Chapter 24 - Supervisory reserves and capital requirements Flashcards
State how, in theory, the assets and liabilities should be ideally value when using a market-consistent approach (3)
- Often referred to as a fair valuation which can be used to set reserves with assets being valued at market value
- In theory, liabilities would be valued as price that someone would charge for taking responsibility for them, in a market in which such liabilities are freely traded. In the usual absence of such a market, an approximate approach has to be taken.
- The value of the liabilities should be equivalent to the current market value of a notional portfolio of risk-free assets that match the liability cash flows exactly
Describe how the investment return assumption would be determined for a market-consistent valuation of the liabilities (4)
- Would be based on the risk-free rate, irrespective of the type of asset actually held.
- This risk-free rate may be based on government bond yields, or on swap rates (if there’s a sufficiently deep and liquid market for these).
- A deduction may be made for credit risk, as appropriate.
- Credit might be taken for the liquidity premium in corporate bond yields, provided the liabilities for which the rates are to be used
+are long term,
+and have reasonably predictable duration,
+and for which matching assets can be held to maturity (eg immediate annuities)
Why might it be possible to take credit for the illiquidity premium when determining the risk-free rate of return from these yields?
- Lack of liquidity is not a risk if the assets are held to maturity.
- So, provided the liability cashflows have relatively fixed and predictable duration, illiquidity premium can be allowed for in the ‘risk-free’ rate
- Where this practice is permitted by regulation, there would normally be strict rules about how and when it can be applied, eg there may be a requirement that matching bonds are held to maturity.
Describe the risk margin based approach to market consistent valuations:
Explain the approach that normally has to be used to obtain market-consistent assumptions for mortality, persistency, and expenses.
- Usually impossible to obtain market values of assumptions directly, because markets are insufficiently (a) deep or (b) liquid.
- In some cases, may be possible to use some market-consistent estimates:
mortality: may derive from reinsurance risk premium rates
expenses: may derive from expense agreements available in market eg 3rd party administrators - Instead, the approach is normally to take a best estimate of the future experience, plus a ‘risk margin’.
- The risk margin would reflect the extra price that the market would require, in order to compensate for the uncertainties inherent in the liability cashflows due to the assumption.
- Overall risk margin could be determined by
+adding a margin to each assumption
+alternatively, an overall reserving margin in respect of these risks could be determined using the ‘cost of capital’ approach.
Describe the risk margin based approach to market consistent valuations:
Outline the ‘cost of capital’ approach to calculating an overall risk margin for the mortality, persistency, and expense assumptions, for the purpose of a market-consistent valuation of the liabilities.
- Project required capital
project forward the future capital required to hold in excess of market-consistent estimate of the liabilities
determined at the end of each future year, for current in force book
+projection guided by relevant regulatory solvency basis - Multiply projected capital amounts by “Cost of Capital Rate”
+for each future year this rate can be considered to represent cost of raising incremental capital, in excess of risk free rate; representing the frictional cost/loss in return cause by locking in this capital rather than being able to invest it freely for higher reward
+cost of capital rate, may, for example, be dertemined as excess of the weighted average cost of capital over the risk-free rate, in some cases it may be a fixed rate
there may also be other frictional costs eg tax which affect CoC - Discount at the appropriate risk-free rate of return for each term, and sum to obtain the risk margin.
- Projection of future capital may be
+simple eg fixed percent of reserves, or
+complex, leading to:
stochastic modelling and correlation matrices
+approximations eg expressing capital required as simple formula based on drivers such as the size of the reserves and the sum at risk
Give 2 broad areas of risk where solvency capital can protect policyholders (2)
Solvency capital requirements can protect polichyholders against:
- reserve being underestimated, ie adverse future experience relative to reserving assumptions.
- a drop in asset values (including individual asset defaults).
Solvency capital requirements: Value at Risk approach
What is the VaR approach to deriving solvency capital required by an insurer? (2)
VaR approach is
- risk-based solvency capital requirement approach, normally expressed as a min required confidence level over a defined period (eg 99.5% over 1 year)
- Under VaR approach, amount of capital needed:
+set min required confidence level, eg 99.5%, over a given defined period, eg 1 year => assets won’t exceed liabilities over 1 year, with 99.5% confidence
Solvency capital requirements: Value at Risk approach
Outline the Value at Risk (VaR) approach to deriving the risk-based solvency capital required by an insurance company.
supervisory balance sheet=>often market consistent for this approach type
- conduct stress tests/shocks on supervisory balance sheet for each risk factor separately, at defined confidence level, over the defined period.
- each stress test involves projecting the company’s future assets and liabilities, based on the actual liabiltiies and assets currently held.
- for each risk factor, amount of capital needed at the present time, in excess of its liabilities due to stress test, is calculated to ensure that assets exceed liabilities at the end of the defined period with the required probability.
- alternatively, determine single shock scenario with 99.5% confidence which involved simultaneously shocking mortality, expenses, investment return, withdrawals, etc => currently too computationally difficult, so separate stress test used instead
- for individual stress tests done, combine capital required over all risk factors, allowing appropriately for interactions, eg via correlation matrix
- Additional capital may be needed across individual risks to cover any
+non-linearity (1% increase in shock <> 1% change in cap required)
+non-separability (events happen together > if happen separately)
Define what is meant by a passive valuation approach (2)
Features of passive valuation approach (4)
Passive valuation approach uses a:
* valuation method that’s relatively insensitive to market condition changes
- valuation basis which is updated relatively infrequently
Features of passive valuation approach: - assumptions may be locked in
+mortality/expense inflation assumptions rarely change - non-economic assumption change when experience worsens in order to recognise related loss and need for higher reserves
- assets at book price - possibly with amortisation/write down over time.
- simplified approach for solvency capital requirement - eg holding prescribed % of base liabilities
Define what is meant by an active valuation approach ( 3 )
Active valuation approach would be
- based more closely on market conditions (than a passive valuation)
- with the assumptions being updated on a frequent basis
+market consistent valuation for both assets/liabilities, and risk based capital approach to solvency capital requirements - more informative in terms of understanding impact of market conditions on company’s ability to meet obligations, particularly in relation to financial guarantees and options.
State 3 advantages of passive valuations (3)
Disadvantages of passive valuation approach (4)
Advantages of passive valuation approaches are that they:
- Tend to be more straightforward to implement
- Involve less subjectivity
- Results in relatively stable profit emergence, to extent that it’s used for accounting purposes
Disadvantages of passive valuation approaches are that they:
- can become outdated
- relatively insensitive to changes in market conditions
- valuation basis updated infrequently (may not take account of important trends eg rising expense inflation, worsening claims experience)
- false sense of security eg management failing to take appropriate actions in response to emerging problems until too late, because solvency position hasn’t appeared to change
What are the disadvantages of using an active valuation approach? ( 5 )
Disadvantages of active valuation approach
- More volatile results
implications due to procyclicality
adverse equity market conditions => active approach using risk based capital would indicate higher capital requirements needed. To reduce this requirement, companies would have to sell equities, which itself could exacerbate the market conditions. - Systematic risk
since this would be case for all insurers
regulators may amend valuation approach under certain conditions to avoid systematic risk - More complex
- More time consuming
- More costly
