Chapter 37 - Capital requirements

Question 1

List 2 types of assessments of capital

Answer 1

1. Regulatory capital
2. Economic capital

Question 2

List 3 types of liabilities covered by provisions

Answer 2

1. Liabilities that have accrued but which have not yet been paid.
2. Claims that have incurred but not yet settled.
3. Future (unexpired) periods of insurance against which premiums have been received but where the risk event has not yet occurred.

Question 3

Define regulatory capital

Answer 3

Regulatory capital is capital required by the regulator to protect against the risk of statutory insolvency.

Question 4

Define the solvency capital requirement

Answer 4

The solvency capital requirement is the total assets required to be held in excess of provisions that are calculated on a best estimate basis.

It therefore comprises:
- any excess of the provisions established on a regulatory basis over the best estimate valuation of the provisions

• any additional capital requirement in excess of the provisions established

Question 5

Give 2 disadvantages of a regime where provisions are determined on a prudent basis and additional solvency capital requirements are based on simple formulae

Answer 5

1. The levels of prudence within the provisions can vary between providers, making comparisons difficult.
2. The solvency capital requirements are not risk-based, making it difficult to ensure that sufficient security is provided for policyholders

Question 6

What is Solvency II and what are the three pillars on which it is based?

Answer 6

Solvency II is a solvency regime for insurance companies. It is a regulatory requirement for all EU states.

The three pillars are: RAD
1. Quantification of RISK exposures and capital requirements
2. A supervisory regime
3. DISCLOSURE requirements

Question 7

What are the 2 levels of capital requirements under Solvency II?

Answer 7

1. The MCR (Minimum Capital Requirement) is the threshold at which companies will no longer be permitted to trade.
2. The SCR (Solvency Capital Requirement) is the target level of capital below which companies may need to discuss remedies with their regulators.

Question 8

Outline 2 methods that could be used to calculate the SCR

Answer 8

1. A standard formula prescribed by regulation
2. A company’s own internal model (usually a stochastic model reflecting the company’s own business structure), which may be benchmarked against the standard formula output.

(An internal model is likely to be used by the largest companies who can afford the considerable extra work needed to justify using an internal model)

Question 9

What are banks main risks

Answer 9

• credit risk
• market risk
• operational risk

Question 10

What is the purpose of ORSA (Own risk and solvency assessment)

Answer 10

to provide the board and senior management of an insurance company with an assessment of:
- the adequacy of its risk management
- its current, and likely future, solvency position

Question 11

What does the ORSA require each insurer to do?

Answer 11

RRRAQ

• to identify the:
  – RISKS to which it is exposed
  – RISK management processes and controls in place
  – RELATIONSHIP between risk management and the level and quality of financial resources needed and available
• to ANALYSE quantitative and qualitative elements of its business strategy
• to QUANTIFY its ongoing ability to continue to meet its solvency capital requirements

Question 12

Define economic capital

Answer 12

Economic capital is the amount of capital the provider determines it is appropriate to hold given its assets, liabilities and business objectives.

It is typically based on:
- the risk profile of the individual assets and liabilities in its portfolio
- the correlations of the risks
- the desired level of overall credit deterioration that the provider wishes to be able to withstand.

Question 13

Which risks do the standard formula for assessing capital requirements under solvency II cover?

Answer 13

• Credit / default risk
• Underwriting risk
• Market risk
• Operational risk

Question 14

What are factor-based charges? and give 2 examples of factor based charges

Answer 14

it is a simple mechanism to determine capital requirements

e.g
- factor x sum at risk - to determine a capital requirement in relation to mortality risk
- factor x reserves - to determine a capital requirement in relation to inadequate reserves

Question 15

The components of profits by financial product providers (2)

Answer 15

• Trading profits
  it includes premiums and investment income on the provisions for future liabilities, less claims, expenses, tax and the net increase in any provisions for future liabilities
• Investment profits
  is the investment return, less tax and investment expenses, earned on that part of the assets not required for the provisions for future liabilities

Question 16

Give two examples of risk return measures

Answer 16

• Risk-adjusted return on capital
  –(risk adjusted return)/Capital
  – can be calculated for an institution as a whole
  – can be used to compare different and diverse business activities ( identify activities that are creating or destroying shareholder value )
  – can be based on actual or expected return and capital
• Economic income created
  – captures the quantity of return generated by a unit of activity
  – EIC = (RAROC - hurdle rate ) x Capital

Question 17

What are the two ways SCR can be calculated

Answer 17

• a prescribed standard formula - which makes approximation and aims to capture the risk profile of an average
• an internal model - which is more complex to implement but can better reflect the actual risk profile and business structure of the company