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
Reasons for analysis of surplus
(DIVERGENCED)
- Divergence of the actual experience vs the expected results financial effect
- Information given to management and for accounts
- Variance in the total financial effect is described by the variance of the individual levers, Does individual levers add up to total?
- Experience monitoring to feed back into the ACC
- Reconcile valuations for successive years to check consistency of the assumptions
- Group into recurring/once-off sources of surplus enabling appropriate decisions to be made on the distribution of surplus
- Executive remuneration scheme data - golden handcuff schemes
- New business strain affects
- Check on valuation assumptions and calculations
- Extra check on valuation data and process
- Determine the assumptions that are the most financially significant
Levers/sources on surplus/profit
Claim likelihood and amount
Renewal rates
Investment strategy
Effective management strategies
Expenses
Commission
Lapse rates
Inflation (Claim size and expenses)
Mix of business
Volume of business
Valuation basis and method
Carried forward surplus/deficit
Change in tax, policies
Carrying out surplus analysis
Project income statement and balance sheet of product into future, starting with initial pricing model and ensuring assumptions are consistent and realistic
Compare three models:
Expected experience and expected volume of business
Expected experience and actual volume of business
Actual experience and actual volume of business
Factors determining the application of surplus for a benefit scheme
Legislation
Industrial relations
Scheme rules
Tax benefit
Discretionary decision making
Source of surplus
Speed of corrective action
Competition/ other funds / employers
Expectations of members
Funding level of the fund
Ease of calculation
Factors determining the application of surplus for a life insurer
Provision of capital and margins
Pace of surplus arising and distribution difference
Working capital retained
Objectives of the business
Expectations of the policyholder/ Shareholder
Smoothness of results / smoothness in the distribution
Sources of surplus for pension funds
- Mortality
- Morbidity
- Early retirement
- Investment returns
- Salary inflation
- Expense inflation
Causes of a change in claims experience
Claims frequency
Catastrophe
Loose policy wording
Anti-selection and Attitude of claimants
Random variation
Business mix changes
Education of clients on eligibility of claims
New Risk factors not allowed for
Volumes of Business
Risk factors missed by underwriting
Underwriting standards decreased
Internal claims processing improved
Fraud
Claim Size:
Demand for services increased
Regulation increased, increasing cost of benefit
Inflation
New services available - cheaper or expensive
State subsidizing Decreased
Reasons for monitoring experience
Part of ACC (Assess the solution developed, assess the effectiveness of the problem identification)
Actual experience of a provider monitored to check:
- If the method and assumptions adopted for financing
the benefits continue to be appropriate
- If not - changes made to achieve the desired level of
profit.
Update assumptions as to future experience
Monitor any adverse trends in experience to take corrective actions
Provide management information`
Investment performance and strategy investigated
Effectiveness of management control systems in place
Allowances made when analysing exprience
Cycles
Abnormal events
Random fluctuations
Trends
Heterogeneity between current and future groups
Prudence (to account for uncertainty)
When making changes after monitoring, consider
Significance of assumption/ model changes
Correlation between various factors
Regulatory requirements
Random variation
Margins used - what risks should be allowed for
Time horizons
Changes of contract design over time
Credibility of the results used (volumes and duration of data
Reasons why a (general) insurance company would want to monitor their experience
- To set assumptions for Provisioning and to monitor the run-off of claims against expectations
- to assess the Profitability of its business and the key components of profitability
- to assess Reinsurance requirements and to monitor the adequacy of reinsurance
- to determine an appropriate Investment strategy or to monitor effectiveness of existing one
- to determine Capital requirements
- to monitor the Solvency level of the company
- to assist with Financial planning and strategy
- to provide Management information
- to help with Marketing new contracts
Why solvency position might have changed?
Think A/L as well as BEE
Basis and methods used change
- change in valuation method
- change in the valuation assumptions
Experience between valuation periods
- claims experience
- Investment experience
- mortality/morbidity experience
- expense experience
- new business volumes
Events that happened between valuation periods
- Fraud
- Distribution of surplus via special dividend
- Errors in data, model or valuation.
- Competition
