Economic Capital Framework By Michel Rochette, MBA Enterprise Risk Advisory, LLC Introduction Economic capital (EC) frameworks are evolving quickly and respond to different needs as expressed by different stakeholders. For example, an economic capital framework will base the assessment of the capital necessary to withstand adverse financial consequences based solely on an economic view of risk. However, even if insurance companies view EC from an economic point of view and take a longer term perspective to it in order to increase shareholders’ value, other stakeholders may take a different point of view, more focused on solvency as is usually the case with regulators – where EC would be looked at over a one-year period to assess ‘how bad things can get” - and as a going concern basis as is the case of rating agencies. Methodologies are also evolving very quickly, encompassing not only new mathematical tools but also new methods to incorporate risk that were not considered part of this framework, not a long while ago, like operational risk. Also, although some specific risk-based capital frameworks are developing in different regions of the world, the underlying principles and approaches to economic capital calculations are essentially the same worldwide and between different financial services’ industries. Finally, when viewed from an enterprise risk management approach, an EC framework becomes the common risk language – common currency of risk - across the firm, and allows relationships and trade-offs between risks to become explicitly recognized. EC becomes the essential link between the risk management function and the strategic function of the firm. Ultimately, EC helps a firm develops a risk appetite and becomes part of a risk-adjusted performance framework.
General Economic Capital Framework Components An economic capital framework is composed of many elements that describe its functioning. These components are usually found in any economic capital framework whether it is implemented for solvency or general business management. Total Balance Sheet Approach An important aspect of an economic capital framework is the fact that a total balance sheet approach should be taken. All assets and liabilities should be calculated on a consistent basis, namely a market consistent approach in order to represent the true
risk situation of a company at one point in time, and not a smoothed or historical view as is often found in traditional valuation methods. Risk Appetite Another major component of a framework is to define the risk appetite or the risk tolerance that a firm intends to pursue. This risk appetite should be described in general terms using both quantitative and qualitative objectives like a mission statement. It should link its major products, services, and markets that the firm intends to pursue while taking into account risks that may keep the firm from attaining those objectives over a given horizon. The risk appetite should be explicit to which stakeholder it is addressed. In fact, a firm could choose different levels of risk appetite depending if the risk appetite is directed at protecting policyholders’ interests or shareholder’s interests. Once the overall risk appetite statement is defined, it could be translated as an explicit confidence level statement using a specific risk measure over a chosen horizon. For example, it could be set at a 90% confidence level based on a ruin probability, or it could be set at another percentage level corresponding to a desired target rating as assigned by specific rating agencies, like long-term financial strength rating in the case of insurance companies. If the economic capital framework is in a solvency context, the confidence level and the metric used would likely satisfy the regulator’s point of view and preferences. An important aspect of setting up the risk appetite, the chosen time horizon should be part of the statement. Is the firm targeting a one-year time horizon as mentioned in some solvency frameworks or is it trying to define it as a longer-term aspect? Ideally, an economic capital should be ultimately used by the business to make business decisions while supporting its strategic objectives. In this sense, such a framework should be prospective and extend into many years in the future and include the effect of the strategic choices of the company including projections of new business and new products. A one-year interval might be appropriate from a regulatory perspective as it gives time for the regulators to intervene, but, on a goingconcern basis, a longer term horizon should be envisioned and linked to the company’s risk appetite as mentioned previously. Definition of Risks and Controls The framework should define the risks and their definition will become part of it. As a general rule, all economic capital frameworks should be based on the risk exposures of each company, encompassing all the major risks that a company is exposed to. For specific purposes, like an economic capital framework used for solvency, a subset of risks could be covered. In the case of insurance companies, risks described by relevant industry associations could form the basis of such risk classification. – IAA risk classification -.
All economic capital frameworks include not only the amount of capital necessary to face unexpected risks but also the means and the controls by which companies manage those risks and their impact on the resulting capital that the firm should hold. Many of the risk mitigation techniques in place from financial risk tools like corporate insurance, reinsurance, derivatives, and alternative risk transfers to non financial tools like quantitative and qualitative controls used in non financial risks like operational, reputation, and business risk should be integrated and their effectiveness assessed. In other words, the calculation cannot be accomplished in isolation of the risk management framework of any company. Diversification All economic capital frameworks should encompass diversification, concentration and dependencies between risks, whether performed from a top down or a bottom up approach. The concentration and diversification should take into account the diversity of products, regions, operations where companies operate. In essence, the economic capital framework should take an enterprise view of the risks and the capital required and available to cover them. According to the Chief Risk Officer Forum, four levels of diversification exist. A level 1 which applies within-risk types, a level 2, which applies across-risk types, a level 3 which applies across entities within a geographic region, and a level 4 which applies to entities across geographic and regulatory regions. Thus, dependencies should be integrated in the capital framework when they are part of the business decision making and can be supported by empirical, technical, scientific or expert opinion of casual linkages. Modeling Approach In any economic capital frameworks, both internal models and standard formulas are appropriate depending on the complexity of the firm, the time required and the specific risks considered in the framework. Internal capital models are better suited to recognize the specific risk characteristics of an entity while standard formulas may be appropriate as the first building block of a comprehensive capital framework. They are more appropriate for more standard lines of businesses and when risks are less quantifiable. However, internal models introduce the notion of model risk, an important component of any operational risk approach. Those internal models should be based on a series of methods appropriate to the complexity of the risks involved in the many different portfolios. For example, approximate methods – Ex. Delta-Normal – might be appropriate for portfolios that do not contain embedded options. Historical simulations could be appropriate for a risk that hasn’t changed too much recently – probably not the weather! -, and full stochastic simulations are appropriate and reliable to account for correlations. In spite of all the sophistications of the above methods, scenarios by experts remain a valid approach to implement in an economic capital framework, especially when the goal is to protect the firm at a very high confidence level. Reporting
An EC framework must define up front the extent of internal and external reporting. Internal report should be coordinated with other risk ERM reporting and should follow the governance already in place. External reporting could include components like the risk tolerance of the firm and some specific goals that it is targeting, so that the financial markets have adequate information to evaluate the firm and its risk profile. Then, appropriate investment portfolios by investors can be set up given a particular company’s risk profile. Risk and Capital From an economic capital perspective, risk and capital work together. Capital management delivers the optimal resources – both paid-up – equity, debt, preferred, and hybrid – and contingent – line of credit, insurance, interest rate swap, risk-linked securities - sufficient to satisfy the financial needs of the firm and cover the risks it faces. And in turn, risk management ensures that the firm’s operational and financial exposures are controlled and supportable by its capital resources. All economic capital frameworks should include an analysis of the actual available capital necessary to support the risks. In this case, the definitions of capital should be consistent in order to avoid double counting of risks in the capital calculation and in the risk margins of the reserves whose purpose should be only to allow protecting shareholders’ interest in stress situations by allowing the transfer of reserves to another party. For large financial groups, all economic capital should include allocation rules that reflect the fundamental risk characteristics of each entity, whether legal or operational. In the case of international firms, some elements of the economic capital framework like diversification effects, capital mobility, and risk transfer should take into consideration the legal capacity or the legal incapacity of firms to move capital around or take into account internal risk transfer between the different entities of the firm. Risk-Adjusted Performance An economic capital framework must be embedded in the business strategies of the firm from the new product development, investment operations and measurement of performance through a RAROC type approach to complete the circle. The riskadjusted performance measures must be defined and communicated so that they become part of the strategic and day-to-day functioning of the company, and be linked to its capital management. And in order to change behaviors in a manner consistent with the economic capital framework, compensation will have to be aligned with the desired results, resulting in a change in the culture of the company. Other Operational Aspects
The economic capital framework should cover the main entity as well as relevant affiliates and subsidiaries, even though, for regulatory purposes, they may not be subject to an economic capital calculation. An important element of an economic capital framework often neglected is the quality of the whole process itself. Data quality, documentation, validation, back testing, stress testing are essential to the credibility of the whole process. An economic capital calculation, although it is not part of the company’s official financial statements yet, should be subject to the same level of rigor as for published financial values mandated by SOX in this US. In terms of the actual implementation, a data warehouse should be developed that would contain the relevant positions held by the company, both on the asset and the liability side. Economic Capital Frameworks Used for Solvency Purposes: Solvency II, Basle II and US Regulatory Regimes Solvency II is a risk based capital framework that draws upon many of the main components of an economic capital framework but will be used for a regulatory purpose. Although some minimum capital levels will be defined and can be calculated based on a factor-type approach, internal models will be encouraged. Thus, insurance company, which develops internal models for their own economic capital needs, can capitalize on that effort and use them as well to satisfy Solvency II. This section provides an overview of the proposed framework. It appears at this point that it will be applicable starting in 2011. It will replace the non life and life capital directives that were put in place in 1973 and 1979 respectively. This framework will apply to life, non life and reinsurance companies in the European Union. The whole framework is based on three pillars. Solvency II has certain objectives: • • • • • • •
Provide adequate policyholder protection. Create a level playing field in the financial markets, in particular between the insurance companies and banks. Harmonize insurance supervision between the Member States in order to reduce regulatory arbitrage. Harmonize it with the principles approach laid down by the International Association of Insurance Supervisors (IAIS), thus creating ultimately an international solvency standard. Align the risk taking activities of insurance companies with their capital requirements. Take into account the evolving requirements at the International Accounting Standards Board, in particular the fair value basis approach for insurance contracts. Make sure that it is not too onerous to operate for small companies, providing both standard formulas and allowing internal models for larger and more complex organizations.
Solvency II is mirrored after Basle II. • • • •
It consists of three main pillars. Pillar I relates to the quantitative calculations of capital based on material risks. Pillar II relates to the aspects of the supervisory review process and how to treat the non-quantifiable risks. Pillar III relates to the market discipline brought about by public reporting and disclosures to the supervisors.
Pillar I consists of: • • • • •
• • • •
•
A minimum capital Requirement (MCR) and a Solvency Capital Requirement (SCR). The SCR will be set using either factor-based formulae or internal models with stress tests and correlation matrices. Will target an overall ruin probability of 0.5% (Value at Risk of 99.5%) over a one-year horizon for the SCR. Economic capital will be measured by VAR, not Conditional Tail Var. Material risks to consider in the SCR formulas and in internal models are: o Life, non-life and health underwriting. o Market risk, credit risk including spread and counterparty default risk. o Operational risk. o Other risks like liquidity should be taken into in internal models or will be subject to capital add-ons if substantial as determined in Pillar II. o Solvency II follows the IAA risk classification. In addition to the standard formula, companies will be allowed to substitute the results of superior approved capital models for the SCR. The MCR will simply consist of a standard formula, likely set at the 90% confidence level on a VAR basis. There will be a minimum floor. Breach of SCR will require a plan to restore the company’s’ capital position while breach of the MCR will require immediate action to restore position. Actuarial reserves - technical provisions – will be calculated in order to extinguish future liabilities. They will be calculated on an expected basis plus risk margins taking into account the information provided by financial markets. The risk margin will most likely be set at the 75% percentile of the underlying distribution until run-off. The choice of correlation coefficients will be determined to arrive at an overall ruin probability of 0.5% over a one-year horizon.
Pillar 2 consists of: •
Enhanced supervisory review process in particular as it relates to material risks, the risk management system in place at the insurance company, governance, conduct of stress tests and scenarios by insurers, hedging strategies and policy on capital management.
• • • • • • •
•
Development of early warning indicators. Ability by supervisors to set additional capital requirements for risks not modeled in Pillar 2 and for lack of appropriate controls. Greater harmonization of supervisory standards and methods. Creation of the approach of the Lead Supervisor who will coordinate supervision among different countries. Establishment of rules to assess internal models used by insurers. Evaluation of the comprehensiveness of the risk management system including governance by the Board. Internal models will be judged based upon three factors: o Statistical quality test o calibration test o U test. Enhanced cooperation between supervisory authorities.
Pillar 3 consists of: • Public and private disclosures to the regulators. • Internal SCR calculation to be disclosed to the public. • Aim to enhance transparency and ensure well functioning financial markets. • Will likely follow the IAIS’ enhanced disclosure standards. • Will be the same for life, non life and reinsurers and compatible with the requirements in the banking sector. Comparison of Basel II and Solvency II The Solvency II framework shares some similarities to the Basle II framework: • • • • • • • • • •
The two frameworks have three pillars which cover the same components. Both embed incentives to reward better risk management with lower capital requirements. Both have two approaches to calculate capital, a standard formula approach and allow internal models. Internal models could result in lower capital requirements. Both approaches will allow regulators, ratting agencies and investors to better assess a financial institution since risk management in encouraged and risk and capital requirements will be better disclosed. Both frameworks would recognize the effect of hedging in internal models. Both frameworks will use a similar risk metric that is the VAR metric. Both frameworks will have minimum capital requirements. Solvency II will handle this through the MCR while Basle II will be more arbitrary. Both will define group supervision of entities by leading regulators. Both will better define how regulators assess financial institutions with consistent approaches. Both frameworks don’t account for risks that may have huge impact on financial institutions, namely strategic, business, reputational, and other similar type risks. However, Pillar II in both frameworks is flexible enough to handle these.
However, the two frameworks bear some differences: •
•
•
• •
•
Risk Types:, Solvency II is aligned with the risk classification of the IAA – underwriting risk, market and ALM, credit and counterparty risk, operational risk and liquidity risk while Basle II Pillar I, which covers the risks for which capital needs to be estimated, includes only credit risk – the main risk of banks -, market risk – on trading portfolios – and operational risk. In Basle II, if regulators determine that a banking group faces some specific risk for which Pillar I capital calculations are not sufficient, they will have the possibility to impose additional capital requirements in Basle II, Pillar II. For example, the ALM risk of banks, called structural risk of the banking book, will be handled for the time being in Pillar II, Basle II. The future Basle III discussions will include those risks. Solvency II will be headed of Basle II in taking a broader assessment of all risks facing an institution. Confidence level: Solvency II is based on the concept of the probability of ruin for the protection of policyholders while Basle II targets a confidence level based on a desired target rating for the protection of bondholders and depositors. Confidence level is set at 99.9% for Basle II while for Solvency II, it is set at 99.5%. Basle II was designed for the large international banking groups while Solvency II is designed to be applicable to all life, non life and rein surer groups whether they have international activities or not. The US banking regulatory agencies have decided to implement Basle II in the US for only large US institutions – Ex. Bank of America, Citigroup, Chase… - and forcing them to implement internal models. Smaller and the US financial institutions that don’t have international activities will be subject to an enhanced Basle I regulation, called Basle IA. Discussion is still underway while Basle II is being implemented in Europe and is known as the Capital Adequacy Directives. Many countries of the world will be using carbon copies of Basle II and Solvency II as their regulatory regime. In the insurance sector, the IAIS, which the NAIC is a member, is taking the lead.
Comparison of Solvency II and the US Risk Based Capital Frameworks •
•
The US RBC framework risk-weights assets and liabilities to account for the main risk categories faced by insurers, namely asset risk – i.e. market risk -, underwriting risk, reserve risk, credit risk, and a small component for business risk. Solvency II standard capital formula will be based on risk-weighting assets and liabilities but determining these weights through scenarios and static ratios for some risk like operational risk. The US RBC formulae bear similarities to the 1988 Basle I framework but use different factors. Solvency II will allow internal models as an advanced approach while the actual RBC frameworks don’t have that possibility except for some specific lines of businesses like annuities with guarantees – Q: C3 Phase II –
• •
•
•
Some states mandate some additional work to be done by insurance companies like Cash Flow testing and some scenarios. Principles-based approaches are being developed in the US although they tend to focus on statutory reserves for new business only, and will impact the valuation process of insurers, not their EC framework for the time being. However, even at this stage, there will be an indirect impact on capital as reserves and capital are complementary. With time, the principles based approach will become part of the new capital framework for the US while the components found in Pillars II and III of Solvency II will have to be developed in the US. The NAIC has issued a draft law on Corporate Governance for Risk Management Act, which will impact any economic capital framework that US insurers will implement. Diversification is reflected in the RBC formula as well as in the Solvency II Pillar I formulae. In the RBC formula, it is reflected by the square root approach, which implies that risks are normally related. In Solvency II, correlation matrices can take many forms – square root, copula, correlation in the tail – in the many internal models implemented by firms.
Rating Agencies’ Economic Capital Frameworks Rating agencies are building their own economic capital frameworks, which include models for some and general principles for others. They intend to integrate their economic models into their rating process along with their new ERM frameworks. They will expect insurance companies to demonstrate a balance between the qualitative and quantitative risk management, and will link capital adequacy requirements directly to ratings. All rating agencies will give credit for a company’s own economic capital model as long as the model satisfies three main elements: a quality test, an assumption test, and a use test. • • •
The quality test means that the model and its results must be understandable by management and must incorporate all significant risks to which an insurer is exposed. Data and model must be verified and back tested. The assumption test refers to the appropriateness of the assumptions and the stress tests used to obtain the results. A major difference of assumptions used by a company compared to its peers will have to be justified. The use test means that the EC model must become part of the company’s ERM framework, and have a direct impact on the business decisions made by the insurer. In other words, it cannot just be a window dressing and theoretical exercise. Concrete business decisions must happen based on the results. For example, if the EC model determines that an insurer is over exposed to a certain risk, management must demonstrate that it took concrete actions to face this risk and bring it back within its declared risk tolerance and risk limits.
•
Fitch introduced a model called Prism to analyze EC in insurance companies. It will become part of its rating process but the exact weighting has not been stated yet. Its main features are: o Model determines capital adequacy using a stochastic approach. o The whole financial profile generates a unique risk distribution that reflects the asset and liability characteristics of the portfolio. o Fitch model measures capital across sectors and countries but based on local market data when available. o Includes an economic scenario generator and generates results based on 5000 scenarios. o The model will recognize the effect of diversification. o Operational risk for the time being will be included as a load between 5% and 15% of capital. o The output of required capital for a specific rating level corresponding to a specific confidence level will be compared to available capital. o Fitch will put more weighting on the insurer’s own EC model depending on the model transparency, its track record in helping strategic business decisions, its level of sophistication, and appropriate back testing and controls of use.
•
Moody’s framework is based on “interrogation not replication.” Moody’s doesn’t have a model per se for the EC but undertakes an in-depth quantitative and qualitative analysis of the company’s EC framework and take the results into account with its own more traditional risk based capital calculation. Its framework includes: o A scorecard for each dimension of the model. o Emphasis is on stress tests to make sure that the model is conservative enough. o Output is integrated with Moody’s overall risk assessment. o Output used as an input in the overall ratings. o Moody’s determines if model is used regularly into its business and risk management processes. o Moody’s determines if EC model is comprehensive in its risk identification. o Moody’s determines if scenarios are used in the EC calculation. o Moody’s determines if recognized external risk sources are used in the construction of the model.
•
AM Best considers an EC model as neither necessary nor sufficient for a successful ERM framework. EC model should aid the ERM process and not be the process itself. Its main features are:
o Base its rating judgments on balance sheet strength determined by its own risk-based model called BCAR in combination with the insurer’s own EC model. This will be done more subjectively for the time being. o The rater may give credit to an insurer for its EC model if the model captures the material risks associated with the insurer’s business. o AM Best must see evidence that management uses the model to make business decisions and has an in-depth understanding of how the model works. •
S & P has developed an approach to evaluate a firm’s ERM framework, and an EC framework is a major component of an ERM framework. Also, S & P is in the process to put forward criteria to judge the internal economic capital models used by insurers. For an insurer to have a Strong or Excellent ERM rating, they will have to have an EC model. Once the ERM framework is in full operational mode, it will influence the rating process. At this point, it appears that only partial credit will be given to an insurer’s proprietary EC model. In addition, S & P has its own risk-based model. Its main features are: o S & P CAR will not be a stochastic model for the time being. o Rating changes will not be necessarily be influenced by changes to a company’s internal EC model. o S & P own model will not take into account diversification. o S & P will now link the amount of capital required for a company based on the desired rating.
Regulatory Agencies’ Economic Capital Frameworks: IAIS Proposed Framework The International Association of Insurance Supervisors (IAIS) has published many papers over the last few on the topic of solvency. In particular, its most recent document entitled The IAIS Common Structure for the Assessment of Insurer Solvency is the paper that contains most of the elements of an economic capital framework dedicated at the solvency of insurers. As mentioned throughout the paper, there is a convergence between the general principles and methods of a general economic capital framework and some of the elements found in the publications of the IAIS, which will influence what most insurance regulators will implement in the coming years. Thus, a quick review of this documentation is warranted. Most of the components of solvency as mentioned in the IAIS paper form an integrated and interrelated assembly of components. Its major components are financial aspects, governance aspects, market conduct, supervisory assessment and intervention as well as public disclosure. Although expressed differently from the requirements of Solvency II, the IAIS proposes the same components. In a sense,
once adopted by all regulators, insurance solvency frameworks based on an economic approach will converge and become the international norm. As mentioned elsewhere in this document, one of the goals of an economic capital framework is to provide incentives for insurers to align their risk profile with proper risk management approaches including a relevant economic capital framework. Concerning its financial aspects, the proposed components are: • • • •
• • •
•
• • • •
All material risks to which an insurer is exposed to must become part of an economic capital framework, whether they can are readily quantifiable or not. As a minimum, underwriting risk – mortality, morbidity, policy holder behavior …-, credit risk, market, operational and liquidity must be considered. A total balance sheet approach must be implemented with market consistent valuations both for the assets and the liabilities must be implemented. Technical provisions must be evaluated on a best estimate basis plus a risk margin over the term of the liabilities consistent with a market consistent valuation approach. A market consistent approach implies that technical provisions are evaluated based on the risk characteristics of the portfolio and not the insurer, so that a transfer at market value could be done. Capital becomes the buffer to make sure that despite adverse situations, the policy obligations will be met and that the regulators and the company will have enough time to react. Internal models are allowed and are appropriate both for capital and technical provisions. The determination of capital should be done over a time period over which a shock is applied to a risk while taking into account the period of the impact of that shock at a given confidence level. The level of confidence is left at the discretion of the regulators. Shocks and scenarios should be sudden in nature and their impact limited in time. However, if the impact of certain shocks extends in the future, their impact must be reflected in the run-off of the insurance business, although the required capital is limited to a shorter time period. The shock period should be the same for all risks, and should be based on historical data but a forward looking aspect to them as well. Industry wide minimum economic capital requirements should be imposed in order to protect against systemic risk. Diversification of economic capital models should encouraged by regulators as it reduces the overall systemic risk to the financial system. Diversification should be built in the economic capital calculations but further research by IAIS will be done on this aspect.
Other Economic Capital Frameworks: Swiss Solvency Test Framework The Swiss Solvency Test (SST) framework is a solvency framework but it is based on economic principles. The Swiss are moving away from a standard formulaic approach to solvency as the formulas are not flexible enough to handle the types of
risks faced by insurers and reinsurers, and usually transfer the responsibility of risk management to the regulator instead of the company. Also, as in many other frameworks, a risk-based solvency framework is based on the actual risks faced by the company as well as reward companies for better managing their risk profile. An economic approach is taken as assets and liabilities are valued on a market consistent basis. Internal models will be encouraged with the ultimate goal that there will be a convergence between the solvency and the economic capital frameworks that companies intend to use going forward. In addition, it is expected that SST will be fully compatible with Solvency II for insurers. It integrates many of the recommendations of the IAA, and for of its provisions – credit risk – is compatible with Basle II in order to minimize the possibility of capital arbitrage. There will be integration between the calculation of the best-estimate provisions and the resulting capital in order to prevent doublecounting. The calculation of a target capital level will act as an early-warning signal from which different levels of intervention would occur. In terms of transparency, annual reports will have to be submitted to the regulator on the capital calculation framework as well as the risk management and risk governance approaches of the insurer. In addition, the annual report will have to contain an analysis of the other relevant risks faced by an insurer that are not directly taken into account the actual capital methodology. As in Solvency II, public disclosure will occur. The main components of the SST are: • Assets and liabilities are valued on a market-consistent approach. • Annual risk-bearing capital calculation like in many other frameworks. The approaches that can be used are standard models prescribed by the regulator or approved internal models that satisfy pre-defined requirements. Risk capital will be measured as the expected shortfall. • Standard models calculation will follow a hybrid approach: stochastic based on multi-variate normal curves for the risk factors as it is easier to implement and supervise by the regulators but coupled with scenarios to complement the tail portions of the risk curves to determine the target capital. The two results will be aggregated to derive the risk-bearing capital of an insurer. • Scenarios are different from stress tests which usually focus on shocking one risk element at a time. Global scenarios will be prescribed by the regulators which will affect different risk factors and will vary by industry. • Relevant risks are market, credit and insurance risks. o Market: Interest rates, equity, FX, property, concentration, liquidity. The proposed standard approach is similar to the Risk Metrics approach used in banking and in trading portfolios. o Credit: migration, default, spread, concentration, country, industry, counterparty. The proposed standard approach is identical to Basle II.
•
•
• •
•
o Insurance on old and new business: biometric, behavioral, catastrophes, concentration. o Operational risks: qualitative initially but move to quantitative as banks are doing. Standards models for market, credit and insurance risks will be prescribed and they all follow multivariate normals. Within each risk category, the risk sensitivities will be aggregated by correlation matrices prescribed by the regulators. The extremes will be handled through scenarios and aggregated. The other less quantifiable risk like operational risk will be handled trough scenarios as well. Internal models will be allowed and must be documented in an annual report. These models will have to satisfy quantitative, qualitative as well as organizational requirements like in the banking sector, one of them being that they have to be deeply embedded in the day-to-day internal business operations and processes of insurers, and must not be used only to calculate target capital. The incentive to develop internal models is the fact the standard models are more conservative than the mentioned “best-estimate” for liabilities and other features like assuming that reinsurers all default at the same time in the standard models while an internal model could be more refined. Hedging activities will be taken into account. Market-consistent liabilities will be the sum of the best estimate plus a risk margin to allow transfer to a third party. The risk margin will be defined in such a way that it would cover the present value of the financial cost of regulatory capital that a third party would have to come up with in order to assume the run-off of the liabilities transferred following financial distress by the insurer. Target capital will be the sum of the 1-year risk capital – based on expected short fall at a confidence level prescribed by the regulator - plus the risk margin embedded in the reserve calculation.
Other Economic Capital Frameworks: UK Framework In the general Prudential Requirements for insurers, the Financial Services Authority requires that insurers determine an amount of financial resources that is sufficient to carry on their business of insurance. This is part of general management principles that insurers must follow. In particular, those general management principles form part of an integrated risk management framework that insurers must put in place with appropriate risk identification and controls. Insurers are free to choose the confidence level that they want to achieve, the investment horizon of their analysis as long as they consider all material risks that may have an impact on their capacity to operate on a going concern basis. In addition, insurers must perform stress tests and scenarios for each of the major source of risk identified as part of their general risk management processes and framework in order to determine its capital resources in line with its risk appetite.
So, the overall UK risk management framework and its resulting determination of financial and capital resources requirements (CRR) for insurers to operate is an economic capital framework based on the principles outlined above. In addition to the responsibility given to manage to demonstrate that the amount of economic capital is sufficient to satisfy their strategic goals, they must also demonstrate the quality of that capital as we will describe in the next section. This amount of capital resources is subject to a minimum, the Minimum Capital Requirement (MCR) based on a set of risk factors applied to balance sheets items. In addition to the general framework, insurers have to perform an additional set of calculations where some of the parameters of the economic capital framework are set by the regulator. This set of calculations will allow the regulator to ascertain itself that the insurers will be in a position to meet its obligations to policyholders, which is a solvency test. This set of calculation is called the Enhanced Capital Requirements (ECR), which is based on a series of scenarios of each material risks identified by the insurer as part of its regular risk management framework. In essence, the UK Individual Capital Assessment, as this process is known (ICA), is a subset of a general Economic Capital Framework that all insurers must have in place to be in the business of insurance in the UK. Here are some of its main features: •
• • • • • • • •
An insurer must perform the ICA based on scenarios and stress tests appropriate for all material risks with a minimum list of risks. As in other frameworks, the ICA doesn’t limit itself only to the risks that can be quantified but covers all material risks to which an insurer is exposed to except extreme scenarios. The ICA doesn’t prevent other approaches to be used, like stochastic approaches, but the scenario approach is the preferred one by most UK insurers as scenarios are the most appropriate approach to determine the amount of capital required in unexpected situations. The calculation is prescribed over a one-year observation period at a prescribed confidence level of 99.5%. The balance sheet must be calculated on a “realistic basis”, that is an economic basis. That applies to both assets and liabilities. Liabilities do not include risk margins. The focus of the ICA is on the solvency of the insurer to policyholders. Hedging has to be considered in the calculation including reinsurance. Although the ICA allows the inclusion of new business but in relation to its impact on capital, most firms in the UK are only including one year of new business in their calculations. The ICA should include all administrative expenses necessary to discharge its obligations to policyholders. The ICA should consider the effect of intra-group transactions on the ECR and their associated risks like non payment, default by another legal entity. Management actions can be included in the ICA as long as the real intentions of management are well understood in times of distress and if they are coherent with the risk processes in place. In other words, if management cannot react
•
quickly enough, such management actions should not form part of the ICA. Most UK insurers include management actions in their ICA. Most companies aggregate the results of their risk scenarios both within each risk category – ex. correlations between equity and interest rate risks – and between risk categories. The methods used vary. About 50% of companies use the root sum of squares while the rest use a correlation matrix, using their own judgment to set the correlation factors.
Economic Capital Framework: Risk Bearing Capital Available Once insurers have determined their overall economic capital requirements to sustain their strategic objectives and the material risks that they face within a certain confidence level that reflects their risk appetite over their strategic horizons, they need to assess the actual capital resources available to them to absorb losses when they materialize. This aspect is often neglected in discussions on economic capital frameworks. This is where risk management and capital management at the firm level interact. Also, this analysis is prescribed by many of the regulators and is completed by firms when they complete their planning process. In fact, regulators in the financial services industry have established some guidelines as to what constitutes available capital resources to insurers through allowed and disallowed assets categories and the inclusion or exclusion of some financial instruments and how they are valued. The determination of allowed capital by the regulators then determines their level of intervention. In general, if allowed capital falls below the amount of required capital, some regulatory intervention will occur. For some regulatory frameworks, like Solvency II, the levels of regulatory interventions will occur at different stages depending on the amount of available capital compared to the MCR and SCR. The economic value of the financial instruments that constitute the amount of available capital should be sufficient to absorb losses without triggering a liquidation of the firm. Since we are in the context of an economic capital framework, the allowed financial instruments should be valued on an economic capital basis as well. Thus, the available actual capital resources of the firm should be simply the difference between the market value of assets and the market value of technical reserves in the case of insurers, the whole difference being ultimately available to absorb unexpected losses. The available resources could also include the value of many contingent capital that could be available to firms like deposit insurance in the case of banks, the value of CAT bonds, reinsurance, and the value of other hedging instruments like alternative risk transfer instruments. However, the available capital is “owned” by different stakeholders who have different rights to it. Those rights are usually recognized in the business laws of each country, and will define the order by which the different owners of capital will absorb losses similarly to tranches in some structured financial products.
In the context of regulatory frameworks, – Basle II, Solvency II, GDV, SST, FSA -, allowed capital instruments are usually divided into two categories, the so-called Tier 1 capital – Core Capital – and the Tier 2 Capital – Supplementary Capital -. The tier 1 capital is the most sought after capital to absorb losses and sustain growth. This capital is usually composed of: • Permanent shareholders’ equity, which is the value of capital that is owned by the shareholders, which comes from their past contributions, the retained earnings from past profits, and the value of non cumulative perpetual preferred shares. • In the context of Solvency II and new economic capital calculations of technical reserves, the overall risk margin that would be calculated and included as part of the technical reserves, but not the technical reserves themselves, would be counted as tier 1 capital. The value of the technical provisions is not included as such since it represents the value of the funds and future benefits to policyholders. Policyholders and the value of their benefits that the technical provisions represent are not the ones who are called upon first to absorb losses. • In this calculations were done on a GAAP basis, for example, elements of AVR and IMR would be included while a DAC value would be subtracted as well. However, in the context of an economic capital framework, these artificial accounting values are reflected in the actual market value of assets taken into account in the capital calculation, so they become irrelevant. • Different appropriations of equity in the forms of reserves for different accounting purposes. • Innovative loss absorption instruments like ART and the like – UK GENPRU The Tier 2 capital represents – Tier 3 in some regulatory regimes - the second level of capital resources available to absorb losses. The owner of that capital represents usually: • Preferred shareholder. • Hybrid instruments that have both the characteristics of debt and equity without triggering a liquidation of the firm. • Subordinated long-term, non callable debt and securities. • General provisions. For example, for future credit, operational, and legal losses, not the technical insurance provisions. On a going concern basis, the calculation of available capital resources should end at this point. In fact, if a major loss were to happen and totally wipe out the available actual capital resources, and, if investors judge at that point that the company can still be profitable, they would be willing to reinvest and keep it going. This is essentially what happens when company restructures itself, the so-called Chapter 11 in the US, for example. However, from the regulators’ point of view, in order to approach the valuation of available capital resources from a solvency perspective, the market value of some assets is subtracted to come up with the allowed capital. The subtraction is done
from the Tier 1 capital resources. The instruments represent assets that could easily loose their value in case of a major loss. Some examples are: • • • • • • • • •
Inadmissible assets. Value of goodwill. Value of patents, copyrights and other intangible assets like franchise value. A percentage of investments in subsidiaries. If a conglomerate, the value of capital held in other regulated financial institutions could be excluded. Value of investment in own company’s shares. Assets in excess of market and counterparty limits – UK PRU Securitization positions. Assets of ancillary service undertakings.