Latest in ALM: ERM in a Corporate Finance context

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Latest in ALMERM in a Corporate Finance context

• Prakash Shimpi
• President, Fraime LLC
• Senior Fellow, The Wharton School
• Visiting Fellow, The London School of Economics

CAS/SOA/PRMIA/Bowles ERM Symposium 2004 Chicago,
April 26, 2004
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What we will discuss today.

• An ALM perspective applied to corporate finance
• Reconsider our notions of capital and risk
• The Insurative Model

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. to bring risk and capital management together

• A firms capital structure is a response to its
  risk structure
• Insurance is a capital resource and should be
  treated as such
• Risk leverage is another way to create
  shareholder value
• The economic value of risk leverage is still in
  development
• Practitioners must develop better metrics and
  processes
• Nevertheless, transactions can be executed today

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An ALM perspective to corporate finance
Obligation to be fulfilled
Funding Instruments
ALM
Corporate Finance
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Managing risk The ALM view
gt
So wheres the risk?
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Who bears the risk of getting it wrong?

• Fixed liability Pay 100 for 10 years on
  Christmas
• Funding strategies
• Keep cash equal to sum of payouts, 1,000, in
  bank vault
• Cash match liability with 10 US Treasury zeros
  paying on Christmas eve, say for 900
• Buy securities portfolio (bonds, equities) with
  PV of assets equal to PV of liabilities under
  current yield curve and spreads, say for 800
• Risk profiles
• Each of these strategies has a different risk
  profile
• Who bears the risk?

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Who bears the risk?
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Managing risk The corporate finance view
gt
How does this relate to corporate finance?
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Corporate finance objectives

• Capital adequacy
• Does the firm have enough capital to achieve its
  corporate finance objectives?
• Does it have proper management of its assets and
  liabilities?
• Financial leverage
• Does it have an appropriate mix of debt and
  equity?
• Is that capital achieving sufficient return?
• Risk leverage
• Is the company adequately managing its risks?
• Does it consider insurance and hedging in its
  capital structure?

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From ALM to corporate finance
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Models of Corporate Capital Structure

• Standard Model
• Considers on-balance sheet capital
• Ignores impact on firms risk
• Paid-up Capital f(Retained Risk)
• Insurance Model
• Considers risk being transferred
• Ignores balance sheet impact
• Contingent Capital f(Transferred Risk)
• Insurative Model
• Considers all sources of capital to manage firms
  risk
• Firm Capital f(Firm Risk)

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The Standard Model
Senior Debt
Hybrid capital
Equity
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The Insurance Model
Paid-up
Insurance Hedge
Retain
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The Insurative Model
Paid-up
Contingent
Insurance Hedge
Retain
Transfer
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The Insurative Model
Insurance Hedge
Risk-Linked Securities
Committed Capital
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Insurative Model is structurally richer

• Standard Model
• K(P) fR(R)
• Insurance Model
• K(C) fT(R)
• Insurative Model
• K(P) p x fR(R) q x fT(R)
• K(C) (1-p) x fR(R) (1-q) x fT(R)

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Impact on cost of capital

• Capital Resource available to firm to finance
  its corporate activities
• Risk Exposure that impairs a firms ability to
  achieve its corporate objectives
• Insurative Capital resource available to
  finance a firms risk exposures
• Cost of capital of a firm should be the cost of
  the insuratives and not only the cost of
  marketable securities

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The baseline firm
Paid-up Capital
Equity Market Value Q Return q First priority
on cash flows First exposure to risk
All Risk Retained
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Standard model of corporate finance
Debt Market Value B Return b First priority
on cash flows Second exposure to risk
Equity Market Value C Return c Second
priority on cash flows First exposure to risk
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The standard WACC equation

• Baseline firm Q capital generates q return on
  assets
• Financially leveraged firm Equity Debt C B
  Q
• Cost of Debt (B) q (q-b) b lt q
• Cost of Equity (C) q (c-q) c gt q
• The adjustments can be viewed as insurance
  premiums
• Paid by debt B(q-b) C(c-q) Received by
  equity

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Insurative model, without debt
Contingent Capital
Insurance Hedge Market Value I Return
i Exposure to transferred risk
Equity Market Value S Return s Exposure to
retained risk
Transferred Risk
Risk Leverage
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The Insurative TACC equation

• Baseline firm Q capital generates q return on
  assets
• Risk leveraged firm Equity Hedge S I Q
• Cost of Hedge (I) q (q-i) i lt q
• Cost of Equity (S) q (s-q) s gt q
• The adjustments can be viewed as gains from risk
  leverage
• Foregone by hedge I(q-i) S(s-q) Gained by
  equity

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Insurative model of corporate finance
Paid-up Capital
Contingent Capital
Q E D H
Financial Leverage
Retained Risk
Transferred Risk
Risk Leverage
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Outsourcing capital

• Companies worry endlessly about the optimal mix
  of debt and equity. They are missing the
  point.by including both the cost of paid-up
  capital and off-balance-sheet capital, managers
  and investors would be more accurate in their
  estimates of company's true cost of capital, and
  therefore of a companys real value.
• The Economist, November 1999