Capital Requirements

Question 1

Regulatory capital: what is regulatory solvency capital comprised of

Answer 1

It is a total of:
• the prudential margins in the regulatory liability valuation basis
• an amount of additional solvency capital in excess of the regulatory provisions

There are different approaches to the balance between these two components

An approach that uses prudent provisions and simple formula-based additional capital requirements makes it more difficult to:
• compare providers (different levels of prudence)
• ensure that there is sufficient security provided to policyholders (not risk-based)

Question 2

Pillars of Solvency II

Answer 2

1. Quantification of risk exposures and capital requirements
2. A supervisory regime
3. Disclosure

Question 3

Levels of capital requirements under Solvency II

Answer 3

Minimum capital requirement (MCR)
The threshold at which companies will no longer be permitted to trade

Solvency capital requirement (SCR)
The target level of capital below which companies may need to discuss remedies with their regulator

Question 4

Ways SCR may be calculated

Answer 4

• a prescribed standard formula
Which makes approximations and aims to capture the risk profile of an average company

• an internal model
Which is more complex to implement but can better reflect the actual risk profile and business structure of the company

Question 5

The Basel records which set out regulatory capital requirements for banks
What does it include

Answer 5

1. Capital requirements are assessed for each of credit, market and operational risk
2. These are aggregated without any allowance for diversification
3. Additional capital conservation and countercyclical capital buffers must be held

Question 6

Economic capital

Answer 6

The amount of capital that a provider determines is appropriate 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 an internal, rather than a regulatory, capital assessment

Typically it will be based on:
• risk profile of the individual asset and liabilities in its portfolio
• correlation of the risks
• business objectives of the provider
• desired level of overall credit deterioration that it wishes to be able to withstand

In an economic balance sheet assets and liabilities are valued at market/fair value, and the excess of assets over liabilities (i.e. the available capital) is compared to the economic capital requirement

Question 7

Internal models

Answer 7

They are used to calculate economic capital requirements and may be used to determine capital requirements under both Solvency II and Basel, rather than using the standardized approach. This is subject to regulatory approval

Companies can use internal models to:
• calculate economic capital using different risk measures, e.g. VaR and Tail VaR
• calculate confidence levels 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

Question 8

Capital requirements and profitability

Answer 8

Pricing of financial products should allow for the cost of holding required capital (lower return due to restrictions on investments, opportunity costs)

The lower investment profit (i.e. investment return earned on available capital) is then offset by the additional trading profit earned from the cost of capital allowance in the premiums