the actuarial profession making financial sense of the future finance & investment conference...

The Actuarial Professionmaking financial sense of the future

Finance & Investment Conference 2003The Caledonian Hilton Hotel, Edinburgh

The Cost of Capital for Financial Firms

Jon Exley and Andrew SmithApplications of Financial TheoryWorking Party

Key Questions

• Pricing (prospective) question:

• what rate of return is required on assets / liabilities

• to create value for shareholders?

• to justify retaining or growing a business unit?• Performance measurement (retrospective) question:

• which business units created value?

Presentation Overview

• Classical cost of capital methods

• ROE, ROC, WACC• What is equity?• Taxes and frictional costs• Financial distress • Implications for pricing, capital structure, accounting

and regulation

Two Schools of Thought

Pricing and Performance Measurement

EconomicCapital

ContingentClaims

This presentation is about the contingent claims approach



Part I: Classical Theory

Simplified Company Balance Sheet

Assets Liabilities

Assets = € 500consisting ofPlantInventory Debt = € 400

Borrow at 6%

Equity = € 100

The Pricing Question

• What is the required return on the assets?

• profit before interest cost

• divided by initial asset value• Classical answer: WACC

• Use for discounting new projects

• And as a target ROE (return on equity)

Cost of Capital in First Year

Assets Liabilities

Assets = € 500consisting of- Plant- Inventory Debt = € 400

Borrow at 6%

Equity = € 100

required return 10%(eg from CAPM)cost of equity € 10

borrow at 6%cost of debt = € 24

total cost of capital= € 10 + € 24= € 34

Weighted Average Cost of Capital

WACC = Equity

Assets* Required equity return

Debt

Assets* Borrowing rate+

= 0.2 * 10% + 0.8 * 6%

= 6.8%

= € 34

€ 500

Summary: Rates of Return So Far

5%

6%

7%

8%

9%

10%

risk-free

market equityreturn

cost ofborrowing

cost ofequity

WACC(weighted

average cost of capital)

Banking and Insurance

• Industrial model translates readily to banking

• assets (loans) to be priced

• given the cost of financing (equity, debt and deposits)• Insurance more challenging

• debt = policyholder liabilities

• pricing problem relates to liabilities, not assets

• Cost of Equity more useful than WACC



Part II: What is equity?

What is equity?

• Balance sheet equity = € 100

• but only € 60 required to meet solvency regulations

• and only € 40 “economic capital” needed if regulations were risk-based

• Market capitalisation = € 150

• € 100 equity plus € 50 franchise value

• shareholder requires return on total investment• So does the 10% cost of equity apply to € 40, € 50, €60, €

100 or € 150?

Profit Target: Impact on Valuation

corp

orat

e va

luat

ion

supp

orte

d

equity for setting profit target

zero economiccapital

net assets

market capitalisation

regulatorycapital

bookequity

equity+ franchise

A business that earns its cost of book equity should trade at book

value

… but higher profits are required to support an

existing value in

excess of book

Do these statements make sense?

I dare not recognise capital gains in my

balance sheet, because shareholders would

increase my profit targets

When I reduce the capital required for my business, this saves on

cost of capital and creates value for

shareholders

I added value last year because the business achieved a return on equity in excess of its

cost of equity

Least Satisfaction:Link from metrics to market value

-5%

0%

5%

10%

15%

20%

89 90 91 92 93 94 95 96 97 98 99 0 1

P/C insuranceAll companiesLifeCommercial Banks

0

200

400

600

800

1000

1200

1988 1990 1992 1994 1996 1998 2000 2002

P/C Insurance

All companies

Life insuance

Banks

Reconciling ROE to TSR – The role of franchise value

This yearactual

Next yeartarget

100

50

ma

rke

t cap

italis

atio

n

equity

107

52

6

ma

rke

t cap

italis

atio

n

dividend

target total return 10%

target franchise growth 4%

implied 13% target ROE

Franchise Values (Dec 2000)

0%

20%

40%

60%

80%

100%

Sk

and

ia

Gen

eral

i

Pru

den

tial

LT

SB

HS

BC

L&

G

All

ian

z

AX

A

Ab

bey

Nat

ion

al

RB

OS

HB

OS

Iris

h L

ife

His

cox

RS

A

Franchise

Net Assets

Aegon: Equity and Franchise

0

10

20

30

40

50

60

70

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

Franchise

Equity



Part III: Taxes and Agency Costs

Tax and Agency Costs

• Tax: rate τ1 on profit

• Agency costs

• Arising from principal / agent conflicts

• Related to management control over resources

• Proportional to Equity capital or Profit

• Rate τ2 on equity, rate τ3 on profit

Impact of Tax and Agency Costs

Industrial and Banks Insurance

• Tax and agency costs

reduce the return on equity

available to shareholders

• To justify shareholder

investment, a firm must

pass these costs on to

customers

• Higher returns on assets

required (eg higher

mortgage interest rates)

• Tax and agency costs

reduce the return on equity

available to shareholders

• To justify shareholder

investment, a firm must

pass these costs on to

customers

• Lower cost of debt required

(eg lower liability discount

rate in premium basis)



Part IV: Financial Distress Costs

Modelling Financial Distress

statutory net assets at year endsh

are

hold

er v

alu

e

franchise value at risk

limited liabilityput option

Impact of Financial Distress

• Franchise value disappears• Shareholders get nothing• Debtholders and administrators share the assets

• we assume administrators get the lot• Debtholders anticipate this credit risk

• and therefore do not lend at the risk free rate

10

12

14

16

18

20

0 10 20 30 40 50

equity

fran

chis

e

Capital Optimisation

default option

franchise valueat risk

optimalcapitalisation

tax/agency costs too high

treating tax, agency costs, default, existing / new business split

what the market sees(share price × shares in issue)

what the accountantrecognises:

investments (?estate)in-force liabilities

value of new businesscapital raising / holding

/ distribution costsagency costsown credit risk

Defining net assets necessarily involves accounting decisions.

There is no unique “economic” view that abstracts from these decisions



Part V: Pricing

How the Answer Looks

95

96

97

98

99

100

101

102

103

104

105

Discount atrisk-free rate

CAPM liabs Expenses ontechnical

assets

Cost ofCapital

Tax DefaultOption

PlannedMargin

FranchiseInsurance

Pre

miu

m p

er

£1

00

Lia

bil

ity

Comparison: New vs Old

Premium =

+ PV Mean claims

+ Market risk load

+ Credit risk load

+ Operational risk load

+ Event risk load

+ Other risk load

Premium =

+ Mean claims (PV risk free)

+ Systematic risk load

+ Agency cost of capital

+ Tax

- Default option

+ Margin for profit

+ Franchise protection

Questions for Discussion

• Is there any meaningful “economic” capital value that

• differs from market capitalisation

• transcends accounting and regulatory distortions• Do you accept that shareholders require a return on their

franchise value

• Market price should drive profit margins

• EVA measures overstate new value created?• Are actuaries adequately prepared to understand the strengths

and weaknesses of banking techniques when applied to insurance firms?


Finance & Investment Conference 2003The Caledonian Hilton Hotel, Edinburgh


Jon Exley and Andrew SmithApplications of Financial TheoryWorking Party

the actuarial profession making financial sense of the future finance & investment conference...

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