Chapter 47: Capital Management (2)

Question 1

Regulatory solvency capital requirement

Answer 1

The total of:

• the margins between the best estimate basis and the regulatory liability valuation basis
• an amount of additional capital required in excess of the regulatory provisions.

Question 2

The Basel Accord

Answer 2

Set requirements for the amount of capital that banks need to hold to reflect the level of risk in the business that they write and manage.

Question 3

3 Pillars of Solvency II

Answer 3

• quantification of risk exposures and capital requirements
• supervisory regime
• disclosure requirements

Question 4

2 levels of capital requirements for Solvency II

Answer 4

• Minimum Capital Requirement

- Solvency Capital Requirement

Question 5

Minimum Capital Requirement (MCR)

Answer 5

Threshold at which companies will no longer be permitted to trade

Question 6

Solvency Capital Requirement (SCR)

Answer 6

The target level of capital below which companies may need to discuss remedies with their regulators.

Question 7

Economic capital

Answer 7

The amount of capital that a provider determines is appropriate to hold given

• its assets,
• liabilities,
• business objectives.

Question 8

Economic Capital will be determined based upon:

Answer 8

• risk profile of the individual assets and liabilities in its portfolio
• correlation of the risks
• desired level of overall credit deterioration that the provider wishes to be able to withstand

Question 9

The economic balance sheet shows:

Answer 9

• market values of a provider’s assets (MVA)
• market values of a provider’s liabilities (MVL)
• provider’s available capital, defined as MVA - MVL

Question 10

Internal models

Answer 10

Used to calculate economic capital requirements and may be used to determine the Solvency II SCR.

Aim to create a stochastic model that reflects a company’s own business structure.

Question 11

4 things internal models allow us to do:

Answer 11

• to include other risks not covered in the standard model.
• to calculate economic capital using different risk measures, eg VaR and Tail VaR
• to calculate levels of confidence in the level of economic capital calculated
• to apply different time horizons to the assessment of solvency and risk

Question 12

A provider of financial benefits need to hold provisions for… (4)

Answer 12

• liabilites that have been accrued but which have not yet been paid
• future periods of insurance against which premiums have already been received
• claims already incurred but which have yet to be settled.

Question 13

How is the capital requirement determined (Solvency II)

Answer 13

Combination of

• stress tests,
• scenarios
• factor-based capital charges

Question 14

4 Risks that standard model allows for (Solvency II)

Answer 14

• underwriting risk
• market risk
• credit / default risk
• operational risk

Question 15

Examples of Underwriting risk

Answer 15

premium, 
reserve, 
catastrophe, 
expenses 
and lapse risks.

Question 16

Examples of Market risk

Answer 16

Equity, 
property, 
interest rate, 
currency risk
concentration risk
illiquidity risks
credit spread

Question 17

Advantage of the standard model (Solvency II)

Answer 17

Solvency Capital requirement calculation is

• less complex
• less time-consuming

Question 18

Disadvantage of the standard model (Solvency II)

Answer 18

• It aims to capture the risk profile of an average company
• Approximations made in modelling risks which mean that it is not necessarily appropriate to the actual companies that use it.

Question 19

Solvency II:

Pillar 1

Answer 19

includes
- rules for VALUING both:
—-> assets
—-> provisions for liabilities
(valuing the portfolio of A&L incorporates quantification of risk exposure)
- and also the determinations of two levels of capital requirement (MCR and SCR).

Question 20

Solvency II:

Pillar 2

Answer 20

Pillar 2 deals with qualitative aspects, eg a company’s internal controls and risk management process.
Includes visits by the regulator to monitor companies

Question 21

Solvency II:

Pillar 3

Answer 21

Disclosure requirements include both public disclosure and private disclosure by the company to the regulator.

Question 22

Suggest examples of remedies that may be required in the event of a company breaching the SCR.

Answer 22

Proposed remedies need to increase the amount of available capital, or reduce the company’s levels of risk.
E.g.:
- closing to new business
- moving to a more matched investment position

Question 23

To whom will the Solvency II Directive apply?

Answer 23

All insurance and reinsurance companies with

• gross premium income exceeding €5 million, or
• gross technical provisions in excess of €25 million

Question 24

By whom are the Basel Accords issued?

Answer 24

The Committee on Banking Regulations and Supervisory Practices of the Bank for International Settlements (BIS)

Question 25

What factors might the regulator take into account when assessing a bank’s risk profile / management systems? (6)

Answer 25

• reviews of the work of internal and external AUDITORS
• the bank’s ADHERENCE to sound valuation and accounting standards
• the bank’s risk appetite and its TRACK RECORD in managing risk
• the bank’s DIVERSIFICATION of activities
• the NATURE OF THE MARKETS in which the bank operates
• the quality, reliability and VOLATILITY OF ITS EARNINGS

Question 26

To which banks does the Basel accord apply?

Answer 26

All internationally active banks.

Question 27

First stage in a risk-based capital assessment for a provider

Answer 27

to produce an economic balance sheet

Question 28

2 Possible forms of factor-based capital charges

Answer 28

• 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 29

4 Disadvantages of factor-based capital charges

Answer 29

• the large number of factors required to capture all the risks insurance companies may face
• the factors may be chosen to be appropriate for a typical insurance company with typical risks (and might be unsuitable for all companies)
• the simple calculation may not be appropriate to deal with some types of risk, eg catastrophes
• to retain an appropriately stringent capital requirement in different conditions, the factors would need to be updated in the light of changing conditions.