Capital management, allocation and solvency risk
What the exam tests
Capital management and solvency: regulatory versus economic capital, allocation, diversification, fungibility and stress.
Core rules
- Regulatory capital is the minimum required by the supervisor; economic capital is the firm's own estimate of risk. They differ in confidence level, horizon, calibration and treatment of diversification.
- Under Solvency II, the SCR is calibrated to a 1-in-200 one-year event; MCR is a lower threshold; own funds are tiered by quality.
- Capital allocation: standalone, marginal and Euler methods. Allocate diversification benefit explicitly; do not simply sum standalone capital.
- Consider fungibility, double leverage, liquidity and transfer restrictions across legal entities.
- Stress testing and recovery/resolution planning test capital adequacy beyond the model.
Worked example
Two business lines have standalone capital of £100m and £150m. Group capital is £200m, so diversification benefit is £50m. A marginal allocation shows line A adds £70m and line B £130m. Reasoning: summing standalone capital (£250m) overstates group need; allocating £200m pro rata ignores risk contribution. Marginal allocation reflects the capital released or consumed at the margin, but order dependence must be managed. The benefit should be visible, not hidden.
Traps
Treating regulatory capital as economic capital; allocating standalone sums; ignoring fungibility; double counting diversification; assuming capital equals liquidity.