Chapter 24 Flashcards
Why do supervisory authorities require insurers to hold solvency capital?
- To provide protection against asset fluctuations
- To provide protection against insufficient reserves under adverse experience
Describe the relationships that exist between the reserves and the solvency capital requirements.
- Strong supervisory reserving with small solvency capital
- Weak supervisory reserving with large solvency capital
How is the SCR determined?
It is determined using risk-based capital techniques.
What is the aim of the SCR?
To set aside an extra amount of capital where the amount is appropriate to the extent of the risks involved.
The level of solvency capital may be based on:
- A formula
- Risk measure (e.g. Var)
How is the VaR calculated?
By subjecting the supervisory balance sheet to stress tests:
* On each of the risk factors
* At a defined confidence level
* Over a defined period - fixed term or a runoff period (until the last policy has gone off the books)
* The surplus is recalculated at the end of the period, and this gives the capital requirement for each risk in isolation
Name an example of non-linearity of risks.
A one percentage fall in interest rates does not contribute the same increase in the capital requirement.
What is non-separability of risks?
If two events happen together the combined impact is worse than if they happen separately, e.g. longevity risk and expense risk for annuites.
What is used to quantify the capital requirements in relation to economic risks?
Stochastic models.
What is the role of the PDF assigned to the variable being modelled?
The PDF used should properly reproduce the more extreme behaviour of the variable being modelled, both in terms of:
* The size of the tail distribution
* The path taken during the simulation period
What are the two different valuation approaches?
Active and Passive.
Describe the active valuation approach.
- It is based on market conditions
- The basis is updated frequently
- Examples:
Market-consistent valuation of both A+L
Risk-based capital approach to solvency capital - In general, an active approach would be preferred
Describe the passive valuation approach.
- It is relatively insensitive to changes in market conditions
- The basis is updated infrequently
Assumptions may be “locked-in”
It may be a requirement that non-economic assumptions are updated if experience worsens, in order to recognise the related loss and the need for higher reserves - Suitable when the valuation of liabilities is largely ignoring market movements
- Examples: assets valued at book value and reserves calculated based on the net premium valuation
What are the advantages of the active valuation approach?
- It is more informative of the impact of the different market conditions on the ability of the company to meet its obligations - particularly with regards to options and guarantees
- It is good for managerial decisions
What are the advantages of the passive valuation approach?
- It is easier to implement
- It is less subjective
- It is relatively insensitive to changes in the market conditions and basis - thus smooths profit/surplus emergence
- Solvency capital may be a % of supervisory reserves
- It is normally associated with a net premium valuation - implicit allowance for expenses and future bonuses
What are the disadvantages of the active valuation approach?
- It is complex - calculations take longer and are costlier
- It has volatile valuation results
- Accentuates the impact under extreme conditions
What are the disadvantages of the passive valuation approach?
- It cannot be used to assess the impact of management decisions
- It is much less sensitive to changes in economic environment and therefore runs the risk of being out of date
- It underestimates the impact of large economic changes
Management may therefore not act in time
May miss the impact of recent trends
Providing a false sense of security - It does not explicitly consider the impact of any guarantees or options
What is the consequence of the overall valuation approach being somewhere in between the active and passive valuation approaches?
It can result in a greater mismatch between assets and liabilities and therefore greater changes in the profits or losses or free assets when market conditions change.
