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Cost of Capital approach-Ch20

Discussion in 'SP2' started by Actuary@22, Jan 24, 2022.

  1. Actuary@22

    Actuary@22 Very Active Member

    Hi
    I am not clear with how the liabilities are projected under the cost of capital approach -pg 10 of ch 20 as per acted 2019 notes .Please explain.
    Also,under this section we are talking about determining the market consistent valuation of liabilities ,for which we are using the cost of capital approach to determine the risk margin for additional risk in the liability cashflows.But then under this method the 1st step is projecting the required capital(for which we need the projected liabilities).
    So then this is a loop.Pleas explain.
     
    Actuary@22, Jan 24, 2022
    #1
  2. Mark Willder

    Mark Willder ActEd Tutor Staff Member

    Hi

    Yes, the calculations required here could introduce a circularity. This is one of the reasons why simplified approaches are often used in practice.

    The Core Reading mentions several different ways to project the capital:

    "For some chosen regulatory frameworks, the projection of required capital can be relatively straightforward, for example where it is defined as a fixed percentage of reserves.

    However, for others it can be complicated if the calculation of required capital itself requires projections, stochastic modelling and/or application of correlation matrices.

    In such situations, a simplified approach can normally be used. This might involve selecting a driver (eg reserves or sum at risk) which has an approximately linear relationship with the required capital or its components.

    The initial capital requirement can be expressed as a percentage of that driver, and the projected capital is then approximated as the same percentage of the projected values of the driver.

    In practice, more sophisticated methods using a combination of drivers and correlations may have to be used."

    Best wishes

    Mark
     
    Mark Willder, Jan 25, 2022
    #2

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