Chapter 36 - Capital Management Flashcards
Definition
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 maximising the reported profits of the provider
Start-up capital and development expenses
When taking on risks for the first time or when taking on a new type of liability, there will be costs for the provider in:
- setting up suitable management systems to administer the liabilities
- collecting premiums / contributions
- paying commission to third parties
- investment expenses
- administration expenses
Until sufficient premiums / contributions have been
collected, the provider will need to meet these start-up
costs from capital
If business volumes remain level, this additional capital can be rolled forward to the next tranche of business.
If volumes increase, additional capital will be required, while if volumes reduce, some of this capital can be released.
Why is capital needed ?
Statutory or solvency requirements
- Solvency requirements for corporations normally require sufficient capital to be held in advance, rather than assuming it could be borrowed later when required.
- At the start of an enterprise, or during a time of expansion, additional funding may be needed to maintain the statutory requirement
Investment freedom
- Risks can be taken on by product providers by means other than issuing contracts. Capital will provide a cushion to absorb any deficits arising if liabilities are greater than assets
Products with Guarantees
- The extent of guarantees in a product impacts the level of capital needed to cover the risk of the guarantees being in the money at the exercise date
Financial strength
- The financial strength of providers may be significant in determining new business levels. Financial strength may be rated as one of the key determinants used by potential clients and their advisers when deciding whether or not to place business with any particular provider
Impact on Accounts
- Companies can manage their capital to smooth income statements and improve the solvency and matching position of their balance sheet
Strategic aims
- As well as being a constraint on the amount of new risks a company can take on in its normal business operations, the level of capital held will impact acquisitions, mergers and new ventures.
A measure of available capital is thus a key tool in the management of any company, and particularly of a financial product provider.
Sources of Capital
Retained profits
- All companies can increase their working capital by retaining profits or surpluses within the business and not distributing them as dividends or bonus
Equity and Debt Capital
- A proprietary company may raise funds through the issue of shares or debt securities. Issues can be to existing shareholders (rights issues) or to new shareholders (tender offers, etc.).
- A mutual company has less access to the capital markets but can raise capital through the issue of subordinated debt, where repayment is subordinate to the calls from all other creditors, including policyholders.
Other Capital Sources
- State , microinsurance schemes may have capital support from the state, given their usual purpose of supporting individuals on low incomes.
- Sponsors of benefit schemes , may be prepared to put up the initial capital for the arrangements, particularly those required to cover the expenses of setting up the scheme
- Reinsurance Companies
Equity capital
An obvious source of capital is simply to increase equity, which increases assets without increasing regulatory liabilities. The equity may come:
- from a parent company
- from existing shareholders by a rights issue
- directly from the market by a new placement of shares
Internal sources of capital
There may be ways to simply reorganise the existing financial structure of an organisation in a more efficient way.
- funds could be merged
- assets could be changed
- the valuation basis could be weakened
- the distribution of surplus could be deferred
- capital could be retained in the organisation, possibly by not paying dividends to shareholders
Capital Management Tools
There are a variety of tools to manage capital.The effectiveness of, and hence likely use of, the tools will depend on the regulatory and tax environment that the insurer is operating in. It is also possible that the effectiveness of a given approach to managing an insurer’s capital may change over time if the regulatory / tax environment changes
Financial Reinsurance
- 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, being different from that of the provider
Securitisation
- Involves converting an illiquid asset into tradable instruments. The primary motivations are often to achieve regulatory or accounting ‘off balance sheet’ treatment. Typical transactions will be structured with an element of transfer of the risk associated with the value of the asset. This will result in any potential loss in value of the asset being capped
Subordinated Debt
- A provider can raise capital through issuing subordinated debt in the capital markets
- Main aim 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
- Repayment of capital can only be made if, after repayment, regulatory solvency capital requirements continue to be met and if they are authorised by the regulator. In the event of wind-up, the subordinated debt in all cases ranks behind policyholder liabilities, including non-guaranteed bonuses
Banking Products
- liquidity facilities , used to provide short-term financing for companies facing rapid business growth
- Contingent capital , can be a cost-effective method of protecting the capital base of an insurance company. Under such an arrangement, capital would be provided as it was required following a deterioration of experience (i.e. it is provided when it is needed)
- Senior Unsecured Financing
Derivatives
- Prudent management requires that any provider entering into derivative contracts must exercise caution. The provider needs to ensure that its derivative strategy assists in the efficient management of its business and serves to reduce risk
