Ch 37: Capital requirements

Question 1

What are the two components of Regulatory Solvency Capital?

Answer 1

1) The prudential margins in the regulatory liability valuation basis.
2) The amount of additional solvency capital in excess of the regulatory provisions.

Question 2

What is the use of the additional solvency capital in the regulatory solvency capital?

Answer 2

Used as an estimate of non-financial risk

Question 3

What does a provider of financial benefits have to hold provisions for?

Answer 3

1) Liabilities that have accrued but which have not been paid.
2) Future periods of insurance against which premiums have already been received.
3) Claims already incurred but which have yet to be settled.

Question 4

Give the advantages and disadvantages or using formula-based additional capital requirements

Answer 4

Adv:
- Simple and easy to implement

Disadv:
- Makes it more difficult to compare providers who use different levels of prudence
- not a risk-based approach

Question 5

Give the 3 pillars for Solvency II

Answer 5

1) Quantification of risk exposures and capital requirements
2) A supervisory regime - internal capital requirements
3) Disclosure

Question 6

Give the 2 levels of capital requirements under Solvency II

Answer 6

1) Minimum Capital Requirements (MCR) - below which the company is technically insolvent and may no longer conduct business
2) Solvency Capital Requirement (SCR) - under which companies require attention from the regulator

Question 7

Give the advantage and disadvantage of using standard formula in the SCR calculation

Answer 7

Pros:
- Less complex
- Less time-consuming

Cons:
- Aims to capture the risk profile of an average company
- This may not be appropriate for the actual companies that need to use it

Question 8

Give the 3 pillars for the Basel Accords

Answer 8

1) Minimum capital requirements
2) Risk management and supervision
3) Market discipline and disclosure

Question 9

Define: Economic capital

Answer 9

It is the amount of capital that a provider determines is appropriate to hold given its assets, liabilities and business objectives.

It is typically determined based upon:
1) The risk profile of the individual assets and liabilities in its portfolio
2) Correlation of the risks
3) The desired level of overall credit deterioration that the provider wished to be able to withstand.

Question 10

Give the factors that determine economic capital (3)

Answer 10

1) The risk profile of the individual assets and liabilities in its portfolio
2) Correlation of the risks
3) The desired level of overall credit deterioration that the provider wished to be able to withstand.

Question 11

Under which pillar of Solvency II does Own Risk and Solvency Assessment (ORSA) fall under?

Answer 11

Pillar 2: A supervisory regime
The company’s own solvency regime

Question 12

Give the main purpose of the ORSA (2)

Answer 12

Provides management with assessment of:
1) Adequacy of its risk management
2) Its current, and likely future, solvency position

Question 13

Give the requirements of the ORSA on financial providers (5)

Answer 13

1) Identify the risks to which it is exposed.
2) To identify the risk management process and controls in place.
3) To quantify its ongoing ability to continue to meet its solvency capital requirements - projections of financial position.
4) To analyse quantitative and qualitative elements of its business strategy.
5) To identify the relationship between risk management and the level and quality of financial resources needed and available.

Question 14

What is “ICAAP” and which pillar in the Basal Accords does it fall under?

Answer 14

International Capital Adequacy Assessment Process
- and it falls under pillar 2: Risk management and supervision

Question 15

Give the purpose of the ICAAP

Answer 15

ICAAP enables banks to:
1) Identify, measure and aggregate material risks that it faces.
2) Calculate the economic or internal capital necessary to cover the risks.

Question 16

Give the main aim of internal models in Solvency II

Answer 16

Aim to create a stochastic model that reflects the company’s own business structure.
Used mainly to calculate Economic Capital.

Question 17

Give the main uses of internal models with regards to Required Capital

Answer 17

1) To calculate economic capital using different risk measures - Var and TVaR.
2) To calculate levels of confidence in the level of economic capital required.
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 18

How does pricing allow for Capital requirements? (3)

Answer 18

1) Pricing of financial products should allow for the cost of holding the required capital
2) Return on the capital is lower due to restrictions on investments, since it now needs to be more liquid or cant be used for other, higher expected return, investments. This has an opportunity cost.
3) Lower investment profit is offset by the additional trading profit earned from allowance for Cost of capital built into premiums.

Question 19

What is the main purpose of allowing for required capital in the pricing models of financial products?

Answer 19

The lower investment income from the solvency capital can be offset by the additional trading profits earned.

Question 20

Why is Capital allocation important in a business model?

Answer 20

1) Business planning
2) Measure business performance (Return on capital)
3) Pricing purposes
4) Risk control limits

Question 21

Give two performance measurements that take risk into account (i.e. risk-return measures)

Answer 21

1) RAROC - Risk Adjusted Return On Capital
2) EIC - Economic Income Created

Question 22

Give the disadvantages of using a factor-based approach for calculating the required capital (4)

Answer 22

1) The large number of factors required to capture all the risk that insurance companies may face.
2) The factors may have been chosen to be appropriate for a typical insurance company with typical risks - they are unlikely to be suitable for all companies
3) This approach may not be appropriate to deal with some types of risk - catastrophes
4) To retain an appropriately stringent capital requirement in different conditions, the factors would need to be updated in the light of changing conditions - changing asset values and risks

Question 23

Explain why the factor-based approach for calculating required capital may lead to higher amounts of capital held on average

Answer 23

It is seen as an approximation and this would probably be leaning towards a prudent view since it is regulatory capital
- Too much is safer than too little

Question 24

Describe the main components of determining a company’s economic capital position

Answer 24

1) Economic capital requirement
2) Economic capital available

Question 25

Describe how a company can assess its required economic capital.

Answer 25

1) This is the amount the company determines is appropriate to hold given its assets, liabilities and its business objectives.
2) Based upon 3 factors:
- risk profile
- correlation of risks
- acceptable level of credit deterioration
3) For each major risk, a stochastic distribution/model is required.
4) Projection of the balance sheet in a large number of future scenarios
5) A risk measure needs to be chosen - VaR or TVaR

Question 26

Describe how a company may evaluate its available economic capital

Answer 26

1) Economic balance sheet - market value of assets and liabilities
2) Market value of liabilities can be determined using a discounted cashflow approach
3) Economic capital is the excess of assets over liabilities
4) Asset market values are not readily available for all asset classes - property
5) Consider the availability and cost of further capital

Question 27

Give the advantages of using standard formula in the SCR calculations under Solvency II

Answer 27

1) Less complex, less time-consuming and resource-intensive
2) Attractive to smaller companies with less modelling expertise and resources
3) Avoids considerable work of developing an internal model
4) The relative cost of developing an appropriate internal model may outweigh the advantages gained from that model, and potentially having a lower SCR
5) It is time consuming and costly to achieve regulatory approval for an internal model to calculate SCR

Question 28

Give the disadvantages of using standard formula in the SCR calculations under Solvency II

Answer 28

1) Calibration of the formula is based on the average company and is thus an approximation
2) Inappropriate for a company with a different risk profile than the average, either lower or higher
3) Companies may have sophisticated risk management systems and thus a lower SCR
4) The company may already be developing an internal model and this might reduce these inconsistencies at a lower cost than developing a model from scratch

Question 29

Give the similarities between regulatory capital and economic capital requirements

Answer 29

1) Both relate to the amount of capital that needs to be held in order that future obligations are met
2) An internal model may be useful for either calculation

Question 30

Give the differences between regulatory capital and economic capital requirements

Answer 30

1) Regulatory requirements assumptions are prescribed where economic assumptions are internally chosen.
2) Economic capital requirements are more likely to be modelled where regulatory methods are more likely to be factor-based.
3) Regulatory capital requirements may be defined in a number of ways, where economic capital requirements are the excess over the market value of liabilities.
4) Economic may be lower due to more sophisticated allowance for diversification of benefits
5) Economic requirements may be higher if:
- Take long-term strategic objectives into account
- Is very risk averse
- Use a more stringent risk measure such as TVaR compared to VaR
- Uses standard formula for regulatory but is riskier than the average company, which comes through in its own economic valuations
- May be targeting a higher credit rating