Session 16, Investment Capital Charges, A Top-Down Observable Price Approach Moderator: Mark Yu, FSA, MAAA

Transcription

1 Session 16, Investment Capital Charges, A Top-Down Observable Price Approach Moderator: Mark Yu, FSA, MAAA Presenters: Tobias Gummersbach Erik J. Thoren, FSA, CERA, CFA, MAAA Mark Yu, FSA, MAAA

2 2015 SOA Investment Symposium Session 16: Investment Capital Charges: A Top-Down Observable Price Approach Mark Yu and Tobias Gummersbach March 2015 The material contained in this presentation has been prepared solely for informational purposes by General Re-New England Asset Management, Inc. ( GR-NEAM, Inc. ), and is not to be distributed outside of the organization to which it is presented. The material is based on sources believed to be reliable and/or from proprietary data developed by GR-NEAM, but we do not represent as to its accuracy or its completeness. This is not an offer to buy or sell any security or financial instrument. Certain assumptions, including tax assumptions, may have been made which have resulted in any returns detailed herein. Past performance results are not necessarily indicative of future performance. Changes to the assumptions, including valuations or cash flows of any instrument, may have a material impact on any results. Please consult with your tax experts before relying on this material. Additional information is available upon request. This document and its contents are proprietary to GR-NEAM, Inc. They were prepared for the exclusive use of your company. Neither this document nor its contents are to be given or discussed with anyone other than employees, directors, trustees or auditors of your company without our prior written consent.

3 Objectives Highlight Solvency II latest developments Share the Observable Price approach to evaluate investment capital charges (VaR) Consider implications for portfolio management & asset allocation Proprietary & Confidential General Re New England Asset Management, Inc. 2

4 Agenda Context Solvency II Standard Formula Overview GR-NEAM Observable Price Approach Case Study US Life Industry De-mystify Correlations Proprietary & Confidential General Re New England Asset Management, Inc. 3

5 Context Various views of capital requirement: regulatory vs. rating agency vs. economic Solvency II capital requirement (one-year 99.5% VaR): Standard model formula vs. internal capital model Asset risk charge Motivation Understand why the clearly-defined 1-year 99.5% VaR estimate can vary significantly among different methods? Proprietary & Confidential General Re New England Asset Management, Inc. 4

6 Solvency II Standard Formula Approach (Bottom-Up) Proprietary & Confidential General Re New England Asset Management, Inc. 5

7 The Solvency II Standard Formula Refresh Source: EIOPA The underlying assumptions in the standard formula for the Solvency Capital Requirement calculation ; July 25, 2014; p.6 Proprietary & Confidential General Re New England Asset Management, Inc. 6

8 Solvency II: Bottom Up Approach Step2: Portfolio Risk charges aggregated via correlation matrix Assumed Correlation Matrix Step1: Risk charges calculated separately for each factor Proprietary & Confidential General Re New England Asset Management, Inc. 7

9 Observable Price: Top Down Approach Step 1: Portfolio VaR calculated via either historically observed or forward-looking prospective returns Step 2: Portfolio VaR further decomposed into various risk factors Proprietary & Confidential General Re New England Asset Management, Inc. 8

10 GR-NEAM Observable Price Approach (Top-Down) Proprietary & Confidential General Re New England Asset Management, Inc. 9

11 Underlying Data Historical Observable Total Return Time Series Structure Index-based construction Daily observable prices & market statistics of underlying constituents (~55,000 fixed income securities, 55 trillion $US) Fixed income metrics: total/excess return & market yields/spreads Equity metrics: total return (Income/price) Equity cusip level modeling possible Considerations Strengths Observable prices and correlations Not simulated / calibrated estimates or values Independent third party providers Global coverage/multi-currency Intra-Period Estimates Weaknesses Infrequent lack of granularity Seventeen years of daily fixed income returns/statistics Dependent on providers data rules Proprietary & Confidential General Re New England Asset Management, Inc. 10

12 Fixed Income Security - Total Return and Excess Return Annual Return U.S. Investment Grade Corporate Return Building Blocks Total Return Excess Return Underlying Treasury Total Return Attribution: Interest rates Others -25 D-97 D-98 D-99 D-00 D-01 D-02 D-03 D-04 D-05 D-06 D-07 D-08 D-09 D-10 D-11 D-12 D-13 Credit Default Perception of Default Liquidity Optionality Currency Proprietary & Confidential General Re New England Asset Management, Inc. 11

13 Value-at-Risk (VaR) Decomposition Top Down Approach 1. Portfolio s total return time series (TRR) selected and aggregated based on underlying individual securities and indices 2. Portfolio s overall VaR is quantified 3. Each asset class is further assigned with following risk components (US view): Asset Class US Government Bonds Foreign Government Bonds / Sovereigns Risk Factor Exposure Currency Equity Interest Rate Credit Structure X X X* US Corporate Bonds X X Foreign Corporate Bonds X X X Mortgage Backed Securities (MBS) X X X Commercial Mortgage Backed Securities (CMBS) X X Asset Backed Securities (ABS) X X Municipal Bonds X X Equity-like X *For countries issuing their own currencies, we assume no credit risk associated with their government issued bonds in our VaR decomposition framework Proprietary & Confidential General Re New England Asset Management, Inc. 12

14 Value-at-Risk (VaR) Decomposition Top Down Approach (cont d) 4. For fixed income securities, a. interest rate risk is first determined using the TRR of the durationmatched government securities b. the excess return then is attributed to either credit or structure risk, depending on the asset class 5. Each risk component for the portfolio is quantified individually 6. The difference between the portfolio s overall VaR and the sum of individual VaR from each risk component is attributed as diversification benefit 7. Correlation risk is an add-on VaR (+/-) by changing the observed correlations among securities and indices Proprietary & Confidential General Re New England Asset Management, Inc. 13

15 Marked-to-Market Observable Price-Based Portfolio Risk Decomposition: Top Down vs. Bottom Up Traditional Bottom-Up Approach Risk impact by key risk factor evaluated separately and independently Explicitly assumed correlation matrix among risk factors Portfolio risk results aggregated via assumed correlation matrix GR-NEAM s Top-Down Approach Portfolio level risk impact evaluated holistically Not sensitive to correlation assumptions Risk factor impacts assessed marginally Proprietary & Confidential General Re New England Asset Management, Inc. 14

16 Case Study: U.S. Life Industry Proprietary & Confidential General Re New England Asset Management, Inc. 15

17 Life Industry: Fixed Income Sector Allocation (Trends) Fixed Income Sector Allocation 100% 90% 80% 70% 60% 50% 40% 30% 20% 0.4% 0.5% 1.9% 2.4% 2.7% 3.5% 2.3% 1.8% 13.7% 15.4% 14.7% 13.0% 13.2% 13.5% 14.4% 14.3% 0.9% 1.0% 1.0% 2.2% 7.9% 3.7% 3.8% 4.1% 4.3% 8.8% 8.6% 7.7% 6.4% 5.7% 5.3% 5.1% 7.8% 8.6% 7.6% 5.8% 4.8% 4.4% 3.9% 3.6% 11.3% 10.2% 9.3% 8.9% 8.3% 7.5% 10.2% 11.4% 2.8% 3.4% 3.3% 3.3% 3.4% 4.1% 3.6% 2.8% 45.8% 45.6% 46.5% 47.0% 48.3% 49.4% 41.7% 44.0% Foreign Privates Munis - Tax Exempt Munis - Taxable CMBS - Non Agcy CMBS - Agcy RMBS - Non Agcy RMBS - Agcy ABS Corp Gov't/Agcy 10% 0% 7.9% 7.1% 6.9% 8.2% 8.4% 8.0% 7.9% 7.5% Source: GR-NEAM Analytics, SNL, Bloomberg Proprietary & Confidential General Re New England Asset Management, Inc. 16

18 Life Industry: Asset Allocation by Credit Rating (Trends) 100% Fixed Income Credit Quality 90% 16.4% 19.2% 18.2% 16.4% 16.4% 16.8% 17.5% 16.6% 80% 3.9% 4.2% 4.2% 6.8% 6.6% 7.1% 7.1% 7.0% 70% 60% 50% 40% 30% 18.0% 18.5% 20.2% 18.5% 15.6% 20.6% 8.9% 6.8% 7.7% 21.7% 21.9% 22.4% 21.0% 21.3% 21.6% 9.0% 10.1% 24.5% 25.1% 21.0% 21.5% NA <BBB BBB A AA AAA 20% 10% 0% 34.3% 35.8% 20.1% 19.6% 29.1% 25.1% 23.7% 23.0% 12.0% 10.4% 6.8% Source: GR-NEAM Analytics, SNL, Bloomberg Proprietary & Confidential General Re New England Asset Management, Inc. 17

19 Life Industry: Duration (Trends) Fixed Income OAD Sector Gov't/Agcy Corp ABS RMBS - Agcy RMBS - Non Agcy CMBS - Agcy CMBS - Non Agcy Munis - Taxable Munis - Tax Exempt Foreign Other Grand Total Source: GR-NEAM Analytics, SNL, Bloomberg Proprietary & Confidential General Re New England Asset Management, Inc. 18

20 Life Industry Holdings Capital Charges: Solvency II Bottom Up vs Observable Price Top Down Source: GR-NEAM Analytics Proprietary & Confidential General Re New England Asset Management, Inc. 19

21 The Assumed Correlation Creates SIGNIFICANT Differences Life Industry Year End 2013 Holdings Observable Prices Capital Charges ($BB) Observed Correlation Solvency II Assumed Correlation Solvency II diversification Observed diversification Source: GR-NEAM Analytics Proprietary & Confidential General Re New England Asset Management, Inc. 20

22 De-mystify Correlations Proprietary & Confidential General Re New England Asset Management, Inc. 21

23 Understand Historical Correlations - Assumptions Analysis of historic correlations: Rate Risk (when contrasted to Equity Risk): Total return volatility of 10-year constant maturity U.S. Treasury bond Rate Risk (when contrasted to Spread Risk): Total return volatility of 20-year constant maturity U.S. Treasury bond Spread Risk: Volatility of Moody s BBB 20-year corporate bond excess returns Equity Risk: Volatility of S&P total return index Analysis Horizon: 1962 to 2013, rolling 20-year window on annual returns Proprietary & Confidential General Re New England Asset Management, Inc. 22

24 Compare and Contrast: Assumed vs. Historically Observed Correlations Solvency II Interest Rate Shock Down matrix* * Source Technical Specification for the Preparatory Phase (Part I), EIOPA, April 2014, SCR.5.5. Historically Observed Rolling Correlations Proprietary & Confidential General Re New England Asset Management, Inc. 23

25 Correlations in Diversified Portfolios Life Industry s 2013 Investment Holdings Total Returns, Volatility & Correlation Rolling Standard Deviation Rolling Correlation Conventional wisdom: In periods of stress, (all) asset valuations become highly correlated Historically not supported. High quality assets valuations might very well increase while lesser credits valuations might collapse ( Flight to Quality ) Source: GR-NEAM Analytics Proprietary & Confidential General Re New England Asset Management, Inc. 24

26 Application Comprehensive Asset Stress Test Contrast prospective VaR/T-VaR with historical stress events Estimate potential prospective losses by asset class and risk factors Proprietary & Confidential General Re New England Asset Management, Inc. Source: GR-NEAM Analytics 25

27 Summary Proprietary & Confidential General Re New England Asset Management, Inc. 26

28 Summary VaR: Observable Price vs. Solvency II approaches result in material differences in capital charges The role of correlation/choice of dependency structure is significant Multiple approaches to risk measurement and stress testing in line with ORSA best practice Observable Price methodology can serve as an unbiased benchmark for fine-tuning internal models Proprietary & Confidential General Re New England Asset Management, Inc. 27

29 Parting Thoughts Significant differences in VaR estimates will impact investment risk assessments, asset allocations and capital management as they are woven into internal decision making processes. Proprietary & Confidential General Re New England Asset Management, Inc. 28

30 Q&A Mark Yu, FSA, CFA, FRM, MAAA General Re New England Asset Management, Inc Tobias Gummersbach General Re New England Asset Management, Inc Proprietary & Confidential General Re New England Asset Management, Inc. 29

31 Introduction to Solvency II SCR Standard Formula for Market Risk Erik Thoren 26 March 2015

32 Agenda Introduction to Solvency II Market risk module Asset allocation considerations Page 2

33 Introduction to Solvency II

34 Introduction to Solvency II Three pillar structure Pillar 1 Pillar 2 Pillar 3 Technical provisions Own funds Minimum Capital Requirement (MCR) Solvency Capital Requirement (SCR) SCR internal model approval Own Risk and Solvency Assessment Risk management Governance Reviewed by supervisor Disclosure Solvency and financial condition report Report to supervisor Market discipline Page 4

35 Introduction to Solvency II SCR and MCR calculation approach Pillar 1 balance sheet SCR Free assets ($50) 99.5% one-year Value at Risk (VaR) measure Enables insurer to withstand significant loss MCR ($20) SCR ($50) Own funds ($100) Accounts for several separate risks Standard Formula / Internal Model, or a combination of both (Partial Internal Model) Assets ($200) Risk margin ($10) MCR Solvency II has a minimum capital requirement Represents lowest acceptable capital level Corridor of 25% - 45% of total SCR BEL ($90) Technical provisions ($100) Non-coverage of MCR triggers supervisory intervention *Discount rate used in BEL calculation may include matching adjustment or volatility adjustment Page 5

36 Introduction to Solvency II SCR basic concept: Shock approach SCR can be described as the change of basic own funds in a shock scenario Normal conditions (best estimate + risk margin) Basic own NAV funds Stressed conditions (99.5 percentile) MV Assets assets MV Liabilities liabilities MV MV Assets Basic NAV own funds MV Liabilities Basic own funds NAV Basic own NAV funds Solvency Capital Requirement (SCR) Page 6

37 Introduction to Solvency II Overview of SCR standard formula Comprises individual risk modules, aggregated using correlation matrices Each of the risks modules will be calibrated with a 99.5% confidence level over a one-year period i.e., capital held for the possibility of a 1 in 200- year event happening in 12 months Same design and specifications for risk modules used for all companies SCR is calculated on solo entity level and group level separately (group level usually based on the consolidated balance sheet) The standard formula is likely to be required for a number of reasons Interest rate Equity Property Spread Currency Con - centration SLT Health Mortality Longevity Disability / Morbidity Lapse Expenses Revision Adj Health CAT SCR Basic SCR Non-SLT health Premium reserve Lapse Operational Risk Market Health Default Life Non - Life Intangibles Mortality Longevity Disability/ Morbidity Lapse Expenses Revision Premium Reserve = included in the adjustment for loss absorbing capacity of technical provisions of future profit sharing CAT Lapse CAT Page 7

38 Market risk module

39 Market risk module Overview Market Risk definition Risk of loss or of adverse change in the financial situation resulting, directly or indirectly, from fluctuations in the level and in the volatility of market prices of assets, liabilities and financial instruments. Interest rate Equity Modular-based approach Summary of approach Correlation matrix to aggregate components Property Market risk module aggregation SCR market = Corr ij i,j x SCRi x SCRj Spread Currency Concentration Risk Interest rate Equity Property Spread Concentration Currency Interest rate 1 A A A Equity A Property A Spread A Concentration Currency A = 0 (0.5) where the capital requirement for interest rate risk is given by an upward (downward) shock in the interest rate term structure Page 9

40 Market risk module Interest rate risk Risk definition Risk that the value of an asset or liability will change due to a change in term structure of interest rates or interest rate volatility. Summary of approach Instantaneous increase/decrease to basic risk-free interest rates for each currency at different maturities (shown at right). Capital requirement equals the larger of the sum, over all currencies, of the capital requirements for the risk of an increase or decrease in the term structure of interest rates. Technicalities/practicalities Interest rates also directly affect the value of liability cash flows, as the present value of cash flows is dependent on the yield a riskless investment can achieve up to the time the cash flow is expected. Rate increases shall be at least 1% in absolute terms. No rate decreases shall be applied where rates are negative. For maturities not specified in the table at right, the value of the increase/ decrease shall be linearly interpolated. For maturities shorter than one year, the increase shall be 70% and the decrease shall be 75%. For maturities longer than 90 years, the increase/decrease shall be 20%. Maturity in (years) Increases Decreases 1 70% 75% 2 70% 65% 3 64% 56% 4 59% 50% 5 55% 46% 6 52% 42% 7 49% 39% 8 47% 36% 9 44% 33% 10 42% 31% 11 39% 30% 12 37% 29% 13 35% 28% 14 34% 28% 15 33% 27% 16 31% 28% 17 30% 28% 18 29% 28% 19 27% 29% 20 26% 29% 90 20% 20% Page 10

41 Market risk module Equity risk Risk definition Risk that the value of an asset or liability will change due to fluctuations in the level or volatility of the market prices for equities. Classify equities as Type 1 or Type 2 Summary of approach Type 1 Equities listed in regulated markets in the countries that are members of the EEA or OECD Type 2 (Other equities) Equities listed only in emerging markets, non-listed equity, hedge funds and any other investments not included elsewhere in the market risk module Instantaneous decrease based on type, symmetric adjustment and potentially other considerations Technicalities/practicalities Base shock of 46.5% and 56.5% for Type 1 and Type 2, respectively Strategic participation or duration-based equity approaches may instead apply (22% shock) Transitional measure may instead apply (22% shock grading to full stress over time) Symmetric adjustment included to avoid pro-cyclical effects of regulatory requirements (+7.5% as of 12/31/13) Increases/decreases shock based on current index value compared with its average over the last three years Calculation formula: Page 11

42 Market risk module Property risk Risk definition Risk that arises as a result of sensitivity of assets, liabilities and financial investments to the level or volatility of market prices of property. Summary of approach Immediate effect on the net value of asset and liabilities expected in the event of an instantaneous decrease of 25% in the value of investments in real estate. Technicalities/practicalities The following are considered to be property: Land, buildings, immovable-property rights Property investment for the own use of the insurance undertaking Investment in real estate through collective investment undertakings, or other investments packaged as funds. This should be done via the look-through approach. Investment in a company engaged in real estate management, or investment in a company engaged in real estate project development or similar activities are excluded from property risk and are included under equity risk. Calculation formula: Mkt prop max( NAV property shock;0) Page 12

43 Market risk module Spread risk Risk definition Risk that arises from the sensitivity of the value of assets and liabilities to changes in the level or in the volatility of credit spreads over the risk-free interest rate term structure Summary of approach Classify source of spread risk (sub-module for each) Bonds and loans (other than residential mortgage loans) Securitizations Credit derivatives (such as CDSes and TRSes) Apply methodology specific to source No diversification between components SCR spread SCR bonds SCR securitisation SCR cd Technicalities / practicalities Bonds and loans capital charge = MV * risk factor (which is based on duration and credit quality) Risk factor stress may be impacted by availability of collateral, issuer (e.g., EEA sovereign) Securitizations capital charge = MV * modified duration * risk factor (which is based on type and rating) Classified as Type 1, Type 2 and Re-securitizations Credit derivative capital charge = max (loss in BOF from instantaneous absolute increase in credit spread of underlying; loss in BOF from instantaneous relative decrease of 75% of credit spread of underlying) Magnitude of spread widening depends on credit rating Page 13

44 Market risk module Currency risk Risk definition Risk that arises from changes in the level or volatility of currency exchange rates Summary of approach For each foreign currency, the contribution to the capital requirement is determined as the maximum of the currency up-shock and the currency down-shock relative to the local currency Technicalities/practicalities Shocks up and down are 25% and (25%), respectively Factors can be reduced for currencies pegged to Euro The local currency is the currency in which the undertaking prepares its financial statements. All of the participant's individual currency positions and its investment policy (e.g., hedging arrangements, gearing, etc.) should be taken into account Includes any investment in foreign instruments where the currency risk is not hedged. Investments in listed equity should be assumed to be sensitive to the currency of its main listing. Non-listed equity and property should be assumed to be sensitive to the currency of its location Page 14

45 Market risk module Concentration risk Risk definition Risk that arises from large investment in individual counterparties and single name exposures. Summary of approach Determine excess exposure per single name exposure (XS_i) Determine risk concentration requirement per single name exposure (Conc_i), which is the loss in basic own funds caused by an instantaneous decrease in the value of assets corresponding to single name exposure i Aggregate across single name exposures (SCR_conc) Technicalities/practicalities XS i = Max(0; E i CT i Assets) E_i = Total exposure at default to single name i out of assets less counterparties with g_i = 0 Assets = Total value of all assets held by the undertaking with some exclusions CT_i = Exposure threshold, which varies between 15% and 1.5% depending on credit quality step and asset class Conc i = g i XS i g_i = Risk factor which varies between 0% and 73% by credit quality step or undertaking s solvency ratio where no External Credit Assessment Institutions credit rating is available, as well as asset class Page 15

46 Asset allocation considerations

47 SCR as % of market value Asset allocation considerations Indicative SCR charges on investments 110% 90% 70% 50% 30% 10% -10% Source: Non-traditional investments Key Considerations for Insurers, Institute and Faculty of Actuaries Non-Traditional Investments Working Party Page 17

48 Asset allocation considerations Spread risk SCR comparison January 2014 Spread risk (B i duration i ) Securitizations Commercial real estate loans treated in line with corporate bonds. Unrated could get some reduced capital charge, depending on collateral Retail real estate loans treated under counterparty default risk Page 18

49 Asset allocation considerations Spread risk SCR comparison July 2014 Spread risk (B i duration i ) Securitizations Commercial real estate loans treated in line with corporate bonds. Unrated could get some reduced capital charge, depending on collateral Retail real estate loans treated under counterparty default risk Page 19

50 Asset allocation considerations Spread risk SCR comparison October 2014 Spread risk (B i duration i ) Securitizations Commercial real estate loans treated in line with corporate bonds. Unrated could get some reduced capital charge, depending on collateral Retail real estate loans treated under counterparty default risk Page 20

51 Asset allocation considerations Securitizations now viable? Risk retention requirements No less than 5% Measured as nominal value Measured at origination Exceptions ECB bonds and loans EU government loans EU central bank loans Multilateral development banks International organizations Qualitative What happens when rule is broken? Due diligence Inform the supervisory authority immediately Proportionate increase to the SCR Features of originator Reporting/Monitoring Risk factors progressively increased with each subsequent breach Page 21

52 Asset allocation considerations Takeaways Portfolio management is becoming more complex The rules are still being figured out New opportunities? Page 22

53 Questions?