23 + 24. Reserves III - Solvency capital

Question 1

What is the purpose of surplus capital?

Answer 1

Provides extra protection to policy holders

Question 2

What are the approaches to calculating solvency capital?

Answer 2

• Formula based e.g. run-off
• Risk-measure e.g. VaR

Question 3

Explain the run-off approach

Answer 3

• Calculate the capital required to cover liabilities till the last policy is off the books allowing for stresses to the risk factors

Question 4

How is solvency capital calculated using the run-off approach?

Answer 4

• Each risk factor is stress tested and the capital required for each risk is calculated.
• The stress tests are compined allowing for correlation between the risks
• Allowance must be made for non-linearity and non-separability of risks.

Question 5

How is solvency capital calculated using the VaR approach?

Answer 5

• Stress test each risk factor at a defined confidence interval.
• Calculate the supervisory balance sheet
• Recalculate the surplus
• Free surplus will be the available surplus minus the required solvency capital

Question 6

What is an active valuation approach?

Answer 6

• Approach that’s based more closely on market conditions
• Assumptions changed frequently

Question 7

What is an passive valuation approach?

Answer 7

• Approach that’s insensitive market conditions
• Assumptions not changed frequently

Question 8

Give an example of an active and passive valuation method

Answer 8

Active:
* Market consistent for A+L
* Run off method for solvency capital

Passive:
* Net premium valuation for L
* Book value for assets
* % of base L for solvency capital

Question 9

What are the merits of an active approach?

Answer 9

Advantages:
* More informative as can understand impact of market on solvency

Disadvantages:
* Volatility
* Systematic effect of adverse conditions in the market
* Complex, time consuming and costly.

Question 10

What are the merits of a passive approach?

Answer 10

Advantages:
* Straightforward
* Less subjective
* Relatively stable profit emergence

Disadvantages:
* May become out-of-date over time giving false sense of security

Question 11

Describe relationship between solvency margin and supervisory reserve

Answer 11

• The required margins in the reserve calculation and solvency margin calculation should reflect the risk of the insurer.
• There is a direct relationship between the level of prudence in the supervisory reserves and a suitable level for the required solvency margin.
• The level of prudence in the reserves (i.e. prescribed margins) implies that the minimum solvency margin required as protection for policyholders should be lower.

Question 12

What are the biggest contributors to capital requirements under VaR approach

Answer 12

Risks that:
a. have significant probability of being worse than valuation assumptions
b. give rise to large financial losses if experience is worse than expected