 Hi everyone, it's MJ the fellow Actree and in this video, I want to talk about capital. What exactly is it? So what I want to do is start off with this diagram, which we should be familiar with from financial mathematics back in first year actuarial science. And essentially what we have here is we've got a large negative cash flow followed by a whole bunch of running costs. And then we've got some positive cash flow coming in in the form of an income. This can be for rendering services or selling a product. Now let's start off quite simple. Let's assume a certain future and a certain future. What we're implying then is that these cash flows are going to happen exactly when we think they're going to happen and their size is going to be as expected. So what we're seeing with generally most businesses is that they have this large negative initial cash flow and this represents the equipment needed, the three months deposit of rent and any other start up costs needed in order to get the business up and running. However, once the business is running, there's still going to be some running costs. You've got to pay salaries, you've got to pay rent. But now you're also going to be enjoying a positive cash flow. The positive cash flow represents the income that you generate. Like I said, from either selling your product or from rendering your services. Now if the positive cash flows are greater than the negative cash flows, the business is going to enjoy a profit and investor can calculate their returns by saying, well, OK, the amount of profit this business is going to make divided by the start up cost is going to equal a return. And what an investor is going to do is they're going to compare that return to other opportunities. And if this return is higher than the other opportunities, then they're going to invest and carry out this venture. And what we can see is that because we have said that the future is certain in this instance, no additional capital is needed because the start up costs and the running costs are going to occur as expected. And the amount of income we're going to make is going to be as expected. So if we can predict the future, we don't need to hold any additional capital. However, we know that in reality, the future definitely appears to be uncertain to us. And what this means is that all future cash flows are unknown and we can model them with random variables. Think about it when you start a business. You don't know if you're going to sell 10 of your product, 20 of your product or 30 of your product in the next month. It is a little bit of an unknown. Of course, if you've done your market research and you've done a whole bunch of surveys and all these other things, you know, spoken to customers, then you can work with some sort of expected value and you kind of know what your expenses are going to sort of be. So again, you can work with expected values there and you can work with this expected value to determine if we expect a profit or a loss. But it's important to appreciate that these still are random variables. No matter how much research you do, there still is going to be variants. And that means that there's a chance that we're going to incur a loss when we expected a profit. And a good example of this is with, say, the coronavirus. Not a lot of businesses were expecting a shutdown of this duration, which has disrupted business. It has seen income decrease and, in some cases, expenses increase as they try and adjust to the new situation. And the whole big thing here, and this is a sad thing that a lot of businesses are experiencing, is that if we incur a loss and we haven't set aside any additional capital, then we can't cover the next period's expenses. And this is why a lot of people are getting fired and some businesses are panicking because essentially what happens is if you can't meet your expenses going forward, it's game over for a business and we refer to this as ruin. So because of an uncertain future, additional capital is needed by the business to prevent ruin. So no matter how well you think you've understood the market, no matter how well you think you've done your research, unexpected things can happen, like the coronavirus or something else that can put all your business plans into a shamble. And therefore you do need additional capital to try and prevent ruin. So the big lesson here is that if the future was certain, we wouldn't need any additional capital other than that, which we've budgeted for. But because the future is uncertain, we do need to set aside more capital in case the unexpected happens. Of course, the big question now is, well, okay, but how much is needed? And this is gonna be the question that actuaries and other analysts really spend a lot of time thinking about how much capital is actually needed. And we could say, oh, the better capital or the more capital we have, the less chance of ruin. So let's try and hold as much capital as possible. And that's great, except for the realities that, one, we have limited access to capital. Remember, we live in a capitalistic society where capital is very much scarce. Also, there are lots and lots of competing opportunities for capital. If the return is higher on another venture, then the money's gonna move there and not to your venture. So what investors are actually looking for is they actually are looking for businesses that require less capital. That's gonna be more attractive to a shareholder because it's gonna result in a higher expected return. But it's important to balance this with the idea that, okay, but the more capital means the less chance of ruin. And this is something that we're kind of seeing with the airlines specifically in America is what they were doing is they were taking the capital that they had because they had, during from 2010 to 2020, they made lots and lots of money. Instead of storing this capital as a reserve for a rainy day, like what's happening with coronavirus, they bought back shares from the shareholders. And what this did is it reduced capital so that the returns looked better. However, now that this big disaster has struck, the ones that were doing these buyback schedules, they now have a much higher chance of ruin. And this is the thing is when it's a non-financial business, it is the owners of these companies that get to decide on the level of capital. And of course, if the one competitor is buying back all their shares and boasting these high returns, the others in the industry almost have to do the same, otherwise shareholders are gonna dump their stock and buy the other one. So that's a bit of a problem when we're seeing that it's causing quite a lot of issues now in America in the aviation industry. Fortunately, in the financial business, they don't leave it to just the owners because something crazy like that could happen. Instead, what they do is they create a regulator who then decides the minimum level of capital. And there's quite a lot that we can talk about with regulators, but I think we'll save that for a different video, but the whole regulators and why they insist on a minimum level of capital. But let's maybe return to our original question. So what exactly is capital? And we can say that it is the additional funds needed to cover uncertainty around future cash flows. And future cash flows, they kind of can be broken into four things. We have unexpected falls in income streams. This is when we don't sell as many products as we thought we were going to. There could be an unexpected fall in asset value. Maybe you've set aside some money, but you bought shares and now with the coronavirus, the stock market has crashed and now your assets have gone down. You could see an unexpected rise in expenses. This is because now you have to find alternative suppliers and they're charging much higher because there's so much more demand for whatever service that they're offering. And you could also see an unexpected rise in liability value. And this tends to happen more with long-term insurance, but it is something that could even happen with your general business where you could get an unexpected rise in liability value. It's also important to see how capital management links in with risk management because capital management at the end of the day is the most basic form of risk management. You just hold more capital. You've got less chance of ruin. Of course, that's not the only thing you can do. What you can do is there's also a whole bunch of other risk management strategies that one can deploy that can reduce uncertainty in future cash flows. And this can be from transferring risk to sitting in policies and procedures, some sort of internal controls, but essentially at the end of the day, what they're aiming to do is to reduce the required capital that is needed to prevent ruin at a given level of confidence. So let's maybe talk about this in with, well, yeah, let's maybe look at this with some graphs. So let's say we have the following loss distribution. Frequency is the probability that it happens. Severity is how bad it was. So you can think over here, this is like a few hundred million. And then as it gets over here, it's like a few billion. So let's think of this as our loss distribution. How much capital do we need for a given level of confidence with ruin? So let's look at these two graphs over here. What we can see is that the capital required in the first one is less than the capital that we've set aside for the second one. And what that's gonna result in is a higher chance of ruin than the second one. And this is basically just driving home that point that the more capital you hold, the less likely ruin's going to happen. So you can see as the capital increases, the probability of ruin represented by this alpha is going to shrink. Of course, that's not the only way you can reduce the probability of ruin. What we're seeing here is good risk management, which is represented by the orange curve, is showing that we can actually implement certain strategies and risk management policies and procedures that can shift the loss distribution curve and actually make it smaller. And so what we see with risk management is that for the same level of capital, we can reduce the probability of ruin. So like I say, risk management and capital management kind of go side by side because both of them want to lower the chance of ruin. And because capital is limited, risk management can kind of come to the aid and say, okay, look, if we just act smart about it or be a little bit more cautious, we can reduce this probability of ruin. Of course, risk management also has an impact on returns. So it's not that easy and you need to balance whether the cost of the extra risk management and by cost I mean even the unexpected or the upside risk that you're foregoing is better than the amount of additional capital that you needed to set aside to get that same amount of reduction in ruin. So it's not as simple as that, but what I wanted to show you that to decrease the chances of ruin, you can either introduce more capital or you can improve your risk management. But let's maybe talk a little bit more about ruin in the next video where we're gonna dive deep into ruin theory. I'll see you guys there.