Latest in ALM: ERM in a Corporate Finance context

1. Latest in ALM:ERM 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

2. What we will discuss today…. • An ALM perspective applied to corporate finance • Reconsider our notions of capital and risk • The Insurative Model

3. …. to bring risk and capital management together • A firm’s 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

4. Portfolio of Liabilities Portfolio of Investments Corporate Biz Plan Portfolio of Capital An ALM perspective to corporate finance Obligation to be fulfilled Funding Instruments ALM Corporate Finance

5. Scenarios Scenarios Horizons Horizons r (s,h) q (s,h) Asset Portfolio Expected Performance Liability Portfolio Expected Requirements Managing risk – The ALM view > So where’s the risk?

6. 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?

7. Who bears the risk?

8. Scenarios Scenarios Horizons Horizons r (s,h) q (s,h) Capital Required to Realize Business Plan Projected Realization of Business Plan Managing risk – The corporate finance view > How does this relate to corporate finance?

9. 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?

10. Capital adequacy Assets ALM Liabilities Insurance Debt Financial Leverage Equity Risk leverage From ALM to corporate finance

11. Models of Corporate Capital Structure • Standard Model • Considers on-balance sheet capital; • Ignores impact on firm’s 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 firm’s risk; • Firm Capital = f(Firm Risk)

12. Paid-up Capital high low Risk exposure Priority high low Risk Retain The Standard Model Senior Debt Hybrid capital Equity

13. Contingent Capital low Risk exposure high Risk Transfer The Insurance Model Paid-up Insurance Hedge Retain

14. Capital low Senior Debt Hybrid capital Risk exposure Equity high Risk The Insurative Model Contingent Paid-up Insurance Hedge Transfer Retain

15. Contingent Paid-up Capital Senior Debt Hybrid capital Equity Risk Transfer Retain Transfer The Insurative Model Insurance Hedge Risk-Linked Securities Committed Capital

16. Insurative Model is structurally richer • Standard Model • K(P) = f{R(R)} • Insurance Model • K(C) = f{T(R)} • Insurative Model • K(P) = p x f{R(R)} + q x f{T(R)} • K(C) = (1-p) x f{R(R)} + (1-q) x f{T(R)}

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

18. The baseline firm Paid-up Capital Equity Market Value = Q Return = q First priority on cash flows First exposure to risk All Risk Retained

19. Paid-up Capital Financial Leverage All Risk Retained Q = C + B 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

20. 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 < q Cost of Equity (C): q + (c-q) = c > q The adjustments can be viewed as insurance premiums: Paid by debt: B(q-b) = C(c-q) Received by equity

21. Paid-up Capital Retained Risk Q = S + I 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

22. 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 < q Cost of Equity (S): q + (s-q) = s > q The adjustments can be viewed as gains from risk leverage: Foregone by hedge: I(q-i) = S(s-q) Gained by equity

23. Insurance Hedge Market Value = H Return = h Debt Market Value = D Return = d Equity Market Value = E Return = e Insurative model of corporate finance Contingent Capital Paid-up Capital Q = E + D + H Financial Leverage Retained Risk Transferred Risk Risk Leverage

24. 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 company’s real value.” The Economist, November 1999