Question: What are the determinants of post-loss investment fundability?

What are the determinants of post-loss investment fundability?

            The reasons for managing corporate risk include the avoidance of bankruptcy costs and the protection of the firm’s continuing ability to pay for sudden losses and to finance investment opportunities. One way to address these concerns is to re-capitalize the firm after a loss. The gain is that the firm receives an injection of funds when it is most needed without an increase in leverage. Moreover, an insurer may unable to pay for catastrophe losses from current liquid assets, despite having substantial illiquid assets, especially the franchise value of future operations. Re-capitalization is a tool to release these illiquid assets and permits the firm to continue operating and preserve its franchise value.

 Doherty (1997) states there are two strategies to go about this. The first is simple post-loss equity financing. A feature of this strategy is that the price at which new equity can be issued is reduced by the loss. This may or may not, involve a hedging arrangement. When a insurer sustains abnormally large losses, its internal capital is depleted and its ability to fund new investment projects is compromised. The most prominent “project” is for the firm to continue to operate into the future and to reap future profits. Refer to the present value of future earnings as the “franchise value” and consider a firm that suffers very large losses but still has a significant franchise value. The firm can still have a positive equity value, but the franchise component of that value is illiquid. If losses exhaust available funds, the insurer may be unable to continue to operate and lose the value of its franchise. The problem is that the franchise value is not liquid, and cannot be used to pay for current losses. Post-loss equity financing provides a method for releasing the franchise value or, more generally, for releasing illiquid assets. Absent transaction costs, post-loss financing should always enable a firm to pay its losses as long as the value of the franchise and post-loss surplus is positive.8 However, the issue of new equity can lead to severe dilution, ceding much control to new shareholders and leaving existing shareholders with little value after a severe loss. Nevertheless, post-loss re-capitalization can be a rational strategy for a firm with high franchise value.

A second strategy is for the insurer to purchase a put option on its own stock that can be exercised after a catastrophe of defined magnitude.

Post-loss equity capitalization also can be useful following less traumatic losses. A more modest liquidity crisis can arise without severe financial distress. With large losses and a asset portfolio predominantly illiquid, the insurer will be forced to a “fire sale” or to other forms of control such as delaying claims payments to policyholders. The former results in a direct asset loss, the latter may compromise reputation and future profitability. If the ex ante advantages of holding a relatively illiquid portfolio are substantial, then post-loss equity financing provides a method of avoiding the potential liquidity crunch (Doherty, 1997).

 

Reference:

Doherty, Neil. 1997. Financial Innovation in the Management of Catastrophe risk, presented ASTIN conference in Cairns, Australia.

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