37. Capital requirements Flashcards
What are the two types of assessment capital?
- Regulatory Cap
- Economic Cap
What is regulatory Cap?
- Cap required by regulators
- Protect against risk of insolvency
List three types of liabilities covered by provisions for an insurer
- L that have accrued but which have not yet been paid
- Claims that have been incurred but not yet settled
- Future (unexpired) periods of insurnance against which premiums have been received but where the risk event has not yet occured
What is the solvency capital requirement?
- Total assets required to be held
- In excess of provisions
- Which are calculated on the best estimate basis
- Comprises of excess of provisions established on a regulatory basis over the best estimate valuation of provisions AND
- Additional capital requirement in excess of the provisions established.
What is the relationship between additional capital requirement and provisions?
In some territories:
- Reg basis used for provisions is best estimate
- additional cap req is substantial
In other territories:
- Reg basis used for provisions is significantly more prudent than the best estimate
- and additional cap req is small (zero)
Give two disadvantages of a regime where provisions are determined on a prudent basis and additional SCR are based on simple formulae
- Comparision is difficult - levels of prudence varies between providers
- SCR are not risk-based - Difficult to ensure security to PHs
What is Solvency II and what are the pillars?
- Solvency regime for insurance companies
- Regulatory requirement for all EU states.
Three pillars are:
- Quantification of risk exposure and capital requirements
- Supervisory regime
- Disclosure requirements
What are the two levels of capital requirements under solvency II?
- MCR- CANNOT TRADE IF BELOW
- SCR- target level of capital below which DISCUSS REMIDIES with regulators
What are the two methods to calculate the SCR?
- 1 Standard formula prescribed by regulation
- 2.Internal model (usually stochastic) => expensive
- Benchmarked against standard formula
- Large companies
How does the standard formula determine the amount of capital to be held?
Combination of:
- Stress tests
- Scenarios
- Factor-based capital charges
What are the disadvantages of factor based capital requirement?
4
- A large number of factors are needed to captures all the risks that insurance companies face
- The factors may be appropriate for average insurer with average risks - not necessarily suitable for all companies
- Simple calculation not appropriate to deal with some risks e.g. catastrophes
- Require constant maintenance with changing conditions e.g. change in assets avalues
What type of risks does the standard formula to calculate capital allow for?
- Underwriting risks
- Market risks
- Credit/default
- Operational
Aims to assess the net level of risk allowing for diversification and risk mitigation options
What the merits of the standard formula to calculate capital requirements?
- +SRC Calc less time consuming and less complex
- +Particulary attractive to small insurers
- +cost of work on interal could be greater than benefit from SCR savings
- -Aimed to capture risk profile of the average company=> not necessarily appropriate for all companies
- -Companies with sophisticated risk management systems and controls could benefit from interal models
- -Company may be using internal model for other purposes (e.g. economic capital position) - Cost of developing is lower as not starting from scratch
Other than deriving Solvency II capital requirements, what are the other four uses of the internal models?
- Calculate economic capital using different risk measures e.g. VaR and Tail VaR
- Calculate confidence levels in the level of Economic capital calculated
- Apply different time horizons to the assessment of solvency and risk
- Include other risk classes not covered in the standard formula
What is the purpose of Basel accords?
- Set Cap requirements for banks
- Must reflect the level of risk
- In the business they write+ manage
- Has three pillars similar to Solvency II
What three main risks must a bank quantify its capital requirements for, under Pillar I of the Basel regulations
- Credit risk
- Market risk
- Operational risk
Risks are considered separately and cap req aggregated with no allowance of diversification
What capital must banks hold in addition to MCR
CCB and CyCB
- Capital conservation buffer
- A countercyclical capital buffer
Regulator may require banks to hold capital greater than required by Basel regulations
What is economic capital REQUIREMENT?
- Amount of capital
- Provider determines
- Sufficient to hold (in excess of liabilities)
- To cover its risks under adverse outcomes
- Generally with a given degree of confidence and
- Over a given time horizon
It is typically based on the:
- Risk profile of individual A+L in the portfolio
- Correlation of risks
- Business objectives of the provider
- Level of credit deterioration that the provider wishes to be able to withstand
What is the starting point in an economic Capial assessment?
- Produce an economic balance sheet to calculate capital on market basis => Gives ‘Available capital’
- Available Cap compared with economic Cap requirement (happy if available cap is more)
- Economic cap req assessed using risk-based approach
- Economic avaible capital = MV(A) - MV(L)
How can providers determine MV(A) and MV(L) for the inclusion within the economic balance sheet
- MV(A)-Easily and instantly avaible from Financial markets
- MV(L)- EPV (unpaid liabilities on BE)+risk margin => requires judgement!
How is profit made from a financial products split?
2
- Trading profit = premiums + investment income on provisions and net cashflows - claims - expenses-tax - net increase in provisions
- investment profit = investment return (net of tax and investment expenses) on available capital
What is cost of capital? And its relevance to the pricing of financial products and the generation of profit?
7 pts
- Cost of capital refers to investment restrictions on capital backing in-force business.
- This capital earns a lower return than if it were used elsewhere.
- The reduction in return due to limited investment options is the cost of capital, also seen as an opportunity cost.
- Premiums or charges should include an allowance for the cost of capital.
- This allowance results in higher premiums or charges.
- The goal is for shareholders to earn the same return whether capital is freely invested or tied up.
- When used as required capital, the capital earns less investment profit but trading profit comes from the built-in allowance in premiums.
What is Solvency II Pillar 2 about
- Requires all insurance companies to consider their internal economic capital requirements under the ORSA
What is the purpose of ORSA (Solvency II pillar 2)
The purpose of Own Risk Solvency Assessment (ORSA) is to provide the board and senior management of an insurance company with the assessment of:
- The adequency of its risk management, and
- its current and likely future solvency position
