Capital Modelling

ST7-ST8
Dr. Elphas Luchemo,
PhD. eokango@Strathmore.edu
1 Overview
1. Types of capital?
2. Components of a capital model
3. Capital modelling methodologies
3
What is
capital?
4
Insurance risk
5
Insurance risk
6
Insurance
Risk
7
Capital
Capital modelling – allowance for
diversification

modelling –
allowance for
diversification
8
• Diversification effects arise because the various risks from a
company’s
• operations are not perfectly correlated.

• Since risks are not perfectly correlated, the sum of the standalone
Diversificati capital requirements for each risk will usually be greater than the
on capital requirement for all risks combined.

• In other words, an adverse event (eg a catastrophic claim event)

should not affect diversified policies simultaneously (by
definition), and so some credit can be given for the level of
diversification.

• This will result in a lower overall capital requirement.

 o Correlations may arise because specific types of risks affect
different segments of the company’s overall portfolio.

o Correlations may also arise between the different types of risks.

o Ideally, the correlations would be negative correlations. Perfect

Diversificati positive correlations will give rise to accumulations of risk,
on which will require a higher capital charge.
o Consider a motor insurance portfolio. There are a number of
perils for this type of business, each of which can be expressed
as a type of risk:
 Theft is a peril, and the associated risk is that theft increases
 accidents are a peril, and an associated risk is that the damage
resulting from the accident is greater than expected.

o Therefore the insurer is at risk of more theft than expected and

higher claim amounts resulting from accidents.
 During a recession we might expect:

• theft risk to increase (general crime rates might tend to increase in

recessions)
• claim sizes to reduce as drivers are less able to afford bigger, more
expensive
vehicles.
Correlation
of risks These two risks are negatively correlated, ie in a recession, one risk will
get worse, and the other will improve.

▸ While the ideal is to have negatively correlated risks, uncorrelated

risks can also successfully lead to diversification benefits.

▸ Example: Consider two

uncorrelated:
risks, which we can assume to be

• earthquakes in Japan
• hurricanes in California.
 o An insurance company can write up to $2m of written premium
of property damage insurance globally. If it writes $2m of
property damage business in Japan, then it will be far less
diversified than if it writes $1m of property damage business in
Japan and $1m in California.
Benefits of diversification in capital modelling
o The benefits of diversification varies, depending on the purpose
Diversification of the specific investigation.
o Capital modelling investigations include:
 assessing solvency capital requirements
 allocating the capital held between classes, products or individual
policies for: performance measurement, pricing, business planning
and strategy setting
 reinsurance purchasing
 asset allocation studies
 studies of enterprise level risks such as credit risk and operational
risk.
 ▸ Capital modelling involves combining risks to give an overall
capital requirement. However, it could involve determining
capital requirements at a number of different levels. For
example, we might be interested in the capital requirements of:
 a single policy
 a particular product, eg residential buildings insurance

Capital  a class of business, eg property damage business

Modelling  the insurer’s whole portfolio of business.

Capital
Modeling
Investigatio
ns

Some methodologies used for allocating the capital held between classes of
business or products include:
Proportional
Marginal last in
 Some capital allocation models include:
• The proportional methods determine the allocation of capital with reference to
a single risk measure: Var, Variance, Expected shortfall, standard deviation, etc.
• We apply the risk measure to each business unit and then allocate the total
capital by the ratio of business unit risk measure to the sum of all the units’ risk
measures
• The proportional method allocates the aggregate capital requirement across all
the sub-portfolios of the business in proportion to the value of the VaR for
Deterministi each sub-portfolio.
c and
stochastic • It may be necessary to scale the resultant allocation to ensure that the sum of
models the
individual allocations is equal to the whole.

• The proportional method does not allow for levels of correlation between sub-
portfolios.
• The remaining allocation methods are based on the marginal impact on the
firm’s risk measure of changing the business profile in some way.

• We then use the marginal contribution of a business unit to the firm’s overall
risk measure / capital requirement to decide an appropriate allocation.
 • Marginal analysis measures the risk of the company with and without a

15
specified business unit.

• The difference in required total capital is then the marginal capital for the
business unit.

• The total capital can then be allocated by the ratio of the business unit
marginal capital to the sum of the marginal capital of all the units.

Example
Consider the following two lines of Business A and B, with Insured amounts:

A B

1300 3500

1500 2500

2500 2000

2700 4000
 ▸ Assume that we set capital requirements equal to 2 of standard deviations.

16 ▸ The Empirical rule for normally distributed data

 ▸ Mean of A=2500, sd of A= 702.3769

17
▸ Mean of B=3000, sd of B=912.8709

▸ The capital requirement for A would be 2500+2(702.3769)=3904.7538

▸ For B would be 3000+2(912.87)=5477.22

▸ The overall capital requirement for the entire company is 6726.5921 i.e. (square root
of the sum of the squares)

3904.7538 2 + 5477.22 2 = 6726.5921

Clearly, the aggregate company requirement is less than the sum of the requirements of
the LOBs

We will allocate the total company requirement to the LOBs, so there is a benefit to
writing these two LOBs in a single company.
The issue is how to determine how the benefit is allocated to each LOB.
 ▸ In proportional allocation, we calculate the capital requirements of each LOB as if it

18
were a stand-alone company.
▸ We then rescale these amounts so that the sum adds up to the total requirement
for the company.
▸ In this instance, the individual requirements are 3904.7538 and 5477.22 respectively
making a total of 3904.7538+5477.22=9381.9738

Proportional ▸ The total company requirement is 6726.5921

Allocation
▸ We multiply each line's requirement by (6726.5921/9381.9738)=0.717

▸ The resulting capital requirements for the two LOBs are roughly A=2799.708 and
B=3927.167
 ▸ Here, we look at the marginal capital requirements for each LOB.

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Marginal
▸ For example, to determine the capital requirement for line B, we will imagine that
our company has been writing line A and then adds line B.
▸ We calculate how much more capital is needed by the entire company than the
▸
company without the new line.

The marginal capital requirement for line B is 6726.5921 −3904.7538=2821.838

Allocation
▸ The marginal capital requirement for line A is 6726.5921 − 5477.22=1249.372

▸ In this case, the sum of the marginal capital requirements does not equal the total
company requirement. (2821.838+1249.372=4071.21)

▸ matches the total company requirement.

Commonly, we scale up the marginal capital requirements so that the sum
20
▸ 6726.5921/4071.21=1.6522
In this case, we have to multiply each marginal capital requirement by

▸ 1.6522*2821.838=4662.24
These revised capital requirements are 1.6522*1249.372=2064.21 for A and

▸ Marginal allocation is sometimes called the "last-in" method, because it determines

the capital requirements as if the line of business were the last one added to a
company.
▸ For similar reasons the proportional allocation is sometimes called the "first-in"
method.
21 Thank
You

Q&A