INSURANCE & ACTUARIAL ADVISORY SERVICES!@# Session 35 Advanced Click to edit Economic Master Reserves title styleand Capital Matthew Clark FSA, CFA Valuation Actuary Symposium Austin, TX www.ey.com/us/actuarial Agenda Methodology Modeling Challenges Scenario Generation Aggregation Diversification 1
Methodology 2 Methodology Selection Most organizations are implementing a single economic capital methodology Statutory Balance Sheet Fair Value Balance Sheet Other Multiple economic capital audiences Internal External 3
Methodology Challenges Statutory Balance Sheet Approach Distribution of total assets required (TAR) is not informative Stranded capital Consider including a cash balance approach to gain insight into the redundancy of reserves Limited number of scenarios requiring additional capital 4 Methodology Challenges Cont. Fair Value Balance Sheet Approach Applying fair value mechanics can be a challenge Difficult to reconcile results to existing metrics Defining risk margins Cost of Capital Percentile Margin by source 5
Modeling Challenges 6 Modeling Challenges Runtime Considerations Policyholder Behavior Management Actions 7
Runtime Considerations How many scenarios is enough? Tail metrics Aggregation challenges Cell Compression Accuracy of results Balance precision with practicality Need to balance shelf life of the results and the production time 8 Runtime Considerations Cont. Solutions: Perform sensitivity analysis on cell compression Note that the tail metric will impact the number of cells and/or scenarios needed Consider impact across the distribution Balance the robustness of the population with the entire process Focus on both the assets and liabilities Understand the value introduced by additional cells versus the runtime 9
Policyholder Behavior Predicting policyholder behavior is difficult in the tail events Need to balance historic events with the universe of possible events Does a single dynamic assumption meet your needs? Accept the fact that policyholder behavior is a difficult to predict 10 Policyholder Behavior Cont. Lapse Assumptions Dynamic equations lose functionality in the tail Realize that the focus may be on the extreme tail events How does lapse activity impact mortality or morbidity? Premium Assumptions Premiums are not traditionally considered a dynamic assumption Tail events where the product guarantees are rich need to be considered Consider the impact of premium payments at both ends of the distribution 11
Policyholder Behavior Cont. 12 Solutions Perform sensitivity tests to understand the policyholder behavior across the distribution Awareness of the limitations in your policyholder behavior is important Consider optimal policyholder behavior Consider the perfect storm conditions Do not ingore the impact lapses might have on other assumptions Management Actions Modeling management actions tends to challenging Need to balance historic actions with emerging risk management platform Note there is a difference between what management can do versus what management will do Consider management actions across the organization 13
Scenario Generation 14 15 Scenario Generation Market Risks Economic scenario considerations Are the market parameters generated in a single generator? Are interest, equity and credit generated on a consistent basis? Are credit charges consistent with credit spreads? Does your generator regime switching? Understand the limitations of your generator and aggregations techniques
16 Scenario Generation Non-Market Risks Mortality and Morbidity Considerations Do you have a mortality generator? What parameters are being used? Trend Volatility Underwriting Catastrophe Consider calibration to tail events How sensitive are your results to the nonmarket risks? Aggregation 17
Aggregation Techniques Correlation Matrix Mix of business Tail considerations What point in the tail? What metric is being used? Black box What events contribute to the tail metrics Note the distribution is more important than a single tail metric 18 Aggregation Techniques Cont. Integrated Scenarios Requires correlation assumptions Allows the user to understand the impact of correlation assumptions Requires more scenarios than other techniques Fuzzy Tail versus Black Box 19
Diversification 20 Diversification Organizations are determined to allocate capital back to business units/profit centers How do you treat the diversification impact? Allocate all or part to the business unit? Allocate all to corporate? How will diversification impact business decisions? Pricing Sales Compensation 21
2007 Valuation Actuary Symposium Economic Capital Implementation Issues Howard L. Rosen Chief Insurance Risk Officer & Chief Actuary Retail Life ING USFS Agenda Definition of Economic Capital Implementation Issues ING Responses 1
Definition of Economic Capital ( EC ) Capital requirements are set to meet S&P requirements for a AA rated Insurer on a required total asset basis and have been defined as: The amount of capital required to protect the market value of the liabilities with a 99.95% one-sided confidence over a 1-year time horizon Market Value of Liabilities ( MVL ) is the value at which the liabilities could be transferred to a willing, rational, diversified counterparty in an arms length transaction under normal business conditions The risk that is captured in the capital also relates to uncertainties beyond the 1-year period through the MVL 2 Risk Types Correspond To Sources Of Economic Loss CREDIT RISK Unexpected Loss Earnings Deviation due to variations in Credit Losses RISK Earnings Deviation Total Economic Risk Inter-risk diversification TRANSFER RISK Unexpected Transfer Loss MARKET RISK Value at Risk BUSINESS RISK Residual Earnings Deviation OPERATIONAL RISK Event Loss Deviation LIFE RISK Mortality Deviation Earnings Deviation due to inability to repatriate funds - immaterial for insurance Earnings Deviation due to changes in the Market Price or Liquidity Earnings Deviation due to changes in Operating Economics (e.g. Volume, Margins or Costs) Earnings Deviation due to One-off Losses unrelated to Volume, Margins and Costs Earnings Deviation due to unexpected changes in mortality rates 3
Implementation Issues Cost Processing Time Volatility of Results Definition of 1 in 2000 Event Treatment of Taxes Treatment of Lazy Capital Charges Credited Rates Diversification Level Playing Field??? 4 Implementation Issues Cost Issue(s) New System Hardware Operating Environment People Conversion Ongoing ING Response Prophet Upgraded Machines Grid Environment Additional FTEs These Are Table Stakes 5
Implementation Issues Processing Time Issue(s) 45 day Reporting Lag Need For Up-to-date Asset Files Delayed Input From Other Functional Areas Need To Aggregate Results ING Response Replicating Portfolios For Assets & Liabilities Interim Quarter Gross-ups ECAPs 6 Implementation Issues Volatility Of Results Issue(s) Use of Risk Free Rates Creates Market Risk Volatility Inconsistency With Retail Life Business Model Methodology Improvements ING Response LIVE WITH IT! 7
Implementation Issues One In 2000 Event Issue How Do You Define For Risk Capitals Not Subject To Stochastic Projection? ING Response Arbitrary Sensitivities Expense Lapse 8 Implementation Issues Treatment Of Taxes Issue Not Currently Considered Not Clear How To Reflect ING Response Still Under Review 9
Implementation Issues Treatment Of Lazy Capital Issue Redundant Reserves Don t Exist In MC Environment LOC Or Other Charges Are Real ING Response Assume Borne By Corporate Limited Or Unlimited? 10 Implementation Issues Credited Rates Issue(s) Real World Or Spread Off Of Risk Free? Real World Inconsistent With Risk Free Rates Spread Off Of Risk Free Rates Inconsistent With Real Costs, CV, etc. ING Response Currently Use Real World Methodology Currently Under Review 11
Implementation Issues Diversification Issue(s) How To Properly Reflect Benefits of Multiple Risks Within Same Product Risks Within Same Business Unit Risks Across (Global) Business Units ING Response Enormous Multidimensional Matrix Within ECAPS Black Box Process Significant Reduction in EC Hard To Conceptually Understand Potentially Inconsistent With Rating Agency Perspective 12 Implementation Issues Level Playing Field??? Issue(s) Are We Consistent With Our Competitors? Methodology Definitions Are They On EC Methodology? 13
Implementation Issues STAY TUNED 14 Implementation Issues Questions? 15