Chapter 37: Capital requirements Flashcards
(23 cards)
List 2 types of assessment of capital
- Regulatory capital
- Economic capital
Define regulatory capital
Regulatory capital is capital required by the regulator to protect against the risk of statutory insolvency
List 3 types of liabilities covered by provisions
- Liabilities that have accrued but which have not yet been paid
- Claims that have incurred but not yet settled
- Future periods of insurance against which premiums have already been received but where the risk event has not yet occurred
Define the 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 the 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
* the additional capital requirement is small (or zero)
Give 2 disadvantags 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 3 pillars on which it is based?
Solvency II is a solvency regime for insurance companies. It is a regulatory requirement for all EU states.
The three pillars are:
1. Quantification of risk exposures and capital requirements
2. A supervisory regime
3. 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
If SCR is breached, the risk management tools can be implemented, alongside:
* closing to new business
* moving to a better matched investment position
Outline 2 methods that could be used to calculated 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.
SCR targets: 0.5% Ruin Probability in 1 year period
(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 charges
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
(The various risks are aggregated using a correlation matrix, to make allowance for any diversification benefits)
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 4 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?
These accords set out requirements for the amount of capital that banks need to hold to reflect the level of risk in the business that they write and manage
Define economic capital
Economic capital is the amount of capital the provider determines it is appropriate to hold given its assets, liabilities and business objectives.
It is typically based on:
* the risk profile of the individual assets and liabilities in its portfolio
* the correlations of the risks
* the desired level of overall credit deterioration that the provider wishes to be able to withstand (ruin probability)
What is ORSA (Own Risk and Solvency Assessment)?
The purpose of ORSA 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 liabily to continue to meet its solvency 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
What is ICAAP (Internal Capital Adequacy Assessment Process)?
Similarly to ORSA, banks are required to assess and ensure that their internal capital adequacy is sufficient over the long term.
The ICAAP ensures that there exists:
* the appropriate identification and measurement of all balance sheet risks
* an appropriate level of internal capital in relation to the bank’s risk profile
* the application and further development of suitable risk management systems
The minimum requirements of the ICAAP include:
* Banks should have a process for assessing their overall capital adequacy levels
* Supervisors should review and evaluate a bank’s ICAAP
* Supervisors should be able to require banks to hold capital in excess of the minimum levels
* Supervisors should require quick remedial action if capital levels are not maintained
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 - and hopefully the former will be less than the latter.
The available capital is calculated as:
MVA - 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
State how providers can obtain market values of assets, and outline two approaches that can be used to determine market values of liabilities for inclusion within the economic balance sheet
Market values of assets are usually easily and instantly available from the financial markets.
The determination of the market values of 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
Outline the 2 components into which the profit made by a financial product provider can be split
- Trading profit: the total of premiums and investment income on the provisions for future liabilities, less claims, expenses, tax and the net increase in any provisions for future liabilities
- Investment profit: The investment return, less tax and investment expenses, earned on that part of the assets not required for the provisions for future liabilities.
Explain what is meant by the “cost of capital” and its relevance to the pricing of financial products and the generation of profits
The premium charged should include an allowance for the loss of return on the capital tied up in the contract for regulatory purposes.
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.
The aim of the product provider is that the shareholders should earn the same return on the free assets whether they are used to support business issued or whether they can be invested freely.
Give 2 risk-return measures
The objective of risk management should be to optimise the balance between risk and return - where optimality is judged by reference to risk appetite. Risk management is not simply about minimising risk.
Understanding return on capital is one way of ensuring that the company is putting its limited capital resources to the best use. The main measure is RAROC (Risk-adjusted return on capital)
RAROC = Risk-adjusted return / Capital
RAROC:
* can be calculated for an institution as a whole
* can be used to compare different and diverse business activities, i.e. to identify activities that are creating or destroying shareholder value
* can be based on actual or expected return and actual or expected capital
Unlike RAROC, economic income created (EIC) captures the quantity of return generated by a unit of activity (i.e. it is a monetary amount rather than a percentage):
EIC = (RAROC - hurdle rate) x Capital
As EIC is a monetary amount, it can be used to encourage marginal growth opportunities, i.e. those activities that do add value, yet may not meet RAROC targets.
The hurdle rate of return on capital is a standard against which business activities must be measured. If a proposed activity does not offer a RAROC above the hurdle rate, then that is one basis upon which it might be rejected.
What is Capital Allocation?
Aftern the required capital has been determined at an overall level, the next question is then how this should be translated in a fair way into capital requirements at the level of individual business units, products or other “segments”.
How to allow for concentration or diversification of risk in capital allocation?
Any method of allocation needs to allow for concentration / diversification of risk between the business units. In particular, not all business areas have the same degree of risk. Some allocations of capital may result in the less risky areas subsidising the more risky areas.
At an aggregate level, most approaches to the evaluation of the capital requirement and its allocation to different units involve taking into account correlation and dependency. In making these adjustments it is important to remember that the level of dependency between different lines of business and risk categories might be different during times of stress from those experienced under normal conditions. As required capital is typically calculated with reference to extreme events, tail dependency will have to be considered carefully.
Some approaches to capital allocation calculate capital required for each business unit and/or risk category followed by an adjustment for the benefit of diversification. This adjustment is retained at the level of the enterprise and not passed on to the individual units.
