Capital, Risk and Financial Management
Domain 3 tests how capital, risk and asset-liability management interact on a real balance sheet: how much capital is needed, how it is measured, how risk is transferred, and what is left over after the transfer.
Core rules
- The solvency capital requirement is calibrated to a 1-in-200 adverse event over one year. Individual modules (market, counterparty default, life underwriting, operational and so on) are aggregated through a correlation matrix, so diversification benefit is recognised but is not additive.
- The risk margin is a separate, run-off-based cost-of-capital charge on the capital needed after the valuation date; it is not the same measure as the one-year requirement.
- Own-funds tiers matter: not all capital counts equally, and eligibility limits bite on the smallest balance sheets.
- Asset-liability management ranges from duration and key-rate-duration matching to full cash-flow matching; long-dated guarantees introduce convexity that duration alone will miss.
- Hedging instruments (swaps, swaptions, equity puts) remove some risk and leave basis risk, counterparty risk and collateral/liquidity demands.
Worked example
An annuity writer holds 10bn of assets with duration 9 against liabilities of duration 14. A 1% fall in yields raises liabilities by roughly 14% (+1.4bn) and assets by 9% (+0.9bn), so surplus falls by about 0.5bn. Duration is a local approximation, so the correct response is not simply to buy duration 14: cash-flow matching of the liability profile, plus convexity analysis, is more robust for a closed book. If the gap is closed with receive-fixed swaps, quantify the collateral call in the same yield fall and note the residual basis risk between swap and bond curves.
Traps that cost marks
- Netting assets and liabilities before applying shocks, instead of aggregating modules with correlations.
- Confusing the one-year capital requirement with the run-off risk margin.
- Forgetting that reinsurance brings a counterparty-default module with it.
- Treating hedge notional as proof of protection when basis and liquidity risk remain.
- Quoting a capital number without saying what it is calibrated to.