Q7, (v) part, April 2011, understanding about the "15%"

[Smith]

Hi tutor,

In Q7, (v) part, April 2011, refer to the understanding about the "15%", have confuse about the solution given in examiner's report, that,

From my understanding, the listed risk components in the question are all non-insurance risk, insurance risk charge was not included. Therefore, the sum 17 m is supposed to be divided by 15%, to derive the total capital requirement for the insurer.

From the understanding of the solution in the examiner's report, it treated the 17m as total capital requirement, which including insurance risk charge.

The fact is, that credit risk, market risk, operational risk and diversification items were clearly set out, insurance risk is another separate item in captial modelling.

To be honest, it's really difficult to agree with the way of examiner's report take. Could you help explain how the examiner think?

thanks and regards,

 

[Katherine Young]

The basic idea was simple enough; to determine whether the cost of the risk management strategy was outweighed by the consequent reduction in capital. Perhaps you're confused by the apparently sketchy detail provided in the question and by the definition of the term “capital requirement”.

The Core Reading for Subject ST7 refers to the “capital requirement” as a nominal amount. In this context however, it refers to the cost of capital.

Therefore the cost of holding capital (in absolute terms) is:

Capital charge (£) = capital held x cost of capital (%)

If the risk management strategy is not introduced, the opportunity cost of holding capital (ie the capital charge) is:

capital held x cost of capital (%)
​

=(750+500+750-300)x15%=255m​

If the strategy is introduced, the capital charge is:

capital held x cost of capital (%)​

=(750+500+750-300)x0.70x15%=178.5m​

Hence there is a saving of 255 -178.5 = £76.5m for a cost of £50m and the strategy should be introduced.

Alternatively, think about it this way: The release in capital will be:

(750+750+500-300)x0.3 = 510m​

so the reduction in capital charge will be 510x0.15=76.5m . Hence as above, the reduction in capital charge exceeds the £50m cost of the strategy.