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.
Capital is another word for wealth or financial resources
Why do individuals need capital?
- To provide a cushion against future unexpected events, e.g. car repairs
- To overcome timing differences between income and outgo, e.g. between salary income and expenditure.
- To save for large future expenses, e.g. a holiday or buying a house
Why do trading companies need capital?
- To provide a cushion against fluctuating trading volumes.
- To build up funds for a planned expansion
- To fund the cashflow strain arising from the need to pay suppliers, fund work in progress and finance stock before the finished good is sold
- To provide start-up capital, e.g. to obtain premises and equipment and hire staff
Why do providers of financial services need capital?
- All the same needs as other companies
- Start-up capital and development expenses
- Statutory or solvency requirements
- Investment freedom (creates a cushion to absorb any deficits arising from not holding a portfolio of assets that do not replicate the liabilities)
- Products withs guarantees (capital needed to cover the risk of the guarantees being in the money at exercise date)
- Financial Strength (significant when determining new business levels, as it is used by clients and their advisors when determining whether or not to place business with a provider)
- Impact on the accounts (capital can be used to smooth income statements and improve solvency and matching position of their balance sheet)
- Strategic aims
> capital helps the company to achieve its overall strategic direction
> the level of capital held will impact acquisitions, mergers, and new ventures
Start-up capital and development expenses as a need of capital for the providers of financial services
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
How is each of the above affected by business volumes?
- Management costs is an overhead and is not affected by business volumes
- Collecting premiums and paying commission are directly related to the volume of business sold
- Investment expenses are likely to be a combination of amounts that are independent of business volumes (such as salaries of investment staff) and expenses relating to the size of the fund under management, which are related to the volumes of business sold
- Administration expenses are a combination of overheads and expenses relating to the volumes of business sold
Why does the State need capital?
For the most part, the State does not need to build up capital because it can raise taxes, issue bonds or print money if it requires funds.
However, governments tend to build up and maintain reserves (often using gold and foreign currency) to support fluctuations in the economic cycle and in the balance of payments, and to manage timing differences between income and outgo.
Printing money is inflationary (the quantity theory of money states that an increase in the money supply will tend to lead to a proportionate increase in the prices - see page 7)
How can proprietary companies raise capital?
- Retaining profits or surplusses within the business and not distributing them as dividends or bonuses
- 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?
- Retaining profits or surplusses within the business and not distributing them as dividends or bonuses
- 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, where repayment is subordinate to the calls from all other creditors, including policyholders
How can benefit schemes raise capital?
The capital requirement by a benefit scheme is usually provided by the sponsor of the scheme.
What us an admissible asset?
An admissible asset is one that is permitted by the regulator to be included in the valuation of assets for the assessment of supervisory solvency, i.e. it can be used to back the provisions and solvency margin.
For example, there may be restrictions on the type of asset that can be used or the amount of a particular asset that can be included in the assessment.
Examples of inadmissible assets might include works of art and derivatives held for speculative purposes.
List 7 capital management tools available to providers to meet their responsibilities and to achieve their goals
- Financial Reinsurance
- Securitization
- Subordinated debt
- Banking products
- Derivatives
- Equity
- Internal sources of capital
Financial Reinsurance as a Capital Management tool
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, being different from that of the provider
This is done in the form of a reinsurance contract between the reinsured and the reinsurer
FinRe has historically been used to improve the balance sheet of a company by crystallising the value of future expected profits
However, the validity of such arrangements is much reduced under regulatory regimes, such as Solvency II, which take credit for future profit
An example: The arrangement takes the form of a contingent loan from the reinsurer to the insurance company, where the repayments are made contingent on future profits being made.
The regulator may allow the insurer to not make any provisions for the future repayments on a statutory basis since the insurer has no liability unless profits emerge.
The insurer thereby improves its solvency position, but only over a short-term as the company will need to repay the loan over time
Securitisation as a capital management tool
Securitization (as a capital management tool) involves turning an illiquid asset into tradable instruments.
The primary motivation is often to achieve regulatory arbitrage, e.g. by turning an inadmissible asset into an admissible one.
There is typically an element of risk transfer involved in the transaction.
Securitization often involves the issuance of a bond where the interest and/or capital payments are contingent on some factor, e.g.:
- future profits emerging on a block of insurance business
- the repayment of mortgages or loans
Securitizations are less effective in regimes which take credit for future profits in the regulatory balance sheet, e.g. Solvency II.
See figure page 14
Company sells securitised assets to special purpose vehicle (SPV) in return for an initial capital, which in turn issues asset- backed bonds to investors to raise the inital capital. The payment stream generated by the assets is paid to the SPV, which use it to repay the capital and interest on the bonds
5 key benefits of securitisation to the originator
- converts a bundle of assets into a structured instrument which is then negotiable
In doing so, it offers:
- a way for a company to raise money, that is directly related to the cashflow that it anticipates receiving in the future
- an alternative source of financing to issuing normal secured or unsecured bonds
- a way of passing the risk in the assets to a third party, removing them from the balance sheet, and reducing required capital
- a way of effectively selling exposure to what may be an otherwise unmarketable pool of assets
Subordinate Debt as a Capital Management tool
A provider can raise capital through issuing subordinate debt in the capital markets.
Subordinated debt ranks behind all other liabilities, including meeting policyholders’ liabilities (including non-guaranteed bonuses).
The 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 solvency assesments
Interest payments can only be made if regulatory solvency capital requirements will continue to be met or, in some countries, if authorized by the regulator.
Capital repayments can only be made if regulatory solvency capital requirements will continue to be met and if authorized by the regulator.
