Economic capital, regulatory capital and risk-based capital

Introduction to Capital in Actuarial Practice

Welcome to one of the most important chapters in the CP1 curriculum! If you’ve ever wondered why financial companies don't just spend all their profits immediately, the answer is capital. In simple terms, capital is the "cushion" or "safety net" that a provider of financial products keeps to ensure it can pay out benefits even when things go wrong.

In this chapter, we will explore the different ways we measure this safety net—specifically regulatory capital, economic capital, and risk-based capital—and how these requirements influence the way a business is run.

1. The Interrelationship Between Risk and Capital

The core principle of actuarial practice is that risk and capital are two sides of the same coin. The more risk a provider takes on, the more capital it needs to hold to remain solvent.

Think of it like a personal emergency fund. If you have a very stable job and low expenses, you might only need a small fund. If you are a freelancer with unpredictable income (high risk), you need a much larger fund (capital) to feel secure. For a financial provider, capital protects against:

• Adverse experience: Such as more deaths than expected in life insurance or higher claim amounts in general insurance.
• Investment shocks: Sudden drops in the value of assets.
• Operational failures: Such as fraud or system crashes.

Key Takeaway: Capital is held to provide a buffer against unexpected losses. Provisions are held for expected future benefit payments; capital is what we hold on top of those provisions for the "what ifs."

2. Regulatory Capital: The "Rules"

Regulatory capital is the minimum amount of capital that a provider must hold as determined by the industry regulator (the "policeman" of the financial world). The primary aim of the regulator is to protect consumers and maintain stability in the financial system.

Why do we have Regulatory Capital?

• To ensure security for policyholders/members.
• To maintain public confidence in the financial markets.
• To provide an early warning system (if capital levels drop, the regulator intervenes).

Note: If a company's capital falls below the regulatory minimum, it may be forced to stop writing new business or, in extreme cases, be closed down.

3. Economic Capital: The "Reality"

While regulators set a "one-size-fits-all" or "minimum" standard, economic capital is the company’s own internal estimate of how much capital it needs. It is calculated based on the firm's specific risk profile and its own risk appetite.

How is Economic Capital determined?

It is usually calculated as the amount of capital needed to ensure that the provider remains solvent over a certain time horizon (e.g., one year) with a very high degree of confidence (e.g., \(99.5\%\)).

Economic Capital vs. Regulatory Capital:

• Regulatory: Often uses standard formulas; focused on consumer protection.
• Economic: Uses internal models; focused on true risk and business management.

Helpful Analogy: Regulatory capital is like the legal minimum tread depth on your car tires. Economic capital is how much tread you want on your tires because you know you often drive in heavy rain on mountain roads.

4. Risk-Based Capital (RBC)

Risk-based capital is a method where the capital requirement is directly linked to the specific risks the provider faces. Instead of saying "every insurance company must hold \$100 million," the requirement is built up by looking at different risk categories.

Common components of RBC:

• Market Risk: Risk of losses from changes in equity prices, interest rates, or property values.
• Credit Risk: Risk that others (like bond issuers) won't pay what they owe.
• Underwriting/Insurance Risk: Risk that the actual claims experience is worse than the assumptions used in provisions.
• Operational Risk: Risk of loss from inadequate internal processes.

Risk Aggregation: Providers must combine these different risks. Because it is unlikely that the "worst-case scenario" happens for every risk at the exact same time, companies often allow for diversification when aggregating these risks.

5. The Economic Balance Sheet and Internal Models

To calculate capital accurately, many actuaries advocate for the use of an economic balance sheet. This means:

• Assets are valued at their current market value.
• Liabilities (provisions) are valued on a market-consistent basis, often using the present value of expected future cash flows plus a risk margin.

Internal Models: Large or complex providers often build their own internal models to calculate their capital requirements. These models are tailored to the provider's specific assets and liabilities, providing a more accurate "economic" view than a standard regulatory formula.

6. Impact on Pricing and Profitability

Capital isn't "free." The money tied up as capital belongs to the shareholders (or members), and they expect a return on that money. This leads to two major impacts:

1. Impact on Pricing (Objective 4.3)

When an actuary sets the price for a financial product, they must include the cost of capital. Since the company must set aside capital to back the contract, and that capital has an opportunity cost, the consumer must pay a premium that covers this cost. Higher capital requirements usually lead to higher prices for the consumer.

2. Impact on Profitability (Objective 5.1)

Holding more capital generally reduces profitability (measured as Return on Equity). If a company is forced by a regulator to hold a massive amount of capital, the profit it makes is spread over a larger "base," making the percentage return look smaller. Actuaries must balance the need for security (holding more capital) with the need for profitability (holding less capital).

Quick Review: Comparison Table

Common Student Mistakes to Avoid

• Confusing Provisions and Capital: Remember, provisions are for expected payments. Capital is for unexpected events. If you are asked about capital, don't just talk about valuing liabilities!
• Ignoring the Cost of Capital: In exam questions about pricing, students often forget that the capital held "behind" a product must earn a return, which increases the required price.
• Thinking "More Capital is Always Better": While more capital increases security, it decreases the return on equity for shareholders. It’s always a balance!

For more on how capital is managed alongside other risk responses, see the chapter on "Risk and capital management interrelationship".