Chapter 30: Capital Management

Question 1

Purpose of economic capital BAMTCR

Answer 1

o Buffer held of liability value
o Adverse outcomes covered:
 fall in A,
 rise in L
 unexpected expenses
o Maintain solvency level/credit rating
o Time horizon specified
o Confidence level
o Risk measure used specified

Question 2

Uses of internal capital models BI PRET PAP ISI BAR

Answer 2

 Budgeting of capital done
 Impact of strategy on capital requirements assessed
 Performance measurement
 Return on capital calculation
 Extreme event planning
 Tolerance level assessed
 Profile of risk determined – company or product level
 Alternative capital calc to regulatory requirement
 Product pricing
 Investment strategy setting
 Strategy evaluation and setting
 Incentive compensation
 Reinsurance programs
 Acquisitions and mergers
 Business mix determined

Question 3

Desirable features of a capital model DRIMAC

Answer 3

o Dynamic model
o Reinsurance agreements allowed for
o Integrations of assets and liabilities
o Mitigations and interactions between risks allowed for
o Asset liability correlation allowed for
o Correlation between asset classes

Question 4

How internal and generic models might differ DOT HAT VAC

Answer 4

o Diversification allowance
o Objective
o Tolerance levels
o Horizons
o Accounting assumptions – going concern vs. wind up assumption
o Types of risks considered may differ
o Volatility view of business classes
o Assets available for capital differ
o Countries considered may require a different assessment

Question 5

Steps in operating a capital model PISMMI

Answer 5

o Purpose specified
 Going concern, resourcing, accuracy
 Enterprise wide/standalone risk
 Complexity of the calculations done
o ID and rank risks
o Simulation approach chosen
o Metric of risk defined
 Output: VAR, TVAR
o Time horizon specified
o Modelling criteria chosen
 Exit value
 Credit rating
 Confidence interval
o Implementation method chosen
 Single fully integrated vs several univariate models combined in some way (copulas)

Question 6

Factors to consider when doing a continuity analysis LIP RIM

Answer 6

o Limitations of long-term modelling stated
o Interpretation of long-term modelling required
o Point in time or runoff view?
o Reliability of long-term forecast assessed
o Injection of capital policies considered
o Management actions PAD DM

Question 7

Management actions for continuity planning PAD DM

Answer 7

 Premium setting
 Asset allocation
 Discretionary benefits
 Dividend policy
 Mitigation strategy

Question 8

How effective management can create shareholder value PRPR

Answer 8

o Pricing
o Reserving
o Performance management
o Risk management

Question 9

Practical methods to calculated capital requirements FOES CROSS (lists that relate to each)

Answer 9

• Factor tables – capital req per unit of risk
• Operational risk
• Economic scenarios
• Stress testing
• Credit risk (ratings agency, Merton)
• Ruin probability and cost calculation
• Option pricing theory (Merton)
• Stochastic models (Monte Carlo)
• Statistical methods (MVN)

Question 10

Allocated capital used in BALPP

Answer 10

• Business planning
• Amount of business written
• Limit setting for risk controls
• Performance management
• Pricing

Question 11

Methods of capital allocation CRIMP G

Answer 11

• Centrally retained
o Could lead to inefficient capital allocation
o Easier and risk of erroneous capital allocation is avoided
• Risk measure approach
o The Euler method – can be applied to risk measures that show positive homogeneity
• Individual/standalone basis
o Capital requirements determined in isolation to other BU’s – diversification benefit lost
• Marginal approach
o Additional capital required to write a line of business, assuming all other line are written
• Pro-rata basis
o Addition according to some basis
• Game theory approach
o Marginal approach but assessing adding the BU at different timings to the business

Question 12

Factors to consider when comparing capital allocation methods DROM BEC & CACI

Answer 12

• Diversification benefit allowed for
• Risky business unit over investment risk
• Other business units’ effect on the measure
• Marginal pricing principle allowed for
• Basis effect on allocation
• Ease of communication
• Complexity and computational intensity
• Coherence of the risk measure considered
• Additional capital
• Changes over time
• Implementation of capital allocation
o Communication skills required
o Conflicts the allocation can create should be understood

Question 13

Internal capital models MASDA

Answer 13

 Management creates it
 Accuracy is better
 Specific context of company considered
 Decision making process assisted by it
 Allocation of capital across business lines

Question 14

Factors and limitations to model capital requirements VEC CAMP RC

Answer 14

• Volatility of assets and labilities
• Expected returns on assets
• Correlation between assets and liabilities
• Consistent valuations
• Assumptions made
• Measures of risk should be appropriate
• Parameters needed
• Robust estimates made
• Continuous estimates

Question 15

Credit risk under Basel ROM (II) & TECL (III)

Answer 15

o Risk weighting to credit assets (Gov Bonds: 0%, Unsecured debt 100%)
o Off-BS items brought on BS
o MCR taken as 8% of RWA
• Tiered approach to RWA MCR
• Equity deductions – common equity exposure
• Conservation buffer
• Liquidity requirements