With the advent of new risk-based regulations for financial services firms, specifically Basel 2 for banks\udand Solvency 2 for insurers, there is now a heightened focus on the practical implementation of\udquantitative risk management techniques for firms operating within the financial services industry.\udIn particular, financial services firms are now expected to self assess and quantify the amount of capital\udthat they need, to cover the risks they are running. This self assessed quantum of capital is commonly\udtermed risk, or economic, capital.\udThis talk is concerned with two important questions:\udQuestion 1: How should a capital constrained firm allocate its assets to minimise its economic capital\udrequirement?\udQuestion 2: How should a firm allocate its assets to optimise its risk adjusted performance?\udThe talk will focus on the impact that asset allocation has on the economic capital and the risk adjusted\udperformance of financial services firms. A stochastic approach, using graphical models, is used in\udconjunction with a life insurance annuity firm as an illustrative example. It is shown that traditional\udsolvency-driven deterministic approaches to financial services firm asset allocation can yield suboptimal\udresults in terms of minimising economic capital or maximising risk adjusted performance.\udOur results challenge the conventional wisdom that the assets backing life insurance annuities and\udfinancial services firm capital should be invested in low risk, bond type, assets. Implications for firms,\udcustomers, capital providers and regulators are also considered.
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