ORSA Overall Solvency Needs and Implementation within the European Market

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1 ORSA Overall Solvency Needs and Implementation within the European Market Sam Morgan Principal Hong Kong 1

2 Contents Introduction Risk appetite and the overall solvency needs Selection of risk factors Definition of the scenarios Link with risk tolerance Conclusions 2

3 Contents Introduction Risk appetite and the overall solvency needs Selection of risk factors Definition of the scenarios Link with risk tolerance Conclusions 3

4 Introduction Over the past decade there have been a focus on Risk Based Capital around the world Solvency II in Europe RBC in Singapore C-ROSS in China One of the common features of each of these frameworks, is the concept of an ORSA Own Risk Solvency Assessment The concept is fairly straight forward The regulatory capital requirement, although Risk Based, is sometime a little blunt Companies need to understand all the risks that they are exposed to and integrate this into the risk management procedures Contains both quantitative and qualitative elements An ORSA report, signed off by senior management and containing the risk management procedures and analyses, is provided to the regulator The implementation however faces a number of technical issues This presentation outlines how companies have responded to these issues in the context of Solvency II in Europe 4

5 Introduction A brief introduction to Solvency II The Solvency II capital requirement is based on a the following fundamental principal The capital required today to ensure with a 99.5% probability that the company will not be in economic ruin over the next year Probability of Economic Ruin < 99.5% Current Available Capital Net Asset Value Economic ruin is defined as the situation where Net Asset Value = MV Assets - Fair Value of Liabilities <= 0 5

6 Introduction A brief introduction to Solvency II To calculate the fair value of liabilities, we need to perform an economic valuation of the liabilities : Risk neutral, "Market consistent valuation Explicit valuation of time value of embedded options and guarantees Requires stochastic simulations to define calculate a single point on the curve Therefore, in its purest form, should use some nested stochastic to find the 99.5% percentile 6

7 Introduction A brief introduction to Solvency II To avoid the nested stochastic requirement, the standard formula is set up such that Each of the risk capital charges are calculated as the difference between the NAV before shock and the NAV after shock (noting that each calculation is a stochastic calculation) The total SCR (Solvency Capital Requirement) is the aggregation of these individual risk charges Calculation of individual risk charge Aggregation of individual risk charges into total SCR - = 7

8 Introduction An introduction to ORSA within Solvency II Article 45 of the Solvency II directive states : As part of its risk-management system every insurance undertaking and reinsurance undertaking shall conduct its own risk and solvency assessment. That assessment shall include at least the following: (a) the overall solvency needs taking into account the specific risk profile, approved risk tolerance limits and the business strategy of the undertaking; (b) the compliance, on a continuous basis, with the capital requirements and with the requirements regarding technical provisions; (c) the significance with which the risk profile of the undertaking concerned deviates from the assumptions underlying the Solvency Capital Requirement In addition, the ORSA guidelines gives the following guidelines related to the overall solvency needs Guideline 8 : The undertaking should express the overall solvency needs in quantitative terms and complement the quantification by a qualitative description of the risks. Guideline 9 : The undertaking should subject the identified risks to a sufficiently wide range of stress test/scenario analyses to provide an adequate basis for the assessment of the overall solvency needs. Guideline 10 : The undertaking s assessment of the overall solvency needs should be forward-looking and at least cover separately each year of the business planning period. Guideline 14 : The undertaking should take the results of the ORSA and the insights gained in the process into account at least for the system of governance including long term capital management, business planning and product development and design. 8

9 Introduction An introduction to ORSA within Solvency II The overall solvency needs is the strategic solvency indicator at the heart of the risk management and decision making of the business Reflects the internally defined risk appetite Includes all risks, including those not included the regulatory capital calculation, and on a wider basis than the standard formula, most notably including future new business Contains a forward looking component covering the horizon of the business plan including capital management and future capital needs The key indicator when making strategic decisions within the company (eg. modification of the asset allocation, launching a new product, purchase of a new portfolio, ) Is used in the risk tolerance framework 9

10 Introduction An introduction to ORSA within Solvency II An expression of the company s global risk framework Breakdown of risk appetite into elements actionable by business line managers Expressed in the form of risk budgets and / or risk limits Covers continuous compliance requirement Internally defined measure reflecting the risk appetite Includes all material risks Forward looking Covers not just regulatory capital but a wider vision (ie. stressed scenarios) 10

11 Contents Introduction Risk appetite and the overall solvency needs Selection of risk factors Definition of the scenarios Link with risk tolerance Conclusions 11

12 Risk appetite and the overall solvency needs The definition of the overall solvency needs is the key quantitative element mentioned in Article 45 of the Solvency II Directive. It is based on a risk appetite which transfers the key aim of the insurer; this could be for example : To always be a going concern even after the impact of certain pre-defined adverse events 100 % coverage of the regulatory capital ; To conserve a sufficient rating after these same adverse events solvency ratio as a % of the regulatory requirement depends on the target rating Rating AA A BBB BB Equivalent solvency ratio 200 % 175 % 120 % < 100 % etc. Furthermore, two possible target levels can be considered : A target of X1 % in the case of a «central» scenario; A target of X2 % in the case of adverse events, the probability of which is to be defined. 12

13 Risk appetite and the overall solvency needs The definition of the risk appetite will usually take the following form : «a level of capital sufficient to maintain the available capital greater than X% of the internal capital requirement after the realisation of a scenario cumulating adverse events over a specific time horizon». The elements that need to be defined : Internal capital requirement : can include additional risks or be recalibrated to a different confidence level. Most commonly uses the regulatory requirement as this is the key driver in the management of the business and becomes difficult to create the link between the regulatory capital and the internal capital The use of Internal model or standard formula capital depends on the company situation Time horizon : length, method of application Definition of adverse events : risks covered, definition of amplitude and combination of shocks 13

14 Risk appetite and the overall solvency needs The elements that need to be defined (cont d) : X% : the impact of different choice s of X : Definition of the target level of solvency Target of X% where X is close to the initial solvency ratio Target of X% where X is far from the initial solvency ratio, possibly even <100% Advantages Ability to show a high solvency ratio, even after stress Ability to include relatively onerous stress tests. Disadvantages Risk being constrained in the definition of the scenarios > construction of a less useful risk framework If X < 100%, ORSA framework not coherent with the regulatory requirements Also depends on the value of X before shock => if the initial solvency ratio is low, no point in testing large stresses that give a solvency ratio < 100% of regulatory capital 14

15 Risk appetite and the overall solvency needs Some examples Example 1 : Risk appetite statement Available Capital > Target Capital Excess Capital Where Target Capital = Required Capital + Buffer Capital Required Capital = Max ( Regulatory capital, Internal Model (RBC) capital, Internal Rating Regulatory Required Buffer Target Available Rating Agencies) Model agencies model capital capital capital capital Buffer capital = Example 2 : Risk Appetite statement Capital required to be 90% sure that the available capital remains Available above Capital the required > X% capital internal (alternatively, model capital the 90% VaR of the required capital) And stresses defined as : Where X = Equity drop: Market values of all equity investments drop by 25%. Limit 1 Limit 2 Interest rates up: Parallel shift in yield curves by 250 bps up. Base case 140% 100% Interest rates down: Parallel shift in yield curves by 200 bps down. Credit: Operating entity specific 1-in-15 year credit event. Stresses * 130% 100% Combined scenario: Drop in market values of all equity investments by 10% and parallel shift in yield curves by 80 bps up. Limit 1 : Continuous monitoring when breached Limit 2 : Action must be taken when breached 15

16 Risk appetite and the overall solvency needs The overall solvency needs covers only one of the key strategic axes of the company => its solvency. Additional Key Risk Indicators will be included in the ORSA projections to help in making any business decisions : Profitability, based on the projected profits; Commercial performance, by looking at the credited rate for interest sensitive policies (in the case of a life company) ; Operational performance, based on the combined ratio or expense ratio ; Etc.. 16

17 Risk appetite and the overall solvency needs Benchmark (1/2) Bancassurer 1 Bancassurer 2 Traditional insurer Mutual Specialist insurer Reinsurer 1 International Group Bancassurer 3 Reinsurer 2 Solvency Profits Profitability (ROE, ) Bonus strategy Market Consistent Embedded Value (MCEV) Embedded Value with risk premium (real world) Rating 17

18 Risk appetite and the overall solvency needs Benchmark (1/2) Examples Profit / Profitability Maximum reduction in the IFRS profit Minimum constraints on the return on equity Minimum constraints on Return on Risk adjusted capital (IFRS Profit / SCR VIF) Risk Adjusted Return On Risk Adjusted Capital : MCEV / (PV projected SII capital requirement) Profitability must be > 3 month risk free rate + X basis points Maximum reduction in cumulative 5 year accounting profit Bonus strategy Impact within the scenarios on the future bonus rates and the bonus fund Capacity to pay a bonus rate > minimum level with a probability of X% Embedded Value (MC & RW) Maximum reduction of 30% Minimum level of Embedded value 18 18

19 Contents Introduction Risk appetite and the overall solvency needs Selection of risk factors Definition of the scenarios Link with risk tolerance Conclusions 19

20 Selection of risk factors Introduction The identification of risk factors is a key step in the ORSA process for those insurers using the standard formula for the calculation of their economic capital For those insurers that are using an internal model, this should have already been undertaken during the regulatory approval process For these insurers, the identification of risk factors should be summarised into the following: Cat. 1: Material risk AND included in the SCR calculation. Shocks on the risk factor in the ORSA calculations : Regulatory capital requirement : yes, in the case of future SCR or SCR after shock ; Stress scenarios : Yes, in order to calculate the capital after shocks or in the projections. Cat. 3 : Material risk BUT not in the SCR calculation. Shocks on the risk factor in the ORSA calculations : XRegulatory capital requirement : non, no change to the regulatory requirement within the projections ; Stress scenarios: yes, these risks specific to the insurer should be included in the shock or in the projections to ensure risk being adequately accounted for Cat. 2 : Non material risk BUT included in the SCR calculations. Shocks on the risk factor in the ORSA calculations :?Regulatory capital requirement : Yes, if a full calculation is being done, but might not be necessary if proxies are being used for projected SCR; XStress scenarios : non, do not want to unnecessarily to complicate the ORSA process. Cat. 4: Non material risk AND not included in the SCR calculation. Shocks on the risk factor in the ORSA calculations : XRegulatory capital requirement : non, no change to the regulatory requirement within the projections ; XStress scenarios : non, do not want to unnecessarily to complicate the ORSA process. 20

21 Selection of risk factors Risk mapping and quantification In Europe, the Solvency II standard formula has provided a very good starting point for the analysis of the risk Most of the major risks are already included All risks are considered to be evaluated on a consistent basis - at the 99.5% confidence level Some key risks not covered by the Solvency II standard formula Risks covered by the Solvency II standard formula 21 The identification of additional risks is primarily achieved through interviews with key stakeholders and decision makers across the business These risks should be evaluated on an equivalent basis to the standard formula (99.5%) Some risks not covered by the Solvency II standard formula European Sovereign risk : No capital charge is applied to European government bonds Volatility risk : Increased volatility has impacts on the economic balance sheet of the insurers Basis risk : primarily for VA writers Catastrophe Risk : specific forms outside of SF Liquidity risk Regulatory risk Reputation risk Strategic Risk Some risks are only evaluated using a qualitative framework

22 Selection of risk factors Classification of risks Each of the risks must be classified as material or not Between Category 1 and Category 2 for risks included in Standard Formula Between Category 3 and Category 4 for other risks Definition of materiality limits Fixed materiality limits can create volatility in the list of material risks Over time, between entities Usually aim to have an upper and lower limits and use expert judgment to classify risk between the two levels Upper materiality limit Lower materiality limit Material risk Use of expert judgment Non material risk 22

23 Contents Introduction Risk appetite and the overall solvency needs Selection of risk factors Definition of the scenarios Link with risk tolerance Conclusions 23

24 Definition of the scenarios Key concepts The calibration and composition of the scenarios should provide the ability to test the future solvency of the company in a number of realistic but varied stress scenarios. The calibration of the scenarios is based on the (i) selected risk measure and the (ii) intensity of the shocks being considered The composition of the scenarios gives the capacity to test multi-directional shocks in order to take into account the expected correlations between the risk factors 24

25 Definition of the scenarios Objective or Understandable? Trade-off between Objective versus Understandable nature of the scenarios Realistic scenarios can be constructed in three different manners : Simulation of past crises (for example, the tech crash in 2000, the subprime crisis, the property bubble crash in Japan, the Asian currency crisis ) Simulations of dreaded events which are linked to the economic situation or geopolitical situation (break up of the Eurozone, break out of war in Ukraine, continuation of political crisis in Thailand, ) ; Definition of scenarios based on percentiles (use of historical analysis to determine percentiles for individual risk levels). + Graphical representation of the trade-off between Objective / Understandable - Dread events Simulation of pas crises Understandable - Shocks based on percentiles Objective + 25

26 Definition of the scenarios Objective or Understandable? Trade-off between Objective versus Understandable nature of the scenarios (cont d) Some additional elements that must be considered when deciding on the appropriateness of the different approaches presented previously : Simulations of past crises Easy to understand, but only takes into account risks that have already occurred but doesn t take into account any new risks in the future (will history always repeat itself?) Dreaded events It is difficult to estimate the impact of the dreaded event on each of the risk factors ie. How are the correlations going to react? Shocks based on percentiles Need to dispose of a sufficiently long history of data points (the higher the percentile, the deeper the history that is needed) ; Where the risk factor or the history of data available makes an evaluation of the percentile impossible, need to turn to expert judgment -> ultimately, removes much of the objectivity of the scenarios. Can perform reverse stress tests -> illustration by «understandable» scenarios shocks that are initially based on percentiles 26

27 Definition of the scenarios Countercyclical scenarios A feature of Solvency II is that as the market conditions worsen, the capital position itself worsens, and vice, versa creating significant volatility in the regulatory solvency ratio of the company. A key objective of many insurers is to make the overall solvency needs capital less volatility than the SCR, a an often criticised feature of Solvency II. This can be done through the definition of the scenarios that take into account the relative position in the business cycle countercyclical scenarios 27

28 Definition of the scenarios Countercyclical scenarios example 1 : equity shock The equity scenario for the ORSA will be based on a «central» shock plus a cyclical adjustment factor : Step 1 : Calculation of the central shock The level of shock is based on the based on the relevant percentile as per the risk tolerance of the company The following table gives the example of the distribution of the MSCI Europe, assuming a normal distribution of the log returns based on a historic between 1973 and 2009 : Step 2 : Calculation of the adjustment factor Percentile 99.5% 99.0% 95% 90% Level of shock -43% -38% -25% -18% The adjustment factor is based on the current position of the index versus the average position of the index over the previous 3 or 5 years (corrected for the expected growth in the index) Current index above average index : adjustment factor is positive Expected growth line Current index below average index : adjustment factor is negative 28

29 Definition of the scenarios Countercyclical scenarios example 1 : equity shock 29

30 Definition of the scenarios Countercyclical scenarios example 2 : spread shock For certain financial risks, the counter cyclical effects can be of a different nature to the symmetrical adjustment, most notably for the spread shock. Example of how this can be implemented : 1/ Calculation of the absolute level of spread for each rating «AAA», «AA», «A», «BBB», for the percentiles 99%, 90% or 95% based on the historical level of a bond index (Markitt or other) ; 2/ The level of shock to be considered in the ORSA, is the absolute level of the shock at the percentile level in question less the current level of the spread. 2 bis/ In order to take into account particular cases, an absolute minimum shock equal to 50 basis points is applied. The following slides contain a numerical example of the, based on the iboxx index over the period

31 Definition of the scenarios Countercyclical scenarios example 2 : spread shock Absolute level of spread for corporate obligations at the different percentiles In bps AA A BBB 99.5% % % % Current end of year spreads for the period 2009 to 2012 En bps AA A BBB 31/12/ /12/ /12/ /12/ = Calibration of the shocks 95th Percentile En bps AA A BBB 31/12/ /12/ /12/ /12/ th percentile En bps AA A BBB 31/12/ /12/ /12/ /12/

32 Definition of the scenarios Countercyclical scenarios example 2 : spread shock 32

33 Definition of the scenarios Completeness All risk factors identified as material should be considered during the calculation of the ORSA capital Each risk from Category 1 or Category 3 should be included in at least one stress scenario. In order to define the ORSA capital based on a reasonable number of scenarios, it seems necessary to combine several shocks on different factors into the same scenario. The risk factors can be combined into a realistic scenario taking into account the existing interactions : Shocks based on percentiles : In combined scenarios, the marginal percentiles needs to be reduced such that the resulting scenario corresponds to the target percentile => a non-reduction will lead to overestimation of the overall combined scenario The simulation of past crises or dreaded events should, in themselves, be based on a combination multiple financial and / or technical shocks. 33

34 Definition of the scenarios Completeness combining scenarios A very simplified approach : Percentile of a normal distribution Assumption : The intensity of the shock follows approximately a normal distribution ( standard formula) The shocks can be correlated amongst themselves. The intensity of the combination of several shocks also follows a normal distribution but with different parameters ; A reduced percentile can be deduced based on the initial percentile for each of the individual shocks Number of risk factors included in the shocks Reduced percentile shocks Assumption : 0% correlation between the risk factors Reduced percentile shocks Assumption : 50% correlation between the risk factors 1 risk factors shocked 95% 95% 2 risk factors shocked 88% 92% 3 risk factors shocked 83% 91% 4 risk factors shocked 79% 90% 5 risk factors shocked 77% 90%!! Method is based on two strong assumptions : -The volatility of each individual risk not taken into account; -Impact of individual risk on capital not accounted for. 34

35 Contents Introduction Risk appetite and the overall solvency needs Selection of risk factors Definition of the scenarios Link with risk tolerance Conclusions 35

36 The link with risk tolerance The risk appetite gives the minimum level of excess capital that the entity / group wishes to maintain at any moment. In order ensure this, you cannot simply determine a posteriori at certain time intervals; on the contrary, an approach a priori must be used, that is to anticipate all future deviations of the risk profile which would bring about a non respect of the overall solvency needs capital requirement. Therefore, an operational framework for risk tolerance must be implemented. From a practical perspective, this framework should provide the risk takers with a set of tools to help them measure the impact of any decision on the ORSA solvency of the group and therefore validate or reject that decision 36

37 The link with risk tolerance The risk tolerance framework should meet the following criteria Risk tolerance framework 1. Fix limits that are both understandable and actionable by the risk takers 2. Give the possibility to the risk takers to know their position with respect to the limit at any time 3. Anticipate the change in the position with respect to the limit when considering a possible decision Two approaches have been developed to answer this question Risk tolerance framework Approach 1 Implementation and monitoring a risk budget framework Approach 2 Implementation and monitoring a series of risk limits 37

38 The link with risk tolerance In the risk limit approach, the aim is to fix a minimum / maximum level for each of the parameters that are in the hands of the risk taker: Example for financial risks : minimum level of Govt Bonds in the portfolio, maximum level of equity maximum concentration on a single issuer. Advantages Very easy to understand whereby the framework is based on the parameters in the hands of the risk taker (e.g. : equity asset mix) Disadvantages Gives little room for movement to the risk takers, especially in the case of risk mitigation techniques (by either reinsurance or derivatives) In the risk budget approach, simply a minimum level of ORSA surplus will be defined: Advantages Very wide latitude given to the risk taker : as long as the surplus remains over the defined limit, the risk taker can modify their decision as they desire Disadvantages System significantly less understandable : the notion of surplus is not directly related to the operational decisions => tools must be provided to risk taker to facilitate decision making 38

39 Contents Introduction Risk appetite and the overall solvency needs Selection of risk factors Definition of the scenarios Link with risk tolerance Conclusions 39

40 Conclusion An expression of the company s global risk framework «a level of capital sufficient to maintain the available capital greater than X% of the internal capital requirement after the realisation of a scenario cumulating adverse events over a specific time horizon». Breakdown of risk appetite into elements actionable by business line managers Expressed in the form of risk budgets and / or risk limits Covers continuous compliance requirement Internally defined measure reflecting the risk appetite Includes all material risks Forward looking Covers not just regulatory capital but a wider vision (ie. stressed scenarios) 40

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