Chapter 18: Economic Capital

Question 1

Economic capital (definitions)

Answer 1

The additional value of funds needed to cover potential outgoings, falls in asset values and rises in liabilities at some given risk tolerance over a specified time horizon.

It can alos be defined as:
The funds needed to maintain a particular level of solvency at some given risk tolerance over a specified time horizon.

Question 2

Economic capital models

Answer 2

Economic capital is calculated using an economic cpaital model.

This is used to create simulations of the future financial state of an institution so that the range of potential outcomes can be analysed.
These outcomes are then used in the calculation of some measure of risk that allows for an assessment of the level of capital that should be held, given a pre-specified risk tolerance and time horizon.

Question 3

Internal capital model

Answer 3

Allows a firm to determine how much capital to hold to protect it against adverse events.

Question 4

Uses of internal capital models

Answer 4

• to decide how to allocate capital across business lines.
• to assess the amount of economic capital that should be held in respect of new products as they develop over time.
• to assess the impact of changes in investment strategy and the capital structure of an organisation.
• – to help to determine the optimal mixes of assets and funding sources.
• to look at how an organisation copes in the face of extreme events.
• – to determine risk limits, in terms of business taken on, investment and funding.
• to help measure performance.
• useful when carrying out due dilligence for corporate transactions, as they give an idea of the strengths and weaknesses of an organisation.
• they can also provide information over the financial state of an organisation to a regulator.

Question 5

Why are generic capital models often used?

Answer 5

Whilst internal capital models give a firm-specific view of the economic capital needed, they require thorough investigation by regulators if they are being used to calculate regulatory capital.

For this reason, generic capital models are sometimes used instead to give a consistent assessment of the capital required across a range of firms.

Question 6

Steps in designing an economic capital model

Answer 6

• agree what the model is for
• agree over the risks that will be modelled
• Decide on the approach to determine economic capital:
• — factor tables
• — deterministic approaches
• — stochastic approaches
• decide whether a model will be run on an enterprise-wide basis, or whether individual models will be run for each business line with the results being subsequently combined.
• decide on the nature of the output required

Question 7

Steps in running an economic capital model

Answer 7

• decide on the risk metric to be used
• consider the time horizon for calculation
• the risk tolerance must be determined
• decisions are also needed on management actions
• decision on whether the model is to be implemented on a run-off basis (assuming that no new business is won) or allowing for new business

Question 8

7 Examples of management actions (resulting from the economic capital model results)

Answer 8

• changes to investment strategy in response to performance
• sources and amounts of capital
• decisions on the withdrawal of particular products
• levels of reinsurance
• premium rates
• dividends payable
• bonuses payable on with-profits policies

Question 9

What does ‘risk optimisation’ mean?

Answer 9

That the highest return is achieved for the level of risk that is taken.