Estimation of Risk (or Economic) Capital under ORSA (Part 1)

Bogie Ozdemir

Required risk capital or economic capital (risk capital and economical capital are used interchangeably throughout this book) is the second of the three components of ORSA that need to be developed for capital adequacy assessment. It represents the “demand” for capital:

	$$\frac{\text{Available}\text{capital}\text{(ORSA-based)}}{Requiredcapital(riskcapital)}\ge \text{Target}\text{surplus}\text{capital}\text{ratio}$$

This represents the shareholder’s equity under going concern and shareholder’s equity plus debt under the gone concern, as discussed in the previous chapter. Under ORSA, this required capital must be estimated using internal models and methodologies. This chapter will discuss the methodologies for estimating economic capital for different risk types, and for aggregating them to construct the overall risk capital at the enterprise level.

Estimation of risk capital is the most laborious and complex undertaking in ORSA implementation. Consequently, we will cover it in two adjacent chapters (4 and 5). This chapter will focus on the underlying principals in the theoretical background, and explain the conceptual framework for economic capital