Mod 30: Capital management

Question 1

Distinguish between required, available and free capital

Answer 1

Required, available and free capital
Required capital – capital required by an organisation to withstand risks and support its business strategy

Available capital – the capital available to meet this requirement

Free capital – the excess of available capital over required capital
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Question 2

Outline two different assessments of required capital

Answer 2

Different assessments of required capital
1. an organisation’s own assessment of the required capital (economic capital)
2. a third party’s assessment of the required capital for example by regulators (regulatory capital) or by credit rating agencies (rating agency capital)
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Question 3

Define (required) risk capital

Answer 3

Definition of (required) risk capital
There are many different definitions of risk capital in use. However, there are some common threads:
* capital should provide sufficient surplus to cover adverse outcomes
* with a given level of risk tolerance
* over a specified time horizon.

Risk capital can be considered as a function of two quantities:
1. the solvency standard of an organisation
2.its risk profile.
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Question 4

Outline the main ways that effective capital management can increase shareholder value
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Answer 4

Increasing shareholder value through effective capital management
* pricing – ensuring premiums are competitive and an adequate return on capital is achieved
* reserving – eg improving estimates of reserves needed for outstanding claims
* performance management – enabling business outcomes to be measured and processes to be adapted accordingly
* risk management – establishing the overall level of risk tolerance, identifying and assess risks present and keeping all risks under control
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Question 5

Outline the three main interpretations of adverse outcomes (as a common thread in definitions of capital)
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Answer 5

Interpretations of adverse outcomes
1. Capital is the surplus needed to cover all potential outgoings, reductions in assets and/or increases in liabilities at a given level of risk tolerance over a specified time horizon.
2. Capital is equal to the surplus needed to maintain a given level of solvency at a given level of risk tolerance over a specified time horizon.
3. Capital is the excess of the value of the assets over the value of the liabilities at a given level of risk tolerance at a specified time horizon.
Unlike the first two definitions, the final definition above focuses on the values of the assets and liabilities at the specified time horizon – rather than the funding position (cashflow or surplus).
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Question 6

State examples of references against which an appropriate level of risk tolerance (a common thread in definitions of capital) might be set

Answer 6

References for level of risk tolerance
* a certain percentile of the loss distribution
* extreme loss values
* the possibility of some key indicator (eg credit rating) falling outside an acceptable level

Question 7

Outline the purpose of a capital model ©

Answer 7

Capital model
A capital model aims to:
* simulate the internal operations of an organisation and the external environment within which it is operating
* provide a holistic assessment of the key risk drivers facing an organisation
* cover all risks faced by a company, in a consistent way and allow for the interaction between the various risks
* help devise risk management techniques to address these risks, eg determine an appropriate amount of capital to hold.

Most models focus on areas of financial risk but operational risks, asset risks, underwriting risks and other random, catastrophic risks may also be considered. A model may also able to allocate capital across the company.

Question 8

Outline what is meant by an internal capital model (ICM)

Answer 8

Internal capital model (ICM)

• simulates a company-specific view of the capital needed (ie may differ from regulatory assessment of capital)
• may be used to calculate regulatory capital (subject to approval)
• used for key management decisions
• typically comprises an integrated ALM with outputs including forecast future balance sheets, profit and loss accounts or cashflow statements, allowing for reinsurance & correlations
• the ICM may be dynamic, ie linked by some economic variables (eg inflation)

Question 9

State potential benefits of a dynamic internal capital model ©

Answer 9

Potential benefits of a dynamic internal capital model
* improved understanding of the dynamics of the current strategy
* consideration of the impacts of implementing different strategies, eg mix of business, asset mix, sources of capital
* examination of the impacts of using different sources of capital
* useful for due diligence for corporate transactions
* assesses the risk-adjusted performance of different business units
* determine an optimal asset mix
* helps understand the impact of extreme events
* useful in producing Financial Condition Reports

Question 10

Outline what is meant by a generic capital model

Answer 10

Generic capital model

• A generic capital model may be used by capital providers and regulators to gain a consistent assessment of capital requirement across different firms.
• Such models can be very simple in application, eg factor-table approaches determine capital as a multiple of business volume.
• However, generic models are becoming more complex due to:
• the increased sophistication of risk management practices adopted internally at companies
• previous models failing to deal properly with all risks
• increasing pressure on companies to optimise their capital resources.

Question 11

Describe what is meant by a financial condition report (FCR) ©

Answer 11

Financial condition report (FCR)

• An FCR is a formal assessment of the financial viability of an insurer – often required by regulators.
• In addition to the capital model output, an FCR may include hard-to-quantify factors, eg:
• reputational risk
• effectiveness of the ERM framework. ©

Question 12

State the key differences between ICMs and generic models ©

Answer 12

Key differences between ICMs and generic capital models
* different views as to volatility of various classes of business
* different allowances for diversification between / within risk types
* different objectives of the model, risk tolerance levels and/or time horizons
* inclusion of different risk types, or different treatment of the same risks
* different accounting assumptions, eg going concern or wind-up basis
* different views regarding the availability of certain types of asset as capital
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Question 13

List the uses of a capital model ©

Answer 13

Additional uses of a capital model

• simulating a company-specific view of the capital needed (economic capital, can also be used to calculate regulatory capital)
• determining company or product risk profile
• capital budgeting
• assessing the impact of strategic decisions on capital requirements, eg mergers and acquisitions
• insurance product pricing
• risk tolerances / constraints
• setting investment strategy
• calculating RAROC
• performance measurement and incentive compensation
• modelling the impact of extreme events
• disaster planning
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Question 14

List the six stages of a capital modelling process

Answer 14

Capital modelling process
1. identify purpose
2.identify and rank risks
3. choose the simulation approach for each risk, eg deterministic, stochastic
4. define the risk metrics, eg including time horizon and confidence level
5. select the modelling criteria, eg exit value
6. decide on the method of implementation, eg univariate + copula, single fully-integrated
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Question 15

Outline what is meant by a continuity analysis ©

Answer 15

Continuity analysis
* part of an insurer’s ORSA
* an analysis of:
- its ability to continue in business
- the risk management and financial resources required to do so over a longer time horizon than typically used to determine regulatory capital requirements
* it should:
- address a combination of quantitative and qualitative elements in the medium-and longer-term business strategy of the insurer
- include projections of the insurer’s future financial position and modelling of the insurer’s ability to meet future regulatory capital requirements

Question 16

State examples of what needs to be considered when using a capital model as part of a continuity analysis

Answer 16

Considerations when using a capital model as part of continuity analysis
* what time period should be used?
- eg specific point in time, or once specific liabilities have run off?
* what capital reduction / injection policies can be assumed?
* what management actions would be taken in times of crisis?
- eg asset allocation, discretionary benefits, dividend policy, risk mitigation
* how should the model’s results be interpreted?
* what are the limitations of the model?

Question 17

Outline a theoretical method of calculating capital ©

Answer 17

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Question 18

State disadvantages of the theoretical method of calculating capital

Answer 18

Disadvantages of the theoretical method of calculating capital
* the difficulty in obtaining consistent valuations (market or model) for both assets and liabilities
* the need to select an appropriate risk measure (ruin is not the only one!)
* the difficulty in formulating the necessary assumptions, eg how assets (including capital) will be invested
* the large number of parameters needed (which increases exponentially with the number of variables)
* the difficulty in deriving robust estimates of the various parameters needed (correlations and variances etc)
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Question 19

Outline a common pattern for bottom-up processes for calculating capital

Answer 19

Pattern for bottom-up processes for calculating capital
1. generate stand-alone distributions of changes in the enterprise’s value due to each source of risk
2.
combine the distributions – allowing for any diversification / dependency effects (implicitly or explicitly, micro-or macro-level)
3. calculate the total capital for the combined distribution at the desired standard for the selected risk metric(s), eg SCR
4.
attribute capital to each activity based on the amount of risk generated by each activity
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Question 20

List ten methods an organisation might use to calculate its capital requirements

Answer 20

Methods used to calculate capital
1. probability of ruin
2. economic cost of ruin
3. full economic scenarios
4. stress test method
5. factor tables
6. stochastic models
7. statistical models
8. credit risk methods
9. operational risk methods
10. option pricing theory (eg Merton)

Question 21

Define economic cost of ruin and compare it to ruin as a method of calculating capital

Answer 21

Economic cost of ruin
* economic cost of ruin looks at the amount key stakeholders can be expected to lose in the event of ruin (ie when the market value of assets is less than the market value of liabilities)
* this may be expressed as an absolute amount or as a proportion
Advant.
theoretically better than considering only the probability (not the severity) of ruin
Disadvant
* harder to understand and communicate practical problems
* ssociated with calculating the economic cost of ruin

Question 22

Define RAROC and EIC and outline how they might be used

Answer 22

RAROC and EIC
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* RAROC can be calculated for separate parts of the business and used to compare them.
* One basis for rejecting a potential project might be that it doesn’t offer a RAROC above the hurdle rate.
* As EIC captures the quantity of return generated by a unit of activity (ie it is a monetary amount rather than a percentage), it can be used to encourage marginal growth opportunities, ie those activities that do add value, yet may not meet RAROC targets.

Question 23

Define SHV and SVA ©

Answer 23

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Question 24

Explain why, for a proprietary company, it is important not to hold too much ‘unemployed’ capital?
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Answer 24

Why not hold too much unemployed capital

• Shareholders who provide capital expect the organisation to earn a return on their capital by undertaking business activities.
• An organisation with too much (unemployed) capital will make a smaller return on capital than it might otherwise do if it was employed in business activities …
  … and possibly a smaller return for the amount of risk it is taking than the shareholders or equivalent expect.
• The organisation may then need to make plans to return such unemployed capital to shareholders, via dividends.

Question 25

State why a fair allocation of capital to business units is important

Answer 25

Why a fair allocation of capital is important RAROC and impact on performance * The allocation of capital affects the RAROC for each business unit, and hence its relative performance. * In turn, this will affect strategic decisions, eg expansion or contraction of a particular business unit, pricing ... * ... and directly or indirectly, the remuneration of the business units’ managers. Risk limit and impact on volumes * Different lines of business have different risk levels, and so need to be backed by different levels of capital. * In this sense, capital allocation acts as a risk limit, dictating the volumes of business the business units can write and the cost of capital incorporated into the pricing basis. ©

Question 26

State factors which should be considered when determining the method(s) of allocation ©

Answer 26

Factors determining the method of allocation * purpose of the allocation * stakeholder perspectives * practical implications of the results (eg stability of allocation, over-allocation to risky business units) * management judgments made in the light of a comparison of the results of several allocation methods ©

Question 27

Outline the problems in allocating capital caused by the need to allow for dependency between risks / activities

Answer 27

Problems in allocation caused by dependency * level of dependency changes during times of stress * allocation is often very sensitive to tail dependency * tail dependency is problematic to quantify * decision must be made as to the degree any diversification benefit is passed on to individual business units – a significant level of judgment is likely to be required ©

Question 28

List five approaches that could be used to allocate capital ©

Answer 28

Approaches to allocating capital 1. use a risk measure to allocate (eg based on the Euler principle) 2. marginal approach, where each business line receives the change in capital as a result of adding it to the diversified portfolio 3. pro-rata basis (eg weighted by reserves or present value of future expected revenue from the business area) 4. stand-alone basis, with any remaining capital retained in the main corporate business line An alternative to allocation is not to allocate, ie to retain capital in full centrally. ©

Question 29

Suggest two approaches for dealing with the ‘diversification benefit’ when allocating capital

Answer 29

Approaches for dealing with the diversification benefit 1. Calculate the capital required for each business unit and/or risk category separately and then calculate 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. 2. Calculate the capital required for the whole enterprise, including the diversification benefit, and then allocate this capital in a fair way across all units. ©

Question 30

Outline the method of capital allocation using the Euler principle

Answer 30

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Question 31

State factors which might be used to compare capital allocation method

Answer 31

Factors which might be used to compare allocation methods * complexity and computational intensity * ease of communication * degree to which allocation is affected by presence of other business units (eg stand-alone) * degree to which allocation is affected by basis (eg order of allocation in marginal approach) * degree to which method may lead to under-investment business units providing a diversification benefit (eg stand-alone) * degree to which method may lead to over-investment in risky business units (eg no allocation, pro-rata) * correspondence with marginal pricing principle

Question 32

State factors that may cause practical communication issues and prevent buy-in from business units and stakeholders regarding capital allocation

Answer 32

Factors which might cause practical issues and prevent buy-in * use of a different risk measure for the assessment of overall capital requirement and for the allocation of capita * large changes in capital assessment and allocation over time, due to: - modification of capital models, eg due to development cycle or as new techniques emerge - sensitivity to the choice of allocation method, risk measure and/or dependency model * poor understanding of and sensitivity to the conflicts that can be created when implementing an allocation method * un-intuitive results ©

Question 33

Outline the Basel II approach to capital requirements for credit risk

Answer 33

Credit risk capital requirements under Basel II The minimum capital required to be held is based on 8% of the risk-weighted value of assets. There are two methods of categorising assets by risk level: 1. standard approach – based on published credit ratings relates to a risk-weighting category, and therefore to a particular risk weighting, eg, a loan rated A–to A+ is weighted at 20% of its nominal amount. 2. Internal Ratings Based (IRB) approach – credit ratings are determined by the banks own model. A thorough credit assessment is required, and methodology needs to be approved by the regulator. Allowing for the benefits of diversification within the portfolio is not allowed under either approach. Many off-balance sheet credit-related assets (eg securitised loans) are treated as on-balance sheet assets to avoid regulatory arbitrage. ©

Question 34

Outline the Basel II approach to capital requirements for market risk ©

Answer 34

Market risk capital requirements under Basel II Banks may invest their capital in risky securities, and Basel II requires banks to hold additional capital if such additional risks are taken on. This is usually measured by modelling the assets and calculating a 10-day 99% (or 1% tail) Value at Risk (VaR). This leads to a regulatory capital requirement under Pillar I, which is a multiple of this VaR loss (see later card in this pack for details). Banks can also use a standardised approach rather than use an internal VaR model. ©

Question 35

State the three Basel II approaches to capital requirements for operational RISK

Answer 35

Operational risk capital requirements under Basel II The regulatory capital required to be held against operational risk may be based on one of three methods: 1. the Basic Indicator Approach 2. the Standardised Approach 3. the Advanced Measurement Approach.

Question 36

Outline the Basel II Basic Indicator Approach (BIA) to capital requirements for operational risk

Answer 36

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Question 37

Outline the Basel II Standardised Approach (SA) to capital requirements for operational risk ©

Answer 37

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Question 38

Outline the Basel II Advanced Measurement Approach (AMA) to capital requirements for operational risk ©

Answer 38

The Advanced Measurement Approach (AMA) Under the advanced measurement approach the operational risk capital requirement is determined by internal models and scenario analysis (subject to approval and continual checking by the supervisory authorities). Losses are categorised into 8 business lines as for the SA and further into 7 loss-event types – eg internal fraud. Credible data (on probability and expected size of potential losses) is needed in three specific areas to apply the AMA: * internal data on repetitive, high frequency losses over a 3-to 5-year period * external data on non-repetitive, low frequency losses * suitable stress scenarios to consider. ©

Question 39

State the minimum capital requirement required of a bank under Basel II

Answer 39

Minimum capital under Basel II Capital is classed in tiers. The combined Tier 1 and Tier 2 capital ratio must be greater than the minimum capital requirement of 8% of total risk-weighted assets (defined below). (Tier 3 contains certain types of shorter-dated capital, eg unsecured debt capital repayable within 2 years.) The total risk-weighted assets comprise: * the risk-weighted assets with respect of credit risk, plus * the corresponding amount for market risk (eg the 10-day 99% VaR) multiplied by 12.5, plus * the corresponding amount for operational risk (calculated under one of the three permitted approaches) multiplied by 12.5. Certain balance sheet assets are not allowed as sources of capital, eg goodwill.

Question 40

Outline how Basel III strengthens the accord’s capital requirements

Answer 40

Basel III * Tier 1 capital to be at least 6% of RWAs * new conservation buffer of 2.5% of RWAs aiming to reduce pro-cyclicality (as can be drawn on during financial distress) * further assets disallowed, so as to reduce systemic risk * establishment of liquidity requirements (LCR and NSFR)

Question 41

Summarise the requirements of Pillar I of Solvency II ©

Answer 41

Summary of Pillar I of Solvency II * Involves a 2-tier (“twin peak”) approach: − - first is a market-consistent valuation, the Solvency Capital Requirement (SCR) - second is a more basic valuation based on the Solvency I Minimum Capital Requirement (MCR). * Assets are taken at fair value (normally market value). * Capital is classed as Tier 1, 2 or 3 depending on how readily it can be called upon, if required.

Question 42

Describe the SCR and the MCR under Solvency II

Answer 42

The SCR and MCR under Solvency II The SCR: * must be achievable with 99.5% confidence * over a one-year time horizon * based on a standard formula, or on a firm’s approved internal model * failure to maintain the SCR would result in action by the regulator. The MCR: * €3m plus a margin based on premium (volume) or reserve (risk) amounts * must be achievable with 80 – 90% confidence * over a one-year time horizon * failure to maintain the MCR would result in withdrawal of the company’s authorisation. ©

Question 43

Describe the standard formula approach for the SCR under Solvency II

Answer 43

The standard formula for the SCR under Solvency II The standard formula: * is based on a specific deterministic basis but with some stochastic elements (eg for the valuation of guarantees) * deals with market risk through limited admissibility of some assets, plus a number of stress tests * deals with credit risk through limiting exposure to individual counterparties (eg reinsurers) * deals with underwriting risk by requiring additional solvency margins, generally calculated by reference to business volumes (eg premiums) or risks (eg claims incurred, sums assured). ©

Question 44

Describe the standards an internal model (for the SCR) must satisfy

Answer 44

Standards an internal model (for the SCR) must satisfy The internal model must satisfy certain standards including: * a use test, ie the company must actually use the model in its decision making and risk management systems * statistical quality standards – to ensure assumptions are realistic and reliable * calibration standards – to ensure the output can be used to properly calculate the SCR * profit and loss attribution * validation standards * documentation standards. ©