Provider of financial benefits will need to hold provisions for:
- Liabilities that have accrued but not yet been paid
- Future period of insurance for which premiums have been received
- Claims already incurred but which are yet to be settled
- Regulators to be able to ensure that financial promises made to the member of the public will be kept
What is solvency capital?
- The amount of capital required by regulations to be held in excess of the provisions calculated on a best estimate basis (Solvency II)
- Regulator may require provisions to be calculated on a basis significantly more prudent than best estimate and only a much smaller (or zero) amount of capital required on top of provisions.
- Both approaches would yield effectively the same solvency capital
The security provided by a regulatory regime is measured by:
The regulator monitored adequacy of:
- Provisions set aside against future liabilities
- Capital set aside against future liabilities
How does a regulator ensure that the calculation of provisions and capital is sufficiently prudent?
- Regulator may prescribe assumptions & methodology used for calculations
In some countries provisions are set on prudent basis and/or additional solvency capital reqs are based on simple formulae, what is the impact of this?
This has the disadvantages that:
- Levels of prudence within provisions vary between providers, making it difficult to make comparisons
- Solvency capital requirements calculated by simple formulae are not risk-based:
o Difficult to ensure that sufficient security is given to policyholders
What are the 3 pillars of the Solvency II framework?
- Quantification of risk exposures & capital reqs. (1)
- Supervisory regime (2)
- Disclosure requirements (3)
What processes does Pillar I deal with?
- Valuation of assets
- Valuation of provisions for liabs.
- Determining the two levels of capital req. :
o Min. Cap. Req. (MCR) - Threshold at which companies are no longer permitted to trade and below which companies are technically insolvent
o Solvency Cap. Req. (SCR) - Target level below which companies may need to discuss remedies with regulator to avoid technical insolvency
Remedies that companies might undertake after breaching the SCR:
- Increase level of available capital using cap. management tools
- Close to new business
- Move to a less risky better matched investment position
What does Pillar II deal with?
- Assessing company’s internal controls
- Assessing company’s risk management processes
- Assessing company’s economic capital requirements
- Regulator might make monitoring visits to the company
What does Pillar III deal with?
- Public disclosure requirements for the company
- Private disclosure requirements by the company to the regulator
What tools does may a company use to determine its SCR?
- A standard formula prescribed by the regulator
- A company’s internal model (benchmarked against std. formula’s output)
o Regulator can compel a company to develop an internal model if std. model does not suit the risk profile of the company
o Considerable effort to justify internal model, large companies likely to find that capital saved is worth the effort
Why is SCR said to be a risk based calculation?
- It is calculated by assessing the cap. required for each risk against a 0.5% ruin probability in 1 year
- Various risks are aggregated in a correlation matrix to allow for diversification benefits
How is economic capital requirement defined? How does this fit into Solvency II?
- The amount of capital that a provider determines is appropriate to hold given its assets, liabilities and business objectives
- Pillar II requires companies to assess their internal economic cap. req. under ORSA (Own Risk & Solvency Assessment)
What is economic capital requirement determined based on?
- Risk profile of individual assets & liabilities in the portfolio
- Correlation between the risks
- Amount of credit deterioration the provider wishes to be able to withstand
How is risk appetite commonly defined?
Requirement for the company to hold an amount of capital that is based on the regulatory capital requirements.
What are the contents of an economic balance sheet? How to use it for capital requirement assessment?
- First stage of capital requirement assessment
- Shows MVA MVL and provider’s available capital (MVA-MVL) (mkt-consistent basis of valuation)
- Available capital compared with economic cap. req. to assess provider’s solvency status
What practices are followed when determining capital requirement using a standard model?
- Stress tests
- Scenario tests
- Applying factor based capital charges
What types of risks does the standard model allow for?
- Operational risk
- Credit/Default Risk
- Underwriting Risk
- Market Risk
Advantages/Disadvantages of using the standard model?
- Solvency Capital Requirement calculation is less complex and less time-consuming.
- Approximations are made in modelling risks aimed at reflecting risk profile of average companies => It is not necessarily appropriate to modelling the risk profile of actual companies that use it
What is the alternative to a standard model? What does it entail?
- Internal models are used as alternatives to the standard
- These are stochastic models tailored to reflect the company’s business structure/risk profile
- Automatically allows for correlations b/w different risk scenarios
What are the uses of internal models in companies?
- Calculating economic capital reqs. wrt diff. risk measures
- Calculate levels of confidence in economic cap. calculated
- Applying different time horizons to assessment of solvency and risk
- Include other risk classes not covered by std formula
What are the components parts of profit for a financial product provider?
- Investment profit (investment return on available capital less expenses and tax)
- Trading profit (premiums + investment returns on provisions - claims - expenses - tax - net increase in provisions)
Why to allow for cost of capital in pricing?
- To cover the opportunity cost of having capital tied up to support the business written (determined on a regulatory basis or economic basis)
- This loss on return should be priced for in the premium
- Aimed at providing investors with a similar return whether they invest in the business or freely elsewhere