Research in economic capital and financial risk management
With the advent of new risk-based regulations for financial services firms, specifically Basel 2 and Basel 3 for banks and Solvency 2 for insurers, there is now a heightened focus on the practical implementation of quantitative risk management techniques for firms and defined benefit pension schemes operating within the financial services sector.
In particular, financial services firms are now expected to self-assess and quantify the amount of capital they need to cover the risks they are running. This self-assessed quantum of capital is commonly termed risk, or economic, capital.
At Kent we are actively involved in developing rigorous risk management techniques to explicitly measure how much risk a firm or pension scheme is taking, holistically, across the entire spectrum of risks it accepts.
Areas of research
Enterprise risk management (ERM)
ERM is generally concerned with the calculation and communication of extreme risks. The management of risk has had an increasing focus since the onset of the recent liquidity crisis. We are looking at the ways in which risks relate to each other, and the ways in which these links can be communicated effectively. We also consider the nature of the risk management failures that can lead to systemic crises.
Prof Paul Sweeting has held a number of roles in pensions, insurance, and investment. He was responsible for developing the longevity reinsurance strategy for Munich Reinsurance, before which he was Director of Research at Fidelity Investments' Retirement Institute.
Financial risk management of pension schemes
After introducing economic capital techniques in the banking and insurance sector, regulators and policy-makers are turning their attention to the pension sector, the other integral player in the financial markets. The emerging view is that aligning pension sector regulations with the broad framework of economic capital principles would ensure coherent treatment of all the major players in the financial markets and avoid regulatory arbitrage. Our research demonstrates that the principles of economic capital can also be applied to quantify and help manage the risks of defined benefit pension schemes.
Our current research focuses on quantifying economic capital of individual defined benefit pension schemes on a stand-alone basis as well as for the UK pension sector as a whole by quantifying economic capital of the Pension Protection Fund (PPF). We also investigate the risk inherent in alternative hybrid pension structures which are intermediate between defined benefit and defined contribution schemes. Finally, we are involved in carrying out research on the impact of population ageing on the underlying risks of pension schemes.
Dr Pradip Tapadar has collaborated with industry experts and researchers at Southwestern University of Finance and Economics, China and University of Waterloo, Canada. He has recently obtained a research grant from the Institute and Faculty of Actuaries to investigate the impact of population ageing on pension schemes.
Economic capital: impact of capital structure & asset allocation
In this area of research, we focus on the impact that capital structure and asset allocation has on economic capital and the risk-adjusted performance of financial services firms, including banks and insurers. Our research challenges the conventional wisdom that the capital backing annuity firms should be invested in low risk, bond type, asset-classes. We also find gearing up Tier 1 capital with Tier 2 capital can be in the interests of banks but not of insurers.
Pensions – Investment risk and pensions design
Funded pension schemes seek to meet the cost of benefits by investing in a range of assets. However, assets must be chosen not simply on the basis of their expected return, but also taking into account the extent to which they are appropriate for meeting particular liabilities.
This means taking into account the certainty and liquidity of asset payments over the term relevant to the liabilities. Because pension schemes have a relatively low need for immediate liquidity, they can invest more in less liquid assets, taking advantage of any liquidity premium available.
However, this means that new measures of solvency need to be developed such that short-term valuation approaches do not make these illiquid assets seem less attractive than they are.
There are also shorter-term investment issues that are of importance to pension schemes, such as the impact of quantitative easing, the level of credit spreads and the long-term attractiveness of various bond asset-classes. These are all highly relevant to investors managing defined benefit pension plans.
Given the global trend away from defined benefit employer-based pension plans, careful thought needs to be put into the design of defined contribution alternatives.