CH36 - Capital requirements

Question 1

A regulatory solvency capital requirement is the total of (2)

Answer 1

1. the prudential margins in the regulatory liability valuation basis
2. 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) and to ensure that there is sufficient security provided to policyholders (not risk-based).

Question 2

Solvency II pillars

Answer 2

Solvency II is based on three pillars:

1. quantification of risk exposures amd capital requirements
2. a supervisory regime
3. disclosure

Question 3

Solvency II levels of capital requirements

Answer 3

Solvency II has two levels of capital requirements:

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

Question 4

SCR formula

Answer 4

The SCR may be calculated using a prescribed standard formula or a company’s internal model.

Using the standard formula has the advantage that the SCR calculation is less complex and less time-consuming. However, the standard formula has the disadvantage that it aims to capture the risk profile of an average company, and approximations are made in modelling risks which mean that it is not necessarily appropriate to the actual companies that need to use it.

Question 5

The Basel Accords

Answer 5

The Basel 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 6

Economic capital

Answer 6

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.

Question 7

Economic capital is determined by (3)

Answer 7

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

Question 8

Economic balance sheet

Answer 8

In an economic balance sheet:

1. Assets and liabilities should be valued at market values, and the excess of the assets over liabilities (i.e. the average capital) should be compared to the economic capital requirement
2. One way to calculate the market value of liabilities is to use the present value on a best estimate basis and add on a risk margin

Question 9

Internal models

Answer 9

Internal models are used to calculate economic capital requirements and may be used to determine Solvency II SCR (provided the internal model gains regulatory approval).

Internal models aim to create a stochastic model that reflects a company’s own business structure.

Question 10

Uses of internal models by companies (4)

Answer 10

1. to calculate economic capital using different risk measures, e.g. VaR and Tail VaR
2. to calculate levels of confidence in the level of economic capital calculated
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 11

Capital requirements and profitability

Answer 11

Profit can be split into trading profit and investment profit, where investment profit is the investment return earned on available capital.

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 is then offset by the additional trading profit earned from the allowance for the cost of capital built into the premiums.