June 13th, 2016

Reserving and Capital Setting: Conclusion

Posted at 1:00 AM ET

The obvious response to the issues emerging risks provide is to make sure reserves and capital position are more than robust enough for any eventuality - however remote - and then release them when the risks fail to materialize. But, there are many arguments against this as a practical strategy:

  • Best estimate reserves are meant to be just that - a “best estimate” without any margins at least in a regulatory sense.
  • Holding reserves or capital much higher than necessary in most instances can put a firm at a commercial disadvantage to its peers both from a pure results perspective (unless the upside or releases are consistent over time) and from a return on capital perspective.
  • With these sorts of risks, which can have a long period of latency, it may never be clear when it is safe to release reserves or capital held.

A more pragmatic approach is to follow the advice provided here. Identify the risks, rank them in terms of materiality, quantify them if possible, create loadings where it is not possible, be mindful of recognition patterns and stress the impact of changing initial assumptions.

Finally, models for emerging risks are in their infancy but are likely to improve rapidly over time where demand is present and data becomes available. Eventually some emerging risks can become business as usual if the past is anything to go by.

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