Chapter 24: Supervisory reserves and capital requirements 2

Question 1

The supervisory authority ensures that insurance companies have sufficient assets to cover their liabilities with high degree of certainty by: (3)

Answer 1

1. requiring insurance companies to hold reserves calculated on a prudent basis
2. requiring a minimum level of solvency capital to be held
3. requiring a combination of prudent reserves and solvency capital to be held.

Question 2

In theory, what is the market-consistent value of a liability

Answer 2

A market consistent value of a liability is the price that someone would charge for taking ownership of the liability, in a market in which such liabilities are freely traded.

Question 3

Market consistent approach - how it is applied: (5)

Answer 3

1. To determine the liabilities, future unknown parameter values and cashflows are set so as to be consistent with market values, where a corresponding market exists.
2. In particular, assumed future investment return is based on a risk-free rate of return, irrespective of the type of asset actually held, and the discount rates are also based on risk-free rates.
3. It may be difficult to obtain a “market-consistent” assumption for some elements of the basis, such as mortality, persistency or expenses, for which there is not a sufficiently deep and liquid market in which to trade or hedge such risks.
4. The starting point for such assumptions would be a best estimate basis.
5. It is then likely that a risk margin would be included in respect of these assumptions, due to the inherent uncertainty.

Question 4

How can the VaR for Solvency Capital be calculated:

Answer 4

The VaR can be calculated by subjecting the supervisory balance sheet to stress tests on each of the identified risk factors, at the defined confidence level and over the defined period.

Question 5

What does the Risk Margin Reflect?

Answer 5

The risk margin reflects the compensation required by the “market” in return for taking those uncertain aspects of the liability cashflows.

Question 6

Passive valuation:

Answer 6

A passive valuation is relatively insensitive to changes in market conditions and has a valuation basis which is updated relatively infrequently.

Question 7

Active valuation:

Answer 7

An active approach is based more closely on market conditions, with the assumptions being updated on a frequent basis.

Question 8

Relative merits of Passive and Active valuation approaches: (4)

Answer 8

Passive approaches:

• easier to implement
• involve less subjectivity
• result in relatively stable profit emergence

Active approaches:

• more informative in terms of understanding the impact of market conditions.
• results are more volatile

Question 9

The “Cost of capital” method for determining the additional risk margin: (3)

Answer 9

1. firstly project the required capital at each future time period (i.e. the amount required in excess of the projected liabilities)
2. multiply the projected capital amounts by the cost of capital.
3. discount using market consistent discount rates to give the overall risk margin.

Question 10

The purpose of solvency capital and how it may be specified:

Answer 10

• Solvency capital can be seen as providing an additional level of protection to policyholders.
• The level of solvency capital required under regulation may be specified as a formula, or it may be based on a risk measure such as Value-at-Risk (VaR)

Question 11

Example of Active valuation:

Answer 11

An example would be the use of market-consistent valuation approaches for both assets and liabilities, and a risk-based capital approach to solvency capital

Question 12

Outline the Value-at-Risk approach for determining solvency capital: (5)

Answer 12

1. The supervisory balance sheet is subject to stress tests on each of the identified risk factors, at the defined confidence level and over a defined period.
2. Applying stress tests to each different factor gives a capital requirement for each separate risk in isolation.
3. In order to arrive at an aggregated capital requirement reflecting all risks, these separate stress tests need to be combined in a way which reflects any diversification benefits that exist between the various risks.
4. This may be done through the use of correlation matrices or by copulas, for example.
5. Separate allowance needs to be made in the capital requirement calculation for the effects of “non-linearity” and “non-separability”

Question 13

Market consistent approach - Mortality: (4)

Answer 13

1. There is unlikely to be a highly liquid active market for mortality risk, so it is not possible to determine a unique and objective market-consistent mortality assumption.
2. Instead, the mortality assumptions is likely to be set by reference to industry statistics, internal experience investigations and information from reinsurerers.
3. The assumptions should include appropriate allowance for future mortality improvements.
4. Appropriate margins will need to be included, reducing/increasing the mortality rate to allow for uncertainty.

Question 14

Market consistent approach - Expenses & inflation

Answer 14

1. The expense assumption might be determined by reference to expense agreements available in the market, for example from third party administration companies,
2. as well as from industry the statistics and features specific to the company’s own experience.
3. The difference between the current market yields of equivalent fixed-interest and index-linked bonds gives an indication of the market’s expectation for future inflation.