Actuarial Portfolio Management of Infrastructure Service Contracts

By Thomas Emil Wendling

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Abstract

A firm will replace a physical asset at the end of its useful life. This fact demonstrates that there is a notion of mortality implicit in the way an enterprise manages its physical assets. We propose a theory that there is also an efficient time to replace a physical asset that is random and observable. Separate economic and financial models converge on agreement that (1) there is only one instant in time that an asset must be replaced in order to minimize the present value cost impact to the enterprise; (2) that this efficient instant is observable, and a function of both the enterprise’s cost of capital and readily obtainable current calendar year information; and (3) that the time to this efficient instant is random, and may be infinite. Through a policy of coordinating the timing of replacements with these efficient, observable instants, lost efficiencies are recovered. Such a policy necessarily creates volatile, fortuitous, future cash flows, which are dealt with through capital adequacy or risk transfer, rather than deferral or other forms of scheduling for convenience. The efficiency gains and accompanying value creation may be material if the enterprise’s assets are mostly physical. The potential role of the extended service contract to implement such a policy, and to transfer the resulting uncertain cash flows between entities, is reviewed. A broad comparison to prior capital expenditure planning methods is made. Possible tax consequences due to the interaction between efficiency and fortuity are discussed.

Keywords: Capital Theory

Citation

Wendling, Thomas Emil, "Actuarial Portfolio Management of Infrastructure Service Contracts," Variance 8:2, 2014, pp. 161-180.

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Mission Statement

Variance (ISSN 1940-6452) is a peer-reviewed journal published by the Casualty Actuarial Society to disseminate work of interest to casualty actuaries worldwide. The focus of Variance is original practical and theoretical research in casualty actuarial science. Significant survey or similar articles are also considered for publication. Membership in the Casualty Actuarial Society is not a prerequisite for submitting papers to the journal and submissions by non-CAS members is encouraged.