I was looking at some of the core reading in chapter 19. I was confused by a list of terms related to financial strength (questions below). Operating leverage Financial leverage Asset leverage Capital structure Liquidity How does Capital Structure differ from Financial leverage- don't they both describe the debt and equity proportions? I understand the effect of high gearing on risk to shareholders. Asset leverage- does this basically mean that if you hold assets that have high value with low volatility of value you will be a lower credit risk and you could be described as having high asset leverage?
I would agree that the first point seems a bit tautological. For the asset leverage, I think it may be an insurance term to mean the ratio of capital assets backing a level of premium income. I found the following:- Investment performance has increased in importance to insurers. The two factors determining the improved investment results were the strong capital market performance from 1995 to 1999 and a long-term trend towards more asset leverage. Asset leverage, the ratio of invested assets to net premiums, has increased in all the major markets primarily because of a structural increase in loss reserves. In all the major markets, loss reserves have risen stronger than premiums along with the increasing importance of liability lines of business. & Underwriting leverage is generated from current premium writings, reinsurance recoverables and loss reserves. Financial leverage is created through debt or debt-like instruments (including financial reinsurance) and is reviewed in conjunction with a company's underwriting leverage. Asset leverage measures the exposure of a company's capital to investment, interest rate and credit risks. Else there is a bit of business speak about leveraging non financial assets inorder to improve profits by e.g. making synergies across the business etc but I would guess that they are referring to the insurance situation.
I agree that this Core Reading isn't very clear. My interpretation of it is as follows: Operating leverage = fixed operating costs/profit before income and tax (so measuring importance of fixed operational costs) Financial leverage = income gearing, i.e. interest payments/profit before income and tax (so measuring extent of fixed financing costs) Asset leverage = capital leverage = debt/(debt + equity), based on balance sheet Capital structure refers to the financial structure of the company more generally, i.e. the balance between debt and equity (and also anything else e.g. preference shares, cash). If you have one, it is probably worth digging out a list of the accounting ratios covered in CT2/108, as they might prove useful in this exam.
