Chapter 37 - Capital requirements Flashcards
Define the solvency capital requirement.
Outline how the SCR is calculated and why it is needed.
SCR is the total assets required to be held in excess of provisions to ensure solvency with a minimum probability (99.5%) for the next year.
- Provisions usually on best estimate basis
- SCR usually on prudent basis
Double check below is correct - might be wrong in notes
Two approaches for calculating provisions lead to different interpretations of solvency capital:
1) Use best estimate basis (possibly with risk margins) for calculating provisions.
- Additional capital requirements are then solvency capital.
2) Use prudent approach to calculate provisions.
- Smaller capital requirement
- Solvency capital forms “prudent” part of provisions as well as smaller capital requirement
See diagram on p.4
Discuss the regulatory framework for solvency capital requirements of insurers
Use Solvency II
- European Union States
- Similar to SAM (Solvency Assessment and Management) in SA
Provisions calculated on a best estimate basis with risk margins and an additional risk-based capital requirement
- These provisions are known as technical provisions
Three pillars of the Solvency II framework:
1) Quantification of risk exposures and capital requirements
- Deals with quantitative aspects of risks
- Rules for valuing assets and provisions
- Rules for determining two levels of capital requirement:
a) minimum capital requirement (MCR)
- Threshold at which companies will no longer be permitted to trade
b) solvency capital requirement (SCR)
- Target level of capital below which companies may need to discuss remedies with their regulators
- Will be larger than MCR
2) A supervisory regime
- Requires Own Risk and Solvency Assessment (ORSA) from companies
- Deals with qualitative aspects of risk:
> Internal risk control processes
> Risk management processes
> View of strategic capital needs (ORSA)
> Monitoring visits by regulator
3) Disclosure requirements
- Requirements for both public and private disclosures to the regulator
If capital levels fall below SCR, remedies should be discussed with regulators to prevent falling below MCR such as:
- Closing to new business
- Better matched investment position
- Essentially any method that would increase capital levels and/or decrease risk (and thereby capital requirements)
Calculating the SCR under Solvency II:
- Capital required for each risk against a 0.5% (1 in 200) ruin probability in 1 year
- Risks aggregated using correlation matrix to allow for diversification benefits, or other method such as copulas if internal model is used
- Use either prescribed formula or company’s internal model
- Considerable work needed to justify use of internal model which is often not worth the extra effort
- May be compelled by regulator to use internal model if standard formula deemed inappropriate for risk profile of the company
The standard formula is a factor based approach which allows for (also read pp. 12-14):
- Underwriting risk
- Market risk
- Credit/default risk
- Operational risk
Discuss the regulatory framework for solvency capital requirements of banks and credit institutions
Use Basel Accords
- Apply to all internationally active banks
- Currently on Basel III
Set requirements for levels of capital banks need to hold to reflect level of risk in business they write and manage
Basel framework based on three pillars:
1) Minimum capital requirements
- Rules for evaluating capital requirements for various risks:
a) credit risk
b) market risk
c) operational risk
2) Risk management and supervision
- Requires Internal Capital Adequacy Assessment Process (ICAAP)
- Addresses corporate governance and enterprise risk management
- Includes evaluation of all other major risk types in the bank
3) Market discipline and disclosure
- Requirements for public and private disclosure to regulator
Outline the ORSA under pillar 2 of Solvency II
Purpose of ORSA is to provide board and senior management of insurance company with assessment of:
- adequacy of its risk management
- current and likely future solvency position
Requirements:
- Identify risks to which insurer is exposed
- Identify risk management processes and controls in place
- Quantify ability to continue to meet MCR and SCR, which will involve long term projections of solvency position
- Analyse quantitative and qualitative elements of business strategy
- Identify relationship between risk management and level of quality of financial resources needed and available
Promoted by international association of insurance supervisors (IAIS) as a tool for:
- improving business practice
- all regulators to improve assessments of ability of companies to withstand stress events
Define economic capital and outline how it is determined
Amount of capital that a provider determines is appropriate to hold given its assets, liabilities and its business objectives
Calculated using a risk-based capital assessment (RBCA) with an internal model based on:
- risk profile of individual assets and liabilities in the portfolio
- correlation of risks
- chosen ruin probability
First stage in RBCA is to produce an economic balance sheet which shows:
1) market value of assets (MVA)
2) market value of liabilities (MVL)
- Difficult to determine actual market value of liabilities
- May instead refer to market-consistent or fair value
3) available capital (MVA - MVL)
Available capital is then compared to economic capital requirement to assess the solvency status.
- Valuable initial comparison of A and L because they are valued on same/similar market-consistent basis
Outline the ICAAP under pillar 2 of Basel III framework.
ICAAP enable banks to identify, measure and aggregate material risks and calculate economic capital necessary to cover these risks
Also allows regulators to enhance assessment of banks and to take action when necessary.
The ICAAP ensures there exists:
- comprehensive and appropriate identification and measurement balance sheet risks (A & L)
- appropriate level of internal capital according to bank’s risk profile
- application and development/improvement of suitable risk management systems
Minimum requirements of ICAAP:
- Process for assessing overall capital adequacy levels
- Regular supervisory review of a bank’s ICAAP
- Hold capital in excess of minimum levels based on risks
- Remedial action if necessary capital levels are not maintained
Outline how profit is calculated for a financial product provider
Profit = Trading profit + investment profit
Trading profit = Premiums + return on assets backing provisions - claims - tax - expenses - net increase in provisions
Investment profit = return on available capital - tax - trading costs
- Recall available capital comprises of assets not required for provisions
Explain the need for risk adjusted return measures and discuss briefly some examples
Profit calculation does not account for:
- Risks borne when achieving profit
- Opportunity cost of holding required capital
These can be accounted for with some risk adjusted return measures:
1) Risk adjusted return on capital (RAROC)
- RAROC = Risk-adjusted return/capital
- Can determine which business activities are creating risk-adjusted profits by comparing RAROC with cost of capital
- Can be an actual or expected calculation
- Popular to use economic capital in the denominator
2) Economic income created (EIC)
- EIC = (RAROC - hurdle rate) x Capital
- The hurdle rate of return on capital is a standard against which business activities must be measured
- Calculates quantity of return generated by a unit of activity
- Encourages marginal growth activities which may not meet RAROC targets
Briefly outline the general method for capital allocation strategies.
Total required capital needs to be allocated between products/business units in a fair and appropriate way. This is important for:
- Business planning
- Performance measurement
- Pricing purposes
Adjustments will be made to allow for concentration risk or diversification which is present:
1) Adjustments for correlation and dependency
- Should especially consider possible increases in correlation and dependency between business units during times of stress
- Required capital typically calculated with reference to extreme events and so tail dependency of risks is vital to consider
- Dependency structure used to model risks will therefore have large effect on required capital and capital allocation
2) Adjustments for diversification
- Determine how to allocate diversification benefits within the enterprise across the individual business units
- Two approaches:
a) Calculate capital required at a business level and adjust for benefit of diversification
b) Calculate capital required at enterprise level and allocate this capital in a fair way across business units, sharing diversification benefits in a fair way
- The “fair” way will depend on the purpose of the allocation and the stakeholders
- Largely subjective allocation
This notional capital allocation will then be applied to management processes which will have an impact on business decisions.
State the three tests to assess if a source of capital is good quality capital
Wind-up test
- Will capital maintain value in the event of wind-up of company
Obligation test
- Will capital still need to be repaid in wind-up event
Permanence
- Is source of capital owned permanently or only temporarily
- i.e. how quickly does capital need to be repaid
What is the solvency/cover ratio and how is available capital calculated.
Available capital/required capital
Available capital = Admissible assets - liabilities
*Will depend on which basis is being used
e.g. SCR is on prudential basis
Economic capital cover will be on pricing basis
See tut question
What is prudential own funds?
A - L on prudential/regulatory solvency basis
