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Portfolio > Economy & Markets > Economic Trends

Economic Capital Discussed As Risk Management Tool

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Economic capital, a capital adequacy measure, is gaining some ground as an accepted tool but still has a way to go, according to a new study found.

Details of the study and why economic capital could be important for the financial services industry was discussed by executives of PricewaterhouseCoopers at a meeting here. The study was conducted in association with the Economist Intelligence Unit, London.

The discussion took place even as U.S. insurance regulators, life insurers and actuaries are undertaking a major initiative to move to a principle-based approach to capital and reserving. A new system would rely more on stochastic modeling than on a formulaic approach.

That migration to a principle-based system is starting with work on variable annuities with guarantees. One component of that migration, called the C-3, Phase II risk-based capital project is scheduled to take effect starting in 2006. Another component, VA-CARVM, which addresses reserving for VA s, is in full throttle. And, other parts of the new system, including changes to the Standard Valuation Law, are just starting to be discussed.

Economic capital is the amount of capital needed to cushion a company against both anticipated and unanticipated losses, according to Shyam Venkat, a partner with PricewaterhouseCoopers, New York.

Another way to look at economic capital, is to think of it as one end of a bridge, according to Fernando De La Mora, a director of advisory and financial services.

For insurers, he continues, one end of the bridge would be risk-based capital, the middle of the bridge would be a Solvency II project that is now underway and the other end of the bridge would be the concept of economic capital. Solvency II is a risk management project for insurers undertaken by the European Union Commission.

For banks, one end of the bridge would be Basil I, followed by Basil II with a final goal of economic capital, De La Mora explained. Basel I and II is work on capital adequacy developed by the Basel Committee on Banking Supervision.

A number of large U.S. banks were at the vanguard of introducing the concept of economic capital in the mid-1990s, said Venkat.

And, according to De La Mora, there is a growing awareness among U.S. banks although fewer insurance companies are using the tool at this point in time.

Among the study’s findings, are:

–44% of respondents are already using economic capital either at business units or across the whole enterprise and 13% are planning to do so in the next year;

–22% of those using economic capital have freed up capital as a result of implementing the tool;

–the 3 top responses for using economic capital were: improved strategic planning, 68%; define risk appetite, 65%; and improve capital adequacy, 51%. Multiple answers were allowed in the survey.

–for those who have not implemented economic capital, 51% said that the reason was that there was no regulatory pressure to adopt economic capital.

Over 200 financial institutions in Asia, Europe and the Americas participated in the survey. Eight percent of those participants were insurers and reinsurers.


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