Chapter 36 - Capital management Flashcards
What does capital management involve?
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 often involves maximizing the reported profits of the provider.
When taking on risks for a first time, there will be costs for the provider in
A PICS
- ADMINISTRATION expenses
- PAYING commission to third parties
- INVESTMENT expenses
- COLLECTING premiums
- SETTING up suitable management systems to administer liabilities
Capital needs for financial providers
ABCD FOG SIP
- achieve strategic AIMS
- meet BENEFITS before sufficient premiums / contributions received
- hold CUSHION against unexpected events (adverse claim experience)
- meet DEVELOPMENT expenses ( product development, R&D, marketing)
- demonstrate FINANCIAL strength to customers and advisors
- OPPORTUNITIES such as new ventures ( M&A)
- sell products with GUARANTEES
- meet STATUTORY capital requirements ( fund new business strain )
- INVEST more freely
- PROFIT smoothing, smoothing discretionary benefits, smoothing dividends
How can proprietary companies raise capital?
- Issue of shares to existing shareholders (e.g. rights issue).
- Issue of shares to new shareholders (e.g. tender offers)
- Issues of debt
How can mutual companies raise capital?
- Initially capital is raised through someone lending the mutual money but with no requirement for it to be repaid unless profits emerge (so no liability need to be shown in the regulatory balance sheet).
- Issues of subordinated debt
Capital management tools
FS DEBRIS
- FINANCIAL reinsurance
- SUBORDINATED debt
- DERIVATIVES
- EQUITY capital
- BANKING products
- REINSURANCE
- INTERNAL restructuring
- SECURITISATION
What is financial reinsurance?
the main aim of FinRe is to exploit some form of regulatory arbitrage in order to manage the capital, solvency or tax position of a provider more efficiently.
it frequently relies on the regulatory, solvency or tax position of a reinsurer, which may be based in an overseas state.
e.g a contingent loan from the reinsurer to the insurance company. the insurer only has to pay it back if it makes profits in the future on a certain block of business
regulatory regime may allow it to not make any provision for these future payments on a statutory basis.
therefore the insurance company improves its statutory position
What is securitisation?
it may involve converting illiquid assets into tradeable instruments
example of illiquid assets:
- future profits e.g a block of in-force insurance policies
- mortgages
Each of these can be securitised into tradeable instruments (e.g. bonds), in order to raise capital. The future cashflow stream generated by the secured assets is then used to meet the interest and capital payments on the bonds.
There is also a typical risk transfer, as the repayments on the bonds are made only if, for example, future profits emerge or mortgage repayments are made
What is subordinated debt?
the main aim of subordinated debt is to generate additional capital that improves the free capital position of the provider, as the debt does not need to be included as a liability in the assessment of solvency
the subordinated debt can only pay interest if regulatory solvency capital requirements will continue to be met after the interest is paid or, in some countries, if authorised by the regulator.
in the event of a wind up, this debt ranks behind policyholder liability, including non-guarantee bonuses
Outline the banking products available as sources of capital to financial providers
- Liquidity facilities (short-term financing for companies - makes existing capital more liquid)
- Contingent capital (an advance agreement to provide capital following a deterioration in experience)
- Senior unsecured financing (financing at the group level, which can be more cost efficient than each subsidiary raising capital separately; unlikely to benefit the capital position at the group level but can be used to improve the capital position of certain subsidiaries.)
Give an example of when a derivative contract may be used by a financial provider
A derivative contract may be used when a provider is concerned about the impact of a fall in the value of its equity portfolio. It could enter into a contract to protect its equity portfolio falling below a certain level.
Potentially, the cost of this ‘downside’ protection could be partially met by the sale of some ‘upside’ potential via a second derivative contract.
List 3 sources of equity capital
- Parent company
- Existing shareholders via a rights issue
- New shareholders via a new placement of shares
Outline the internal sources of capital available to a financial provider
INWARD
- ISSUING script dividends
- NOT paying dividends, i.e. retaining profits within the provider
- WEAKENING the valuation basis
- Changing ASSETS:
– inadmissible to admissible
– matching more closely to reduce the mismatching reserve
– to influence the valuation of interest rates used for the liabilities - RESTRUCTURING the merging funds
- DEFFERING the distributuion of surplus (e.g. bonuses)
