Actuarial Notes

A Multi-Stakeholder Approach to Capital Adequacy

By Robert A. Painter and Dan Isaac · Society of Actuaries · 2006

Study guides: Exam ILA-201I, Exam ILA-201U

A paper by Robert A. Painter and Dan Isaac of Conning Research & Consulting that introduces a practical approach to setting capital targets by considering the objectives of all of an insurance company's stakeholders. Because stakeholders define "risk" and "capital adequacy" differently, its multistakeholder approach produces capital indications across various key financial measures, time horizons and risk tolerances, and it introduces the "Financial Rating Risk Replication" technique, which maps distributions of regulatory and rating agency capital measures to observable financial rating transition matrices.

On the syllabus

  • Exam ILA-201I — Capital Management, outcome 2b; A Multi-Stakeholder Approach to Capital Adequacy, Conning Research, Actuarial Practice Forum.
  • Exam ILA-201U — Capital Management, outcome 2c; A Multi-Stakeholder Approach to Capital Adequacy, Conning Research, Actuarial Practice Forum.

1 Introduction

2 Evolution of Enterprise and Integrated Risk Management

3 Evolution of Capital Adequacy Measures: Traditional Measures

  • 3.1 Evolution of Capital Adequacy Measures: Regulatory and Rating Agency Measures
  • 3.2 Evolution of Capital Adequacy Measures: Economic Capital Measures
    • 3.2.1 Customized
    • 3.2.2 More Robust View of Risk
    • 3.2.3 Economic Basis

4 Illustration of an Economic Capital Method

5 Weaknesses of Economic Capital Models

  • 5.1 Single Financial Measure of Required Capital
  • 5.2 No External Consequences
  • 5.3 Inflexible in Terms of Time Horizon
  • 5.4 Inflexible in Terms of Risk Tolerance
  • 5.5 Risk Thresholds Are Arbitrary and Parameter Risk in the Extreme Tail Is Significant

6 "Capital Adequacy" Has Different Meanings for Different Stakeholders

  • 6.1 Policyholders
  • 6.2 Regulators
  • 6.3 Debtholders
  • 6.4 Rating Agencies
  • 6.5 Shareholders and Equity Analysts
  • 6.6 Company Management
  • 6.7 All Stakeholder Needs Should Be Considered in Setting a Capital Target

7 Multistakeholder Approach to Capital Adequacy

  • 7.1 Dimension no. 1: Financial Variables
    • 7.1.1 Return on Capital
    • 7.1.2 Rating Agency Standardized Measures
    • 7.1.3 Regulatory Measures
    • 7.1.4 Economic Capital Measures
  • 7.2 Dimension no. 2: Time Horizon
    • 7.2.1 Risks Interact Differently over Time
    • 7.2.2 Current Capital Supports Future Growth
    • 7.2.3 Capital Is a Fair-Weather Friend: Elusive When You Need It the Most
  • 7.3 Dimension no. 3: Risk Threshold

8 Illustration of the Multi-Objective Approach Using the "Financial Rating Risk Replication" Technique

  • 8.1 The "Financial Rating Risk Replication" Technique
    • 8.1.1 Step 1: Calculate a Distribution of Results for Each Financial Variable, Risk Threshold, and Time Horizon
    • 8.1.2 Step 2: Calculate the Probability of Each of the Distributions Falling below the Risk Threshold
    • 8.1.3 Step 3: Calculate the Probability of the Company Rating Transitioning from the Current Rating to the Target Rating
    • 8.1.4 Step 4: Adjust Current Capital Such That the Probability Calculated in Step 2 Equals the Probability Calculated in Step 3
  • 8.2 Setting a Capital Target Using the Multi-Objective Framework

9 Result Comparison: Economic Capital Method and Multi-Objective Framework Approach

10 Benefits of the Proposed Approach—Revisited

  • 10.1 Incorporates Unique Objectives
  • 10.2 Aligned with Real World Decision-Making Processes
  • 10.3 Produces Multiple Estimates of Capital Adequacy
  • 10.4 Goes beyond Solvency Analysis
  • 10.5 Consistent Evaluation
  • 10.6 Multiple Risk Thresholds and Sensitivity Testing
  • 10.7 Multiyear Time Horizon
  • 10.8 Appropriately Represents Risk Diversification and Aggregation over Time
  • 10.9 Risk Thresholds Calibrated to Observable Information

11 Areas for Future Research

  • 11.1 Management Intervention
  • 11.2 Multiyear Transition Matrices
  • 11.3 Rating Standards Shifts

Acknowledgments

Appendix A Transition Matrices

Appendix B Capital Adequacy Formulas and Ratings

Appendix C Falcon Insurance Company Illustrative Calculations

Appendix D The Marriage of ERM and DFA

Appendix E Tail Value at Risk Defined

Appendix F Model Specifications to Support a Multi-Objective Approach

Appendix G Description of Falcon Insurance Company

References

Sources