Study Notes and Published Refences - Note TSA XXXVIII - STRATEGIC MANAGEMENT OF LIFE INS CO SURPLUS

Strategic Planning

"capital budgeting" process for allocating capital to various activities
- won't tell co if activity is worth doing in first place - strategic planning for that
textbook approach to capital budgeting can result in random group of project w/ no clear stategic focus
sometimes necessary to fund projects taht return less tahn the co's cost of captial to support co's strategic direction
strategic planning - basic tool to evaluate attractiveness of each SBU for inv of copr resources
- "attractive" - both achieve sustained competitive advantage
  - earn ROE >= cost of captial

Financial Planning

Creating a Structure for Financial Planning
- necessary to determine amt of co surplus devoted to each business
- "business" s/b defined in a strategically significant way
- one technique for determining amt - "req'd surplus formulas"
  - by applying formulas @ different points in time, possible to see amt fo surplus flowing into or out of each profit center
- residual surplus - unallocated surplus acct
- usually need to convert from Stat Req'd Surplus to GAAP to reflect investment in acq cost and surplus strain
  - GAAP req'd surplus = Stat req'd surplus + unamort GAAP DAC + excess of stat benefit reserves over GAAP benefit reserves
- side benefit - meaning ROE can be calced for each profit center
- keep GAAP-ROE limitation in mind
  - may or may not correspond to internal rate of return used in pricing
  - differences
    - some acq costs not deferrable under GAAP
    - GAAP amortizatoin @ expected earned rate, pricing uses cost of captial, therefore different patter of profits and req'd surplus
    - GAAP includes PADs, causes GAAP profits to be deferred
  - these distortions can be prevented/lessened by selecting GAAP assumptions
  - another soln - sep accting system for managment acctg
    - stock - GAAP close enough w/ minor adjustments
    - Mutual - gross prem valn techniques
    - either case, new system can be $$ to implement
- Determing the Cost of Capital
  - Cost of Capital - best benchmark for evaluating ROE from each profit center
  - determined as weighted cost of each source of capital
  - cost of equity capital - adding a risk prem to risk-free rate of return
  - "risk prem" based on the additional yield req'd by investors to compentate for investing in co's common stock
  - cost of debt capital - based on LT int rate could borrow bades on its credit rating
    - since int of debt is tax deductible, appropriate to use after-tax rate
    - cost of debt & equity capital weighted to determine overall cost of capital
    - adjustemnts may be need to extent co incurrs corp expenses
      - not allocated to profit centers
- Concept of Economic Value
  - financial planning objective - increasing the economic value of co
  - economic value - PV free cash flows, discounted using the co's cost of capital
  - free cash flow - excess of increase in stat surplus (before shareholder divs) over increase in req'd stat surplus
  - ignoring cap g/l, free cash flow can be approximated by excess of GAAP earnings over increase in req'd GAAP surplus
  - GAAP def most useful for financial planning
    - actuary can determine which product lines generating cash flow by comparing GAAP-ROE w/ GAAP equity growth rate
    - GAAP equity growth rate - req'd GAAP Equity (EOY) / req'd GAAP Equity (BOY)
  - if GAAP ROE > equity growth rate - generating free cash flow
  - if GAAP ROE > cost of captial - growth is desirable
  - if ROE < cost of capital - destroying economic value
    - explore ways of improving ROE
    - if not possible, amt of capital flowing in s/b minimized
    - if > equity growth rate < cost of capital sometimes tolerated, esp if strategic
  - if ROE < cost of capital and < equity growth rate - most destructive - "cash sinks"
  - can have varying ROE for profit centers based on relative risk
- Financial Planning Process
  - to manage surplus, process needed to ensure capital allocated to most attractive areas
  - financial plan s/b developed annually for each profit center
    - s/b more than 1 year plan
  - 1st yr financial plan #s = objectives for following year
    - often used for incentive compensation
    - tend to be conservative
  - years 2-3 often best representation of future financial performance
  - first version of plan normally unacceptable to mgmt for variety of reasons
    - uses more captial than available
    - allocate too much to an area deemed unattractive
    - insufficient ROE for co as whole
  - should allow enough time to generate & discuss 2-4 different versions of plan
    - important b/c provides insites to fin performance not possible otherwise
  - simplified financial models often work best b/c of tight time frame

Company Organization

profit centers should correspond to organizatoinal untis (SBUs)
failure to use SBU, results in accountability issues
shared business services - bill SBUs for services used
each SBU should develop fin plans for its business
this type of org gives many cos best framework to evaluate performance of each SBU and control resource allocation on relative attractiveness of each SBU

Evaluating Financial Performance

commonly, SBUs not defined in a way that corresponds to co structure
mgmt needs way to allocate current surplus among SBUs to monitor use of surplus
if req'd surplus formula defined simply enough, can be done qtrly/monthly
compare results to fin plan
ROE determined and variance to plan analyzed
mgmt can react quickly if things begin to go awry

Copyright © 2004 Steve Welander.
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