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How to Calculate Economic Capital

Recently, "The Economics Times" has informed that The Insurance Regulatory IRDA has given the order to all non-life insurers companies to calculate economic capital in its balance sheet. Now, to calculate economic capital has become important for non -life insurance co.

What is Economic Capital?

Economic capital includes all the reserves which can be used for covering all the losses ( unexpected )  in insurance business. In other words, total capital which is required for total risk taken in insurance business. When we talk about the higher risk business, we have to compare our profit with our all risk. For covering all these risk, we need sufficient quantity of capital fund. That capital fund will be economic capital.

Importance of Economic Capital

1. # With Economic capital, we can calculate risk-adjusted return on investment. Its formula is

Risk adjusted return / Economic capital

or

revenue - expenses + return on capital - expected losses / economic capital



2.#  We can know the safety of any company at any level of risk



Steps to Calculate Economic Capital 

Ist Step: Calculate the Sum of All Risk 

Risk means fear of loss of money. We can estimate it with following formula.

Total Risk ( In $ ) 

= Credit Risk + Market Risk + Operation Risk + Insurance Risk + Liquidity Risk


(You can take the help of rating agencies, risk consultants for calculating the total amount of risk. )

2nd Step :   Quantifying Economic Capital 


Now we just have to quantify economic capital. Quantify economic capital is just nothing just probability of the quantity of capital for taking all risk. Ist step is useful for second step because without calculating total risk, we can not quantify economic capital.

Formula of Economic Capital = Value at risk (total risk amount) -  Expected Losses 



Some statistics expert show it on normal distribution curve on the graph. You can see below.



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Accounting Education: How to Calculate Economic Capital
How to Calculate Economic Capital
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Accounting Education
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