36 - Capital Requirements Flashcards

1
Q

Provider of financial benefits will need to hold provisions for:

A
  • Liabilities that have accrued but not yet been paid
  • Future period of insurance for which premiums have been received
  • Claims already incurred but which are yet to be settled
  • Regulators to be able to ensure that financial promises made to the member of the public will be kept
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2
Q

What is solvency capital?

A
  • The amount of capital required by regulations to be held in excess of the provisions calculated on a best estimate basis (Solvency II)

OR

  • Regulator may require provisions to be calculated on a basis significantly more prudent than best estimate and only a much smaller (or zero) amount of capital required on top of provisions.
  • Both approaches would yield effectively the same solvency capital
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3
Q

The security provided by a regulatory regime is measured by:

A

The regulator monitored adequacy of:

  • Provisions set aside against future liabilities
  • Capital set aside against future liabilities
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4
Q

How does a regulator ensure that the calculation of provisions and capital is sufficiently prudent?

A
  • Regulator may prescribe assumptions & methodology used for calculations
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5
Q

In some countries provisions are set on prudent basis and/or additional solvency capital reqs are based on simple formulae, what is the impact of this?

A

This has the disadvantages that:

  • Levels of prudence within provisions vary between providers, making it difficult to make comparisons
  • Solvency capital requirements calculated by simple formulae are not risk-based:
    o Difficult to ensure that sufficient security is given to policyholders
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6
Q

What are the 3 pillars of the Solvency II framework?

A
  • Quantification of risk exposures & capital reqs. (1)
  • Supervisory regime (2)
  • Disclosure requirements (3)
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7
Q

What processes does Pillar I deal with?

A
  • Valuation of assets
  • Valuation of provisions for liabs.
  • Determining the two levels of capital req. :
    o Min. Cap. Req. (MCR) - Threshold at which companies are no longer permitted to trade and below which companies are technically insolvent
    o Solvency Cap. Req. (SCR) - Target level below which companies may need to discuss remedies with regulator to avoid technical insolvency
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8
Q

Remedies that companies might undertake after breaching the SCR:

A
  • Increase level of available capital using cap. management tools
  • Close to new business
  • Move to a less risky better matched investment position
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9
Q

What does Pillar II deal with?

A
  • Assessing company’s internal controls
  • Assessing company’s risk management processes
  • Assessing company’s economic capital requirements
  • Regulator might make monitoring visits to the company
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10
Q

What does Pillar III deal with?

A
  • Public disclosure requirements for the company

- Private disclosure requirements by the company to the regulator

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11
Q

What tools does may a company use to determine its SCR?

A
  • A standard formula prescribed by the regulator
  • A company’s internal model (benchmarked against std. formula’s output)
    o Regulator can compel a company to develop an internal model if std. model does not suit the risk profile of the company
    o Considerable effort to justify internal model, large companies likely to find that capital saved is worth the effort
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12
Q

Why is SCR said to be a risk based calculation?

A
  • It is calculated by assessing the cap. required for each risk against a 0.5% ruin probability in 1 year
  • Various risks are aggregated in a correlation matrix to allow for diversification benefits
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13
Q

How is economic capital requirement defined? How does this fit into Solvency II?

A
  • The amount of capital that a provider determines is appropriate to hold given its assets, liabilities and business objectives
  • Pillar II requires companies to assess their internal economic cap. req. under ORSA (Own Risk & Solvency Assessment)
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14
Q

What is economic capital requirement determined based on?

A
  • Risk profile of individual assets & liabilities in the portfolio
  • Correlation between the risks
  • Amount of credit deterioration the provider wishes to be able to withstand
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15
Q

How is risk appetite commonly defined?

A

Requirement for the company to hold an amount of capital that is based on the regulatory capital requirements.

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16
Q

What are the contents of an economic balance sheet? How to use it for capital requirement assessment?

A
  • First stage of capital requirement assessment
  • Shows MVA MVL and provider’s available capital (MVA-MVL) (mkt-consistent basis of valuation)
  • Available capital compared with economic cap. req. to assess provider’s solvency status
17
Q

What practices are followed when determining capital requirement using a standard model?

A
  • Stress tests
  • Scenario tests
  • Applying factor based capital charges
18
Q

What types of risks does the standard model allow for?

A
  • Operational risk
  • Credit/Default Risk
  • Underwriting Risk
  • Market Risk
19
Q

Advantages/Disadvantages of using the standard model?

A
  • Solvency Capital Requirement calculation is less complex and less time-consuming.
  • Approximations are made in modelling risks aimed at reflecting risk profile of average companies => It is not necessarily appropriate to modelling the risk profile of actual companies that use it
20
Q

What is the alternative to a standard model? What does it entail?

A
  • Internal models are used as alternatives to the standard
  • These are stochastic models tailored to reflect the company’s business structure/risk profile
  • Automatically allows for correlations b/w different risk scenarios
21
Q

What are the uses of internal models in companies?

A
  • Calculating economic capital reqs. wrt diff. risk measures
  • Calculate levels of confidence in economic cap. calculated
  • Applying different time horizons to assessment of solvency and risk
  • Include other risk classes not covered by std formula
22
Q

What are the components parts of profit for a financial product provider?

A
  • Investment profit (investment return on available capital less expenses and tax)
  • Trading profit (premiums + investment returns on provisions - claims - expenses - tax - net increase in provisions)
23
Q

Why to allow for cost of capital in pricing?

A
  • To cover the opportunity cost of having capital tied up to support the business written (determined on a regulatory basis or economic basis)
  • This loss on return should be priced for in the premium
  • Aimed at providing investors with a similar return whether they invest in the business or freely elsewhere