Many operators in the financial services industry are required to hold capital. This can be a significant percentage of a company’s assets. It is therefore critical that the amount of required capital be fully understood and the most effective ways of holding this capital are utilised.
Capital related issues also extend past the regulatory framework in to many areas of a company’s operations. Indeed, capital is at the heart of the financing of a company with a key question being how to raise additional funds – via debt or equity. In addition, companies are increasingly focusing on target surplus and strategies used to achieve this.
Deloitte Actuaries & Consultants has a long history of assisting companies with all facets relating to capital calculations. Our practice area experts (including Health Insurance, Banking, Life Insurance, General Insurance and Superannuation) are able to assist clients in many ways including; regulatory capital calculations, efficient capital structures and implications on capital resulting from a strategic change in the direction of a financial services business.
Our client, a large Australian life insurer, was recently offered the chance to invest in a new and unique investment opportunity. The assets underlying the investment were long term in nature and therefore attractive from an asset liability matching perspective. However one complicating feature was the nature of the underlying assets which effectively resulted in the purchaser holding a “short” position in a put option whose term to maturity could be up to 20 or 30 years. Our client was interested in understanding the cash flow profile of the investment along with the capital requirements resulting from purchasing the assets, especially the short position in the put option.
We developed a model to project future cash flows for the asset which enabled our client to gain an understanding of how it might behave in certain market conditions, particularly the underlying put option. We also interpreted and applied the relevant regulatory capital requirements to help our client gain an understanding of the potential impacts this asset may have on their required capital position. As derivative products are often complicated instruments and in many cases unique, capital standards are unable to place specific requirements in all cases. Indeed, the put option in this investment was a classic example of such a derivative instrument and our ability to interpret the standards and develop a reasonable approach to determining capital requirements was instrumental in helping the client to fully understand the implications of this asset.
The client was able to quantify the impact on capital and subsequent increase in the cost of capital resulting from investing in such a product.