Introduction to Economic Reserves and Capital

Transcription

1 Introduction to Economic Reserves and Capital Valuation Actuary Symposium Noel Harewood September 17, Towers Perrin Background Focus on economic reserves Economic capital covered in earlier presentations Overall agenda Definition Technical aspects Practical uses 2007 Towers Perrin 2

2 Definition What are economic reserves? Economic reserves are the reserves required to make full provision for the liability under the insurance contract Key questions What does full provision mean? Settlement vs. transfer What does under the insurance contract mean? Maintenance expenses Various incarnations of economic reserves exist 2007 Towers Perrin 4

3 Technical aspects of economic reserves Technical aspects calculation of an economic reserve Projected cash flows Time value of money Allowance for risk IFRS Phase 2 Building Blocks 2007 Towers Perrin 6

4 Projected cash flows Nature of underlying operating assumptions Best estimates or prudence? Source of operating assumptions Based on ALL available information? Could include information outside the realm of actuarial experience studies Unbiased Stochastic or deterministic? Correlation with economic conditions 2007 Towers Perrin 7 Time value of money What is the discount rate? Market-consistent view Matches up with financial economics (i.e., values cash flows consistently with other financial products) Best estimate view Expected earned rate for backing assets 2007 Towers Perrin 8

5 Allowance for risk Explicit margins in assumptions (PADs) Allowance in discount rate (additional risk premium) Cost of capital approach 2007 Towers Perrin 9 Practical uses of economic reserves

6 Uses of economic reserves Definition of economic earnings E.g., under market-consistent embedded value reporting Solvency reserves under a principles-based framework Definition of redundant reserves under alternative funding structures 2007 Towers Perrin 11 Economic reserves in securitizations Typically gross premium reserves interpretation is settlement of the liability Operating assumptions are best estimates, with no margin for prudence But who sets best estimate? Financial assumptions are best estimates based on environment in effect, and include provision for credit risk premium Assumptions are typically locked-in Likely to diverge from true economics over time Typically floored at zero in aggregate 2007 Towers Perrin 12

7 Economic reserves Principles-Based Reserves Underlying interpretation is settlement (under adverse conditions) Operating assumptions contain margins Economic assumptions not market-consistent for interest/equity scenarios Presence of cash value floor 2007 Towers Perrin 13 Economic reserves IFRS/US GAAP (SFAS 157/159) Underlying interpretation is transfer of the liability Operating assumptions and financial assumptions based on market Assumptions are updated at each valuation to reflect then-current conditions Risk allowed for via risk margins calibrated at each valuation date No clear consensus on method of allowing for risk margins 2007 Towers Perrin 14

8 watsonwyatt.com Valuation Actuary Symposium TS: Introduction to Economic Reserves and Capital Steve Bochanski September 17, 2007 Outline Overview Why Economic Capital? Common methodologies Conclusion 2

9 Traditional measures of risk Silo-based views of risks Interest rate risk Mortality risk Credit risk have naturally created silo-based measures of risk Duration and convexity measures Net amount at risk Top-5 counterparty risk and in other cases no explicit measure at all. Operational risk It is not possible to determine an overall view of risk based on these measures. 3 Traditional measures of risk Traditional attempts to define and quantify risk: Statutory reserves Rating agency capital NAIC RBC Have become inadequate: Based on averages Formulaic / factor-based Risk margins are not explicit Economic capital moves beyond the traditional approach to define and quantify the risk margin explicitly. 4

10 Balance sheet view Statutory Balance Sheet Economic Balance Sheet Statutory Capital and Surplus Excess Capital Required Economic Capital Available Economic Capital Statutory Value of Assets Statutory Reserves Market Value of Assets Economic Reserves 5 What is Economic Capital? Commonly accepted definition: Sufficient surplus to cover potential losses, at a given risk tolerance level, over a specified time horizon. Allows statements such as: Available capital is sufficient to ensure the company will remain solvent for 1 year with 99% probability. 6

11 Alternative definitions of Economic Capital share common themes Alternative definitions include: 1. Sufficient surplus to meet potential negative cashflows and reductions in value of assets or increases in value of liabilities at a given level of risk tolerance, over a specified time horizon. 2. Excess of the market value of the assets over the fair value of liabilities required to ensure that obligations can be satisfied at a given level of risk tolerance, over a specified time horizon. 3. Sufficient surplus to maintain solvency at a given level of risk tolerance, over a specified time horizon. 7 Graphical illustration PV Surplus Confidence Level Economic Capital Base Scenario Cumulative Probability Stress Scenario 8

12 Outline Overview Why Economic Capital? Common methodologies Conclusion 9 Why Economic Capital? Allows comparisons to be made in a common language and currency Reflects the economics of the business Enables better management of risk and return 10

13 Outline Overview Why Economic Capital? Common methodologies Conclusion 11 General approach There is no one, commonly accepted approach to calculating EC, but in general: Three-step process Establish a solvency standard for the company in terms of a probability of default or target debt rating Measure the economic capital for each individual risk based on the risk exposures, the solvency standard, and the time horizon Aggregate the economic capital across all risks while incorporating the correlation between risks 12

14 Methods for calculating EC Method will be determined based on a few key choices: Definition of solvency Valuation basis (Stat, GAAP, Market value) Time horizon Risk measure 13 Methods for calculating EC Some examples: European model: 1-year VAR approach, with assets and liabilities measured at market value RBC model: CTE(90), based on excess of assets over working reserves over life of the liabilities Cashflow-based methods: sufficient assets to fund liability cashflows Every method has its strengths and weaknesses. Ultimately, the method chosen must be fit for purpose. 14

15 Risks to be considered Insurance (Underwriting) Risk Credit Risk Market Risk Liquidity Risk Operational Risk Group Risk 15 Outline Overview Why Economic Capital? Common methodologies Conclusion 16

16 Conclusion Economic capital modeling can bring a holistic view of the risks of an enterprise This enables enhanced decision-making across all risk-taking activities No economic capital methodology is without its weaknesses, BUT this does not negate the great benefits and insights that result from EC modeling 17 watsonwyatt.com Valuation Actuary Symposium TS: Introduction to Economic Reserves and Capital Steve Bochanski September 17, 2007

17 Insurance and Actuarial Advisory Services Session 16 Introduction to Economic Reserves and Capital Matthew Clark FSA, CFA 0 0 Valuation Actuary Symposium Austin, TX Agenda What is Economic Capital? Understand Your Audience Technical Issues Life After Modeling Conclusion 1 1

18 What is Economic Capital? 2 2 What is Economic Capital? Economic Capital (EC) is the amount of capital required to cover risk at a desired confidence level over a given time horizon 3 3

19 Traditional Economic Capital in Insurance Insurance capital requirements Reserves (regulators) Uniform Formulaic Risk-based capital (rating agencies) Factor Based Reflect Limited Risks Evolution of the industry Evolution of product guarantees Accumulation guarantees No lapse guarantees Competition with financial institutions 4 4 Understand Your Audience 5 5

20 Capital Perspectives Regulators/policyholders Solvency Ability to meet policyholder obligations Rating agencies Ability to meet policyholder obligations Ability to meet debt obligations Management Capital allocation Risk management Compensation Investors Solvency + return on equity Risk-adjusted return 6 6 Potential Uses of Economic Capital Regulatory Rating agency Risk management Capital allocation Pricing Performance measurement Compensation External communication 7 7

21 Technical Issues 8 8 Methodology Considerations Fair value versus statutory method Time horizon Discount rate New business Taxes Economic assumptions (real world versus risk free) Risks to include Stranded capital 9 9

22 Aggregation Pros and cons of common aggregation approaches Correlation matrix Positive easy to implement, reduced run time Negative difficult to parameterize, correlations are not constant Approximation techniques Positive reduced run time Negative difficult to integrate approximations across risks/products Integrated scenarios Positive provides an integrated solution without limiting reporting across risks or reporting unit Negative increased run time, complex scenario generation Understand how your aggregation decisions impact your audiences and your uses of the information Diversification Level of risk quantification Product Risk Jurisdiction All of the above Most organizations struggle with the allocation of the diversification benefit Can you afford to not allocate the diversification benefit? What risks do you face when allocating the diversification benefit? 11 11

23 Distribution Considerations Tail metric VAR CTE Modified CTE Consider risk appetite not just risk quantification Understand the events that generate risk Focus on the entire distribution The distribution is more important than isolated tail metrics Life After Modeling 13 13

24 Reporting Economic Capital Results Understanding the results Communication Internal External Reconciliation Period-to-period Versus other reporting frameworks Static versus dynamic reporting Characteristics of Successful Implementations Strong management sponsorship Disciplined methodology development Disciplined approach to implementation Leveraged technology Established production process Communication 15 15

25 16 16 Conclusion