Chapter 46: Capital Management I

Question 1

Why do individuals need capital?

Answer 1

To provide a cushion against future unexpected events.

To save for large future expenses, e.g. buying a house.

Question 2

Why do trading companies need capital?

Answer 2

• To provide a cushion against fluctuating trading volumes.
• To fund the cashflow strain arising from the need to pay suppliers.
• To fund work-in-progress and finance stock before the finished good is sold.
• To provide start-up capital.

Question 3

9 Reasons why a provider of financial services needs capital

Answer 3

• To demonstrate regulatory solvency
• To achieve its strategic objectives, eg mergers & acquisitions, demutualisations and new ventures
• To smooth profits and improve balance sheet solvency
• To fund the cashflow strain that arises from writing new business due to the timing mismatch between expenses and charges, and the requirements to establish initial provisions and solvency capital.
• To fund the one-off startup expenses of launching a new product.
• To provide a cushion against future unexpected events such as catastrophes, fines or a credit deterioration.
• To write business with guarantees, as the solvency margin requirements are typically more onerous.
• To pursue a freer investment strategy.
• To demonstrate financial strength to customers, sales intermediaries, the market and credit rating agencies.

Question 4

Why does the state need capital?

Answer 4

For the most part, the state does not need to build up capital as it can raise taxes, issue bonds, or print money if it requires funds.

However, the state does tend to build up working capital, using gold and foreign currency reserves, to support fluctuations in the economic cycle, and in the balance of payments; and to manage timing differences between income and outgo.

Question 5

What are the 3 main sources of capital used by FSPs?

Answer 5

• equity
• debt
• hybrid

Question 6

List the capital management tools available to providers

Answer 6

• Equity
• Financial reinsurance
• Subordinated debt
• Securitisation
• Banking products
• Internal sources of capital

The effectiveness of these various tools will depend upon the regulatory and tax environment that the insurer is operating in.

Question 7

Why is subordinated debt a source of capital?

Answer 7

Subordinated debt ranks behind all other liabilities, including meeting policyholder expectations.
Hence, the debt repayments may not need to be shown as liabilities in the regulatory accounts.

Question 8

How does securitisation work?

Answer 8

Involves turning illiquid, inadmissible assets into liquid, admissible assets.

E.g. an insurance company may issue a bond with repayments contingent on future profits being made. The insurer has turned the illiquid, inadmissible asset of future profits into cash received from the bond issue.

Securitisation is a way of exploiting regulatory arbitrage, if under a particular regime, the future profit stream is viewed as an inadmissible asset, but the cash raised from the bond would be an admissible asset.

Question 9

Banking product

Answer 9

• liquidity facilities
• contingent capital
• senior unsecured financing
• derivatives

Question 10

What is contingent capital?

Answer 10

Contingent capital involves arranging the terms for raising capital from a bank in advance of a bad event (eg a deterioration in experience) happening.

Question 11

5 Internal sources of capital

Answer 11

• a financial restructure, eg merging funds
• changing the assets held
• deferring the distribution of surplus
• retaining profits
• weakening the valuation basis

Question 12

How does changing the assets held free up capital?

Answer 12

By choosing assets that more closely match the liabilities, the provider can reduce the size of the mismatching reserve held.

By choosing admissible, rather than inadmissible assets, the provider may be able to improve its regulatory solvency position.

Additionally, in an insurance context, the discount rate used to value the liabilities for regulatory purposes, depends on the assets held.
Changing the assets could result in a higher liability discount rate, and a lower value placed on the liabilities.

Question 13

What factors would you take into account in deciding on the source of capital to use?

Answer 13

• the cost of the capital, and of implementing it
• timescales
• existing exposure
• market conditions
• availability of capital from the different sources
• overall strategic objectives
• the nature of the assets held

Question 14

How do mutuals get capital.

Answer 14

Initially from an altruistic gesture.
Then through subordinated debt issues.
They can also use many of the non-equity sources discussed.