Bruce T. Porteous

Economic Capital and Financial Risk Management for Financial Services Firms and Conglomerates

Preface. Introduction Risk Types, Collection and Mitigation Risk Governance Stress Testing to Measure Risk Economic Capital Types of Capital The Stochastic Model Economic Capital for Banks Economic Capital for Non Profit Life Insurance Firms and General Insurance Firms Economic Capital for Asset Management Firms Economic Capital for With Profits Life Insurance and Pension Funds Financial Services Conglomerates Capital Management and Performance Measurement in Practice Regulatory Change Summary and Conclusions References Appendices

The Impact of Capital Structure on Economic Capital and Risk Adjusted Performance

The impact that capital structure and capital asset allocation have on financial services firm economic capital and risk adjusted performance is considered. A stochastic modelling approach is used in conjunction with banking and insurance examples. It is demonstrated that gearing up Tier 1 capital with Tier 2 capital can be in the interests of bank Tier 1 capital providers, but may not always be so for insurance Tier 1 capital providers. It is also shown that, by allocating a bank or insurance firm’s Tier 1 and Tier 2 capital to higher yielding, more risky assets, risk adjusted performance can be enhanced. These results are particularly pertinent with the advent of the new Basel 2 and Solvency 2 risk based capital initiatives, for banks and insurers respectively.

Asset Allocation to Optimise Life Insurance Annuity Firm Economic Capital and Risk Adjusted Performance

ABSTRACT The impact that asset allocation has on the economic capital and the risk adjusted performance of financial services firms is considered in this article. A stochastic modelling approach is used in conjunction with a life insurance annuity firm illustrative example. It is shown that traditional solvency driven deterministic approaches to financial services firm asset allocation can yield sub optimal results in terms of minimising economic capital or maximising risk adjusted performance. Our results challenge the conventional wisdom that the assets backing life insurance annuities and financial services firm capital should be invested in low risk, bond type, assets. Implications for firms, customers, capital providers and regulators are discussed.

Economic capital for defined benefit pension schemes: An application to the UK Universities Superannuation Scheme

This article considers the amount of economic capital that defined benefit (DB) pension schemes potentially need to cover the risks they are running. A real open scheme, the Universities Superannuation Scheme, is modelled and used to illustrate our results and, as expected, economic capital requirements are large. We discuss the appropriateness of these results and what they mean for the DB pension scheme industry and their sponsors. The article is particularly pertinent following the recent European Commission Green Paper on the future of European pensions systems, its call for advice on reviewing the Institutions for Occupational Retirement Provision Directive and the introduction of the Basel 2 and Solvency 2 risk-based regulatory regimes for banking and insurance, respectively.

Types of Capital

In this chapter we describe the role of capital and also discuss the different types of capital that are available to financial services firms to cover their regulatory capital requirements. The discussion is based on a banking model as, at least in the UK, this is the model that has recently been adopted by other types of financial services firms.

The Stochastic Model

As stated in Chapters 4 and 5, our preferred approach in this book is to determine economic capital using a stochastic, rather than a deterministic, approach wherever possible. This chapter develops a stochastic model that is effectively the engine that generates our stochastic stresses.

Risk Types, Collection and Mitigation

It can be argued that the main rationale for the existence of financial services firms is to collect and manage risk, in its widest possible sense. In doing this, they usually aim to both make a profit for their shareholders and to provide value adding services for their customers, specifically managing financial risks on behalf of their customers.

Non Profit Life and General Insurance Firms

In this chapter, we consider economic capital for non profit life insurance firms and general insurance firms. With profits life insurance firms and pension funds are very different and more complex than non profit life insurance and general insurance firms. We, therefore, discuss their economic capital requirements separately in Chapter 11.

Capital Management and Performance Measures

In this chapter, we bring together the material presented in the previous chapters to describe practical approaches to capital management and risk consistent performance measurement. Obviously, individual firms will manage their capital and measure performance in different ways and according to their own philosophies. Nevertheless, at least at the broad level of principle, we believe that the approaches set out in this chapter represent or, at the very least, are similar to approaches adopted by many firms in practice.

Asset Management Firms

In this chapter we give a short discussion of economic capital for asset management firms. This discussion is brief because, as we describe below, the treatment of economic capital for asset management firms is very similar to that for unit linked life insurance firms, as described previously in Section 9.3.