Chapter 37: Capital requirements Flashcards
List 2 types of assessments of capital.
- Regulatory capital
- Economic capital
Regulatory capital
Regulatory capital is capital required by the regulator to protect against the risk of statutory insolvency.
Solvency capital requirement
The solvency capital requirement is the total assets required to be held in excess of provisions that are calculated on a best estimate basis.
It therefore comprises:
- any excess of the provisions established
on a regulatory basis over the best
estimate valuation of the provisions
- any additional capital requirement in
excess of the provisions established
Outline the relationship between provisions and the additional capital requirement.
- In some territories, or for some types of
financial provider:
-> the regulatory basis used for the
provisions is best estimate
-> and additional capital requirement is
substantial - In other territories, or for other types of
financial provider:
-> the regulatory basis used for the
provisions is significantly more prudent
than best estimate
-> and the additional capital requirement
is small (or zero)
Give 2 disadvantages of a regime where provisions are determined on a prudent basis and additional solvency capital requirements are based on simple formulae.
- The levels of prudence within the
provisions can vary between providers,
making comparisons difficult. - The solvency capital requirements are
not risk-based, making it difficult to
ensure that sufficient security is provided
for policyholders.
What is Solvency II and what are the three pillars on which it is based?
The three pillars are:
- Quantification of risk exposures and
capital requirements - A supervisory regime
- Disclosure requirements
What are the 2 levels of capital requirements under Solvency II?
- The MCR (Minimum Capital Requirement)
is the threshold at which companies will
no longer be permitted to trade. - The SCR (Solvency Capital Requirement)
is the target level of capital below which
companies may need to discuss
remedies with their regulators.
Outline 2 methods that could be used to calculate the SCR.
- A standard formula prescribed by
regulation. - A company’s own internal model (usually
a stochastic model reflecting the
company’s own business structure),
which may be benchmarked against the
standard formula output.
(An internal model is likely to be used by the largest companies who can afford the considerable extra work needed to justify using an internal model)
Outline how the standard formula determines the amount of capital to hold.
The standard formula determines the capital requirement through a combination of:
- stress tests
- scenarios
- factor-based capital changes
It allows for the following types of risks:
- underwriting
- market
- credit/default
- operational
It aims to assess the net level of risk allowing for diversification and risk mitigation options.
Give one advantage and one disadvantage of using the standard formula to determine a provider’s capital requirements
Advantage:
The SCR calculation is less complex and less time consuming.
Disadvantage:
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.
Other than deriving Solvency II capital requirements, state the uses of internal models.
- To calculate economic capital using
different risk measures, such as VaR and
TailVaR. - 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.
What is the purpose of the Basel Accords?
The Basel Accords set out regulatory capital requirements for banks.
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. It is an internal, rather than a regulatory, capital assessment.
Typically, it will be determined based upon the:
- business objectives of the provider
- desired level of overall credit deterioration
that it wishes to be able to withstand
- risk profile of the individual assets and
liabilities in its portfolio
- correlation of the risks
What is the starting point in an economic capital assessment?
The starting point is to produce an economic balance sheet to calculate how much capital is available on a market value basis. This will enable the provider to compare the economic capital requirement with that it has available.
The available capital is calculated as:
- the market value of the provider’s assets
(MVA) less
- the market value of the provider’s
liabilities (MVL).
The economic capital requirement will then be assessed using a risk-based approach and the techniques described in the chapters on the risk management control cycle.
Outline the 2 components into which the profit made by a financial product provider can be split.
The profit made by a financial product provider can be expressed as:
- Trading profit = premiums plus
investment income on provisions (and
on net cashflows received), less claims,
expenses, tax and the net increase in
provisions. - Investment profit = investment return
(net of tax and investment expenses) on
available capital.
