Capital

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Chapter 5
Asset-Liability Management for Actuaries

• Capital Risk

Shane Whelan, L527
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Two Types of Capital

• We can distinguish between Economic Capital and
  Regulatory Capital.
• Economic capital is the amount of capital
  appropriate to hold given the firms liabilities,
  and its business objectives.
• For a life office it will be determined based
  upon the risk profile of the individual assets
  and liabilities in its portfolio, the correlation
  of the risk and the tolerable level of overall
  credit deterioration.
• Regulatory capital is required to protect against
  the risk of statutory insolvency
• that is, having sufficient capital to demonstrate
  solvency under the regulatory regime.
• Depending on the firm and its regulatory regime,
  either of these requirements may drive the need
  for capital.

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Methods of Providing Capital

• Equity capital such capital is given in return
  for ownership of enterprise
• So, in return for control of company and share in
  profits.
• Debt or loan capital loan so that interest and
  loan capital repaid (but perhaps repayment
  secured on assets of firm).
• Hybrid capital mix of the above, e.g.,
  preference shares, with-profits policies,
  convertibles, etc.
• Ways to increase capital are
• Retain profits
• Raise capital in above form on the markets
  rights issues, IPO, issue loan stock, borrow from
  bank.
• Reinsurance and other ways of reducing risk and
  thereby capital to support the risk.
• Better management!

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Capital Empowers

• A companys capital plays a key role in enabling
  it to achieve its strategic ambitions.
• Feasibility of growing through acquisition, or
  mergers funding new ventures. Hence
  demutualisation often argued.
• Required to fund new business stain - timing
  mismatch of expenses and charges in many
  long-term contracts requires access to capital to
  fund the cashflow or valuation strain.
• Financial strength can also encourage product
  purchasers to favour one provider over another.
• Affects products that can be offered - levels of
  guarantees in a product impact the level of
  solvency margins to hold, and hence capital
  requirements.
• Affects performance of products - level of
  investment mismatch that can be run a function of
  free (or excess) capital.
• Capital can be used to smooth profit and loss
  accounts being politically incorrect.

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Regulatory Capital for Insurer

• Regulator will try to ensure that financial
  promises made to members of the public are kept.
  
• monitor the adequacy of the provisions which the
  insurer sets aside against future liabilities
• may even prescribe the basis (assumptions and
  methodology) by which these amounts are
  calculated.
• Regulatory reserves set on a prudent basis above
  those on a best estimate basis.
• Further, to encompass uncertainty, the regulator
  will generally require that the insurer holds
  further free capital, or solvency margin, as a
  further buffer for general adverse experience.
• The total regulatory capital demanded is termed
  the minimum solvency requirement (or equivalent).
  
• The demonstration of this additional or
  regulatory capital is a requirement for a licence
  to continue trading as an insurer.

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Aside Motto of Capitalism

• You should never have more capital than you need!
• Capitalism is the system that recycles capital so
  it finds itself where it can be most profitably
  used.
• Manage system to internalise those externalities
  so that profit and good-of-society are aligned.
• Is this possible or feasible?
• Intertemporally?

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The State Capital

• State and government organisations do not need to
  build up capital because they can raise taxes or
  borrow money to meet outgo.
• Can the State simply print money if other methods
  of raising funds are insufficient?
• Nevertheless, governments tend to build up and
  try to maintain some reserves to support
  fluctuations in the balance of payments, in the
  economic cycle, or because of timing differences
  between government income and outgo.
• Even some States partially funding pensions.

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Enterprise Risk

• The distinction between capital and risk is fuzzy
  as capital is ultimately there to bear the whole
  enterprise risk. Note here we mean risk to
  shareholder (not to, say, policyholders).
• The management of risk by an organisation has
  three aspects
• establishing management responsibility for risk
• Identification and qualification of the risks
  faced
• measurement/assessment/impact
• financing
• Monitoring
• adoption of control measures that reduce risk at
  an acceptable cost
• In particular to reduce catastrophic risk
  either its probability or severity

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Why is Risk a Problem for Firm?

• Limited Liability is a put option on society
• Risk is borne by shareholders, who can diversify
  it themselves.
• So why is firm or shareholder concerned with risk
  (especially catastrophic risk) when it has the
  effective insurance of limited liability?
• Risk is costly to firms as it creates avoidable
  transactions costs, namely
• Progressive taxation causes non-linearity in
  after-tax profits, so a profit stabilisation
  strategy can create value by reducing expected
  taxes.
• Managerial compensation if enterprise risk
  hedged then can give incentive compensation
  without paying high risk premium.

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Why is Risk a Problem for Firm?

• Direct costs of financial distress
• Firm suffers if under court administrationand
  courts do not make best managers loss to
  creditors
• Who will anticipate such costs, and demand
  compensation for their expected cost, hence they
  are a cost on capital
• The under-investment agency problem
• Clear agency problem between bondholders and
  shareholders, with control of latter allowing
  them to transfer wealth from former by selecting
  projects with asymmetric payoffs the put
  option. Hence cost of debt financing will
  increase unless creditable risk hedging in place.

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Why is Risk a Problem for Firm?

• Costly access to capital and crowding out
• Insurance is a form of internal capital and some
  argue that internal capital is less costly than
  external capitalso loss on an insurable event
  can throw its strategy out-of-kilter.
• For more see Doherty, N.A. (1997) Financial
  Innovation in the Management of Catastrophe Risk.
  Keynote Lecture, ASTIN/AFIR Colloquia, Cairns,
  Australia, 1997 Available on web

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Enterprise Risk

• Risk identification is the recognition of the
  risks that can threaten the income and assets of
  an organisation.
• Risk measurement is the estimation of the
  probability of a risk event occurring and its
  likely severity. It gives the basis for
  evaluating and selecting methods of risk control
  and alternative insurance.

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Risk Financing

• Risk financing is the determination of the likely
  cost of a risk and ensuring that adequate
  financial resources are available to cover the
  risk.
• Risk financing is based on the cost of risk,
  which can be decomposed into four elements
• Risk control measures
• Insurance, Uninsured losses

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Different Types of Risk

• Credit risk risk of failure of third parties to
  repay debts.
• Market risk downside price volatility when
  mismatched
• Operational risks risks other than credit risk
  and market risk that arise in managing a
  commercial enterprise. Operational risk arises
  from
• inadequate or failed internal processes, people
  or systems
• the dominance of a single individual over the
  running of a business, sometimes called dominance
  risk
• external events

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Example Stakeholder Pensions

• Background The State is thinking of making
  pension savings compulsory.
• Foreground Regulator demands that charges on a
  certain regular premium unit-linked pension
  product pensions-for-all can only be an annual
  management charge related to the value of the
  assets, the maximum charge set to be no greater
  than 1 of the value of the units.
• What are the risks to a life company in entering
  this new market?

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Insurance the Market for Risk

• Insurance is one of the processes whereby risk is
  assessed, priced, and perhaps transferred.
• If the price at which one party is happy to
  accept a risk is less than the perceived cost of
  the risk to a second party, the opportunity
  exists for a risk transfer to the mutual
  satisfaction of both parties. Hence market for
  insurance and reinsurance.
• Risk mitigation processes.
• A procedure by which risks are identified and by
  which procedures are proposed to manage and
  control them
• Sell them? Retain them? Risk-sharing?

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Risk Transfer

• It is often supposed that the costs of
  production are threefold, corresponding to the
  rewards of labour, enterprise, and accumulation
  capital. But there is a fourth cost, namely
  risk and the reward of risk-bearing is one of
  the heaviest, and perhaps the most avoidable,
  burden on production.
• J. M. Keynes, Preface to A Tract on
  Monetary Reform (1923).

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Risk Transfer Function Over Last Decades

• Investment Risk
• Withdrawal of investment guarantees
• Savings move to unit-linked
• Pension schemes move to defined contribution
• Other Risks
• Catastrophe risk
• Finite risk reinsurance
• In general, Individualisation of Risk

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Advances in Risk Pricing

• A dyke height of 5.14m above Normal Amsterdam
  level is sufficient with probability of failure
  10-4 (once in every 10,000 years).
• de Haan, Fighting the Arch-Enemy with
  Mathematics, Statistica Neerlandica 44 (1990)

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Risk Inefficiently Distributed

• No insurance
• Markets developing to fill void
• Financial options
• Catastrophe bonds
• Catastrophe options
• Novel new contracts
• Weather-linked derivatives

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Alternative Risk Transfer (ART)

• ART produces tailor-made solutions for risks that
  the conventional market would regard as
  uninsurable.
• ART often uses both banking and insurance
  techniques.
• ART-type contracts include
• Securisation
• Capacity of capital markets several orders of
  magnitude higher than capacity in reinsurance
  market (2 billion versus 10 trillion)
• Post loss funding
• Insurance derivatives
• Discounted covers
• Integrated risk covers
• Swaps

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ART Promising Beginnings

• Recycling equity capitalUGG deal at end 1999
  replacing equity capital with contingent equity
  catEput.
• Debt plus risk transfer substitution for
  equityCanada Airlines, Alterra, Colombia power
  plant, MBO in UK.
• Competition in traditional reinsuranceGoldman
  Sachs place Tokyo Disneylands cat bond, 1999.
• Securitisation of insurance portfoliosHanover
  Re.

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ART and the Actuary in the 21st Century

• Logic of diversification
• The science to price it
• This is where there is some doubt.
• The technology to transfer it cheaply
• Asymptotically, heading towards the completion of
  the markets every contingent claim has a market
  price
• Role of actuaries in pricing, reserving,
  managing, and regulating
• ART the greatest financial development since
  limited libaility of the 19th century?

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Example

• A small final salary pension plan, with just 20
  members, incorporates both retirement and death
  in service benefits. The trustees request the
  actuary to draft a letter setting out the
  possible ways of using insurance contracts to
  reduce the mortality risks.
• List the different insurance contracts that may
  be used and mention in which context.
• Outline the advantages and disadvantages of using
  each contract type identified.

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Completes Chapter 5
Asset-Liability Management for Actuaries

• Capital Risk

Shane Whelan, L527