Difference between global provisions and required capital

[Adithyan]

I remember seeing in ActEd video that assets backing global provisions are for credit, operational and market risk.

And then it goes ahead to say that required capital is calculated by means of stress test (eg: capital required to meet 35% fall in equity yield) , scenario test and so on.

Can you give me a clear distinction between the both.

Thank you

Regards
Amarnath

 

[Mark Willder]

I remember seeing in ActEd video that assets backing global provisions are for credit, operational and market risk.

And then it goes ahead to say that required capital is calculated by means of stress test (eg: capital required to meet 35% fall in equity yield) , scenario test and so on.

Can you give me a clear distinction between the both.

Thank you

Regards
Amarnath

Hello Amarnath

You are right that for some risks we might set a global reserve, or we might set additional solvency capital. The approach used in practice depends on the regulations of the country.

For many risks we might calculate reserves on a policy by policy basis, eg the risk of a claim being made.

For other risks that apply to a group of policies we might instead calculate a global reserve. So we look at the portfolio of policies, rather than considering each policy one at a time.

In addition (or alternatively) we might calculate the required capital to cover a risk. For example, we might calculate the capital required to cover losses 99.5% of the time.

Different approaches exist, and different names are given to the components, but the end result is that the insurer is required to hold assets to cover the sum of the various reserves and required capital. Some countries require large reserves and little capital. Other countries require smaller reserves but have much larger required capital. In a sense, it doesn't matter how big a particular component is, as long as the sum of all the solvency components is large enough to give good security to policyholders.

I hope this helps.

Best wishes

Mark

 

[Adithyan]

Dear Sir,

Thank you very much for your prompt reply.

I just wanted to have the following clarified:

Do you mean to say that required capital will be held in addition to global provision or only one of these (i.e. either required capital or global provision) may be held at a time depending on regulation?

What would be the reason to hold both required capital and global provision at the same time in addition to free reserves? Doesn't this increase the cost of capital for the company by holding too much of money?

I feel your reply for this question would completely clarify the questions I have with regard to this concept.

I would like to thank you for your time and patience for helping me out.

Regards
Adithyan

 

[Mark Willder]

Dear Sir,

Thank you very much for your prompt reply.

I just wanted to have the following clarified:

Do you mean to say that required capital will be held in addition to global provision or only one of these (i.e. either required capital or global provision) may be held at a time depending on regulation?

What would be the reason to hold both required capital and global provision at the same time in addition to free reserves? Doesn't this increase the cost of capital for the company by holding too much of money?

I feel your reply for this question would completely clarify the questions I have with regard to this concept.

I would like to thank you for your time and patience for helping me out.

Regards
Adithyan

Hello Adithyan

I think most regulators require only one of a global reserve or solvency capital. However, in theory the insurer could be required to hold both at the same time.

Yes, there is a danger of double counting where insurers hold a reserve and solvency capital. However, that need not be the case. The reserve might be to cover the best estimate of the operational risk say, while the required capital is there to cover the possibility that the risk is worse than expected. This might give exactly the same total requirement as a prudent reserve for operational risk and no solvency capital.

Best wishes

Mark

 

[Adithyan]

Thank you very much Sir! This is highly useful.