Ch36: Capital management

Question 1

Capital management definition

Answer 1

• Capital management involves ensuring that a provider has sufficient solvency and liquidity to enable both its existing liabilities and future growth aspirations to be met in all reasonable foreseeable circumstances
• It also often involves maximizing the reported profits of the provider

Question 2

Why individuals need capital (3)

Answer 2

• Provide cushion against unexpected events
• Saving for a future large expense
• In anticipation of a future fall in income (retirement)
• Timing differences between income and outgo

Question 3

Why companies require capital (5)

Answer 3

• Deal with financial consequences of adverse events
• Provide cushion against fluctuating trading volumes
• Finance expansion
• Finance stock and work in progress (trading companies)
• Obtain premises, hire staff, purchase equipment (start-up capital)

Question 4

Start-up capital and development expenses (5)

Answer 4

• Setting up management systems to administer liabilities
• Collecting premiums/contributions
• Paying commission
• Investment expenses
• Administration expenses

Question 5

Capital needs for providers of financial services products (9)

Answer 5

• 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 (mismatch)
• Sell products with guarantees
• Demonstrate financial strength to attract business and sustain good credit ratings
• Smooth reported profits
• Achieve strategic aims

Question 6

Sources of capital for financial product providers

Answer 6

• Retained profits
• Equity (Owners of company; receive dividends which are variable and paid out from profits)
• Debt (Creditors of company; receive interest which are liability to company; e.g. bonds)

Question 7

Capital management tools (8)

Answer 7

• Reinsurance
  + Reduce the amount of capital required
• Financial reinsurance
  + Aim is to exploit some form of regulatory arbitrage in order to manage capital, solvency or tax position of a provider more efficiently.
  + Reinsurer normally operates in a different state to provider.
• Securitization
  + Involves converting an illiquid asset into tradable instruments
  + Typically involves a risk transfer; repayments on bond are made only if for example future profits emerge from a block of business
  + May achieve regulatory or accounting “off balance sheet” treatment
• Subordinated debt
  + Generate additional capital that improves free capital position of provider, since debt does not need to be included as a liability in the assessment of solvency
  + Can only pay interest or capital if after payment, regulatory solvency capital requirements are still met
• Banking products
  + liquidity facilities (short-term financing in times of rapid growth)
  + contingent capital (Capital provided following deterioration of experience)
  + senior unsecured financing (Increases assets and liabilities, but at a group level can be used to finance insurance subsidiaries)
• Derivatives
  + Reduce risk (less need for capital) or increase risk in order to improve expected returns
• Equity capital
  + Increase assets without increasing regulatory liabilities
  + May come from: parent company, existing shareholders (rights issue) or from market (placement of new shares)
• Internal sources of capital
  + Reorganize existing financial structure of organization in more efficient way
  + Merge funds
  + Change assets
  + Weaken valuation basis
  + Defer distribution of surplus
  + Retain capital (not paying dividends)

Question 8

Contingent loan in reinsurance

Answer 8

• Normal loan would increase insurance company’s assets, but would also have to identify the amount owning as a liability
• Contingent loan is only paid back if profits emerge on a block of business. Since company has no liability to repay the loan unless profits emerge, regulator may allow it to not make provision for these future payments on a statutory basis, therefore improves solvency position.

Question 9

Factors that influence effectiveness of capital management

Answer 9

• Regulatory and tax environment
• Cost
• Level of funding required
• Solvency level
• Amount of free capital