Ch 24: Supervisory reserves and cap reqs (2)

Question 1

Supervisory regulator’s primary concern?

Answer 1

• Ensure that insurance companies have sufficient assets to cover liabilities with a high degree of certainty.
• This could be achieved by:
  * Requiring insurance companies to hold reserves calculated on a prudent basis
  * Requiring a min level of solvency capital to be held
  * Requiring a combination of prudent reserves and solvency capital to be held.

Question 2

Theoretical def of market-consistent value of liability

Answer 2

• Price that someone would charge for taking responsibility of the liability in a market in which such liabilities are freely traded.
• In usual absence of such a market, approximate approach has to be taken

Question 3

Market-consistent methodology

Answer 3

• To determine liabilities, future unknown parameter values and cahsflows are set as to be consistent with market values, where a corresponding market exists
• Devise portfolio of assets whose cashflows exactly replicate those of the liabilities, then the current market price of this replicating portfolio is taken as the market value of the liabilities.
• Or disocunt cashflows at current risk-free rates of interest
• Risk-free rates determined based on government bond yields or swap rates (strip out credit risk)
• Regulations may allow company to take credit for illiquidity premium in corporate bond yields (therefore discount at a higher than risk free rate) (normally restricted to long-term predictable liabilities for which matching assets can be held to maturity i.e. not exposed to illiquidity risk/volatile yields. Added restrictions

Question 4

Market-consistent indicators for setting assumptions for elements of basis for which a deep market does not exist

Answer 4

• Mortality assumption based on risk premium rates quoted by reinsurance companies
• Expense assumption quoted by reference to expense agreements available in market (third party administration companies
• With-profit endowment assurances may be traded as investment vehicles (may be current market price)

Question 5

If no market exists for element of basis in market-consistent valuation, what is the procedure?

Answer 5

• Starting point would be best estimate assumptions
• Likely that a risk margin should be included due to inherent uncertainty and the compensation required by the market in return for taking on this uncertainty.
• Done by adding a margin to each assumption
• Alternatively, an overall margin in respect of these risks could be determined using the cost of capital approach:
  * Project required capital at each future time period (amount required in excess of projected liabilities) (in some regulatory areas just a % of reserves, but could be complex otherwise)
  * Multiply projected capital amounts by cost of capital (represents cost of raising incremental capital in excess of risk-free rate or opportunity cost of locking in capital at risk-free rates)
  * Discount using market consistent dicount rates to give overall risk margin

Question 6

Purpose of solvency capital requirements

Answer 6

• Require that life insurer maintain at least a specified level of solvency capital.
• Provides an additional level of protection for PHs against company holding too little reserves for their liabilities and from harmful effects of asset volatility

Question 7

Two approaches to reserving and solvency cap req mix

Answer 7

• Relatively realistic basis with small margins + substantial solvency cap req based on risk measures
• relatively prudent basis with large margins + relatively small solvency cap req not related to the risks borne by the company

Question 8

How is solvency cap req calculated

Answer 8

• May be a specified formula or based on risk measures such as VaR or the “run-off” method.
• The VaR is calculated by subjecting the supervisory balance sheet to stress tests on each of the identified risk factors in isolation, at the desired confidence level and over the defined period
• Run-off method determines the amount of capital needed at outset to ensure firms ability to cover liabilities untill the last policy has gone off the books, allowing for suitable stresses to the risk factors.
• The aggregated cap req combines the seperate stress tests to reflect any diversification benefits that exist between the various risks. This may be done through the use of correlation matrices or by copulas.
• Seperate allowance needs to be made in cap req calc for non-linearity and non-separability of individual risks, stochastic models used to quantify cap reqs in relation to economic risks (prob distribution can properly allow for extreme behaviour)

Question 9

Passive vs active valuation approaches def

Answer 9

• Passive valuation approach is relatively insensitive to changes in market conditions and has a valuation basis which is updated relatively infrequently
• Active approach is based more closely on market conditions with the assumptions updated on a frequent basis

Question 10

Advantages and disadvantages of passive valuation approaches (5 & 2)

Answer 10

• Tend to be straightforward to implement
• Involve less subjectivity
• Result in relatively stable profit emergence (if used for accounting purposes)
• Active results are more volatile and if all companies use it, risk of introducing systemic risk were all companies need to sell equities (enhances the market condition issues). Regulators include amendmends to approaches in such conditions
• Active more complex and calcs would take longer and be more costly

Disadvantages:
* Risk of becoming out of date - leading to overvalued assets/ undervalued liabilities which may provide a false sense of security and inappropriate management actions.
* Active approaches more informative in terms of understanding the impact of market conditions particularly in relation to options and guarantees