Economic Capital Defined
Economic capital is the capital required to support all risks carried by a firm at its target level of financial strength. The firm's desired financial strength–or solvency standard–is expressed as a probability of ruin.
To provide firms with intuition around acceptable probabilities of ruin, we look to corporate bond default rates. The reasons for choosing corporate bond default rates are that there is a long history of default data from the rating agencies and that people have good intuition about how bond ratings relate to financial strength.
From historical bond default data, we know that the probability of a single-A bond defaulting is .07 percent or 7 basis points. If an insurer seeks a solvency standard of 7 basis points, then it can express this as a "single-A" solvency standard. One can see how "I would like to be as financially strong as an A-rated company" has more intuitive appeal than "I would like my companys probability of ruin to be 7 basis points."
Notice that it is important to understand that we are using bond ratings as a convenient shorthand for describing low probability events. We are not saying that if you have a certain amount of capital, then you will earn a single-A rating. Rather, if you have the right amount of capital, then you will have the same probability of default as a single-A bond. This is a subtle distinction, but one that confuses many practitioners.
Another question that arises frequently is "why use corporate bond default rates rather than insurance company default rates?" The answer is that there is much more data on corporate bond defaults, and the probabilities of defaults are designed to be consistent across industries.
Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, November 5, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.
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