Ch37: Capital requirements Flashcards
Two approaches to determine capital required
- Best estimate approach to the calculation of provisions with an additional risk margin plus significant further capital to be held as a buffer for general adverse experience. (Solvency II)
- Significantly more prudent approach to calculation of provisions plus a much smaller amount of capital to be held as a buffer.
* Has disadvantages: - Levels of prudence may vary between providers, making ot difficult to make comparisons & SCR’s are not risk based - making ot difficult to ensure sufficient security is provided to policyholders
Solvency II framework pillars
- Quantification of risk exposures and capital requirements - MCR + SCR and ruels for valuing assets and provisions for liabilities
- Supervisory regime - Qualitative aspects (such as internal controls and risk management processes) + company’s own view of its strategic capital needs
- Disclosure requirements - public and private to regulator
MCR and SCR
- MCR: Threshold at which companies will no longer be permitted to trade - same for all companies in industry
- SCR: Target level of capital below which companies may need to discuss remedies with their regulators
* Can be standard formula, full internal model or vary between
* 0.5% ruin probability in 1 year (VaR)
* i.e. Risk-based
Basel three pillars
- Quantify min capital requirements for their main risks: credit, market and operational. Risks assessed seperately and capital reqs for each type of risk are then aggregated, whithout allowance for diversification (might only be Basel II; Basel III more sophisticated)
- On top of min requirements: Capital conservation buffer & countercyclical capital buffer
- In addition to above, banks regulated and supervised by national regulator who may require banks to hold greater capital in excess
Economic capital definition
Amount of capital that a provider determines is appropriate to hold given its assets, its liabilities and its business objectives
Purpose of ORSA (Own Risk Solvency Assessment)
Provide board and senior management of an insurance company with an assessment of:
* The adequacy of its risk management
* its current, likely future, solvency position
ORSA requires each insurer:
* Identify risks to which it is exposed
* Identify the risk managemnet processes and controls in place
* To quantify its ongoing ability to continue to meet its solvency capital requirements (MCR & SCR)
* Involves projections of financial position over terms longer than that normally required to calculate regulatory capital requirements
* To analyse quantitative and qualitative elements of its business strategy
* To identify the relationship between risk management and the level and quality of financial resources needed and available
Economic capital determined based upon:
- Risk profile of individual assets and liabilities in its portfolio
- Correlation of the risks
- Desired level of overall credit deterioration that the provider wishes to be able to withstand
Banks’s ICAAP (Internal Capital Adequacy Assessment Process) ensures:
- Appropriate identification and measuremnet od balance sheet risks
- Appropriate level of internal capital in relation to bank’s risk profile
- Application and further development of suitable risk management systems
Standard formula for SCR
- Capital requirement is determined through a combination of stress tests, scenarios and factor-based capital charges
- Standard formula allows for:
* Underwriting risk (premium, mortality, morbidity, expense, lapse)
* Market risk
* Credit/default risk
* Operational risk - Solvency II aims to assess the company’s net risk, i.e. determine capital requirement after recognising all risk mitigation arrangements in place
- Factor-based charges is a simple mechanism for calculating cap reqs: E.g. factor x sum at risk = determine cap req in relation to mortality risk
- Allows for diversification benefits by specifying how component parts should be aggregated
- Advantages: Less complex and time consuming
- Disadvantages: Aims to capture risk profile of an average company, approximatins are made in modelling risks - may not be necessarily appropriate to the actual companies that need to use it
Internal model of risks
- Need to gain regulatory approval
- Aim to create stochastic model that reflects company’ss own business structure
- More sophisticated
- Can automatically allow for correlations between different risk scenarios
- Risk measure then used to determine cap req - such as VaR
Can also use internal models:
* To calculate economic capital using different risk measures such as VaR or TailVaR
* To calculate levels of confidence in the level of economic capital calculated
* To apply different time horizons in assessment of solvency and risk
* To include other risk classes not included in standard formula
