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Capital at Risk Definition
CaR refers to the capital amount that is earmarked to cater for risks. Capital at risk applies to insurance and self-insured companies responsible for underwriting insurance policies. It’s utilized for loss payment. Also, it is mandatory that an investor has a CaR in investment so as to get some tax benefits.
A Little More on What is Capital at Risk CaR
Insurance companies receive premiums for any policy they underwrite. Ascertaining the premium amount is dependent upon the policyholder’s risk profile, the risk type being covered, as well as, the possibility of incurring a loss once coverage is provided. An insurance company utilizes this premium for funding its operations and earning investment income.
CaR is utilized as buffer above the premium amount made from underwriting policies. Since the capital is surplus, it can serve as collateral. It serves as an insurance company’s health indicator because having enough capital available for claims payment is what ensures that an insurer remains solvent.
The capital amount which insurance companies must hold is calculated based on the policy types which are underwritten by the insurer. The capital at risk for non-life insurance policies is based on estimated claims, as well as, the premium amount which policyholders pay. On the other hand, life insurance companies center their calculations on the full benefits that must be paid.
It’s possible for regulators to set an insolvency margin strictly for insurance companies which would be dependent upon the company’s size and risk types being covered in the underwritten policies. For non-life companies, it’s usually based on the loss encountered within a timeframe. Life insurance companies utilize a certain percent of the whole policy values less technical provisions. The regulations apply to the capital amount which must be earmarked, and it applies to neither the type nor the risk of the capital holding itself.
CaR and Taxes
Capital at risk applies to federal income taxes as well. The Internal Revenue Service demands that an investor has a CaR in investment to enable him to get specific tax benefits. Several tax shelters were previously organized such that an investor couldn’t lose funds but could convert income to unrealized capital gains, which would be taxed over time and also at a lesser rate. This is why having capital at risk is a requirement for taking capital gain.
Reference for “Capital at risk (CAR)”
Academic research on “Capital at risk (CAR)”
Theory of optimal consumption and portfolio selection under a Capital-at-Risk (CaR) and a Value-at-Risk (VaR) constraintAtkinson, C., & Papakokkinou, M. (2005). Theory of optimal consumption and portfolio selection under a Capital-at-Risk (CaR) and a Value-at-Risk (VaR) constraint. IMA Journal of Management Mathematics, 16(1), 37-70. The solution to the optimal portfolio selection and consumption rule subject to Capital-at-Risk and Value-at-Risk constraints is derived via the use of stochastic dynamic programming.
Optimal reinsurance-investment strategies for insurers under mean-CaR criteriaZeng, Y., & Li, Z. (2012). Optimal reinsurance-investment strategies for insurers under mean-CaR criteria. Journal of Industrial & Management Optimization, 8(3), 673-690. This paper considers an optimal reinsurance-investment problem for an insurer, who aims to minimize the risk measured by Capital-at-Risk (CaR) with the constraint that the expected terminal wealth is not less than a predefined level. The surplus of the insurer is described by a Brownian motion with drift. The insurer can control her/his risk by purchasing proportional reinsurance, acquiring new business, and investing her/his surplus in a financial market consisting of one risk-free asset and multiple risky assets. Three mean-CaR models are constructed. By transforming these models into bilevel optimization problems, we derive the explicit expressions of the optimal deterministic rebalance reinsurance-investment strategies and the mean-CaR efficient frontiers. Sensitivity analysis of the results and a numerical example are provided.
CAR 2: The impact of CAR on bank capital Augmentation in SpainAltunbas, Y., Carbo, S., & Gardener, E. (2000). CAR 2: The impact of CAR on bank capital Augmentation in Spain. Applied Financial Economics, 10(5), 507-518. This paper reports on tests, using panel methods, of a new capital augmentation model on Spanish savings banks over the period 1987–1996. It is argued that this banking subsector and time frame provide an interesting laboratory of the potential impact of regulation on bank capital augmentation. Early modelling work in this area is built on by extending the control variables to encompass risks not factored into the regulatory capital adequacy ratio, managerial efficiency, innovation and a new productive efficiency variable. The results indicate strong evidence of the impact of the capital adequacy regulatory regime on bank capital augmentation. Furthermore, this impact appears to be related to the relative strictness of the regulatory regime. At the same time the model also confirms the particular importance of the expected return on bank capital and productive efficiency in explaining capital augmentation.
Risk-based capital requirements for mortgage loansCalem, P. S., & LaCour-Little, M. (2004). Risk-based capital requirements for mortgage loans. Journal of Banking & Finance, 28(3), 647-672. We contribute to the debate over the reform of the Basel Accord by developing risk-based capital requirements for mortgage loans held in portfolio by financial intermediaries. Our approach employs simulation of both economic variables that affect default incidence and conditional loss probability distributions. Results indicate that appropriate capital charges for credit risk vary substantially with loan characteristics and portfolio geographic diversification. Hence, rules that offer little risk differentiation, including the current Basel I regime and “standardized” approach proposed in Basel II result in significant divergence between regulatory and economic capital. These results highlight the incentive problems inherent in simplified methods of capital regulation.
Bank governance, regulation and risk takingLaeven, L., & Levine, R. (2009). Bank governance, regulation and risk taking. Journal of financial economics, 93(2), 259-275. This paper conducts the first empirical assessment of theories concerning risk taking by banks, their ownership structures, and national bank regulations. We focus on conflicts between bank managers and owners over risk, and we show that bank risk taking varies positively with the comparative power of shareholders within the corporate governance structure of each bank. Moreover, we show that the relation between bank risk and capital regulations, deposit insurance policies, and restrictions on bank activities depends critically on each bank’s ownership structure, such that the actual sign of the marginal effect of regulation on risk varies with ownership concentration. These findings show that the same regulation has different effects on bank risk taking depending on the bank’s corporate governance structure.