profit distribution

Can you please explain the next statement from Solution 12.3 .

To the providers of capital, a delay in profit distribution means a reduction in the return on capital, all else being equal.

At The first paragraph of the Solution they wrote:
The more terminal bonus payable the greater a company's investment freedom and the lower its investment risk. this should enable the company to invest in more risky assets, and thereby achieve a better return for its policyholders (and, where applicable its shareholders).

Why shareholders get a lower return when Terminal bonus are distribution?

 

Hi Inbal, I'll give it a go

In order to understand the return on capital remark it is important to remember that this is broady profits (present value)/capital employed.

A delay to the profits distributed will reduce the present value of profits because they are recognised much later in the future. This is because of the effect of discounting!

As a result, the numerator is lower, the capital employed is unchanged bringing down the return on capital.


Your second paragraph is dealing with with profits contracts. This isn't saying that shareholders receive a lower return when terminal bonus is distributed.

The key point is shareholders get an improved return if there is greater investment flexibility and subsequent higher expected return.

This is because both policyholders and shareholders (if the insurer is a company and not a mutual) will share in the surplus generated.

How exactly this sharing of surplus (if at all) is made between policyholders and shareholders would usually be defined.

Hope this helps.

 

I find both the statements contrasting...

- The return on Capital reduces on Profit deferral
- The expected return on Capital increases with teminal bonus distribution because of extra investment freedom and flexibility.

BUT Terminal bonus is itself a way of deferring profits/bonuses !!

So effectively, will the terminal bonus distributions increase or decrease the return on capital ? I agree with the former.

 

I think they are contrasting, but the first one says 'all else being equal', so effectively ignores the higher possible returns through more investment freedom.

My guess is that the higher investment freedom would usually more than outweigh the delay in distribution.

 

Thank you all very much . Inbal

 

Context

Though little late..let me give a shot...

I think both the statements have different context & we are comparing two different things:

- Return on capital reduces on Profit deferral. This is talking about actual return today. Eg:We earn 100 as profit but defer 30, the actual return will come down from 10% to 7% (assuming capital of 1000).

- Expected return on capital increases with terminal bonus distribution. This is talking about expected future return. Eg: By how much can we increase our future profit by deferring 30.

So, basically we are comparing two different things : Actual Profit (Today) & Expected Profit (Future).
Hence, both statements are correct & no point of confusion

I hope I am making some sense.

 

KayKay,

I think to calculate the return on the Capital, you will have to consider the PV of all the future profits even though the profits are deferred to until a later date in the future i.e. you cannot ignore 30 in your example to calculate your return on Capital. Think how we calculate the Internal rate of return (IRR).

Also, whenever we talk about any high expected future return, we generally take account of this higher expected return at t=0 itself for the analysis purposes without waiting for it to get realised in future.This is because the shareholders may want to see the capital requirements at t=0. For instance, if I am investing in equity(8%) or a bond (5%), I may straightaway (!) use 8% as my expected return for current time calculations e.g. for discounting my liabilities assuming that I will realise this high return in the future. Of course with this advance credit we take the risk of return being lesser than expected. (For this risk, the company may keep an additional reserve..but it is not relevant here).

The point we were discussing in this thread was - Whether the extra expected return (may be taken into account today) due to investment freedom from using Terminal bonus distribution compares with the return that will certainly be obtained today if I dont defer my profits via Terminal distribution.