Ch 37: Capital requirements

Question 1

List 2 types of assessments of capital

Answer 1

1. Regulatory capital

2. Economic capital

Question 2

Define regulatory capital

Answer 2

Regulatory capital is capital required by the regulator to protect against the risk of statutory insolvency.

Question 3

List 3 types of liabilities covered by provisions

Answer 3

1. Liabilities that have accrued but which have not yet been paid.
2. Claims that have incurred but not yet settled.
3. Future (unexpired) periods of insurance against which premiums have been received but where the risk event has not yet occurred.

Question 4

Define the solvency capital requirement

Answer 4

The solvency capital requirement is the TOTAL ASSETS REQUIRED to be held IN EXCESS of provisions that are calculated on a best estimate basis.

It therefore comprises:
- any excess of the provisions established on a regulatory basis over the best estimate valuation of the provisions

• any additional capital requirement in excess of the provisions established.

Question 5

Outline the relationship between the provisions and the additional capital requirement

Answer 5

In some territories, or for some types of financial provider:

• the regulatory basis used for the provisions is best estimate
• and additional capital requirement is substantial

In other territories, or for other types of financial provider:

• the regulatory basis used for the provisions is significantly more prudent than best estimate
• the additional capital requirement is small (or zero)

Question 6

Give 2 disadvantages of a regime where provisions are determined on a prudent basis and additional solvency capital requirements are based on simple formulae

Answer 6

1. The levels of prudence within the provisions can vary between providers, making comparisons difficult.
2. The solvency capital requirements are not risk-based, making it difficult to ensure that sufficient security is provided for policyholders

Question 7

What is Solvency II and what are the three pillars on which it is based?

Answer 7

Solvency II is a solvency regime for insurance companies. It is a regulatory requirement for all EU states.

The three pillars are:

1. Quantification of risk exposures and capital requirements (quantitative).
2. A supervisory regime (qualitative).
3. Disclosure requirements (… and supervision).

Question 8

What are the 2 levels of capital requirements under Solvency II?

Answer 8

1. The MCR (Minimum Capital Requirement) is the threshold at which companies will no longer be permitted to trade.
2. The SCR (Solvency Capital Requirement) is the target level of capital below which companies may need to discuss remedies with their regulators.

> If SCR is breached, then risk management tools can be implemented, alongside:

• closing to new business
• moving to a better matched investment position

Question 9

Outline 2 methods that could be used to calculate the SCR.

Answer 9

1. A standard formula prescribed by regulation
2. A company’s own internal model (usually a stochastic model reflecting the company’s own business structure), which may be benchmarked against the standard formula output.

SCR TARGETS: 0.5% Ruin Probability in 1 year period

(An internal model is likely to be used by the largest companies who can afford the considerable extra work needed to justify using an internal model)

Question 10

Outline how the standard formula determines the amount of capital to hold

Answer 10

The standard formula determines the capital requirement through a combination of:

• stress tests
• scenarios
• factor-based capital changes

It allows for the following types of risks:

• underwriting
• market
• credit/default
• operational

It aims to assess the net level of risk allowing for diversification and risk mitigation options.

(The various risks are aggregated using a CORRELATION matrix, to make allowance for any diversification benefits)

Question 11

Give one advantage and one disadvantage of using the standard formula to determine a provider’s capital requirements

Answer 11

Advantage:
- The SCR calculation is less complex and less time consuming

Disadvantage:
- It aims to capture the risk profile of an average company, and so it is not necessarily appropriate to the actual companies that need to use it.

Question 12

Other than deriving Solvency II capital requirements, state 4 uses of internal models

Answer 12

1. To calculate economic capital using different risk measures, such as VaR and TailVaR.
2. To calculate levels of confidence in the level of economic capital calulated.
3. To apply different time horizons to the assessment of solvency and risk.
4. To include other risk classes not covered in the standard formula.

Question 13

What is the purpose of the Basel Accords?

Answer 13

These accords set requirements for the amount of capital that banks need to hold to reflect the level of risk in the business that they write and manage.

Question 14

Define economic capital

Answer 14

Economic capital is the amount of capital the provider determines it is appropriate to hold given its assets, liabilities and business objectives.

It is typically based on:

• the risk profile of the individual assets and liabilities in its portfolio
• the correlations of the risks
• the desired level of overall credit deterioration that the provider wishes to be able to withstand (ruin probability)

Question 15

What is the starting point in an economic capital assessment?

Answer 15

The starting point is to produce an economic balance sheet to calculate how much capital is available on a market value basis. This will enable the provider to compare the economic capital requirement with that it has available - and hopefully the former will be less than the latter.

The available capital is calculated as: (MVA - MVL)
the market value of the provider’s assets (MVA) …
LESS…
the market value of the provider’s liabilities (MVL).

The economic capital requirement will then be assessed using a risk-based approach and the techniques described in the chapters on the risk management control cycle.

Question 16

State how providers can obtain market values of assets, and outline two approaches that can be used to determine market values of liabilities for inclusion within the economic balance sheet.

Answer 16

Market values of assets are usually easily and instantly available from the financial markets.

Determining the market value of liabilities is not so easy and requires a high level of judgement to determine a market consistent (or fair value) liability values. One possible approach is to determine the expected present value of the unpaid liabilities on a best estimate basis and add a risk margin.

(Other approaches were covered in the Valuation of liabilities chapter)

Question 17

Outline the 2 components into which the profit made by a financial product provider can be split.

Answer 17

The profit made by a financial product provider can be expressed as:
1. Trading profit = premiums plus investment income on provisions (and on net cashflows received), less claims, expenses, tax and the net increase in provisions.

2. Investment profit = investment return (net of tax and investment expenses) on available capital.

Question 18

Explain what is meant by the ‘cost of capital’ and its relevance to the pricing of financial products and the generation of profit

Answer 18

‘Cost of capital’ reflects the likelihood of investment restrictions on capital that is earmarked to support in-force business. This means that the investment return earned on that capital is not as high as if it could have been used for some other purpose. The reduction in achieved return that results from this lower investment freedom is the ‘cost of capital’. Alternatively, it may be considered to be the ‘opportunity cost’.

The premium (or charges) for a financial contract should include and allowance for the loss of return on capital tied up in the contract, i.e. the ‘cost of capital’. This will lead to higher premiums (or charges).

The aim of the product provider is that shareholders should earn the same return on available capital, whether used to support business issued or invested freely. If being held as ‘required capital’ investment profit is restricted - but additional trading profit is earned from the ‘cost of capital’ allowance built into the premiums (or charges).

The launch of new financial products should strike a balance between RISK AND RETURN. The Risk-Adjusted Return on Capital (RAROC) can be compared to the risk appetite of the firm.

Question 19

Two broad methods of estimating the needed regulatory capital (estimating value of liabilities + reg. capital)

Answer 19

1) Best estimate basis (with risk margin) + High Solvency Capital Requirement
2) Prudent basis + Low Solvency Capital Requirement

Question 20

Why do Capital Allocation?

Answer 20

Total required capital needs to be allocated in a fair way across products/business units/segments.

• for business planning (strategy)
• for performance measurement (return on capital)
• for pricing (cost of capital)

Capital allocation usually applies to the economic capital.

The main advantage is to disaggregate the diversification benefit across business lines, in a risk-proportional/adjusted manner.

Question 21

How to measure return?

Answer 21

Total profit = trading profit + investment profit (net of charges and tax)

Profit does not account for:

• the risks taken in getting the profit
• the opportunity cost of holding the capital

Some better suited risk-adjusted return measures are:

• Cost of capital
• Economic Income Created (EIC)
• Risk-adjusted return of capital (RAROC)

Question 22

Give an overview of ORSA

Answer 22

Under Solvency II (Pillar 2), all firms are required to consider their internal economic capital requirements under the ORSA.

ORSA’s purpose is to provide management of insurance company with an assessment of:

• adequacy of risk management
• its current and likely future solvency position

ORSA requires:

• identification of risk to which it is exposed
• identify risk management processes and controls in place
• quantify its ongoing ability to meet solvency capital requirements (MCR/SCR)
• forecasting financial positions over periods longer than required by regulatory capital requirements
• analyse quantitative and qualitative elements of business strategy
• analyse relationship between risk management and the level/quality of financial resources available.

ORSA is a tool for improving insurance business practices, which allows for a better (and more holistic) risk management process.

Question 23

Give 2 Risk-Return Measures

Answer 23

1. Risk-adjusted return on capital.
   - RAROC = (risk - adj. return) / Capital

Uses of RAROC:

• can be used to compare different and diverse business activities
• can be based on actual or expected returns / actual or expected capital
• can be calculated for an institution as a whole

2. Economic Income Created
   - EIC = (RAROC - hurdle rate) * Capital

Uses of EIC:

• captures quantity of returns generated, when considering risk and opportunity cost of using the capital
• used to encourage MARGINAL growth opportunities (which may not meet RAROC criteria)
• The hurdle rate is the return on capital of standard business activities

Question 24

What is Capital Allocation, and how does it affect pricing / risk controls / performance measurement?

Answer 24

Capital allocation splits financial resources (capital) between business units. The capital Allocation process links RISK and performance, for each business unit.

The amount of capital that is allocated to each business unit:

• determines the business unit’s performance (as measured by RAROC for ex.)
• could affect the remuneration of the unit managers and their level of motivation and behaviour
• dictates the amount of business that each unit can write
• determines the price at which business is written (e.g. minimum price to satisfied required RAROC)

Allowance should be made for concentrations/ diversification of risk

• aggregate risk across business units, adjust for correlations, and allocate capital accordingly. Can be modelled in a dependency structure, such as a copula.
• calculate capital required at enterprise level (which allows for diversification across business units), and then allocate capital in a FAIR way across all units, including the diversification benefit