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Enterprise Risk Management (IFoA ST9) > Module 30: Capital management > Flashcards

Module 30: Capital management Flashcards

1
Q

Solvency Capital Requirement (SCR) under Solvency II

A

A market-consistent 1-in-200, 1-year VaR performed using a standard formula or the firm’s internal model.

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2
Q

Calculating credit risk capital:

Internal Ratings Based (IRB) approach

A

Basel II allows banks to categorise and risk-weight their assets based upon credit ratings determined by using their own Internal Ratings Based (IRB) model.

A thorough credit assessment is required, and the methodology needs to be approved by the regulator.

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3
Q

Capital modelling process:

Select the modelling criteria

A

E.g. exit value as measured by absolute ruin, attaining a certain investment rating or some ongoing business criteria as measured by supervisory intervention.

Multiple criteria should be used.

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4
Q

Capital modelling process:

Identify purpose

A

A clear purpose is required for the model.

This will influence factors such as:

  • whether or not it is assumed that the business remains open to new business or simply run off
  • whether contingent management actions will be modelled
  • the level of resourcing required
  • the accuracy of results.
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5
Q

Minimum Capital requirement under Basel II

A

Minimum Tier 1 + Tier 2 capital is 8% of RWA (total risk weighted assets).

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6
Q

Capital modelling process:

Choose the simulation approach for each risk

A

Possible approaches include both deterministic (stress scenario) and stochastic (eg parametric, empirical) approaches.

The approach chosen will depend on cost/time considerations and the benefits gained.

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7
Q

ICMs should aim to cover:

A

All risks faced by a company,
in a consistent way,
allowing for the interaction between the various risks.

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8
Q

8 Benefits of a dynamic asset-liability model

A
  • improved understanding of the dynamics of the current strategy
  • consideration of the impacts of implementing different strategies (eg mix of business)
  • examination of the impact of using different sources of capital
  • useful for due diligence for corporate transactions
  • assesses the risk-adjusted performance of different business units
  • determines an optimal asset mix
  • helps understand the impact of extreme events
  • useful in producing Financial Condition Reports
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9
Q

Define hurdle rate

A

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.

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10
Q

7 Factors which might be used to compare different methods of capital allocation

A
  • complexity and computational intensity (eg game theory)
  • ease of communication
  • degree to which allocation is affected by the presence of other business units (eg stand-alone)
  • degree to which allocation is affected by basis (eg order of allocation in the marginal approach)
  • degree to which the method may lead to under-investment business units providing a diversification benefit.
  • degree to which method may lead to over-investment in risky business units.
  • correspondence with the marginal pricing principle
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11
Q

Economic income created (EIC)

A

EIC captures the quantity of return generated by a unit fo activity (ie it is a monetary amount, rather than a percentage)

EIC = (RAROC - hurdle rate) x Capital

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12
Q

Economic cost of ruin

A

Looks at the amount key stakeholders (eg policyholders of an insurance company with depositors with a bank) can be expected to lose in the event of ruin.

This may be expressed as an absolute amount or as a proportion (eg ratio or policyholder benefits).

This is theoretically a better approach than considering only the probability of ruin, but this advantage is usually outweighed by practical problems associated with calculating the economic cost of ruin.

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13
Q

Solvency II
Solvency Capital Requirement

Outline the basis of the standard formula (4)

A

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)
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14
Q

Under Basel II, a bank’s capital is classed in 3 tiers:

A

Tier 1
The bank’s equity and disclosed reserves.

Tier 2
Other reserves and various debt instruments.

Tier 3
Certain types of shorter-dated capital (eg unsecured, subordinated debt with a minimum maturity of two years).

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15
Q

Market risk capital under Basel II

A

determined using either a standardised approach or using asset modelling to calculate a multiple of a 10-day 99% VaR.

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16
Q

Capital modelling process:

Identify and rank risks

A

The dominant risks will vary by insurer.

This may include:
- catastrophe
- underwriting
- reserving 
- pricing
- liquidity
- market
- credit
- operational
risks
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17
Q

Capital modelling process:

Define the risk metrics

A

These typically include

  • VaR or Tail VaR,
  • the time horizon and
  • the confidence interval.
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18
Q

Shareholder Value (SHV)

A

SHV assesses the intrinsic economic value of a business as a going concern.

SHV captures the present value of all future cashflows:

SHV = Discounted value of all future cashflows
= Capital x { (RAROC - g) / (hurdle - g) }

Where

g = prospective future growth rate of the business (usually over three to five years).

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19
Q

Aims of Basel III

A
  • strengthened capital requirements for banks
  • reduce pro-cyclicality by allowing capital requirements to fall in times of financial stress
  • reduce systemic risk by limiting the degree to which holdings in other banks can be allowed for in a bank’s equity
  • strengthen short- and long-term resilience against liquidity risk, as measured by the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR)

However, it doesn’t deal with the concentration risk arising when banks pursue similar business strategies.

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20
Q

Capital allocation:

Particular care should be taken when: (5)

A
  • using a risk measure that is not coherent
  • using different risk measures to calculate the overall requirement and the requirement at unit level
  • allocating ‘excess’ capital (eg capital required to support a credit rating)
  • allocations change significantly over time
  • communicating complex, and potentially unintuitive results
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21
Q

Outline the method used to assess capital requirements:

stochastic model

A

These can either be univariate or multivariate (both can allow for covariance between the variables).

Scenarios are generated at random and capital calculated on the basis of the results of these scenarios.

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22
Q

Dynamic asset-liability model

A

One where the asset and liability cashflows are linked by equivalent economic variables (eg inflation).

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23
Q

Basel II definition of operational risk

A

The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

This definition includes legal risk, but excludes strategic and reputational risk.

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24
Q

Outline key differences between internal and generic capital models

A
  • different views as to volatility of various classes of business
  • different allowances for diversification between / within risk types
  • different objectives of the model
  • inclusion of different risk types, or different treatment of the same risks
  • different views regarding the availability of certain types of asset as capital
25
Q

Solvency II
Solvency Capital Requirement

Outline 6 standards that any approved internal model must satisfy

A
  • 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
26
Q

6 Stages required in operating a successful capital model

A
  1. identify purpose
  2. identify and rank risks
  3. choose the simulation approach for each risk
  4. define the risk metrics
  5. select the modelling criteria
  6. decide on the method of implementation
27
Q

Generic models are becoming more complex due to: (3)

A
  • 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.
28
Q

Financial Condition Report (FCR)

A

A more formal assessment of the financial viability of the insurer.

In addition to the output from an internal CM, an FCR may include hard-to-quantify factors (eg reputational risk and the effectiveness of the ERM framework).

29
Q

Theoretical calculation of the capital requirement

A

Theoretically, the capital requirement should be evaluated as the difference between the value of the assets and liabilities at any future point in time.

A strategy to avoid ruin may be to set capital at a high enough level to ensure the probability that the value of assets falling below a scaled ( >100% ) value of the liabilities is sufficiently low.

This approach is generally impractical, eg due to the large number of parameters required, and the difficulty in deriving robust estimates for these parameters.

30
Q

When does ruin occur?

A

When the market value of a company’s liabilities are greater than the market value of its assets.

31
Q

3 Outputs of the internal capital model

A
  • forecast future balance sheets
  • profit and loss accounts
  • cashflow statements
32
Q

Generic capital model

A

A generic capital model may be used by capital providers and regulators to gain a consistent assessment of capital requirement across different firms.

33
Q

4 Metrics used in risk optimisation

A
  • Risk-adjusted return on capital (RAROC)
    can be used to compare different business activities.
  • Economic income created (EIC)
    quantifies the degree to which RAROC exceeds some hurdle rate.
  • Shareholder value (SHV)
    captures the present value of all future cashflows.
  • Shareholder value added (SHA)
    the excess of SHV over the capital invested.

Both SHV and SHA assess the intrinsic economic value of a business as a going concern.

34
Q

3 Types of capital

A
  • working capital
  • development capital
  • risk (or economic) capital
35
Q

Capital management involves: (3)

A
  • quantification (eg using capital models)
  • allocation
  • optimisation
36
Q

Total risk weighted assets (RWA) under Basel II

A

(1) + [(2) + (3)] x 12.5

Where

(1) credit-risk capital
(2) market risk capital
(3) operational risk capital

37
Q

Credit-risk capital under Basel II

A

based on the risk-weighted value of assets using either
- the standardised approach or
- Internal Ratings Based (IRB) approach
neither of which allow for the benefits of diversification.

38
Q

“Twin peak” approach under Solvency II

A
  • Failure to maintain regulatory capital above the SCR results in action by the regulator.
  • Failure to maintain regulatory capital above a more basic valuation based on the Solvency I Minimum Capital Requirement (MCR) would result in withdrawal of the firm’s authorisation.
39
Q

Internal capital model (ICM)

A

Used to simulate a company-specific view of the capital needed and can help improve management’s understanding of the dynamics of the business and thereby improve decision making.

40
Q

4 Steps of a bottom-up approach to calculation of the capital requirement

A
  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 effects).
  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.
41
Q

10 Methods used to calculate capital

A
  • probability of ruin
  • economic cost of ruin
  • full economic scenarios
  • stress test method
  • factor tables
  • stochastic models
  • statistical models
  • credit risk methods
  • operational risk methods
  • option pricing theory
42
Q

3 Common threads in various definitions of (risk) capital

A
  • capital should provide sufficient surplus to cover adverse outcomes
  • with a given level of risk tolerance
  • over a specified time horizon.
43
Q

Additional uses for an internal capital model:

A
  • determining company or product risk profile
  • capital budgeting
  • working out capital needed in merger and acquisition situations
  • insurance product pricing
  • risk tolerances/constraints
  • setting investment strategy
  • calculating risk-adjusted rate of return on capital
  • performance measurement
  • incentive compensation
  • as an alternative to rating agency / regulatory requirements
  • disaster planning
44
Q

3 Metrics that might be used to set an appropriate level of risk tolerance

A

The appropriate risk tolerance level might be set with reference to:

  1. a certain percentile of the loss distribution
  2. extreme loss values
  3. the possibility of some key indicator (eg credit rating) falling outside an acceptable level
45
Q

4 Desirable features of an internal capital model

A
  • the asset model allows for correlations between different asset classes over time
  • the liability model considers reinsurance and correlations between classes of risk
  • the asset and liability model should be integrated, and allow for correlations between assets and liabilities over time
  • the model is dynamic
46
Q

Effective capital management can increase shareholder value by facilitating better: (4)

A
  • pricing
  • reserving
  • performance management
  • risk management
47
Q

Outline 2 key factors to be considered when determining an appropriate hurdle rate.

A

The hurdle rate should:

  1. reflect the cost of capital
  2. allow not only for the risks inherent within a proposal, but also the degree to which those risks diversify (or hedge) existing risks.
48
Q

Basel III strengthened the requirements by requiring: (3)

A
  • minimum Tier 1 capital of 6% of RWA
  • a conservation buffer to reduce pro-cyclicality
  • further assets to be disallowed so as to reduce systemic risk.
49
Q

Shareholder Value Added (SVA)

A

SVA measures the extent that SHV exceeds the capital invested:

SVA = Discounted value of economic value added

= Capital x { (RAROC - g) / (hurdle - g) - 1 }

50
Q

Explain how the allocation of capital affects pricing, risk control limits and performance measurement.

A

The capital allocation process should be set up to link risk to performance measurement, eg a business unit’s success should be measured relative to the risk it takes in its operations, which in turn reflect the amount of capital the company is willing to allocate to the business unit.

The amount of capital that is allocated to each business unit:

  • determines the business unit’s performance (as measured by RAROC, for example)
  • could affect, directly or indirectly, the remuneration of the unit’s managers and, consequently their level of motivation and behaviour.
  • dictates the amount of business the business unit can write (as each product written consumes capital and the total amount of capital is limited).
  • determines, in part, the price at which business can be written (eg a minimum price might be determined by a stipulated minimum RAROC).
51
Q

Capital allocation:
A decision needs to be made as to the degree to which any diversification benefit is passed on to individual business units.

5 possible allocation methods include:

A
  • use of a risk measure to allocate (eg applying the Euler principle to a positively homogeneous risk measure)
  • marginal approach
  • game theory approach
  • pro-rata basis
  • stand-alone basis, with any remaining capital retained in the main corporate business line.
52
Q

Capital modelling process:

Decide on the method of implementation

A

The type of model should be appropriate to the nature, scale and complexity of the insurer’s business and could be a set of univariate models together with a method by which to combine them (eg copula), or a single fully integrated model.

53
Q

Outline the method used to assess capital requirements:

factor tables

A

Tables of capital requirements per unit risk exposure by risk type are published by supervisors.

The capital requirement is then calculated as the number of units in each activity undertaken by the business multiplied by the relevant factor from the table.

54
Q

Operational risk capital under Basel II

A

based on either scaled gross income (two variants being Basic Indicator or Standardised approaches), or using the Advanced Measurement Approach (based on internal models and scenario analysis).

55
Q

Generic capital model

A

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.

56
Q

Risk-adjusted return on capital (RAROC)

A

RAROC = risk-adjusted return / capital

RAROC:

  • can be calculated for an institution as a whole
  • can be used to compare different and diverse business activites, ie to identify activities that are creating or destroying shareholder value
  • can be based on actual or expected return and actual or expected capital.

Note that there is no single definition of either “return” or “capital”, so RAROC is not well defined.

57
Q

Outline the method used to assess capital requirements:

full economic scenarios

A

A chosen set of economic scenarios is detailed and each business unit estimates their profitability under each scenario.

The results are then aggregated across all units and assessed under a given risk measure, eg VaR.

58
Q

Internal capital model

A

An internal capital model is used to simulate a company-specific view of the capital needed.

Internal Capital Models should aim to cover:

  • all risks faced by a company…
  • … in a consistent way…
  • … allowing for the interaction between the various risks.

Enterprise Risk Management (IFoA ST9) (48 decks)

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