outgo e.g. salary and rent expense
- Save for large future expenses e.g. holiday or buying a house
Why do trading companies need capital
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- Cushion against flunctuating trading volumes
- Build funds for planned expansion
- Working capital for cashflow timing management e.g. suppliers paid before products are sold
- Start-up capital e.g. hire staff, obtain premises and equipment
Why do providers of financial services need capital
REGulatory CUSHION
- Regulatory requirement to demonstrate solvency
- Expenses of launching a new product/ starting a new operation
- Guarantees can be offered (higher solvency capital required)
- Cashflow timing management
- Unexpected event cushions e.g fines
- Smooth profits
- Helps demonstrate financial strength/ obtain new business/ good credit rating
- Investment freedom to mismatch in pursuit of higher return
- Opportunities, e.g. mergers and aquisitions, new ventures
- New business strain financing
Why does the state need capital
- Mostly, the state does not need to build up capital because
- It can raise taxes, issue bonds or print money
- However, states tend to hold capital (gold and foreign currency reserves)
- To support flunctuations in the economic cycle
- and in balance of payments
- And to manage timing differences between income and outgo
What costs will the provider be exposed to for taking on a new risk or type of liability for the first time? And how are they linked to business volume?
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- Set up of suitable management systems to administer the liabilities- Overhead cost
- Collecting premiums/contributions- depends on business volume
- Paying commission to third parties- Business volume
- Investment expenses- Fixed costs + business volume
- Admin expenses- overheads+ business volume
How will these costs be met until before sufficient premiums/ contributions have been collected?
- Capital- Provides an upper limit on the amount of business able to be written.
What are the effects of changing amount business volume on capital required?
- Constant=> additional cap rolled over to the next tranche of business
- Increases=> Additional cap required
- Decreases=> permits release of capital
What is the minimum capital requirement?
- The threshhold at which company will no longer be permitted to trade
What influences the amount of capital required to be held?
6
Investment Freedom
- The riskier the investment strategy
- With the aim of generating excess returns
- The greater the capital requirement
- Capital cushions any adverse movements
Product guarantees
- Products with guarantees have a greater risk attached to them
- Greater capital requirement to write products
- Cap requirement=> max amount of guarantee product able to be written
- The greater the risk of guarantees being exercisable
- The greater the capital requirement
Financial strength - New business levels
Strategic aims
* Key role in achieving overall strategic direction
* Impacts mergers + acquisitions + new ventures
Statutory or solvency requirements
- Minimum level of capital in excess of best estimate of future outgo
- This MCR is normally defined in legislation
Impact on accounts
- Company may want to smooth income statement and improve solvency and matching position on their balance sheet
How can companies increase their working Cap?
- Retaining profits=> NO DIVIDENDS+ BONUESES
- Debt=> Creditors
- Equity Capital=> Members
How can proprietary companies raise capital
- Issue shares to existing shareholders (e.g. rights issues)
- Issues shares to new shareholders (e.g. tender offers)
- Issue a debt
How can mutual companies raise capital
- Initially, capital is lent to mutual with no requirement for it to be repaid unless profits emerge (no liability in reg balance sheet)
- Issues of SUBORDINATED debt
How can benefit schemes raise capital?
- Usually provided by the sponsor of the scheme
- Example- the employer
What is an admissible asset?
- Assets permitted by regulators
- To be included in the valuation of assets
- For assessment of supervisory solvency
- e.g. restrictions on type of asset or derivates or max amount for asset class
What Capital management tools available to financial providers
BIRDS FEDS
- Banking products
- Internal sources of capital
- Reinsurance
- Derivatives
- Securitisation
- Financial reinsurance
- Equity
- Derivatives
- Subordinated debt
How can reinsurance act as a source of capital?
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- Regulator require a smaller solvency capital requirement
- Re help with liquidity issues - swap big claims for small premium
- Re commission from proportional reinsurance can help manage new business strain
- Financial Re exploit regulatory arbitrage - extent of this depends of reg restrictions
- Crystallise (solidify) the value of future profits
- Fin Re takes form of Loan => repayments contingent on future profits
- Fin Re are not viable under regulatory regimes (e.g. Solvency II)
How does securitisation act as a source of capital to a financial provider?
- Securitisation involves => Converting an illiquid asset into a tradeable instrument
- To achieve regulatory arbitrage
- e.g. By converting an inadmissible asset into an admissible one
- There is element of risk transfer involved in the transaction
- Securitisation often involves Issuance of bond => interest + capital repayment contingent on some factor. E.g:
- 1.Future profits emerging from a book of business
- 2.Repayment of mortgages or loans
- Less effective in regimes e.g. Solvency II
How does subordinated debt act as a source of capital to a financial provider?
- Ranks behind all other liabilities…
- Including policyholder expectation
- Including non-guarantee bonuses
- Interest + Cap payments only made when => Regulatory solvency requirements will continue to be met and possibly regulatory authorisation
- Debt repayments do not need to be shown in regulatory balance sheet
What banking products are available as sources of Cap to financial providers?
LUC
- Liquidity facilities (short-term financing for companies)
- Senior unsecured financing (financing at group level)
- Contingent cap (agreement to provide capital following defined event)
Why would a derivative contract be used?
- Provider concerned about fall in value of its equity portfolio
What are the three sources of equity cap?
PEN
- Parent company
- Existing shareholders- Rights issue
- New shares
What are the internal sources of Capital available to a financial provider?
MAD VS
* Restructuring by Merging funds
* Changing Assets:
1. Inadmissible to admissible
2. Matching more closely to reduce mismatching reserve
3. To influence the valuation interest rate used for liabilities
* Not paying Dividends
* Weakening the Valuation basis
* Deferring the distribution of Surplus (e.g. Bonuses)
What is economic capital requirement?
- Amount of capital that a provider determines is appropriate to hold given its assets, its liabilities, and its business objectives.
- Typically it will be determined based upon:
- risk profile of the individual assets and liabilities in its portfolio
- correlation of the risks
- desired level of overall credit deterioration that the provider wishes to be able to withstand
