Chapter 47: Capital Management (2) Flashcards
Regulatory solvency capital requirement
The total of:
- the margins between the best estimate basis and the regulatory liability valuation basis
- an amount of additional capital in excess of the regulatory provisions.
The Basel Accord
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.
3 Pillars of Solvency II
- quantification of risk exposures and capital requirements
- supervisory regime
- disclosure requirements
2 levels of capital requirements for Solvency II
- Minimum Capital Requirement
- Solvency Capital Requirement
Minimum Capital Requirement (MCR)
Threshold at which companies will no longer be permitted to trade
Solvency Capital Requirement (SCR)
The target level of capital below which companies may need to discuss remedies with their regulators.
Economic capital
The amount of capital that a provider determines is appropriate to hold given
- its assets,
- liabilities,
- business objectives.
Economic Capital will be determined based upon:
- 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
The economic balance sheet shows:
- market values of a provider’s assets (MVA)
- market values of a provider’s liabilities (MVL)
- provider’s available capital, defined as MVA - MVL
Internal models
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.
4 Uses for internal models
- 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
- to include other risks not covered in the standard model.
A provider of financial benefits need to hold provisions for… (4)
- 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.
How is the capital requirement determined (Solvency II)
Combination of
- stress tests,
- scenarios
- factor-based capital charges
4 Risks that standard model allows for (Solvency II)
- underwriting risk
- market risk
- credit / default risk
- operational risk
Examples of Underwriting risk
premium, reserve, catastrophe, expenses and lapse risks.
Examples of Market risk
Equity, property, interest rate, credit spread, currency concentration and illiquidity risks.
Advantage of the standard model (Solvency II)
Solvency Capital requirement calculation is
- less complex
- less time-consuming
Disadvantage of the standard model (Solvency II)
- 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.
Solvency II:
Pillar 1
includes
- rules for VALUING both:
- — assets
- — provisions for liabilities
- and also the determinations of two levels of capital requirement (MCR and SCR).
Solvency II:
Pillar 2
Pillar 2 deals with qualitative aspects, eg a company’s internal controls and risk management process.
Includes monitoring visits to companies by the regulator.
Solvency II:
Pillar 3
Disclosure requirements include both public disclosure and private disclosure by the company to the regulator.
Suggest examples of remedies that may be required in the event of a company breaching the SCR.
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
To whom will the Solvency II Directive apply?
All insurance and reinsurance companies with
- gross premium income exceeding €5 million, or
- gross technical provisions in excess of €25 million
By whom are the Basel Accords issued?
The Committee on Banking Regulations and Supervisory Practices of the Bank for International Settlements (BIS)
What factors might the regulator take into account when assessing a bank’s risk profile / management systems? (6)
- reviews of the work of internal and external AUDITORS
- the bank’s risk appetite and its TRACK RECORD in managing risk
- the NATURE OF THE MARKETS in which the bank operates
- the quality, reliability and VOLATILITY OF ITS EARNINGS
- the bank’s ADHERENCE to sound valuation and accounting standards
- the bank’s DIVERSIFICATION of activities
To which banks does the Basel accord apply?
All internationally active banks.
First stage in a risk-based capital assessment for a provider
to produce an economic balance sheet
2 Possible forms of factor-based capital charges
• 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
4 Disadvantages of factor-based capital charges
- 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.
