Leverage or Capitalization
In business, leverage generally refers to the extent on how companies utilize borrowed funds to generate gains or losses. Example, companies may borrow funds to make its equity in leverage; may purchase fixed assets to make its revenue in leverage; or make use of the so called derivatives to leverage. Leverage can demonstrate the extent as to which of the company’s debts or activities are funded by its creditors as against its owners. Leverage is also referred to as capitalization.
Leverage can result to higher investment returns to stockholders. However, high-leveraged companies are exposed to higher risks of losses such as bankruptcy if it is incapable of paying its liabilities regardless of its high surplus.
Financial leverage ratio, or debt/equity ratio, measures the company’s reliance on borrowed funds to finance the company’s assets. It is computed by dividing the company’s total liabilities by its total equity. A company that has a high debt/equity ratio may face problems in paying the principal amount and the interest since it is at the same time borrowing more funds.
On the other hand, insurance leverage represents the effect of the so called insurance reserves on the company’s equity returns. Insurance companies, as well as reinsurance ones, can attain advantage if settled on great leverages. Insurer companies usually have capital accounts and surplus as a small percentage of the total insurance amount it is qualified to sell. Given that the received premiums in addition to the investment income on reserves for losses are sufficient enough to gratify the company’s expenses and losses, leverage can be attained undeniably.
However, there have been a number of debates whether leverage in insurance companies is to be considered as either operating leverage or financial leverage. Operating leverage occurs when insurers use debt or other debt instruments to gain financial assets. These can take form of bonds. On the other hand, financial leverage evaluates the value of debt or other debt funding utilized by the insurer to come across with its wide-ranging capital necessities, as long as asset matching or liability matching is strong and the risk management approach used is effective. There is a huge difference as to the credit effect between operating leverage and financial leverage regarded funding.
Standard & Poor’s, a US based company on financial services, conducted a concise investigation to this matter. It established an explicit definition of related terms to expound its statement underlying the choice to view fund sources as operating leverage or financial leverage in insurance.
It defined financial leverage as the one accomplished by generating activities that could result to increase cash by way of debt or debt instrument issuance; a distinct pool of assets or simply assets and hedging instruments that has cash flows ample enough to pay the debt principal, as well as the returns; and insignificant risks associated to other assets of the paying issuer. Examples of these are lending securities, notes in medium term periods, funding agreements, and group insurance commissions (GIC). Alternatively, it gave meaning to operating leverage as a type of debt incurred while in the course of asset funding. Debts not considered to profit from being treated as operational leverage would then be regarded as financial leverage.