Ch 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.
Why do individuals need capital?
- To provide a cushion 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
- -> need to cover development costs
- -> setting up of systems for administering the liabilities + admin cost
- -> costs wrt collecting premiums
- -> needs to pay commissions
- -> investment expenses
- -> costs of setting up initial reserves
- -> need to meet minimum capital requirements
List 10 reasons why providers of financial services need capital
REG CUSHION
- Regulatory requirement to demonstrate solvency
- Expenses of launching a new product / starting a new operation
- Guarantees can be offered (higher solvency capital requirement)
- Cashflow timing management (mismatch benefits vs premiums / contributions)
- Unexpected events cushion, e.g. adverse experience, fines
- Smooth profit
- Helps demonstrate financial strength / attract new business / obtain a good credit rating
- Investment freedom to mismatch in pursuit of higher returns
- Opportunities, e.g. mergers and acquisitions, new ventures
- New business strain financing
(REGulatory CUSHION)
Some other reasons:
- Demonstrate strength (high credit rating)
- Growth or acquisitions
- Invest more aggressively
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, the State does need to build up working capital (often 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.
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
How can benefit schemes raise capital?
The capital requirement by a benefit scheme is usually provided by the sponsor of the scheme.
What is 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 8 capital management tools available to financial providers
- Reinsurance
- Financial resources
- Securitization
- Subordinated debt
- Banking products
- Derivatives (helps mostly solvency, does not affect liquidity much)
- Equity
- Internal sources of capital
How can reinsurance act as a source of capital?
If an insurer has reinsurance, the regulatory may not require as large a solvency capital requirement as it would without reinsurance. (REDUCTION in SCR)
Reinsurance can help with LIQUIDITY issues. The cedant is swapping the need to find big lump sums to pay claims with smaller reinsurance premiums.
Proportional reinsurance can help with managing a cedant’s NEW BUSINESS STRAIN by means of reinsurance commissions paid at outset.
Financial reinsurance aims to exploit some form of regulatory ARBITRAGE. The extent to which it can help depends upon the particular regulatory regime in place.
Historically, such arrangements have been used to crystalize the value of future expected profits in the balance sheet.
The arrangement takes the form of a loan, where the repayments are made contingent on future profits being made so that the direct writing company may not need to reserve for them on a regulatory basis. However, such methods are not viable under regulatory regimes which already take credit for future profits (Solvency II).
How does securitization act as a source of capital to a financial provider?
Securitization 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 payments 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.
How does subordinated debt act as a source of capital to a finance provider.
Subordinated debt ranks behind all other liabilities, including meeting policyholders’ expectations (including non-guaranteed bonuses).
Interest payments and capital repayments can only be made if regulatory solvency capital requirements will continue to be met and, possibly, if authorized by the regulator.
Therefore, the debt repayments may not need to be shown as liabilities in the regulatory balance sheet.
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.
