Recognising the cost of holding capital is essential in designing and pricing a product.
The products and services that a business provides are offered at a price which allows not only for the cost of providing them to the customer, but also for the expected outcome for the underlying risks. Thus an insurer allows for expected claims, a lender for expected defaults and a manufacturer for expected defects.
In setting capital however, the insurer, the lender or the manufacturer must allow for outcomes that are much worse than those expected; in order to ensure having the financial capacity to withstand such results with the desired level of confidence. The cost of holding this capital becomes another component of the price of the product or service.
Quantifying a risk therefore involves understanding the range of outcomes that it can give rise to, usually represented by the mean and standard deviation of a suitable probability distribution. This leads to an understanding of the likelihood of various adverse outcomes arising in practice.
Quantifying a set or portfolio of risks involves extending this analysis with appropriate allowance for the benefits of diversification. Armed with the resulting insight into the inherent variability of outcomes in its business, the organisation can then proceed to a consideration of its capital requirements.
Key specialist: Jason Slade
 | Relevant experience:
- Wealth management background
- Specialist in enterprise risk and shareholder value management
- Expertise in the connections between risk, capital and profitability
- Chairman of the Institute of Actuaries of Australia Risk Management Practice Committee
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