18.1 Introduction

VaR by itself it too simplistic for insurance companies

Advantages attributed to Economic Capital

• Unifying measure for all risks in an organization

• More meaningful to management than RBC or Capital Adequacy Ratios (e.g. Prem/Surplus, Res/Surplus)

• Forces firm to quantify risks it faces and combine them into a probability distⁿ

• Provides a framework for setting acceptable risk levels for the company and its business units

Remark.

• Many other risk measures have the advantages above (not just “economic capital” under VaR)

• Insurers typically use multiple risk measure to see if a consistent picture emerges

• VaR is typically calculated from the distribution of all risks and then allocate down to inidividual units

  This provides consistent measurement of risk across units

Target Probability Level

• Current modeling approaches are not able to accurately estimate losses deep in the tail like 1-in-3000 (99.97%) event

• Bond ratings are discusses at this level but the ratings are not tied to the probabilities

  • Ratings are defined by factors (e.g. interest coverage)

  • Probabilities are published retrospectively after observing rated bonds for many organizations for many years

• Target probability level is artificial (no theoretical support)

  • Sometimes it is just backed out based on the modeled distribution

• Suggestion: Should just express actual capital under various risk measures

• The company sometimes compare held capital to the loss distⁿ stating that it’s holding capital to cover a 1-in-x year event. But not the other way around like setting the capital based on it

• Modeling difficulty of the tail can be circumvented by focusing on events that can lead to impairment of the company, not just insolvency