Chapter 37: Capital requirement

Question 1

What is regulatory capital

Answer 1

Amount of capital required to protect against statutory insolvency

Question 2

Name the 3 pillars of Solvency II

Answer 2

Pillar 1
- Quantification of risk exposure and capital requirement

Pilla 2
- Superfisory regime

Pillar 3
- Disclosure requirement

Question 3

Discuss what is meant under pillar 1 of Solvency II

Answer 3

Pillar 1 sets out rules on valuing assets and provisions for liabilities. It sets out two levels of capital requirement

1. Minimum capital requirement (MCR): If the threshold is breached a company is no longer permitted to trade
2. Solvency capital requirement (SCR): Target level of capital to hold. Below they need to disclose remedies on how to correct.

Question 4

Discuss what is meant under pillar 2 of Solvency II

Answer 4

Pillar 2 sets out rules on the qualitative aspect, e.g., internal accounts, risk management and strategic capital needed

Question 5

Discuss what is meant under pillar 3 of Solvency II

Answer 5

Pillar 3 discloses rules on public and private disclosure to the regulator

Question 6

What are the two main approaches in accessing capital requirement

Answer 6

1. Internal model - Model used to reflect a company’s own risk and business structure. Use a stochastic model to project and then a VaR measurement to determine the capital requirement
2. Standard formula - Accepted model used by a number of companies, it aims to access the capital requirement of a company with an average risk profile. (use stress, scenario or factor-based charges to access capital)

Question 7

What are the three pillars of Basel?

Answer 7

Pillar 1: Minimum capital requirement
Pillar 2: Risk management and supervision
Pillar 3: Market discipline and disclosure

Question 8

What is economic capital?

Answer 8

Economic capital is the amount of capital that a company determines is appropriate to hold given its assets, libailities and business objective

This will be determined based upon

• Risk profile of the assets and liabilities in the portfolio
• Correlation between risks
• The desired level of overall credit deterioration that the provider wish to withstand

Question 9

What are the steps available to set up an economic balance sheet?

Answer 9

1. Calculate market value of assets (which is available in the financial markets
2. Calculate the market value of liabilities (EPV of liabiltiies on a BE basis + risk margin (determined using option pricing))
3. MVA - MVL = Available cpaital
4. Available capital = Required capital/Economic capital + Free assets

Question 10

What are the advantages and disadvantages of the standard formula (2/2)

Answer 10

+ Less complex and time-consuming
+ Easiest model to use to calculate regulatory capital

• May not be appropriate for all companies
• Cannot be used to determine economic capital

Question 11

What are the advantages and disadvantages of the internal model (4/2)

Answer 11

+ Can be used to calculate economic capital using different risk measures, e.g, VaR
+ Can calculate the level of confidence in the capital
+ Can apply different time horizons to the assessment of solvency and risk
+ Can include other risk classes not covered in the standard formula

• More complex and time-consuming
• Need regulatory approval, and may not realise

Question 12

How are RAROC (risk-adjusted return on capital) and EIC (economic income created) calculated?

Answer 12

RAROC = (risk - Adjusted return)/capital

• compare business activities

EIC = (RAROC - hurdle)*Capital

• quantity of return generated by a unit of an activity