nottheaverageactuary

Actuarial news and views from Cape Town and beyond


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Preference shares

(On behalf of Dineshan)

 

During the lecture with David Kirk, he mentioned preference shares as a means of raising capital. Please click here for a brief reminder on what they are (in a bit of a South African context).

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Financial Reinsurance

An interesting topic raised in Tuesday’s lecture was that of financial reinsurance. This was raised as an alternative source of capital.

This article posted by PartnerRe (a reinsurance company listed on the NYSE) provides a basic outline of how it works.

The article explains that it can be used to alleviate the costs of new business strain or the cost of in-force policies being realised earlier than had been expected. This would therefore allow the reinsurer to use their available capital to “finance growth initiatives” at any point in time.

It states that the type of reinsurance agreement is that of a quota share treaty. The insurer will receive an upfront payment from the reinsurer. This amount is based on the expected future earnings of the policies covered in the treaty. The reinsurer will receive premiums from the insurer contingent on the future earnings of those policies.

According to this article, the contract is similar to that of a standard quota share treaty contract but further clarity will need to be provided from the insurer in terms of the profitability of the policies covered in the treaty. This could be information regarding the cashflow models and their sensitivities, the plans of the business and any operational processes that the reinsurer should be made aware of.


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Securitisation in SA

I looked up a few articles on securitization and I picked 2 which I found quite interesting. Securitization is one of the capital management tools mentioned in the notes.
Overview of securitization as a funding tool by SA home Loans
The overview explains why and how SA home loans use securitization as a funding tool. Even though they provide home loans to individuals, they are not a bank and so they needed to find a means to get capital to fund the loans.
The document provides details of the trust that it has set up – this trust guarantees the payment to the lender. It talks through securitization is SA and gives some reasons as to why there have been no defaults in SA unlike the overseas market.
Link to article
http://www.sahomeloans.com/Portals/0/Documentation/Downloads/Securitisation%20-%20A%20Funding%20Tool.pdf
Securitization: A conspiracy of Silence by NewERA
Gives an introduction of Securitization in SA, the history of securitization (its starts by giving details of where the idea began), it gives examples of the type of financial instruments that can be securitized and gives an example of the subprime problem in the US.

What I found interesting about this article is the secrecy by banks in SA around which loans are securitized (NEWRA have tried to get securitization information from the different banks with no success), implications thereof if the banks did disclose this information ie they lose all rights to that asset, how this structure affects us the individuals and the “gripes” NewRA has with regards to this structure.

This article made me think that as a user of financial products, there is quite a lot that I need to be more aware of and it also highlighted the importance of regulation and why the regulator needs to release TCF regulations in order to protect consumers as businesses sometimes do not have the needs and interests of the consumer at the forefront.

Link to article
http://www.newera.org.za/securitisation-a-conspiracy-of-silence/


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The Capital Management of European Banks (McKinsey 2012)

McKinsey has written a paper that presents the results of a survey on the leading practices in capital management of European banks (download the paper here).

The paper discusses the unwanted complexities of various capital metrics, how capital and risk-weighted assets can be optimised to create opportunities, capital-focused strategies, and the unexplored areas of capital management and resource allocation.

The paper also analyses the pros and cons of some going-concern capital models, what factors are important in ensuring a successful reduction capital wastage, and a new capital-efficient business model.

I know we are probably more interested in the capital management of insurance companies, but it is an enlightening read nonetheless.


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HIH Insurance fraud

HIH was the second largest insurance company in Australia. The company collapsed in 2001 and several members of its management team were imprisoned for committing fraud.

The collapse left policyholders with no insurance cover and it sent the insurance industry into a crisis. The former chief executive admitted to misleading the shareholders by concealing the real financial position of the company and manipulating the accounts to shows profits which did not exist. The company entered the American and British markets without adequate provisions, the premiums they charged were insufficient and they failed to set the correct reserves to cover future claims. They tried to conceal this by using financial reinsurance contracts to turn losses into gains.

Bad decisions were made at senior level and the interests of all stakeholders were not taken into account. The former chief executive used to take company funds for his own personal use (he actually charged the company for his jelly beans!!!) and the whole management team lacked effective corporate governance principles.

Sources:

http://www.independent.co.uk/news/world/australasia/director-is-jailed-over-scandal-of-australian-enron-6148162.html

http://www.smh.com.au/articles/2003/03/14/1047583693489.html


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Cooking The Books

America International Group (AIG) is one of the world’s largest insurer. They faced allegations of accounting fraud by making transactions which would enhance their financial statements by massaging the figures.

AIG were facing low reserves and to deal with this problem, they sought the aid of General Re, a reinsurance company. This was done so as to off load some risks AIG acquired from corporations and individuals. Therefore it is expected for AIG to pay General Re to cover for potential losses.

However, in the deal that they negotiated, they switched roles. General Re agreed to pay AIG a $500 million premium, and in return, AIG took the risk from a number of policies General Re had sold to other companies. These policies that AIG took were seen to have little or no risk hence it was certain that the claim that AIG would have to pay would be the same as this $500 million. Hence AIG received $500 million and paid General Re a substantial fee. This was similar to taking a loan and paying back with interest (which is the fee). This was supposed to have been accounted as a loan which would reduce the companies income and AIG was unwilling to do that.

Instead, according to investigators, AIG categorized the deal as a normal insurance contract, and the $500 million was counted as income that went toward reserves to pay future claims. This was used to enhance their reserves. Accounting regulations by the Federal Accounting Standards Board stipulate that any transaction that does not involve a significant amount of risk should be classified as a loan. the meaning of a “significant” amount of risk has never been classified but in this case, the risk was negligible. This could have led to prosecutions and fines if the risks were rendered negligible.

Insurance companies carry out transactions to help companies massage their financial statements through the sale of so-called “finite risk insurance”. For example, Brightpoint Inc were wanting  a way to reduce their large losses and asked for aid from AIG. Brightpoint paid monthly premiums and AIG paid the money back in from of insurance claims which was used to offset the years losses as insurance receivables. In other words, Brightpoint bought “insurance” to cover losses that had already occurred, the exact opposite of how insurance normally works. This led to AIG paying $10 million in fines.

In summary, don’t cook the books!

https://www.wsws.org/en/articles/2005/03/aig-m24.html


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Mark-to-market movement – a change in disclosure and reporting by firms of gains and losses in pension plans

Since 2010, many firms have made the change to a mark-to-market (MTM) accounting framework for reporting actuarial gains and losses related to their pension plans. This is a change from previous policy which amortised the gains or losses over several years as a part of the pension plan’s expense, effectively smoothing out the losses and gains. The MTM framework reports the losses (and gains) immediately, in the same year they are incurred, with the exception of losses or gains being in the “corridor” (e.g. Honeywell implemented a corridor of 10% of the greater of the market-related value of plan assets or the plans’ projected benefit obligation). In addition, when assessing the pension plan’s assets and calculating expected return, companies have changed from a calculated value to fair value for the plan’s assets.

Benefits of the MTM framework include simpler pension accounting; it is supported by GAAP’s fair value accounting principles, reflects current market returns (as well as interest rates and actuarial assumptions) and recognises losses and gains in the period they were incurred. It also doesn’t change any benefits paid out to plan members, nor the operation of the plan or company. Ultimately, it provides improved clarity and greater transparency.

A result of this change, especially noteworthy in 2010 and 2011 (not being too far from the 2008-2009 financial crisis), was that companies could avoid reporting large (past) losses in current and future financial statements.

Principal and consulting actuary at Mercer LLC, Steve Alpert, said, “So the losses are assigned to the past (statements), which nobody cares about.”

AT&T was among the first few firms to adopt the MTM framework. Richard G. Lindner, AT&T’s senior executive vice president and chief financial officer, said, “In the past, we have amortized actuarial gains and losses over many years. Now these gain and losses, which are driven by changes in the value of benefit plan assets and liabilities due to changing market conditions and assumptions, will be reflected on our income statement annually in the fourth quarter.”

“If we have a large financial loss, like we had in 2008, you see it in our results that year instead of it being reflected over many years in the future.”

In effect, the gains and losses can be tied to actual economic events, improving transparency.

Mr Alpert also noted that the pension plan losses incurred during 2007 and 2008, which would probably have been carried between 5 and 10 years, would be avoided by companies who take on the MTM framework.

References:

http://www.pionline.com/article/20110221/PRINT/302219958/mark-to-market-accounting-helps-companies-shift-pension-plan-losses

http://www2.deloitte.com/us/en/pages/audit/articles/pension-accounting-considerations.html

Further reading:

PRICE REACTION TOWARDS THE PENSION ACCOUNTING DISCLOSURES OF ACTUARIAL GAINS AND LOSSES – Nor Asma Lode, Mohd. ‘Atef Md. Yusof. [https://www.aabss.org.au/system/files/published/000867-published-acbss-2015-sydney.pdf]

Kim, J., Wasley, C. E., & Wu, J. S. (2015). Economic Determinants of the Decision to Voluntarily Adopt Mark-to-Market Accounting for Pension Gains and Losses. Available at SSRN 2576826.