Capital, Solvency and Risk Management
Capital questions ask how much capital the business needs, what consumes it, and what can be done about it. You must be able to compute a simple solvency capital requirement and explain its weaknesses.
Framework
- Technical provisions = best estimate of liabilities + risk margin. Under Solvency II the risk margin is 6% of the cost of capital applied to the SCR for non-hedgeable risks over the run-off.
- SCR is calibrated to a 1-in-200 one-year event. The non-life premium and reserve module combines premium risk and reserve risk into a volume measure V = max(earned premium, reserves), net of reinsurance, and applies roughly 3σV under a lognormal assumption. Catastrophe risk (natural and man-made) is a separate module with its own correlation.
- MCR is the lower floor; breaching it triggers the most severe regulatory intervention.
- Regulatory variation: some regimes use a fixed multiple instead - for example, an available solvency margin of 150% of the required margin.
Worked example
Net earned premium ₹500 crore, net best-estimate reserves ₹300 crore, reserve risk factor 10%. V = max(500, 300) = 500, so SCR (premium and reserve) = 3 × 0.10 × 500 = ₹150 crore. Catastrophe SCR from the model is ₹90 crore. Simple addition gives ₹240 crore; treat that as an upper bound and state the diversification benefit explicitly rather than implying full independence. Reinsurance reduces V but introduces counterparty risk on recoveries.
Traps
Using gross rather than net figures; adding catastrophe and premium/reserve risk at 100% correlation; treating the risk margin as general prudence rather than a defined cost-of-capital calculation; claiming a capital benefit from reinsurance without charging for the reinsurer's default risk.