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One0Six 24 > 30. Capital management I > Flashcards

30. Capital management I Flashcards

1
Q

Why do we need capital

A

To cover unexpected losses

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2
Q

What are the types of capital

A

Economic
Regulatory
Rating agency

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3
Q

What are the two subsets of economic capital

A

Working capital
Risk capital

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4
Q

Define risk capital

A

Capital required to cover unexpected losses from exposure to risks associated with an organisation’s existing assets and liabilities

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5
Q

What are other definitions of capital

A
  • Surplus needed to cover all potential utgoings, redcutsions in assets and/or increases in liabilities at a given risk tolerance over a specified time horizon
  • Surplus needed to maintain given level of solvency at a given risk tolerance over specified time horizon
  • Excess value of assets over value of liabilities at given risk tolerance over specified time horizon
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6
Q

What is free capital?

A
  • Excess of available capital over the required capital
  • BoD decide how much to retain and how much to distribute
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7
Q

What are the benefits of effective capital management

A

Can help transorm risk to increase shareholder value through
* Competititve pricing&raquo_space; adequate ROC
* Reserving e.g. improving reserve estimates needed for claims outstanding
* Performance management- allows business outcomes to be measured and processes to be adapted accordingly
* Risk management - establishing overall risk tolerance, identifying and assessing risks present and keeping risks under control

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8
Q

What are the uses of capital models?

A
  • Help set investment strategy
  • Value business being bought/sold
  • Analyse impact of mergers/acquisitions or sales/divestments, on risk profile and capital requirements
  • Identify impact of a disaster scenario
  • Identify weaknesses in business and help develop appropriate solutions and risk mitigation techniques
  • Allocate capital across business lines
  • Measure risk-adjusted return achieved on capital
  • Develop optimal mix of products to sell
  • Compare cost of holding capital on balance sheet vs cost of reinsurance
  • Incentivise management as part of targeted incentive programme
  • Assist in modelling cashflow requirements, assessing volatility of reserves and in setting appropriate prices / premiums
  • Set risk limits
  • Meet statutory reserving requirements/tests
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9
Q

What are tje two types of capital models

A
  • Generic
  • Internal
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10
Q

Describe an internal capital model

A
  • Gives company-specific view of the capital needed and aims to cover …
    … all the risks faced in a consistent way allowing for interactions between risks
  • Subjective- results must be used with care
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11
Q

What are the 6 stages of implementing a successful internal model?

A
  • Identify purpose of the model
  • Identify and rank key risks to be modelled
  • Choose simulation approach for each risk
  • Select appropriate risk metrics
  • Decide on modelling criteria
  • Determine an implementation method
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12
Q

Compare generic and internal models

A
  • Generic modelnused to simulate general environment in which company operates. The model may produce expected profit info / consider risk of incolvencu
  • Generic models developed by regulatory bodies or investors, while internal developed by management to assess capital needs
  • Generic models may be tailored to some degree to company, while internal models allow for specific circumstances of company concerned and so more accurate and useful in decision-making processes
  • Good internal models can break up and aggregate capital requirements between diff lines of business with a view to improve overall capital return
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13
Q

What are the factors to consider when choosing an internal model over a generic one

A
  • Regulation - allowed? scrutiny? approval?
  • Needs of company
  • Size of business? * Type of business and model complexity?
  • Diff models for diff parts of company?
  • Enough resources, expertise and data?
  • Monitoring and disclosure requirements?
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14
Q

How are capital models used in ORSA

A
  • Must analyse ability to continue business and risk management and financial resources need to so over a longer time horizon than that used for regulatory capital
  • Must address quantitative and qualitative features in medium and long term strategy and include projections of future financial position and modelling an insurer’s ability to meet future regulatory requirements
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15
Q

Considerations when using models for ORSA

A
  • Time period used
  • Must financial positions be assessed at point in time or once specific liabilities have run off?
  • Management actions to be modelled in general and in times of crises
    *Reliability of long-term forecasts
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16
Q

What are the two methods to calculating economic capital requirements?

A
  • Theoretical
  • Practical
17
Q

Outline the theoretical approach to calculating economic capital

A

Let K(t) be capital requirement at time t and A(t) and L(t) be value of assets and liabilities

K(0) = A(0) - L(0) where K(0)>0 with known certainty
K(t( = A(t) - (t) is an unknown random variable

to avoid ruin, K(t) > 0 for all t>= 0
Can ensure K(0) is high enough st:
P[K(t) >= kL(t)] = 1- alpha or
P[A(t) - L(t){1+k} >= 0] = 1-alpha

18
Q

What are the limitations of using the theoretical approach?

A
  • Difficult to obtain consistent valuations for assets and liabilities
  • Need to select appropriate risk measure
  • Difficult to formulate necessary assumptions
  • Large # of parameters needed&raquo_space; exponentially increases with # of variables
  • Difficult to derive robust estimates of various parameters needed
  • K is only considered at discreter tme points- ruin may occur between these points
19
Q

List the practical ways in which economic capital can be calculated

A
  • Ruin probability
  • Economic cost of ruin
  • Full economic scenarios
  • Stress tests
  • Factor tables
  • Stochastic models
  • Statistical methods
  • Credit risk
  • Operational risk
  • Option pricing
20
Q

Describe a generic model

A
  • Used by capital providers and regulators to get consistent assessment of capital requirements across different firms
  • Usually simple, e.g. factor based approaches
21
Q

Why is the complexity of generic capital models increasing?

A
  • Increasing sophistication of internal risk management processes
  • Previous models failing to appropriately deal with risk
  • Increasing pressure to optimise capital
22
Q

Outline the main uses of capital models for an insurer

A
  • Determine regulatory capital requirements
  • Know amount of capital needed to withstand certain level of loss as part of internal risk control processes

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