Part 10: Chapter 36, 37, 38 and 39 Capital management, Capital requirements, Surplus management, Monitoring Flashcards
Why is capital needed?
Individuals
Companies
Providers of financial services and products
Cushion against unexpected events. Car breakdown.
Saving for future
Cushion against fluctuation trade volumes and other events
Liquidity issues due to difference in timing of revenue and cost
Opportunities - mergers and acquisitions
Finance expansion
Finance work in progress and stock
Start-up capital
Regulatory requirement to demonstrate solvency
Expenses of new product launch
Pay Benefits
Cashflows timing management
Unexpected experience cushion
Smooth accounts (e.g. catastrophe equalisation reserve, dividends distribution and bonuses)
Help demonstrate financial strength (and attract new business)
Investment and pricing freedom (mismatching reserve and loss leaders )
Opportunities; Mergers &Acquisitions, new ventures etc
Need to achieve strategic aims/ New business strain
Capital management tools include:
Capital is managed by either:
- Increasing the level of available capital
- Reducing the level of capital required
Banking products
- Liquidity facilities
- Contingent capital, provided when needed - similar to
post loss funding
Reinsurance
Financial Reinsurance to exploit regulation arbitrage (e.g. loan payable only on profit)
Internal restructuring (e.g. to lower mismatching reserve)
Derivatives - hedge risk
Equity capital - (parent, rights issue, new market issue)
Securitisation
Subordinated debt finance (Can add as asset but need not be added as liability)
Other courses of action may include
- Closing to new business: which will reduce the level of new business strain
Run company in a more efficient way:
- Better expense control
- Better Tax management policies
- Revise product pricing
Benefits of holding significant amounts of free capital
Freedom: Investment, Strategic, pricing and from regulator
Can use as a Marketing advantage
Protects against volatility
Enables to write large amounts of new business
Enables to write more risky products
Capital management definition
Capital management involves ensuring that a provider has sufficient solvency and cashflow to enable both its existing liabilities and future growth aspirations to be met in all reasonably foreseeable circumstances. It also often involves maximising the reported profits of the provider.
Providers of financial benefits need to hold provisions for
- Accrued liabilities that have not yet been paid
- Future periods of insurance for which premiums have already been received
- Claims already incurred but not settled
- Additional capital to be held over and above the value provisions
The Basel Accord
Set requirements for the amount of capital banks need to hold to reflect the level of risk in the business that they write and manage
Solvency capital requirement
Margin between best estimate and regulatory basis + the additional capital in excess of the provisions provided
Three pillars of Solvency II:
QSD
- Quantification of risk exposure and capital requirements
- Supervisory regime
- Disclosure requirements
Three pillars of Basel Accords
MRD
- Minimum capital requirement
- Risk management and supervision
- Market discipline and disclosure
Economic capital definition
The amount of capital that a provider determines is appropriate to hold given its assets, liabilities and business objectives which are calculated with an internal model, will depend on:
- The Risk profile of assets and liabilities
- The Correlation of Risks
- Desired level of credit deterioration the provider wishes to withstand
Merits of a standard capital formula as well as its components
Components:
Underwriting risk
Market Risk
Credit Risk
Operational risk
Merits:
Less complex and time-consuming SCR calculations
Less costly because of less modeling requirements
Less risk of parameter/model error
Easier to monitor in the industry
Public confidence is higher
Updates of the factors need to be made regularly
Subjectivity introduced when choosing risk factors
Approximations of risks may not be suitable to non-standard companies
Manipulating of financial results cannot be done
Easier monitoring by regulator
Consistency between valuation of companies - makes financial position more comparable
Cheaper way of modelling requirements
Avoids complex and time consuming calcs
Increased confidence of the financial sector
Merits of a internal capital model
Can lead to smaller capital requirements
Wider range of economic scenarios tested
Unique risks of company considered
An internal model will reflect the insurers specific risk profile
Risk appetite of company allowed for
Calculations will be complex and time consuming Approval needed from regulator - admin and time consuming
The internal model could be very costly to the company especially if stochastic modelling is used
Using standard model will help give financial sector confidence in the results
Risk adjusted return on capital formula (RAROC)
RAROC = Risk adjusted return/ Capital
Economic income created formula
EIC = (RAROC-hurdle rate)* Capital
The notional risk capital allocated to each business unit will
- Determine the business unit’s Performance (With RAROC for example)
- Could affect directly or indirectly, the Remuneration of the unit’s managers and consequently, their level of motivation and behaviour
- Dictates the Amount of business the business unit can write
- Determines the Price at which business can be written
