Chapter 46: Capital Management

Question 1

Capital Management

Answer 1

Involves:

• ensuring sufficient solvency and cashflow to meet
• — (1) existing liabilities
• — (2) future growth aspirations
• maximising the reported profits

Question 2

Capital needs - individuals

Answer 2

• cushion against unexpected events

- save for the future

Question 3

Capital needs:

Companies

Answer 3

• cushion against fluctuating trade volumes
• finance expansion
• finance stock and work in progress
• obtain premises, hire staff, purchase equipment (start-up capital)

Question 4

Capital needs:

Providers of financial services

Answer 4

• MEET BENEFITS before sufficient premiums / contributions are received
• meet development expenses
• cushion against UNEXPECTED EVENTS
• meet STATUTORY requirements (fund new business strain)
• INVEST more freely (mismatch)
• achieve STRATEGIC AIMS
• SMOOTH PROFITS (reported)
• sell products with GUARANTEES
• DEMONSTRATE FINANCIAL STRENGTH to customers and advisors.

Question 5

Capital needs:

The State

Answer 5

State will hold gold and foreign currency reserves to support:

• fluctuations in the balance of payments and economic cycle
• timing differences in income and outgo

Question 6

Methods through which the state can meet its liabilities

Answer 6

• taxation
• borrowing
• printing money

Question 7

Proprietary insurer

Answer 7

An insurance company owned by shareholders.

They may raise funds through the issue of shares or debt securities.

Question 8

Mutual insurer

Answer 8

owned by policyholders to whom all profits belong.

A mutual has less access to the capital markets than a proprietary.

Question 9

8 Capital Management tools

Answer 9

• Reinsurance
• Financial Reinsurance (FinRe)
• Securitisation
• Subordinated debt
• Banking products
• Derivatives
• Equity capital
• Internal restructuring

Question 10

Capital Management:

Reinsurance

Answer 10

To reduce the amount of capital required

Question 11

Capital Management:

Financial Reinsurance

Answer 11

A reinsurance arrangement that provides capital, typically by exploiting some form of regulatory, solvency, or tax arbitrage

Question 12

Capital Management:

Securitisation

Answer 12

Involves converting an illiquid asset into tradeable instruments.

Question 13

Capital Management:

4 Banking Products

Answer 13

• Liquidity facilities
• Contingent capital
• Senior unsecured financing
• Derivatives

Question 14

Capital Management:

Internal resturcturing

Answer 14

• Merging funds
• Changing assets
• Weakening the valuation basis
• Deferring surplus distribution
• Retaining profits

Question 15

Capital Management:

Liquidity facilities

Answer 15

Used to provide short-term financing to companies facing rapid business growth.

Question 16

Capital Management:

Contingent capital

Answer 16

A cost-effective method of protecting the capital base of an insurance company.
Capital would be provided as it was required following a deterioration of experience.

Question 17

Derivatives contracts can be used either:

Answer 17

• to reduce risk (hedging), or

- to increase risk (speculation) in order to improve returns.

Question 18

3 Sources of equity capital

Answer 18

• parent company
• existing shareholder by a rights issue
• directly from the market by a new placement of shares

Question 19

5 INTERNAL sources of capital

Answer 19

• 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 any dividends to any shareholders.

Question 20

Financial Reinsurance

Answer 20

to exploit some form of regulatory arbitrage
… in order to more efficiently manage the capital, solvency or tax position of a provider.

It 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.

Question 21

capital

Answer 21

wealth or financial resources

Question 22

FSP capital needs:

Start-up capital and development expenses

Answer 22

There is a possibility that a claim event might arise before the provider has had time to accumulate sufficient funds from premiums.
They thus need start-up capital.

In addition there are initial costs:

• setting up suitable management systems to administer the liabilities
• collecting premiums / contributions
• paying commission
• investment expenses
• administration expenses

Question 23

FSP capital needs:

Statutory requirements

Answer 23

Due to uncertainties (caused by the long-term nature of financial products), there is a requirement to
… hold a PROVISION for future liabilities
… in EXCESS OF THE BEST-ESTIMATE value of the future outgo.

Question 24

FSP capital needs:

Investment freedom

Answer 24

If a provider makes a decision not to hold a portfolio of assets that replicates its liabilities, its capital requirements will increase.

This is because there is a danger that movements in experience and in particular in interest rates, may result in the liabilities increasing by more than the assets.

Question 25

FSP capital needs: | Strategic aims

Answer 25

The level of a company's capital will have a key role to play in achieving its overall strategic direction. e.g. acquisitions, mergers, demutualisations, new ventures

Question 26

FSP capital needs: | Impact on the accounts

Answer 26

``` Capital can be used to - smooth income statements - and improve ---- the solvency ---- and matching position of the balance sheet for a provider. ```

Question 27

FSP capital needs: | Products with guarantees

Answer 27

The levels of guarantees in a product impact the level of solvency margins a company has to hold and will therefore impact on capital requirements.

Question 28

FSP capital needs: | Financial strength

Answer 28

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 individuals and their advisers when deciding whether or not to place business with any particular provider.

Question 29

How might a reinsurer contribute to the initial new business strain?

Answer 29

by means of reinsurance commissions

Question 30

5 reasons for basing a reinsurance company in an overseas state

Answer 30

- less conservative reserving assumptions - less onerous actuarial certification requirements - reduced income / capital gains and premiums taxes - fewer investment restrictions - lower initial capital requirements

Question 31

admissible assets

Answer 31

assets whose value can be included in the valuation of assets for the purpose of demonstrating statutory solvency

Question 32

Why might senior unsecured financing not have capital benefits for an insurer?

Answer 32

Since the loan would be treated as a liability on the company's balance sheet

Question 33

When might "merging funds" help the solvency situation?

Answer 33

If, e.g., some of the regulatory liabilities or the solvency capital was calculated as a monetary / fixed amount per fund or had a fixed minimum.