SOA 2011 Annual Meeting & Exhibit Oct , Session 69 PD, ERM: Economic Capital Models, "Own Risk Solvency Assessment," Solvency II and You

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1 SOA 2011 Annual Meeting & Exhibit Oct , 2011 Session 69 PD, ERM: Economic Capital Models, "Own Risk Solvency Assessment," Solvency II and You Moderator: Asheet Ruparelia Presenters: Jeffrey A. Klanderman, FSA, MAAA Asheet Ruparelia Gregory J. Slone, ASA, CERA, MAAA Clinton J. Thompson, FSA, MAAA Primary Competency Technical Skills & Analytical Problem Solving

2 Organisation Economic Capital Models SOA Annual Meeting Session 69 Asheet Ruparelia Director US Actuarial Lead for Risk & Capital Management October, 2011 Solvency II Regulatory requirements framework Governance Insurance risk Risk strategy and appetite Monitoring and management Reporting and MI Market risk Quantitative Measures Liquidity risk Credit risk Models and Validation Capital Requirements (SCR/ MCR) Pillar I Outsourcing Use test Own Risk and Solvency Assessment (ORSA) Pillar II Reinsurance Disclosure Pillar III Systems and data Operational risk Policies, standards and definitions Internal control 1 1

3 Market Drivers on ERM and ECM Proposed Regulations Solvency Modernization U.S. Reform: The Solvency Modernization Initiative The U.S. is also forging ahead with the National Association of Insurance Commissioners (NAIC) Solvency Modernization Initiative (SMI). NAIC SMI is a critical self-examination of the United States insurance solvency regulation framework and includes: Review of international developments regarding insurance supervision; International accounting standards and Potential use in U.S. insurance regulation. 2 Market Drivers on ERM and ECM Proposed Regulations Solvency Modernization, Continued SMI Task Force will recommend areas of improvement for the U.S. solvency framework: Risk-based capital requirements refinements to formula and more advanced methods such as ECM where factor-based methods were not sufficient. Group solvency regulation; ORSA; Corporate governance; Risk management; Statutory accounting and financial reporting and reinsurance. 3 2

4 Market Drivers on ERM and ECM Rating Agency Expectations Rating agencies are dictating increasingly stringent risk management requirements on insurers and have become the de facto industry benchmark. Area of focus Risk management culture Risk controls Emerging risk management Transparency Observation Risk tolerances are standardized and used for measuring effectiveness of actions taken Risk tolerances are defined and managed Specific limits are set and are consistent company wide Exposure is managed consistently Proactive Variance tolerances managed 4 Market Drivers on ERM and ECM Rating Agency Expectations, Continued Area of focus Risk and economic capital models Strategic risk management Observation Evaluating risk and return of strategic objectives Manage to optimize risk/reward Models are accurate and timely, robust and comprehensive Complexity of model reflects complexity of risk Actionable information Systematic and consistent Considers external as well as internal perspectives on risk Risk appetite and profile constantly updated Changes to profile or strategic plans are communicated Diversification of risks, and risk correlations 5 3

5 RBC Relationship with Regulatory Economic Capital Management Concept How much capital will we choose to hold? EC I FB Rating Agency Target Level of Capital Starting Point Internal view of Economic Capital Flexibility Buffer Rating Agency Viewpoint Result (Risk Profile) 6 Fresh look at current capital management practices External View Greater scrutiny from equity analysts on the management of available capital Unutilised capital is a significant drag on overall return or value decisions Growth / Return on Capital An integrated approach to strategic planning, finance and risk is required: Capital management is critical to support strategic goals and effective steering Increasing frustration/confusion in BUs as to the target metric and under what capital constraints they should optimise their Internal View 10.0% 9.0% 8.0% Volatility in Reg Capital CAR % Insurer Capital Management Volatility in Capital Base (IFRS) Capital (Billion ) 7.0% Credit Cycle (Time in Years) Regulatory capital will be more volatile and difficult to forecast Rating Agencies Expectations Greater scrutiny from rating agencies on the management of surplus capital Time Earnings and balance sheet volatility under IFRS 7 4

6 Capital Modelling Use Framework Investment management Planning and strategy Pricing and underwriting Reinsurance What is the impact of our decisions on capital requirements? What do we need to do to make best use of our capital? Internal Capital Assessment Capital Allocation Methodology 8 Case Study Prospective Capital Allocation during asset allocation planning cycles Evaluate new asset allocation proposals Qualitative evaluation: Likelihood of success, risks Quantitative evaluation: Necessary economic capital and risk-adjusted return Determine available capital Some current portfolios or asset backing insurance businesses may have unused capital or capital deficiency Choose asst allocation proposals for implementation Use available capital where possible, in particular for short-term (over one year) or aligned to business planning cycle (3 years) Get funding if risk adjusted return is higher than hurdle rate Control implementation of asset allocation proposals Re-allocation apply if capital needs have been either materially overstated: Waste of limited resource capital or materially understated: Inadequate risk projection 9 5

7 Business Case for developing an Economic Capital Market Arguments Without acceptable EC model Rating Agency capital is likely to be much higher Without EC model, natural caution is likely to lead to a firm holding too much (expensive) capital Likely to produce clearer view of Strategic Risk within Operational Risk framework EC model replaces need for many stress and scenario tests EC model is only practical way to deliver bottom up segmentation of EC as expected by Rating Agencies Value Creating Arguments Measure genuine value added in risk taking businesses Minimize capital costs through choosing an optimal capital surplus, capital structure and maturity mix Where Company structure is capital inefficient for tax and other reasons, can optimise capital dedicated to business units Allocation of risk taking capacity to best businesses/products Useful metric for considering acquisition prices and project priorities Single view of overall risk in the organization and its breakdown by and/or business/product KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. 6

8 Economic Capital Modeling Greg Slone ASA CERA MAAA PRM FRM Senior Financial Engineer /Actuary Algorithmics Inc. (US) Economic Capital Modelling Challenges Estimation of Risk Distribution Tails Difficult to attain enough scenarios to credibly estimate tail metrics (VaR, CTE, etc.) Liability Proxy Techniques provide the computational efficiency necessary to simulate the large number of scenarios needed to robustly estimate the tail of the risk distribution Aggregating Capital Across Risk Types Modified Copula Based Aggregation 1

9 Techniques for Integrating Assets and Liabilities in Risk Distribution Tail Estimation Method Speed Economic Probabilities Balance Sheet Approximation Economic Interpretation Nested Stochastic Replicating Portfolios Curve Fitting Replicating Portfolios Asset Portfolio Liability Portfolio Portfolio Replication Optimization Replicating Portfolio 2

10 What are Replicating Portfolios? Replicating portfolio = a portfolio of (potentially hypothetical) market securities whose economic sensitivities and/or cash flows match a portfolio of actual liabilities or assets Value Today Value at target date Instruments Scenarios Instruments Liability q 1 q 2 q 3 s 1 s 2 F(q 11, q 21, q 31 ) = F(liability 1 ) F(q 12, q 22, q 32 ) = F(liability 2 ) Replicating Different Cash Flows Liability Cash Flows Candidate Assets Basic Cash Flows Fixed cash flows Investment Fees Annuity Payouts Zero coupon bonds Equity Index Forwards Interest rate swaps, Swaptions (Physical Settle) Embedded Guarantees Guaranteed accumulation values Participation in investment profits upside Guaranteed minimum credited rates Guaranteed annuity rates, GMIB Ratchets / non-negative reversionary bonus European put options European call options Swaptions (Cash Settle) Swaptions (Physical Settle) Cliquet / lookback options Dynamic Policyholder Behaviour Lapse rates increase/decrease Barrier options 3

11 Replicating Portfolio Process Output Replicating portfolio = set of optimized weights (holdings) for the asset universe Optimization Setup Choice of objective function and attribute to be matched Weight and trading cost constraints Other constraints (duration, max # holdings, etc) Liability Portfolio Simulate liability portfolio across scenarios and through time calculating the relevant attributes (e.g. cash flow, THEO/Value.) Scenarios Can be real world, risk neutral, stress tests, or combination Must evolve all risk factors (e.g. IR, EQ,& FX) through time Asset Universe Simulate asset universe across scenarios and through time calculating relevant attributes (e.g. cash flow, THEO/Value, etc) Curve Fitting Asset Portfolio Liability Portfolio Curve Fitting using values or cash flows Curve Function 4

12 Curve Fitting Process Output Curve Function Parameters Curve Function Configuration Choice of functional form Choice of weights Liability Portfolio Simulate liability portfolio across scenarios and through time calculating the relevant attributes (e.g. cash flow, THEO/Value.) Scenarios Can be real world, risk neutral, stress tests, or combination Must evolve all risk factors (e.g. IR, EQ,& FX) through time Replicating Portfolios vs. Curve Fitting Replicating Portfolios support simulation across time while Curve Fitting provides a proxy at one time point Replicating Portfolios provide more accurate predictions on an out-of-sample basis Curve Fitting simpler to explain Curve Fitting integrates market and non-market risk factors, whereas Replicating Portfolios only measure market risk leaving non-market risk to be aggregated 5

13 Risk Aggregation Techniques Monte Carlo based aggregations Correlation based aggregations Hybrid aggregation (MC-based & correlation-based) Copula-based aggregations Modified Copula-based aggregations Modified Copula Based Risk Aggregation Identify relevant risks Insurance Risk Operational Risk Market Risk Credit Risk Develop loss distribution functions Combine distributions Measure & allocate required capital 6

14 Modified Copula Based Risk Aggregation 1. Generate Market Risk Scenarios on IR Curves, EQ Indices, etc 2. Generate Non-Market Risk Scenarios on N(0,1) Risk Drivers 3. Value assets using market risk scenarios 4. Value non market risks using marginal risk distributions Scenarios are correlated => values are additive Key Benefits 1. Full drill down into Market Risk 2. Hedge analysis 3. Stress tests Question & Answer Discussion 14 7

15 Economic Capital Models SOA Annual Meeting Session 69 Clint Thompson, FSA, MAAA Chief Risk Officer October, 2011 Economic Capital Model Hannover Re Strategy Economic capital is the quantitative foundation for internal risk management across Hannover Re Economic capital will become the external regulatory capital standard for European subsidiaries and the group as a whole under Solvency II Our Solvency II strategy is to be a stable low risk counterparty Our goal is to double and triple use economic capital model learnings Additionally, internal model approval is a priority because the SII Standard Model does not fully reflect the various types of diversification available to a reinsurer 2 Economic Capital Models 1

16 Economic Capital Model at HLR America Hannover Re in Pre-application phase since 2008 The German regulator BaFin is our group supervisor under the Solvency II regime and thus leads the pre-approval process The pre-approval process (pre-application) for the group model started in 2008 The Hannover Re group plans to seek formalized approval as soon as the legal foundation has been established in Germany Regardless of US equivalence discussions, the Hannover Re group views economic capital as a key management tool across all subsidiaries and business lines 3 Economic Capital Models Economic Capital Model at HLR America Current Implementation Phase Evolving standards have made capital model development an iterative process of improvement HLR US now has almost all business modeled at a detailed cash flow projection level across ~1100 scenarios all on a unified modeling platform Pillar 2 (ORSA) and Pillar 3 (external disclosure) work-streams proceed on parallel tracks Internal model framework is already integrated into group wide strategy, decision-making, and new business assessment; ongoing improvements allow for further granularity and embedding 2011 production model run with latest improvements Ongoing integration & controls to support approval final model approval Pillar 2 Work-stream: ORSA, etc. Pillar 3 Work-stream: external disclosures 4 Economic Capital Models 2

17 Economic Capital Model at HLR America Model Results Model output is a distribution of required economic capital at the enterprise level Percentiles of this distribution (Value at Risk) are used for internal and external purposes The methodology and aggregation is owned and coordinated by Risk Management Models are owned and reviewed by BU, actuarial, investments, and reporting functions Group Risk consolidates into standard scenario set reflecting diversification Production reporting across group, BU s and entities, diversification levels, & risk type MCR 15% Failure Level (85% Confidence Level) SCR 0.5% Failure Level (99.5% Confidence Level) HR Group Standard 0.03% Failure Level (99.97% Confidence Level) 5 Economic Capital Models Economic Capital Models In the ERM Context Economic capital is only truly relevant and useful as part of a wider Enterprise Risk Management framework Hannover Re s ERM framework includes 5 key elements to directly link day-to-day risk taking to a firm s overall Corporate Strategy Economic capital is the common risk language that allows aggregation and analysis of risks across products, business units, regulatory frameworks, and risk types The economic capital model makes it possible to put the E in ERM Corporate Strategy 1. Risk Strategy (aka Appetite) 2. Governance (Roles and Responsibilities) 3. Risk Registry (Identification) 4. Limits, Thresholds & Polices 5. Risk Reporting & Monitoring 6 Economic Capital Models 3

18 Economic Capital Models In the ERM Context Corporate Strategy 1. Risk Strategy (aka Appetite) 2. Governance (Roles and Responsibilities) 3. Risk Registry (Identification) 4. Limits, Thresholds & Polices 5. Risk Reporting & Monitoring Risk Strategy links Corporate Strategy to quantitative and qualitative risk standards; simple example: If Corporate Strategy is to maintain strong capital levels then => Risk Strategy might include the statement 99.97% probability of economic solvency for our group and 99.5% at individual subsidiary level as defined by our economic capital model Note that the risk strategy / appetite should also include other quantitative and qualitative statements based on the Corporate Strategy (ie. consider US statutory RBC, earnings, etc ) 7 Economic Capital Models Economic Capital Models In the ERM Context Corporate Strategy 1. Risk Strategy (aka Appetite) 2. Governance (Roles and Responsibilities) 3. Risk Registry (Identification) 4. Limits, Thresholds & polices 5. Risk Reporting & Monitoring Roles and responsibilities need to be clearly defined Should be clear organizational separation between business steering versus risk oversight, monitoring, and methodology Risk management responsible for setting consistent economic capital model methodology across business units, products, and entities; and reporting results Business units are responsible for managing within the agreed risk framework 8 Economic Capital Models 4

19 Economic Capital Models In the ERM Context Corporate Strategy 1. Risk Strategy (aka Appetite) 2. Governance (Roles and Responsibilities) Every material risk to the strategy needs to be identified Material risks need to have limits, thresholds, and policies established Economic capital model allows limits to be set (for quantitative risks) so that they tie back clearly & directly to the enterprise level Risk Strategy 3. Risk Registry (Identification) 4. Limits, Thresholds & polices 5. Risk Reporting & Monitoring Risk Strategy Strategic Risk Capacity (economic capital) Limits & Thresholds Exposure Limit Credit Market UW-Life UW-Non Life Operational 9 Economic Capital Models Economic Capital Models Not just for European companies It is not yet exactly clear how economic capital requirements will filter into the US regulatory framework and other areas of actuarial practice It is clear that economic capital models are now a central part of best practice standards expected by a wide range of stakeholders IAIS ICP s & FSAP Solvency II NAIC ORSA & SMI Rating Agency Standards New Standards of ERM Best Practice Financial Crisis Experiences FIO / Dodd- Frank NAIC Risk Based Exams, etc. ASB Draft ERM ASOP s 10 Economic Capital Models 5