The Actuarial Profession making financial sense of the future Finance & Investment Conference 2003 The Caledonian Hilton Hotel, Edinburgh The Cost of Capital for Financial Firms Jon Exley and Andrew Smith Applications of Financial Theory Working 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 Economic Capital Contingent Claims This presentation is about the contingent claims approach

The Actuarial Profession making financial sense of the future The Cost of Capital for Financial Firms Part I: Classical Theory

Simplified Company Balance Sheet AssetsLiabilities Assets = € 500 consisting of Plant Inventory 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 AssetsLiabilities Assets = € 500 consisting 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% * 6% = 6.8% = € 34 € 500

Why is Required Equity Return 10%? CAPM: E(R p ) = R f + Cov(R p, R m ) Var( R m ) * [ E(R m ) – R f ] R f = risk free rate R m = return on market R p = return for company shareholders E(R p ) = mean (target) return R f = 5% E(R m ) = 9% E(R p ) = 10% equity β = 1.25market risk premium = 4%

Deriving Equity β Top – down (retrospective) Historic data for R m, R p (derived from share price history) Regression of R p against R m Slope = 1.25 = β Bottom – up (prospective) Prospective distribution of asset returns R a Regression of R a against R m Slope = 0.25 (operational leverage) Then allow for gearing: €500 assets to €100 equity So equity β = [500 / 100] * 0.25 = 1.25 For financial firms, top-down typically implies higher β

Summary: Rates of Return So Far 5% 6% 7% 8% 9% 10% risk-free market equity return cost of borrowing cost of equity 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

The Actuarial Profession making financial sense of the future The Cost of Capital for Financial Firms 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 corporate valuation supported equity for setting profit target zero economic capital net assets market capitalisation regulatory capital book 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

Reconciling ROE to TSR – The role of franchise value This year actual Next year target market capitalisation equity market capitalisation dividend target total return 10% target franchise growth 4% implied 13% target ROE

Franchise Values (Dec 2000)

Aegon: Equity and Franchise

The Actuarial Profession making financial sense of the future The Cost of Capital for Financial Firms Part III: Taxes and Agency Costs

Tax and Agency Costs Tax: rate τ 1 on profit Agency costs Arising from principal / agent conflicts Related to management control over resources Proportional to Equity capital or Profit Rate τ 2 on equity, rate τ 3 on profit

Impact of Tax and Agency Costs Industrial and BanksInsurance 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)

The Actuarial Profession making financial sense of the future The Cost of Capital for Financial Firms Part IV: Financial Distress Costs

Modelling Financial Distress statutory net assets at year end shareholder value franchise value at risk limited liability put 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

Capital Optimisation default option franchise value at risk optimal capitalisation 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 accountant recognises: investments (?estate) in-force liabilities value of new business capital raising / holding / distribution costs agency costs own credit risk Defining net assets necessarily involves accounting decisions. There is no unique “economic” view that abstracts from these decisions

The Actuarial Profession making financial sense of the future The Cost of Capital for Financial Firms Part V: Pricing

How the Answer Looks

Sensitivity: No Systematic Risk base case sensitivity

Sensitivity: 10% liability volatility base case sensitivity

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

A Changing World, More Suited to Market-Based Performance Measures Accounting based on deferral and matching Margins amortised over years Sustainable earnings a key objective Performance measurement relative to passive benchmark Asset and liability accounting model Margins capitalised on inception Volatile earnings based on mark-to-market Performance measurement relative to market returns

Conclusions Return on Equity has become a standard measure of value creation for financial companies but it reconciles poorly to shareholder returns We propose an alternative methodology that decomposes shareholder return into: asset return plus franchise return minus financing cost We show how to establish targets and performance measures for each of these items

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?

The Actuarial Profession making financial sense of the future Finance & Investment Conference 2003 The Caledonian Hilton Hotel, Edinburgh The Cost of Capital for Financial Firms Jon Exley and Andrew Smith Applications of Financial Theory Working Party