Hi everyone I maybe over-thinking this or just completely missed the point. Economic capital is defined as the capital required by a life company to meet its liabilities over 1 year with 99.5% probability. In practice, this is done by shocking the asset and liability assumptions and calculating the capital under shocked scenarios. For example, for a lapse shock, the shocked lapse rates are applied to calculate the shocked liabilities. My question is - if economic capital by definition considers capital required over a 1 year time horizon, why are the lapse rates for all years shocked? Shouldn't we just shock the lapse rate in year 1 but keep all future lapse rates as the best estimate rate? Thank you for clearing my confusion!
Fair question. I suppose the short answer is that a change to future lapses will change your reserves now, and hence your capital requirement now.
A life company will have business which has been on the books for varying amounts of time. For example, there will be policies which have been in force for 2 years, 3 years, 4 years, etc. You need to shock all the lapse rates in order to pick up the shocked effect of policies at different stages of maturity. And yes, Calum's point about reserves also applies.
