Chapter 36: Capital Management Flashcards
What is capital?
Capital can mean:
- Total assets
- Excess of assets over liabilities
What different types of capital do assets comprise? (4)
- Assets backing individual provisions
- Assets backing global provisions: cover risks not relating to an individual product or policy, e.g., credit, operational and market risk
- Assets backing solvency capital requirement: Buffer against adverse experience. The size reflects the type of basis used
- Free assets (A-L)
Why do individuals hold capital?
- Setting money aside for unexpected events, e.g., fridge breaks down
- Saving for the future, e.g., retirement
- Cashflow management, e.g., paying a bill before salary is paid
Why do companies hold capital?
- Setting money aside for unexpected events, e.g., a period of unexpected low sales
- Saving for the future, e.g., expanding in the future
- Cashflow management, e.g., timing mismatch between paying for inventory before it is being bought by customers
- Start-up capital, e.g., purchase premise, machinery and staff
Why do providers of financial services hold capital?
REG CUSHION
R - Regulatory requirement to hold capital over liabilities, to demonstrate solvency
E - Expanding in the future, by launching a new product (saving for the future)
G - Guarantees can be offered
C - Cashflow management, e.g., timing mismatch between receiving premiums and paying claims and expenses
U - Unexpected events, e.g., adverse claims experience
S - Smooth profits to provide stable dividends
H - Help demonstrate financial strength, this will attract new business and get a good credit rating
I - Investment freedom to mismatch liabilities
O - Opportunities, e.g., mergers and acquisitions or expansions
N - New business strain (start-up capital)
What are the two main aims of capital management
- Ensuring that the provider has sufficient cashflow
- Ensuring that the provider has sufficient liquidity
This ensures existing liabilities and future growth aspirations are met in all reasonably foreseeable circumstances
What are the 3 main sources of capital to manage cashflows?
- Equity
- Rights issue
- Demutualisation - Debt
- Ordinary debt: Borrowing money by issuing bonds
- Subordinate date: Not included in the assessment of liability solvency - Banking products
- Liquidity facilities (short-term financing for companies facing rapid business growth/overdrafts)
- Contingency capital (arrangement with the bank in which the bank agrees to provide capital in a deterioration of experience)
- Senior unsecured financing: Senior company obtaining a loan which is then transferred to another company in the group
- Derivatives
What are the X main sources of capital to manage solvency?
- Equity
- No obligation to pay dividends - Debt
- Subordinate date: Not included in the assessment of liability solvency - Banking products
- Senior unsecured financing: Senior company obtaining a loan which is then transferred to another company in the group, with no requirement to repay it - Securitisation
- Provider takes a block of business, e.g., a portfolio of mortgages and creates a special purpose vehicle. The SPV then issues a bond
- Investor purchases the bond
- Provider pays coupon + redemption payments on the securitised business
- Payments will default if the securitised business fails to reproduce the required revenues
- The provider has swapped the future profits of the mortgage business for the upfront cash benefits - Reinsurance
- Financial reinsurance
- Improve regulatory capital requirement
- Source of capital
- Decrease initial capital strain of selling insurance by contributing to initial expenses, i.e., reinsurance premium - Internal sources
- Retaining profits
- Merger of funds
- Defer with-profit bonuses and dividends (regulation)
- Weakening valuation basis
- Better match assets
