C36 : Capital Requirements Flashcards
(17 cards)
List reasons that a provider of financial benefits will need to hold provisions for
A provider of financial benefits will need to hold provisions for:
1. Liabilities that have accrued but which have not yet been paid
2. Claims that have been incurred but not yet settled
3. Future (unexpired) periods of insurance against which premiums have been received but where the risk event has not yet occurred
What is solvency capital requirement?
Solvency Capital Requirement
Total of:
1. Excess of provisions established on a regulatory basis over the best estimate valuation of the provisions
2. An additional capital requirement in excess of the provisions established
Describe Solvency II and its three pillars
Solvency II – Three pillars
- Solvency II is a solvency requirement for insurance companies’ risks.
- Insurance equivalent to Basel II for banks
- Intended the it will become a regulatory requirement for all EU states
Three pillars are:
1. Quantification of risk exposures and capital requirements
2. Supervisory regime
3. Disclosure requirements
Describe Two levels of Capital Requirement Under Solvency II
Two levels of Capital Requirement Under Solvency II
- MCR (Minimum Capital Requirement) is threshold at which companies will be no longer permitted to trade
- SCR (Solvency Capital Requirement) is target level of capital below which companies may need to discuss remedies with regulator.
Discuss the two ways the SCR may be calculates
Models used to calculate SCR
- A standard model (formula) prescribed by regulation
- A company’s internal model benchmarked against the output of the standard model.
- It is likely to be used only by the largest companies who can afford the considerable extra work need to justify an internal model
- usually a stochastic model reflecting company’s own business structure/risk profile
- The SCR is calculated by assessing the capital required for each risk against a 0.5% ruin probability in one year.
- The various risks are aggregated using a correlation matrix to make allowance for any diversification benefits.
What is Basel Accord?
- Capital adequacy for banks issued by the Committee on Banking Regulations and Supervisory Practices of the Bank for International Settlements (BIS).
- These accords set requirements for the levels of capital that banks need to hold to reflect the level of risk in the business that they write and manage.
Suggest factors that the regulator would take into account in assessing a bank’s risk profile and risk management systems.
Factors the regulator could take into account in assessing a bank include:
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.
Explain how a company, that is subject to solvency II, can define its risk appetite
- The SCR under Solvency II is a risk-based capital measure.
- In practice, financial product providers will have a risk appetite that limits the amount of risk they are prepared to take on.
- The risk appetite is commonly expressed as a requirement for the company to hold an amount of capital that is based on the regulatory capital requirements.
Describe economic capital
How is it determined
Economic capital is the amount of capital that a provider determines is appropriate to hold given its assets, its liabilities, and its business objectives.
It is typically determined based on:
1. Risk profile of individual assets and liabilities in its portfolio
2. Correlation of risks
3. Desired level of overall credit deterioration that the provider wishes to be able to withstand
Describe economic balance sheet
Economic balance sheet shows:
1. Market values of a provider’s assets (MVA)
2. Market values of a provider’s liabilities (MVL)
3. Provider’s available capital, which is defined as MVA – MVL.
The available capital is then compared with the economic capital requirement to assess the provider’s solvency status.
Available Economic capital can be shown as :
Free Capital + Eco capital Req
Market values of assets are usually easily and instantly available from the financial markets.
Market value for a provider’s liabilities is not so easy and a high level of judgment is required to determine market-consistent liability values.
Discuss the use of standard model to determine SCR under solvency II
How the standard model works
Under Solvency II, the standard model will determine capital requirement through a combination of:
- Stress tests
- Scenarios
- Factor-based capital charges
The standard formula allows for:
1. Underwriting risk e.g. premium (general insurance), mortality, morbidity, catastrophe, expense and lapse
risks
2. Market risk e.g. equity, property, interest rate, credit spread and currency risks
3. Credit / default risk, including reinsurance default risk
4. Operational risk.
-It aims to assess the net level of risk allowing for diversification and risk mitigation options
Advantages and Disadvantages of standard formula for SCR
Advantages and Disadvantages of the Standard Model
+ SCR calculation is less complex and less time consuming
- It aims to capture the risk profile of an average company, and so it is not necessarily appropriate to the actual companies that need to use it
Discuss the use of Internal model to determine SCR under solvency II
Uses of Internal Models
1. To calculate economic capital using different tail measures, such as VaR and Tail VaR
2. To calculate levels of confidence in the level of economic capital calculated
3. To apply different time horizons to the assessment of solvency and risk
4. To include other risk classes not covered in the standard model
Two ways a financial provider’s profits can be expressed
The profit made by a financial product provider can be expressed as two components:
1. Trading profit
2. Investment profit (on available capital)
What is cost of capital ?
Why financial product providers should allow for it in their pricing calculations?
This cost of capital reflects the likelihood of investment restrictions on capital supporting business in force, meaning that the investment return is not as great as if the capital tied up in the business could be used for some other purpose.
Why raise debt over other options of raising capital
- Private company :
- Need to go public to raise equity,
- May not be willing to dilute ownership
- Existing S/H may not be interested in buying more shares.
- May be a temporary investment, may sell soon - Purpose
- The investment may not be attractive to potential equity investors
- Underperforming Market/industry - Size of issue : May not be able to raise large equity
- Other forms of capital may be cheaper
- Economic cycle : Equity may be depressed
- Prior track record
- Expenses of raising debt lower
- Raising debt may be more tax efficient
Risk of debt capital
- Repayments/coupon are fixed, no flexibility
- Variability in earnings/profit can expose default risk
- Short term borrowing means the capital repayments will be needed soon
- Default could mean loss of reputation, credit rating downgrade, creditors asking for repayments, bankruptcy
- Variable interest rate: cost of servicing debt will increase if int rate rise.
- High level of gearing will make profits volatile.
- May reduce credit rating
