Chapter 37 - Capital Requirements Flashcards
Solvency II
Solvency II is a regulatory regime for all European Union states and the framework is based on 3 pillars:
- quantification of risk exposures and capital requirements
- a supervisory regime
- disclosure requirements
Solvency II establishes two levels of capital requirements:
1. Minimum Capital Requirement (MCR) ‒ the threshold at which companies will no longer be permitted to trade
2. Solvency Capital Requirement (SCR) ‒ the target level of capital below which companies may need to discuss remedies with their regulators
The SCR may be calculated using a prescribed standard formula or a company’s internal model, where the latter may be benchmarked against the output of the standard formula.
Considerable work is needed to justify using an internal model, and all but the largest companies are likely to find that any reduction in capital requirements is more than offset by the work needed to support the internal model
The various risks are aggregated using a correlation matrix to make allowance for any diversification benefits. In the standard formula, the risks tested and the correlation matrix are prescribed. For the market risks, firms may need to use an economic scenario generator to assess the capital required for each risk
In South Africa ,SAM which is based on Solvency II is used. SAM has been adapted to reflect local market conditions and regulatory requirements in South Africa.
Under the SAM framework, insurers are required to conduct an ORSA on a regular basis to assess the adequacy of their capital and risk management strategies. The ORSA process involves identifying and assessing all material risks that the insurer faces, quantifying those risks, and determining whether the insurer has sufficient capital to absorb potential losses.
The Basel Accords for banks and credit institutions
Banks also have to hold capital for unexpected losses – including unexpected credit losses, which can be large in periods of recession.
Banks in many countries operate under the Basel regulations, which set out requirements for minimum levels of capital. The Basel Accords apply to all internationally active banks.
Under Pillar 1, banks must quantify their minimum capital requirements for their main risks:
- credit risk
- market risk
- operational risk
Risks are assessed separately, and capital requirements for each type of risk are then aggregated, without any allowance for diversification (i.e. low correlations between risks)
On top of their minimum capital requirements, banks must hold capital in the form of:
- a capital conservation buffer. This is to provide banks with an extra layer of usable capital, in the event that the minimum capital requirements are insufficient.
- a countercyclical capital buffer
Own Risk and Solvency Assessment (ORSA)
Under Solvency II Pillar 2, all insurance companies are also required to consider their internal economic capital requirements under the ORSA.
The purpose of the ORSA (Own Risk and Solvency Assessment) is to provide the board and senior management of an insurance company with an assessment of:
- the adequacy of its risk management, and
- its current, and likely future, solvency position.
The ORSA requires each insurer:
- to identify the risks to which it is exposed
- to identify the risk management processes and controls in place
- to quantify its ongoing ability to continue to meet its solvency capital requirements (both MCR and SCR)
Involving projections of financial position over terms longer than that normally required to calculate regulatory capital requirements.
- to analyse quantitative and qualitative elements of its business strategy
- to identify the relationship between risk management and the level and quality of financial resources needed and available
The ORSA concept now forms part of the International Association of Insurance Supervisors (IAIS) standards, and has been introduced in several jurisdictions.
The ORSA is being promoted by the IAIS as a tool both for improving insurance business practice and for allowing regulators to enhance their assessments of the ability of insurance companies to withstand stress events.
Economic Capital
Economic capital is the amount of capital that a provider determines is appropriate to hold (in excess of liabilities) to cover its risks under adverse outcomes, generally with a given degree of confidence and over a given time horizon
Typically, it will be determined based upon the:
- business objectives of the provider
- risk profile of the individual assets and liabilities in its portfolio
- correlation of the risks
- desired level of overall credit deterioration that it wishes to be able to withstand
Economic Balance Sheet
Assets - Liabilites
= Available Economic Capital
= Free capital + Economic Capital Requirement
Market values of assets are usually easily and instantly available from the financial markets.
The determination of a market value for a provider’s liabilities is not so easy and a high level of judgement is required to determine market-consistent liability values. One approach is to determine the expected value of the unpaid liabilities stated on a present value best estimate basis and to add a risk margin.
The value of using an economic balance sheet as a starting point for capital requirement assessment is that it starts with assets and liabilities both being assessed on the same, market-consistent, basis.
Solvency II is an example of the economic balance sheet assessment being the first stage
Other methods that involve a deterministic valuation of liabilities necessarily use a basis that does not set out to be market-consistent. Some liability valuation bases used for supervisory purposes have an inbuilt prudential margin, to a greater or lesser extent, depending on the regulatory regime.
Models for assessing capital requirements
- Standard Formula
Under the Solvency II standard formula, the capital requirement is determined through a combination of stress tests, scenarios and factor-based capital charges
The standard formula allows for: ·
- underwriting risk
e.g. premium (general insurance), mortality, morbidity, catastrophe, expense and lapse risks
- market risk e.g. equity, property, interest rate, credit spread and currency risks
- credit / default risk including reinsurance default risk
- operational risk
Using the standard formula has the advantage that the Solvency Capital Requirement calculation is less complex and less time-consuming.
However, using the standard formula has the disadvantage that it aims to capture the risk profile of an average company, and approximations are made in modelling risks which mean that it is not necessarily appropriate to the actual companies that need to use it
Models for assessing capital requirements
- Internal Formula/Models
Internal models aim to create a stochastic model that reflects the company’s own business structure
Companies can also use internal models:
- to calculate economic capital using different risk measures, such as Value at Risk (VaR) and Tail Value at Risk (Tail VaR)
- to calculate levels of confidence in the level of economic capital calculated
- to apply different time horizons to the assessment of solvency and risk
- to include other risk classes not covered in the standard formula
