Economic Capital Framework By Michel Rochette, MBA Enterprise Risk Advisory, LLC Introduction Economic capital (EC) frameworks are evolving quickly and respond to different needs as expressed by different stakeholders. For example, an economic capital framework will base the assessment of the capital necessary to withstand adverse financial consequences based solely on an economic view of risk. However, even if insurance companies view EC from an economic point of view and take a longer term perspective to it in order to increase shareholders’ value, other stakeholders may take a different point of view, more focused on solvency as is usually the case with regulators – where EC would be looked at over a one-year period to assess ‘how bad things can get” - and as a going concern basis as is the case of rating agencies. Methodologies are also evolving very quickly, encompassing not only new mathematical tools but also new methods to incorporate risk that were not considered part of this framework, not a long while ago, like operational risk. Also, although some specific risk-based capital frameworks are developing in different regions of the world, the underlying principles and approaches to economic capital calculations are essentially the same worldwide and between different financial services’ industries. Finally, when viewed from an enterprise risk management approach, an EC framework becomes the common risk language – common currency of risk - across the firm, and allows relationships and trade-offs between risks to become explicitly recognized. EC becomes the essential link between the risk management function and the strategic function of the firm. Ultimately, EC helps a firm develops a risk appetite and becomes part of a risk-adjusted performance framework.
General Economic Capital Framework Components An economic capital framework is composed of many elements that describe its functioning. These components are usually found in any economic capital framework whether it is implemented for solvency or general business management. Total Balance Sheet Approach An important aspect of an economic capital framework is the fact that a total balance sheet approach should be taken. All assets and liabilities should be calculated on a consistent basis, namely a market consistent approach in order to represent the true