ERM Practice and Challenge in China Insurance Company. Zhang Chensong, FSA,CERA,FIA,FCAA Head of Risk Management Taikang Life Insurance

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1 ERM Practice and Challenge in China Insurance Company Zhang Chensong, FSA,CERA,FIA,FCAA Head of Risk Management Taikang Life Insurance

2 Agenda ERM development in China ERM framework Economic capital application Challenges in practice and going forward 2

3 Global Financial Crisis In March, 2008, The Bear Stearns Company who exploded a liquidity crisis got purchased by Morgan Stanley, In September, 2008, Freddie Mac and Fannie Mae who had been exposed to four quarters continuous loss, were taken control of by US government. In September, 2008, the fourth biggest US investment bank, Lehman Brothers Holdings experienced a 90% drop in its stock price within 9 months and required a bankruptcy protection. In October, 2008, The three biggest banks of Iceland went out of business completely and leaded Iceland to face national bankruptcy. In June, 2009, US GM announced its bankruptcy. In November, 2009, the biggest financial group of Dubai claimed the delay of debt reimbursement, and undertook a debt reorganization which reached a 59 billion USD high. And then the Dubai financial crisis erupted. In November, 2009, the national debt of Greece hit its historical high. The most three authorized rating agencies degraded the sovereign credit rate of Greece because of the worries of its debt crisis. In February, 2010, the Spanish government announced that its financial deficit accounts for 9.8% of GDP.In April, Spain and Portugal met a credit rating downgrade, which deepened the European debt crisis. 3

4 Solvency II Solvency II Capital Requirement Risk Management Market Discipline In 1997, Muller s report brought in the Solvency I plan and the Solvency II plan. In 2001, the European Union formally launched the project of Solvency II. In 2003, KPMG and Sharma s report released. The Solvency II is estimated to be implemented in In 2000, the EU Commission and the Council of EU presented FSAP. In 2002, EU achieves the expected objects of Solvency I Between 2006 and 2008, the research results of QIS were announced and the QIS5 research is undertaken in

5 Risk Management Regulations for Insurance Industry In China 1999 Internal Control Directive and Principle for Insurance Companies 2004 Provisions on the Administration of Insurance Companies 2004 The Guidelines for Risk Control in Investment of Insurance Companies 2006 Guiding Opinions on Regulating the Governance Structure of Insurance Companies 2007 The Directive for Risk Management of Insurance Companies 2007 The Directive for Compliance Management of Insurance Companies 2008 The Administrative Provisions on the Solvency of Insurance Companies 2008 The Basic Internal Control Norms for Enterprises 2008 Classified Supervision of Insurance Companies Estimated in September, 2010 Guidelines for Enterprise Risk Management in Life Insurance Companies 5

6 Guidelines for ERM in Life Insurance Company Explicitly propose that life insurer should build up the three defenses for the enterprise risk management Require life insurance companies to establish the risk management committee as sub-committee of the board of the directors Propose that the companies should have a position that is Chief Risk Officer responsible for risk management control Explicitly require that life insurance co. should have a risk management department which should be independent from sales, finance, investment, actuarial, etc. Classify the risks of life insurance companies into 8 categories : market risk, credit risk, insurance risk, business risk, operational risk, strategy risk, reputation risk and liquidity risk For the first time, state the Economic Capital model as the basis of risk quantitative measurement Explicitly propose that life insurance companies should establish effective risk appetite and tolerance Explicitly propose that life insurance company should build up an asset and liability management organization Propose that life insurance company should build up KRI system 6

7 Current Status: Risk Management Governance Early 2010, CIRC initiated a survey on Risk management status of life insurance industry in China. Questionnaires were released to all life insurance companies, health insurance companies and pension companies locate in China, and 35 valid replies were received. The result indicated following points: Risk management organization - 25 companies have set up Risk Management Committee, and 14 of them are established at Board-Level companies have person in charge of risk management, only 6 companies have the role of Chief Risk Officer companies have set risk management department, but only 10 of them are independent, the rest of them are combined with other functions, such as compliance, legal, internal control and etc. At Board Level, 43% No RMC, 28.6% Indepentdent Dept., 40% Risk Management Committee Risk Management Department At ExecutiveLevel, 28.4% Combined Dept, 28.57% No RMD, 31.43% 7

8 Current Status: Risk Management Fundamental Risk management fundamental - 22 companies have established their own risks category - Only 8 companies have built up EC model for risk quantification - 16 companies have tried to establish risk appetite and tolerance system, but still at the exploratory stage Risk Category EC Model Risk Appitite Yes, 22.86% No, 37.14% No, 44.29% Yes, 45.71% Yes, 62.86% NO, 77.14% 8

9 Agenda ERM development in China ERM framework Economic capital application Challenges in practice and going forward 9

10 Current Environment Internal Drivers Oversight from Shareholders and Board External Factors Customer Expectation Uncertain Business Environment Fierce Competition Strategic Risk Management Market Risk Management Credit Risk Management Insurance Risk Management Operational Risk Management Other Risk Management Capital Management Risk Management Framework: Strategies and Policies Organization and People Processes Methodology Reporting Regulation Solvency II SOX COSO Risk Management Directive Systems & Data 10

11 ERM Process Enterprise risk management is a process, effected by an entity s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives. Risk management framework (Establishing risk management process and a common language) Risk Assessment (Identifying and evaluating the risks) Optimization (Improvement of risk management capabilities) Risk Management Information Risk Strategy (Developing risk strategy, design and implementing risk mitigation plan) Risk Monitoring (Monitoring the implementation of risk management; reporting) 11

12 ERM vs. Traditional Risk management ERM Integration Approach Communicate and evaluate the overall risk of the whole organization and consider the diversification Risk and Opportunity Consider both risk and opportunity Control risk and hold opportunity Managing Risk Choose the strategy with optimal return for given risk tolerance to achieve the balance between risk and return Traditional Risk management Silo approach Each business unit just concerns its own risks without consideration of whole impacts and relations among risks Only Risk Only focusing on the risk prevention but not the opportunity catching Controlling Risk No actively manage risks and just control risk under certain restriction 12

13 Two Levels of ERM Risk Control Strategic Risk Management Risk Identification Identify internal and external incidents that could affect the achievement of the company s goals. Risk Assessment Assess the possible impacts to objectives from potential risks. Assess risks in two dimension: probability and impact. Risk Response Select and execute responses based on the results of risk assessment. Risk responses fall into the following categories: avoidance, mitigation, transfer and acceptance. Risk Control and Monitoring Monitor the operation of enterprise risk management, the effectiveness of risk responses and the control activities Risk Quantification Build risk model with consideration of risk diversification and quantify risk impacts Risk Pricing Consider risk and risk management explicitly in the pricing process to ensure the price reflects the cost of risk. Risk Capital Allocation Allocate capitals to business line based on risk capital, setting up business plan with risk management plan. RAPM Apply risk-adjusted financial performance management process metrics in Integrated KRI within KPI 13

14 Three Defenses of ERM Board of Directors Set the tone of the risk management Establish risk appetite and strategy Approve risk management framework, policies, responsibilities, etc. Take risk related information into decision making process, making decision of risk responses Internal Audit The 3 rd defense Validate the compliance of company s business lines Validate the risk management framework Review the implementation of risk management process, and provide improvement suggestion Risk Management Committee and Department The 2 nd defense Design the ERM framework Supervise the business units accordance with the ERM framework and company strategy Coordinate risk management activities among business units Risk modeling and quantification Establish risk management policies and procedures, monitor the implementation Report risks Business lines Function departments Branches Subsidiaries The 1st defense The owners of risks Identify, assess, response, control and report risks Collect the loss data and events 14

15 Agenda ERM development in China ERM framework Economic capital application Challenges in practice and going forward 15

16 Uniform Risk Measurement Economic Capital defined as the capital requirement to ensure company s daily operation and solvency even in extremely unfavourable environment EC is the basic risk measurement Enable to focus on major risks from company s perspective Applied to the establishment of risk limit Key tools for risk measurement, capital planning and management Considerable side-benefits in terms of risk transparency EC is the complement to other customised tools, but not the replacement EC is not the substitute of risk management process 16

17 Quantifiable Risks Definition MARKET RISK CREDIT RISK INSURANCE RISK BUSINESS RISK OPERATIONAL RISK Losses due to changes in market factors such as price, volatility, and correlation factors Losses due to changes in the creditworthiness of other entities Deviations of income due to unexpected claims and adverse developments of reserves Deviations of income due to unexpected business volume reduction Adverse impact to business as consequence of conducting it in an improper or inadequate manner Economic Capital Consistent and comprehensive risk measurement across quantifiable risks Value-at-Risk to a confidence level of 99% EC reported on a monthly basis for company 17

18 Calculation Framework Current Status Stress Scenarios Result Risks Involved Revenue Streams Balance Sheet Asset Cost Profit Liability Equity Revenue Significant Financial Crisis Impact on other revenues and expenses Erosion of MTM values of assets and increase of liabilities Estimation of expense coverage from commission/fee and net interest income = = Market, Credit, Insurance Risk EC + Business Risk EC + Calculated at a confidence interval of 99% Calculated at a confidence interval of 99% Operations Operations Operational or external events Estimation of potentially operational loss event based on = industry-wide historical experience Operational Risk EC Calculated at a confidence interval of 99% = Total EC 18

19 Key Applications: Risk Appetites Set risk tolerance using EC Allocate risk tolerance to business lines and units as risk limit Relationship of the elements of risk appetite system Risk Capacity The risk amount company is able to take Risk Appetite Risk Tolerance Risk Limit The risk types and amount company prefer to take The maximum amount for single risk company accepts The limit of KRI or limits for business units 19

20 Key Applications: Capital Managment Business Risk Operational Risk Insurance Risk Credit Risk Market Risk Divers. Benefit Net Adjustment Economic capital needed to support risk profile Total EC Economic capital available to support risk profile Available Economic Capital Capital Adjustment Book Equity Capital Needs Capital Resources Coverage Ratio = Available Economic Total ERC Capital 20

21 Key Applications: Performance Measurement Risk adjusted return of capital RAROC =Economic Return / EC Major contributions Economic return as ultimate driver of shareholder value RAROC captures fair value changes not reflected in accounting P/L RAROC not meant to replace other Key Performance Indicators performance assessment in complex environment should never be done using just one measure purely internal measure complements other KPIs Economic Return 21

22 Agenda ERM development in China ERM framework Economic capital application Challenges in practice and going forward 22

23 Drawbacks of Current Regulation Framework Focus on compliance, but not risk management Rule-based but not principle-based The assessment is based on book accounting but not marked-to-market basis, which is inconsistent with IFRS as well as MCEV Current statuary minimum solvency margin doesn t account for risks properly 23

24 Practical Issues China Insurance industry is growing rapidly, business growth could be the unique goal and lack of risk awareness for many companies Risk management is simply equated as internal control No historical loss data sharing mechanism Overlook the development of risk models 24

25 Challenges in Use of EC Few companies had built up EC model EC not be applied in daily risk management No market consistency Credit risk parameter determination Operational risk quantification difficulties Risks integration 25

26 Going forward: Regulation CRIC should establish a new regulation system: Focus on risk management Principle based regulation Establish three pillars: solvency, internal risk management and information disclosure Insurance companies should be required to build internal risk model according to their own risk profile other than the minimum statutory solvency requirement 26

27 Going forward: ERM framework Insurance company should establish ERM framework as following: The framework should cover each business units and all types of risks. Board of Directors is ultimately responsible for the framework Senior management is responsible for the daily risk management operation And risk management department is responsible for the framework implementation Risk management department is responsible for: ERM system establishment and maintenance Risk management coordination among business units Risk identification and assessment Establish risk appetites system including risk appetite, risk tolerance and risk limits Build a risk reporting system and a database of risk events and losses 27

28 Going forward: EC Model Use EC as the key internal risk quantification approach Sensitivity analysis, scenarios analysis and stress testing as supplement risk measurements Apply EC model to pricing and investment strategy Apply EC to risk limit setting Accomplish capital allocation based on EC, and implement risk-adjusted performance 28

29 Thank You

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