37 - Capital Requirements COPY Flashcards
Why do providers of financial benefits need to hold provisions?
- Liabilities that have accrued but which have not yet been paid
- Future periods of insurance against which premiums have already been received
- Claims already incurred but which have yet to be settled
What 2 components make up the regulatory solvency capital
- Prudential margins in the regulatory liability valuation basis
- Additional solvency capital in excess of regulatory provisions
What 2 approaches are available for balancing between regulatory capital components?
- Strong reserving with small SCR
2. Weak reserving with large SCR
State the disadvantage of using Prudent provisions and Simple formula based Capital requirements
It makes it difficult to compare providers and to ensure there is enough security to p/hs
State 3 Pillars of SII
- Quantification of risk exposures and capital requirements
- A supervisory regime
- Disclosure
Describe what Pillar I of SII covers
- Includes rules for valuing both the assets and provisions for liabilities
- Also includes the determination of two levels of capital requirement (MCR and SCR)
Describe what Pillar II of SII covers
Deals with qualitative aspects, covers eg
1. A company’s internal controls and risk management processes &
- The company’s own view of its strategic capital needs
- Firms are also required to consider their internal economic capital requirements under the ORSA
Describe what Pillar III of SII covers
Covers both public disclosure and private disclosure by the company to the regulator.
What are the 2 levels of SII Capital requirements
- MCR - the threshold at which companies will no longer be permitted to trade
- SCR - the target level of capital below which companies may need to discuss remedies with their regulators.
State 2 types of ways that can be used to calculate the SCR
- Standard formula
2. Internal model (considerable work needs to be done to justify usage)
What are the pros/cons of using the Standard model?
- Less complex
- Less time consuming
- Captures risk profile of average company
- Approximations made in modelling risks
- May not be appropriate to the companies that use it
- Can’t be used to calculate economic capital
What are BASEL accords?
These are global banking capital requirements
They set requirements for the amount of capital needed by banks to reflect level of risks in the business
List 3 Pillars of BASEL III
- Minimum capital requirements
- Risk management and supervisions
- Market discipline and disclosure
Describe what Pillar I of BASEL III covers
Includes rules for evaluating capital requirements for credit, market and operational risks
Describe what Pillar II of BASEL III covers
- Deals with addressing firm-wide governance and risk management.
- Also includes evaluation of all other major risk types in the bank
Describe what Pillar III of BASEL III covers
- Disclosure requirements include both public disclosure and private disclosure by the bank to the regulator
3, Ensures stakeholders are able to evaluate and scrutinise banks
Define Economic Capital
Economic capital is the amount of capital that a provider determines is appropriate to hold given its assets, its liabilities, and its business objectives.
It is an internal, rather than a regulatory, capital assessment.
What is Economic capital typically based upon?
- The risk profile of the individual assets and liabilities in its portfolio
- The correlation of the risks
- The desired level of overall credit deterioration that the provider wishes to be able to withstand.
What is ORSA?
ORSA is the company’s Own Risk and Solvency Assessment.
It links regulatory capital to economic capital.
What is the purpose of ORSA?
To provide the board and senior management of an insurance company with an assessment of:
- The adequacy of its risk management and
- Its current and likely future solvency position
What does ORSA require each insurer to do?
- Identify the risks to which its exposed
- Identify the RM processes and controls in place
- Quantify its ongoing ability to continue to meet its solvency capital requirements (SCR and MCR)
- Analyse quantitative and qualitative elements of its business strategy
- Identify the relationship between RM and the level and quality of financial resources needed and available
What is ICAAP?
Internal Capital Adequacy Assessment Process (ICAAP)
Used by Banks to assess and ensure their internal capital adequacy is sufficient over the long term
What are the purpose of ICAAP
ICAAP enables banks to:
- Identify and aggregate all material risks
- Calculate the economic or internal capital necessary to cover the risks
What does ICAAP require banks to do?
- Have a process for assessing their overall capital adequacy levels
- Supervisors should review and evaluate a bank’s ICAAP
- Supervisors should be able to require banks to hold capital in excess of the minimum levels
- Supervisors should require quick remedial action if capital levels are not maintained
Outline the constituents of an economic balance sheet
- Market value of assets (MVA)
- Market value of liabilities (MVL)
- Available capital = MVA - MVL
The available capital is then compared with the economic capital requirement to assess the provider’s solvency status
How does the Standard formula work in calculating capital requirements?
Through a combination of stress tests, scenario and factor based capital charges
What risks are allowed for by the standard formula
- Underwriting risk
- Market risk
- Credit risk
- Operational risk
What are factor based charges
Factor-based capital charges are a simple mechanism for determining capital requirements
Examples:
- Factor x sum at risk - to determine a capital requirement in relation to mortality risk
- Factor x reserves - to determine a capital requirement in relation to inadequate reserves
How do Internal models work in calculating Capital?
- Create a stochastic model that reflects a company’s own business structure
- Project a company’s balance sheet for each of a large number of scenarios
- Scenarios represent all risks a company faces
- A risk measure can be used to determine capital requirements
What can Internal models be used for?
- Calculate economic capital using different risk measures eg VaR, TailVaR
- Calculate levels of confidence in the 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 2 components make up and insurer’s profits?
- Trading profit (Premiums + Investment income – Claims – Expenses – Tax – Net increase in provisions)
- Investment profit - the investment return earned on available capital (less tax and investment expenses).
How does product pricing allow for capital?
- Pricing should allow for cost of holding capital
- Return on capital is lower due to restrictions on investments, opportunity cost)
- Lower investment profit is offset by the trading profit from the allowance of cost of capital in premiums
What are the 2 risk-return measures to measure return on capital?
- Risk-adjusted return on capital (RAROR)
2. Economic income generated
What is RAROC?
RAROC = (Risk adjusted return)/Capital
- Can be calculated for an institution as a whole
- Used to compare different business activities
Identifies activities that create/destroy shareholder value
Denominator commonly = Economic/Risk based capital
What is EIC
Captures the quantity of return generated by a unit of activity (ie it is monetary rather than a percentage)
EIC = (RAROC - hurdle rate)x Capital
How can EIC be used?
- Monetary amount so useful in encouraging marginal growth opportunities (eg activities that add value but not meet RAROC targets)
- If a proposed activity does not offer a RAROC above the hurdle rate, then that is one basis upon which it might rejected
Calculated total capital needs to be allocated at either business unit, product or other level, Why?
- Business planning
- Performance measurements (return on capital)
- Pricing purposes
- Risk control limits
Why do allocation methods need to allow for Diversification?
Risks are not likely to all occur at the same time (they are not perfectly correlated)
NOTE: Level of dependency may differ during times of distress
Tail dependency needs to be carefully considered as required capital is calculated with reference to extreme events
What approaches are available for allowing for diversification in allocating capital?
- Calculate the capital required for each business unit and/or risk category followed by an adjustment for the benefit of diversification
- Calculate capital required at enterprise level, then allocate this capital in a fair way across units, including diversification benefit
