Capital Management (ch15)

[Mbotha]

I have some questions on available and required capital:

• Does required capital ("regulatory capital") refer to SCR only or SCR + risk margin?
• Is "available capital" within a with-profits fund = the inherited estate?
• Pg4 states "...whilst theoretically the whole company belongs to the policyholders, the available capital is more likely to be regarded as the capital required to support the corporate entity...". So within a mutual, does this mean that the "available capital" is the excess assets available over above the inherited estate?

Any help would be appreciated. Thanks!

 

[Viki2010]

1. Rm is classified as a component of tp so it isn't a regulatory capital.

 

[Lindsay Smitherman]

Hi there - all of these phrases are potentially ambiguous and different companies will take different approaches, so try not to get too hung up on specific definitions. What will be important is how they are defined within an exam question: if it is important, the question should make the meaning clear.

For example, although as Viki says the risk margin is part of technical provisions from a Solvency II perspective, if we think about "required capital" in terms of European or Market Consistent Embedded Value value calculations, some companies might classify the risk margin as part of the liabilities (hence its release forms part of VIF) whilst others might classify it as part of the required capital component.

Yes, the phrase "estate" can be used instead of "available capital" in a with profits fund. Again, the precise definition may vary though, depending on whether we are considering just excess of assets over asset shares, say, or over total realistic liabilities (including cost of guarantees etc) and so on.

The point about a mutual is that when you are considering "available capital" you need to consider to whom it is "available". You might therefore want to split it somehow between what is intended for distribution to the policyholders and what can be used by the company for strategic purposes.

 

[Mbotha]

Yes, the phrase "estate" can be used instead of "available capital" in a with profits fund. Again, the precise definition may vary though, depending on whether we are considering just excess of assets over asset shares, say, or over total realistic liabilities (including cost of guarantees etc) and so on.

So in either case, the inherited estate will always (at least partially) need to be used to fund the regulatory capital requirements (MCR/SCR or perhaps even the risk margin)?

 

[Lindsay Smitherman]

Yes - one purpose of the estate is to cover regulatory capital requirements. However, the more typical phrase used for the "estate" when considering the Solvency II balance sheet would be "own funds".

 

[Mbotha]

Pg10 ch15 states (non-core reading) "In order to ensure that the interests of existing policyholders are protected, it may well be necessary to require that the assets of the company remain above the current asset shares..."

A similar comment is made again on pg11 - "Under the entity approach, the total assets of the company should exceed asset shares."

From a regulatory perspective, assets will always need to be above asset shares though, surely (assets needed to back the cost of the WP guarantees, risk margin and SCR)?

 

[Lindsay Smitherman]

Agreed: there needs to be sufficient assets in the WPF to meet the total regulatory liabilities, which would include cost of guarantees and expected smoothing costs. [Technically assets held outside the WPF can be used to cover the SCR, but it is preferable to use own funds within the WPF to do so.]

 

[Mbotha]

Thanks, Lindsay. What is the significance of these sentences then? Is it just reiterating that the available capital (inherited estate) in a with-profits fund (whether proprietary or mutual company) would need to support cost of guarantees, smoothing, SCR etc and so not all of it is available for distribution?

 

[Lindsay Smitherman]

Yes, I think that's what they are trying to reinforce, but doing so mainly by considering the smoothing angle. In the past, guarantees under with profits business tended not to be particularly onerous, and so smoothing was the main consideration and the main support purpose of the estate. The lower interest rate and inflation (and economic growth) environment of more recent years has made this less the case.

I will make a note of these sentences and we will consider them during the next draft of the notes - thank you for highlighting!

 

[Mbotha]

Please can you confirm my understanding of economic vs regulatory capital:

• Economic capital is assessed by determining realistic capital (MV of assets less MV of liabilities) over a number of scenarios
• Regulatory capital required = MV assets - BEL (possibly less the risk margin as well) where BEL is calculated using a MC approach

So essentially the only difference between them is the (possible) inclusion of the risk margin (within regulatory capital), the (possible) allowance for premiums beyond the contract boundary (within economic capital), and the fact that economic capital is determined using stress tests or stochastic modelling?

 

[Viki2010]

I would say that the:

REGULATORY CAPTIAL REQUIRED = MV assets less liabilities, where liabilities are Technical Provisions (BEL + RM).
My understanding is that the RM has to be included in regulatory capital calculation.

Economic Capital is usually calculated via a stochastic model. Can it be calculated using a stress test approach at all?

Isn't MC = MV ?

 

[Lindsay Smitherman]

Please can you confirm my understanding of economic vs regulatory capital:

• Economic capital is assessed by determining realistic capital (MV of assets less MV of liabilities) over a number of scenarios
• Regulatory capital required = MV assets - BEL (possibly less the risk margin as well) where BEL is calculated using a MC approach

So essentially the only difference between them is the (possible) inclusion of the risk margin (within regulatory capital), the (possible) allowance for premiums beyond the contract boundary (within economic capital), and the fact that economic capital is determined using stress tests or stochastic modelling?

Hi - we need to be a little careful here with definitions.

Economic capital required is the amount of capital needed to meet obligations at a level of confidence determined by the company. It is calculated as the difference between base (i.e. unstressed) net assets (which are as you have defined them, i.e. MV assets - realistic or market consistent value of liabilities) and the same net assets but under stress scenarios that have been determined by the company (and these may be implemented through stochastic modelling).

Regulatory capital required under Solvency II (the SCR) has the same underlying definition, but the level of confidence is set by the regulator (1 in 200 confidence over 1 year) rather than by the company. It is calculated as the difference between base net asset value (defined as assets - BEL) and this net asset value under the stress scenarios. The stress scenarios are prescribed if a standard formula is used, but are up to the company if an internal model is used - although should still be calibrated to be equivalent to the 1 in 200 confidence level over 1 year. (The internal model may be stochastic.)

So the two measures could be similar, if the company's internal risk appetite is equivalent to a 1 in 200 confidence level over 1 year, if the BEL+RM corresponds to its own market consistent valuation of liabilities and if an internal model is used for the SCR calculation.

As you say, the company may wish to include premiums beyond the contract boundary within its own internal liability valuation, and if so this would represent a difference between the two measures.

 

[Lindsay Smitherman]

I would say that the:

REGULATORY CAPTIAL REQUIRED = MV assets less liabilities, where liabilities are Technical Provisions (BEL + RM).
My understanding is that the RM has to be included in regulatory capital calculation.

Economic Capital is usually calculated via a stochastic model. Can it be calculated using a stress test approach at all?

Isn't MC = MV ?

Again, we need to be careful about definitions. Assets less liabilities is available capital, not required capital.

As explained on page 20 of Chapter 12, the SCR stress calculation is performed on {assets - BEL}, not on {assets - (BEL+RM)}. This is for practical reasons.

Economic capital can be calculated using a stress test approach, but the liabilities within the calculation (under base and stressed scenarios) may need to be determined stochastically if they have financial guarantees or options, for example.

 

[Viki2010]

Again, we need to be careful about definitions. Assets less liabilities is available capital, not required capital.

As explained on page 20 of Chapter 12, the SCR stress calculation is performed on {assets - BEL}, not on {assets - (BEL+RM)}. This is for practical reasons.

Economic capital can be calculated using a stress test approach, but the liabilities within the calculation (under base and stressed scenarios) may need to be determined stochastically if they have financial guarantees or options, for example.

Thank you Lindsay.

What does it mean "for practical purposes". I have read that sentence on p. 20 but does that mean that an insurer has to calculate:

- Technical Provisions = BEL + RM as their liabilities but
- Required Capital is calculated based on liabilities excluding RM from liability component? Is that because RM is based on a subset of SCR and that would involve some convoluted vicious circle?

 

[Mbotha]

Thanks, Lindsay. It makes a lot more sense now!

Just one thing that I'm still a little confused about - in reference to the differences between the two calculations, pg17 ch15 states "In particular, the internal calculation...may not include the risk margin." This seems to suggest that the regulatory capital calculation does?

Another thing that I wanted to confirm - the economical capital requirement calculation takes into account the ongoing business strategy, "including planned new business" (according the April 2016 exam) whereas the regulatory capital requirement only considers in-force. Is that right?

 

[Lindsay Smitherman]

Thank you Lindsay.

What does it mean "for practical purposes". I have read that sentence on p. 20 but does that mean that an insurer has to calculate:

- Technical Provisions = BEL + RM as their liabilities but
- Required Capital is calculated based on liabilities excluding RM from liability component? Is that because RM is based on a subset of SCR and that would involve some convoluted vicious circle?

Yes Viki - this is exactly what the problem would be: well deduced. [This is covered in Question 12.4 of the course notes.]

 

[Lindsay Smitherman]

Just one thing that I'm still a little confused about - in reference to the differences between the two calculations, pg17 ch15 states "In particular, the internal calculation...may not include the risk margin." This seems to suggest that the regulatory capital calculation does?

What this refers to is that the total amount of liabilities and capital required under Solvency II (regulatory capital approach) is BEL + RM + SCR.

Whereas under the internal economic capital measure the company would hold: Market consistent value of liabilities + Required economic capital.

The market consistent value of liabilities doesn't have to equal BEL + Risk Margin, and for economic capital purposes the company doesn't have to follow the approaches prescribed by the regulator. The company will use its own approach, and so "may not include the risk margin". Similarly, it may not feel that other regulatory restrictions, such as the contract boundaries applied to the BEL, are appropriate and so would ignore these rules when it does its own internal calculation.

 

[Lindsay Smitherman]

Another thing that I wanted to confirm - the economical capital requirement calculation takes into account the ongoing business strategy, "including planned new business" (according the April 2016 exam) whereas the regulatory capital requirement only considers in-force. Is that right?

Yes, good point: we can add this to the list of possible differences.

Economic capital assessment does typically take into consideration the ability to write new business - although it doesn't have to; there are no "rules" about how economic capital should be determined, so it is up to the company to decide whether it wants to include it. The timeframe over which any future new business is considered will of course also be down to the insurer to decide.

This isn't the case in the SCR, but remember that the ORSA (Pillar 2) does require companies to include future new business within their capital requirement projections "over the business planning horizon (usually three to five years)". The Pillar 2 capital assessment is closest to an internal economic capital measure.

The basics of what both economic capital and regulatory capital assessments are trying to achieve are the same. The key difference tends to be that there are rules for the latter, but total freedom for the company for the former.

Because Solvency II Pillar 2 has significantly fewer rules and restrictions than Pillar 1, the capital requirements there are thus much closer to being an economic capital assessment.

Hope that helps, but it sounds like you are nicely on top of this now - this was a good confirmation post!

 

[Viki2010]

Hi, just a quick question regarding chapter 15. The source of available capital for proprietary companies is from:
- additional amounts subscribed
- retained profits
- under-distribtion of surplus
For mutual companies:
- initial, exceptionally subsequent capital injection
- under-distribution of surplus


I am just wondering why the mutual cannot benefit from the "retained profits" as a source of available capital....?

 

[Lynn Birchall]

Hi

For a mutual, as the retained profits belong to the with-profits policyholders, they could be described as an "under-distribution of surplus", so they are included.

Best wishes
Lynn

 

[Viki2010]

The chapter discusses the idea of market consistent valuation that the liabilities are valued as equal to the equivalent assets e.g. liability with a guarantee after 10 years will be valued in line with e.g. a bond value with 10 year maturity.

How does the above relate to the practical approach to valuing liabilities using projection models with market consistent assumptions? We are valuing liabilities by projecting them into the future based on MC assumptions.