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26 Cards in this Set
- Front
- Back
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Overview of capital structure
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Capital structure of a corporation represents the allocation of long-term debt and equity. Mix of debt and equity affects company risk and return. When a company issues more debt it's taking on more risk and when it takes on more equity, that can lower the overall rate of return for the other shareholders. The goal of financial managers is to maintain a capital structure that meets the company's needs and maximizes the shareholder's wealth. |
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Flow of funds |
Company receives cash and buys assets. Returns on assets can be retained or used to purchase more assets. Company pays dividends and interest. |
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Equity/debt |
Debt can be short-term or long-term. Short-term (commercial paper, lines of credit). Long-term (bonds, mortgages. leases). |
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Financial leverage
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Represents the use of debt to meet company needs and maximize value. Measured by cost of debt, quantitatively the cost of debt typically represents interest paid on outstanding debt. Goal is to have return exceed cost of debt, e.g. if you borrow money and pay interest of 5% you want to be able to invest that borrowed money and have it return 7%. Financial leverage analysis compares earnings per share at different debt/equity levels (to decide if you should borrow or issue more stock you need to take a look at comparisons of earnings per share for each, if you borrow money you will have an interest expense but if stock is issued there is no interest expense aka capitalization plans). Tax shield (because interest on debt is a tax-deductible expense, taking on debt creates a tax shield), (taxes saved due to deductibility of interest expense). In a perfect capital market, the cost of bankruptcy is zero. |
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Financial leverage breakeven earnings formula
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When doing analysis of financial leverage the formula to determine the breakeven earnings before interest and taxes (EBIT) is: EBIT = (total shares outstanding if stock is sold (includes current shares outstanding and shares to be sold)* cost of debt (will be a percentage of capital to be raised)) / additional shares to be sold If actual earnings per share is lower than EBIT, then it makes sense to go with equity financing, you want to issue stock. Equity financing produces a higher earnings per share. |
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Financial leverage limitations |
Additional cost of high debt (lenders often require higher interest rates as debt increases). Reduced cash flow flexibility (interest exp must be paid, reducing available cash which increases liquidity risk). Increased cost of financial distress (as debt rises a company will have increased risk of default and if cost of debt is greater than earnings per share benefit, company value will begin to decrease). |
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Insurer cash flow
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Compared with other industries, insurers typically have lower amounts of traditional debt, so more difficult to determine. Positive cash flow from underwriting operations provides funds to the insurer for investment without requiring other sources of funding. The cash flow dictates how much capital an insurer has to invest, even if there's a policy with underwriting loss there may still be positive cash flow from that policy b/c in the first year of policy the premium is collected upfront but on income stmt they aren't reported as income until they're earned. Insurer would be willing to write a policy at an underwriting loss, if the cash generated by the policy can earn a sufficient return. Cash flow from policy differs from SAP reporting of policy. |
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Insurance leverage
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More difficult to measure than financial leverage. Cost of insurance leverage is difficult to predict because funds often arise from the sale of policies and losses may be unpredictable. Insurer is essentially borrowing money from insured until the insured incurs a loss and insurer pays it. Whereas cost of financial leverage is fixed because this cost is interest expense on bonds issued.
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Measuring insurance leverage
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Measured using the reserves-to-PHs surplus ratio. Reserves / PHs surplus can be broken down into (premiums written / PHs surplus) * (reserves / premiums written) Premium-to-surplus ratio represents insurer's relative exposure to underwriting risks. The lower the premium-to-surplus ratio the more ability the insurer has to write new policies. Liability lines typically have a larger reserves-to-premiums written ratio, while property lines typically have smaller ratios. |
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Cost of debt for an insurer based on underwriting loss/gain |
When estimating the cost of operations (cost of debt), can use "underwriting results to reserves" ratio. Formula = [loss * (1 - tax rate)] / reserves. Underwriting gain results in a negative cost. Formula is comparable to cost of debt formula. Lower cost of liability lines (lower reserves for liability insurers). |
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Limitations of insurance leverage |
Limitations on ability to expand: SAP requires immediate recognition of policy acquisition costs and deferral of revenues. States require minimum surplus. Cost of insurer debt must be less than expected return on investments. As new business is written there is increased chance of underwriting losses. |
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Cost of capital for an insurer
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Varies depending upon the type of capital. Debt/equity or preferred stock. Cost or capital must be balanced against the return on the capital. Weighted average cost should be used when there are multiple sources of capital.
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Insurance cost of equity: discounted cash flow model |
Discounted cash flow model (assumes cost of equity is equal to present value of future cash flows so the first thing you need to do is find next years dividend). Determining the cost of equity can be done using the following equation: Cost = (dividend * (1 + g)) / price + g, g = dividend growth rate ( has to be a constant rate) Can only be used for companies that pay dividends. Capital asset pricing model can be used for companies that do not pay dividend. |
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Equity cost of capital |
Cost of equity capital = (d1/V0) + g d1 = dividend projected for coming year (equals the prior year dividend * (1 + g)) V0 = current value of stock g = growth rate |
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Insurance cost of equity: capital asset pricing model
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Capital asset pricing model (CAPM) (alternative method of determining cost of equity). Cost = rf + [beta * (rm - rf)] <- this subtraction equation is sometimes referred to as the market premium (additional rate of return that will be rec'd when investing in an asset that's more risky) rf = risk free rate (usually the rate applicable to a treasury security) rm = expected market return Formula takes into account both systematic and unsystematic risk. Beta is used to measure systematic risk. Market portfolio has a beta equal to one. |
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Cost of preferred stock for an insurer
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Should generally be valued in the same fashion as the cost of a perpetuity. If preferred stock is callable it should be valued like a bond so you're looking at the cost of debt instead of a perpetuity. Formula for preferred stock treated as a perpetuity (trying to come up with percentage cost of preferred stock): cost of preferred stock = dividend / market price of stock. |
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Insurance cost of debt |
The cost of new debt is the interest expense, which can be divided into two componenets. Cost = (rf + risk premium) * (1 - tax rate) or Cost = YTM * (1 - tax rate) rf = risk free rate Components of interest expense: risk free rate of return (typically U.S. treasury bill rate). Risk premium (additional rate required to due risk incurred). |
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Weighted average cost of capital
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The WACC is used to determine the cost of capital when there are different types of capital. If you raise capital by issuing some equity and some debt this is how to figure out cost of capital. Cost = (cost of equity * % of capital raised through the equity issue) + (cost of debt * % of capital raised through debt issue) WACC is important for budgeting purposes. Projects with expected return that is less than the WACC should be avoided as they will decrease value to shareholders. |
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Risk based capital standard |
Regulators review RBC measures annually. Actual capital is compared to standards. Insurers not meeting requirements face regulatory oversight. |
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Asset risk
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RBC asset risk element represents the risk that the value of assets will be lower than expected. Decrease in value affects surplus. RBC considers equity, fixed income and investments in subsidiaries. Riskier assets require more capital. |
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Credit risk (default risk)
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RBC credit risk represents risk the insurer will not collect amounts owed. Largest risk is the risk a reinsurer will default on a reinsurance agreement. Other risks include accrued investment income, receivables from affiliated companies and receivables from uninsured health plans. |
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Underwriting risk |
Risk that premiums being charged or reserves are too low. Inadequate reserves may reflect a need to draw into capital. Insurer interested in expansion would most likely be affected by the underwriting risk. Excessive premium growth is also a risk recognized in RBC formula. |
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Action levels
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Authorized control level is minimum capital needed under RBC formula. No action required (200% of minimum ACL). Company action level (150%-200% ACL. Insurer must submit plan to regulator). Regulatory action level (100%-150% ACL. Regulator must conduct examination). Authorized control level (regulator may place insurer under regulatory control). Mandatory (<70% ACL). Goal is to get to 200%. |
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Economic capital |
Economic capital determines probabilities of remaining solvent at different risk levels. Insurer sets threshold level and determines economic capital required. E.x. ABC insurer has 99.5% threshold level (have sufficient capital 99.5% of time). |
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Economic capital attempts to quantify |
Market risk (decline in investment prices), credit risk (inability to collect amounts owed), liquidity risk(losses due to poor cash flow management), insurance risk (adverse loss experience), operational risk (failed internal processes). Similar to RBC except economic capital model assigns a probability to the outcome as opposed to setting a minimum requirement. |
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Economic capital: market value surplus (MVS)
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MVS = fair market value of assets - fair market value of liabilities which is determined by present value of liabilities + market value margin If MVS is greater than economic capital, insurer has excess capital. If MVS is less than there is a capital deficit. |
