Capital 1

Question 1

Definitions:

Capital

Answer 1

• Accumulated net wealth of an organisation

- It is the DIFFERENCE b/w value of the assets and liabilities of the organisation

Question 2

Definitions:

Economic Capital

Answer 2

• Amount of capital (gap b/w A&L) a firm believes it needs to remain solvent over a certain time period with a specified probability
• Might be more or less than regulatory cap. depending on how relaxed the regulatory regime is

Question 3

Definitions:

Regulatory Capital

Answer 3

• The amount set by the prudential regulator as the minimum amount of capital (gap b/w A&L) the organisation must hold to remain solvent

Question 4

Definitions:

Free Capital

Answer 4

Economic measure: The amount of assets held in excess of economic capital

Regulatory measure: The amount of assets held in excess of regulatory capital

Question 5

Definitions:

Liabilities on the insurer’s balance sheet

Answer 5

• The amount the insurers thinks they need to hold to meet future claims

Question 6

Sources of capital:

Answer 6

• Equity

- Debt capital

Question 7

Sources of capital highlights:

Equity

Answer 7

• Equity investors share in profits of company
• Company profits may be retained to pay future dividends to equity investors
• Company bankruptcy results in equity holders receiving their money after payment of all debt (likely to lose their money)
• Banks and insurers required to hold min. amt of equity capital

Question 8

Sources of capital highlights:

Debt capital

Answer 8

• Loans increase both assets & liabilities
• Loans increase solvency cap. only if incoming assets from loan are not to be included in “statutory liabilities”
• Companies w high debt/equity ratio are more risky
• Overdrafts/corporate bonds/subordinated debt (ranks behind other debt)

Question 9

Reasons to hold capital:

Individuals

Answer 9

• Protection against unexpected events

- Build up capital (save) for large future expenditure

Question 10

Reasons to hold capital:

State

Answer 10

• May generally not need to build up capital in developed economy. Instead:
  > Raises taxes
  > Borrows money to meet outgo
  > Print money (though inflationary)
• However may build up reserves to support:
  > Fluctuations in balance of pmts. in the economic
  cycle
  > Timing diff. b/w govt. income & outgo

Question 11

Reasons to hold capital:

Businesses

Answer 11

• Initial capital for costs before any income is earned
• Capital needed to finance costs of expansion e.g. expand product line
• Withstand business risks
• Withstand external shocks:- financial crises, terrorist
• Respond to opportunity:- change in govt. policy leading to business opp. , failure of competitor
• Improves customer confidence in the providers of fin. services
• Improves credit rating of fin service provider

Question 12

Reasons to hold capital:

Businesses -> Business Risks

Answer 12

• Loss of client (reduces income)
• Increase to costs such as wages
• Mkt. pressure on prices, reducing income
• Interest rates rise
• Mis-pricing of a contract (losses to company)
• -> Adverse claims experience (business risk for insurer)
• Financial failure of debtors
• Fraud within operations of the company
• Poor investment performance in financial mkt

Question 13

Reasons to hold capital:

Financial Service Providers (FSPs)

Answer 13

FSPs required to hold additional capital relative to other companies because:

• Customer buys the product (pays premiums) BEFORE receiving benefits (legal requirement to hold cap.)
• Nature of products centered on “risk” => need a cushion against unexpected events
• To invest more freely e.g. mismatch, opportunities
• Sell products w guarantees to attract customers
• Demonstrate financial strength to stake/h
• Prudential authority requires min levels of cap.
• –> For p/h & depositor security
• –> To increase stability in financial system

Question 14

Perspective towards holding capital:

Shareholder

Answer 14

• Aim: Maximize return subject to acceptable risk level
• Lower equity cap => higher return on cap. but higher probability of failure + more volatile earnings
• Diff. s/h have diff risk appetites depending on personal investment diversification

Question 15

Perspective towards holding capital:

Board of directors/Senior management (man.)

Answer 15

• Need to understand risk appetites of investors when deciding sources/level of capital to be held
• -> Might hold little cap. to obtain higher returns for s/h
• -> Or hold more cap to be prudent (man. philosophy)
• Need to gauge tolerance towards negative results:
• -> Reduction in dividend
• -> Returns on cap. below benchmark
• -> Liquidity crisis
• -> Loss of mkt. share
• -> Failure of the company
• Need to consider current cap. reqs & effects of future risks (business to be written) on cap. reqs

Question 16

Perspective towards holding capital:

Regulators

Answer 16

• Main aim to protect consumers of financial services so they want higher levels of cap req. broadly
• BUT if capital req. is too high this results in:
• -> Barrier to entry
• -> Competition reduces

Question 17

Perspective towards holding capital:

Customers

Answer 17

• Want best quality product at best available price
• More price sensitive than capital sensitive
• Customers unable to assess solvency, they rely on regulators/rating agencies for this info.

Question 18

Perspective towards holding capital:

Rating agencies

Answer 18

• Rating agencies assess the company’s financial condition & possibility of failure
• They are paid by FSPs to provide credit rating
• -> Consider potential conflict of interest

Question 19

Perspective towards holding capital:

Mutual organisations

Answer 19

• Mutual orgs. build up capital from members (no s/hs)
  –> Issue of fairness b/w
  o diff generations of members eg. profits from good
  years in current gen. held back to support poor
  years
  o diff. types of members eg depositors vs borrowers
  in credit union or diff. classes of p/h in insurance
  company
• There may be concentration of risk in:
  > Geographical region
  > Or particular sector of population
• Past mutuals demutualised & issued shares to
  members who then receive cap built up from future
  generations
• Allowed public funding after demutualisation

Question 20

Perspective towards holding capital:

Defined Benefits Pension Schemes

Answer 20

• Members promised benefits based on salary & service
• Members contribute to scheme & sponsors pay the balance of the cost
• Considered to have less need for capital than insurers because scheme is underwritten by sponsoring company BUT:
  o If company fails & scheme assets are insufficient, members lose retirement benefits & their jobs
  o Regulators therefore require pension schemes to hold min value of assets to meet liabs if the sponsor fails
• Surplus assets can be used to provide members further security, additional benefits or returned to employer
• Employer avoids surplus build up in the fund as there’s possibility that these can’t be recovered
• Funding postn is shown in company accounts => affects financial postn of company -> there is interest in maintaining adequately funded scheme

Question 21

Perspective towards holding capital:

Defined Contribution Scheme

Answer 21

• No financial risk for employer linked to benefit levels
• However, there’s operational risk attached to the scheme eg. admin errors, fraud.
• Sponsoring companies bear these risks, hence some capital is required
• Funds managers incur expenses if competing for business (usually met by charges). Hence capital is needed

Question 22

What is the impact of public losing confidence in a provider of financial services?

Answer 22

Loss of confidence may lead to failure of company eg. depositors withdraw funds at once => bank defaults on its debts => damages financial system as a whole

Question 23

What are the advantages of a good credit rating for a financial service provider?

Answer 23

• -> Strong companies can charge more for products & pay lower interest on its deposits
• -> Directly affects consumer confidence and hence sales