Solvency and Capital Requirement

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Research School of Finance, Actuarial Studies and Applied Statistics

Assignment Cover Sheet

SurnameJaya_________________________________________________________________

First NameAswan_______________________________________________________________

Uni ID4976458______________________________________________________________

Course Code and NameControl Cycle A2/ STAT4032_________________________________

Lecturers NameDavid Allen Service_______________________________________________

Assignment Number2_____________________________________________________________

Due Date22/10/2012___________________________________________________________

Date Submitted21/10/2012____________________________________________________

Word Count3126_________________________________________________________________

I hereby confirm that the work contained in this assignment is solely my own except for reliance on material that is identified and cited according to accepted academic practice.

SignedAswan Jaya__________________________________________________________________

Date18/10/2012__________________________________________________________________

Table of Content
Assignment Cover Sheet1
1.Introduction3
2. Valuation Standard3
2.1.Policy Liability / Insurance Liability4
2.1Asset and non-insurance liabilities4
3.Capital Adequacy Requirement (CAR)5
3.1Insurance Risk Charge5
3.2Asset Risk Charge6
3.3Inflation Risk Charge7
3.4Operational Risk Charge7
3.5Conclusion7
4.Solvency Requirement8
4.1Minimum Capital Requirement (MCR)8
4.2Liquidity Risk Rule9
4.4Conclusion9
5.0 Conclusion9

1.Introduction
This document is written in response to the request of providing advice as to the appropriate rules establishing prudent solvency and capital requirement for workers compensation. Insurance products offered by private entities are less secure compared to product offered by government’s entity due to limited capital availability in private entity. Previously all insurance products are provided by government’s entities. Now market is going to be opened for private insurers, stricter solvency and capital requirement are required to ensure customer security and confidence. Whilst, over conservative solvency and capital requirement demand higher capital which ultimately lead to higher premium (assuming constant required return rate on capital). Due to trade-off between security and cost of providing security, the solvency and capital requirement should be designed by considering the balance between these two factors. Assuming the capital required to absorb losses follows normal distribution, figure (A) depicts the trade off between security and capital requirement. The amount of capital required to increase the probability of solvency is not linear. In panel (B), it is shown that there is a dramatic increase capital required to increase the probability of solvency at the tail. Base on this fact, it is reasonable to set confidence level at 99.5 (indicate with red line in figure 1). With this level, it is expected that one out of twenty insurers may fail every 10 years. Figure 1: (A) Capital Requirement Vs Probability of insolvency, (B) Rate of increase in capital Requirement

2. Valuation Standard
Before setting the minimum capital requirement, we need to first develop valuation standard. It will be difficult to set universal minimum capital requirement fairly across all insurers if they all have different valuation standard. Many asset and liabilities of insurance company do not have absolute value. Their value is calculated on a stochastic basis. Different assumption in stochastic basis will lead to different value. Capital level of a firm is determined by the level of its best estimate assets relative to the best estimates liabilities. Hence, it is important to establish the rule to valuate liabilities and assets...
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