Chapter 36 - Capital management Flashcards
What is 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 reasonably foreseeable circumstances.
It also involves maximising the reported profits of the provider.
Briefly discuss the capital needs of financial service and product providers.
Capital needs of individuals, companies and the state can be found on page 3 and page 7.
- Capital needs arise because of mismatches in amount and timing of income and expenses
- Same needs as other companies, but long-term nature of products and their associated risks give rise to additional capital requirements
The main reasons capital is needed are:
- Solvency
- Liquidity
- Growth
There are various factors which will influence the level of capital required for a provider:
1) Start-up capital and development expenses
- Also see slides
- Will need capital to meet start-up costs from initial expenses and new business strain, as premiums/contributions will not be able to fully cover these:
> Need to set up management systems to administer liabilities
> Systems for collecting premiums/contributions
> Paying commission to third parties
> Investment expenses
> Admin expenses
2) (Statutory) solvency requirements
- Normally required to hold minimum level of capital in excess of the best-estimate value of future liabilities
- This is to account for the risk that provisions are insufficient to meet liabilities
- Will normally be defined in legislation or regulation
3) Investment freedom
- Capital is required to cover risk of losses from investments due to mismatching
4) Products with guarantees
- Capital is required to cover risk that guarantees are in the money when they are exercised
- Level of capital will depend on level of guarantee
5) Financial strength
- Greater financial strength may attract more new business which will require more free capital
6) Impact on accounts
- Capital can be managed in a way to smooth income statements and improve the solvency and matching position of the balance sheet
7) Strategic aims
- Level of capital held will play a role in helping a company achieve its overall strategic direction
- Level of capital held is a constraint on the amount of new risks a company can take on in its normal business operations
- Will also affect acquisitions, mergers, and new ventures
Discuss some of the main capital management tools.
1) FINANCIAL REINSURANCE (FinRe)
- Main aim is to exploit some form of regulatory arbitrage in order to manage the capital, solvency or tax position more efficiently
- This frequently relies on differences in the capital, solvency or tax position of a reinsurer who may be based overseas
- An example is a contingent loan from a reinsurer to direct writer (see p.12&question on p.13)
- Limited use under regulatory regimes which take credit for future profits (such as Solvency II).
2) SECURITISATION
- Also a risk management tool (chapter 30)
- Convert illiquid asset into tradable instruments
- Almost any asset with reasonably predictable income stream can theoretically be used as a basis for securitisation
- Typically structured so that element of transfer of the risk associated with the asset value
- In practice the securitised assets are transferred into a separate legal vehicle which acts as a third party to improve security and transparency for investors
- The 5 key benefits are:
1) Converts a bundle of assets into a structured financial instrument which is then negotiable
2) Funds raised are directly linked to expected cashflows
3) Alternative to secured/unsecured bonds
4) Risk is passed to a third party and reduces required capital
5) Sells exposure to an otherwise (potentially) unmarketable pool of assets - Less effective in regulatory regimes which take credit for future profits
3) SUBORDINATED DEBT
- Main aim is to generate additional capital without increasing liabilities in the solvency assessment
- This will improve the free capital position of the provider
- Interest can only be paid on debt if regulatory solvency capital requirements will continue to be met after payment (or may even require authorisation from regulator)
- Subordinated debt ranks behind policyholder liabilities in all cases, even non-guaranteed bonsuses
4) BANKING PRODUCTS
Liquidity facilities
-Provide short-term financing for companies facing rapid business growth
Contingent capital
- Same principle as post-loss funding
- Capital would be provided as required following a deterioration of experience
- Advantages:
1) May be cost-effective way to protect capital structure/level
2) Improve financial strength of insurer
3) May be given credit by a rating agency - Disadvantages:
1) Lacks visibility (see question on p. 16)
Senior unsecured financing
- Not sure what this is just try to remember it. Explanation in notes unclear
5) DERIVATIVES
- Typically issued by banks but derivatives market is enormous
- Can use derivative strategies to mange capital efficiently and reduce risk through hedging
6) EQUITY CAPITAL
- Can come from parent company
- Can come from rights issues, i.e. existing shareholders
- Can come from initial offerings, i.e. new shareholders
- Several other possibilities - any capital raised from outside without obligation to pay back (but obviously still has some legal semantics and expectations)
7) INTERNAL SOURCES OF CAPITAL
Retained earnings
Returns on solvency or economic capital
Change in assets
Weaken valuation basis
- Only if justified - capital appreciation should not be the objective
Product management
Defer surplus distribution
- Reduce guarantees and therefore capital requirements
Retain surplus
List some factors which could influence the choice of capital management techniques.
Risk appetite
Regulation
Tax regimes
Level of funding required
Solvency level of the company
Amount of free surplus
Availability and cost effectiveness of method
Any other reasonable options
