The Fallacy of Cost of Capital continued

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Friday I teed up the frequent breakdown in implementation of cost of capital constructs. Today I will give an example illustrating the downstream cost of this oversight. While this is, by no means, limited to the life & annuity space – the lessons are broadly applicable; I will continue the life & annuity company example, assuming a few things:

  • Indexed annuity product with a target/expected 12% ROE
  • $3 billion of annual production
  • 10% total compensation paid at issuance
  • Nominal cost of capital of 8%
  • 10 year amortization schedule (straight line for simplicity sake)

Today, with generally flush capital structures, there is little concern about layering in new business in this product. The horns of the dilemma are that in leaner times, say 2009, it would be difficult to authorize more volume despite returns beating corporate targets. A fully executed cost of capital construct would ‘charge’ the business 8% for invested capital, incentivizing the business to find a more efficient capital structure, releasing capital for redeployment (business development, shareholder returns, capital investment, etc.) and easing capital strain.

Here is a comparison of acquisition costs with and without the cost of capital (CoC) charge:

with CoC without CoC Variance V%
Required Capital/Cash (Issue Year) $300.0 $300.0 $0.0 0.0%
Est. GAAP Expense (Issue Year) 43.0 30.0 (13.0) (43.3%)
Total Capital Cost (Over 10 Years) 410.2 300.0 (110.2) (36.7%)

Not applying an explicit cost of capital charge obscures the true cost of running this business, by understating issue year GAAP expense by 43% and total cost by 37%. This is true for any business, not just life & annuity, for any capital cost.

Since alternative solutions do have a cost, not explicitly applying the cost of capital stymies business unit motivation to be more capital efficient. Since we embed our program costs, there is little difference, with or without the cost of capital charge:

with CoC without CoC Variance V%
Required Capital and Cash (Issue Year) $26.4 $26.4 $0.0 0.0%
Est. GAAP Expense (Issue Year) 27.5 26.4 (1.1) (4.2%)
Total Capital Cost 397.2 390.1 (7.1) (1.8%)

Viewed together, you see the economic value of an explicit cost of capital charge:

with CoC without CoC
with Program without Program Variance V% with Program without Program Variance V%
Required Capital and Cash (Issue Year) $26.4 $300.0 ($273.6) (91.2%) $26.4 $300.0 ($273.6) (91.2%)
Est. GAAP Expense (Issue Year) 27.5 43.0 ($15.5) (36.0%) 26.4 20.0 $6.4 32.0%
Total Capital Cost 397.2 410.2 ($13.0) (3.2%) 390.1 300.0 $90.1 30.0%

Only inception costs remain constant, as others, which play out over time, rise. Failing to account for carrying cost masks parent level benefits obtained by seeking alternative capital structures. Here you see that the parent gets the most efficient use of capital by reflecting the cost of capital in business unit financials and incentivizing innovation. The business unit sees lower cash and capital demand in the issue year, lower GAAP expense in the issue year and lower total GAAP expense over the amortization period, all likely forgone without that explicit recognition of the cost of capital.

Call or email me to discuss this interesting insight, learn how it may inadvertently hamstring your growth and to talk about our innovative solutions.

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