Michel Rochette, MBA, FSA, PhD Student 2010 Valuation Actuary Symposium Chicago September 21th 2010
Topics Purpose and principles of any capital framework Modelling issues: Diversification: correlation assumptions Stress testing Management implications: Use test and ORSA Capital types and liquidity
Emerging issues
09/21/2010
Enterprise Risk Advisory LLC
Purpose of an EC framework ¨ Risk management system of an insurer for the
analysis of the overall risk situation of the insurance undertaking, to quantify risks and determine the capital requirement on the basis of the company specific risk profile¨ CEA Groupe Consultatif Required capital is assessed in light of: available capital & other financial resources enterprise risk management processes
strategic goals & risk appetite regulatory requirements 09/21/2010
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Principles: EC Development
All material risks should be covered: links to ERM and emerging risks Models must be appropriate for the scale and complexity of the firm Models must be dynamic and flexible Models must be embedded in the financial, strategic and operational processes: Use Test in Solvency II Governance of models development: Board/top management oversight and involvement documentation of models, limitations & changes internal controls over development: auditable independent review: More than peer review
Others: consistency between valuation and EC models: valuation framework input data verifiable and controllable validation and calibration 09/21/2010
Enterprise Risk Advisory LLC
Correlation: Proposals Correlations exist at different levels: (CRO Forum, Dec. 2009, QIS5) Some risk factors
Corr. Coefficients
Equity/IRR
50%(D)/0%(U)
FX/IRR
25%
Default/Equity
25% CROF,QIS4 75% QIS5
Default/IRR
50%(D)/0%(U)
Between legal entities for Solvency II: zero because of
the non-fungibility of capital and the non recognition of group capital support 09/21/2010
Enterprise Risk Advisory LLC
Correlation: Crisis Dependent ď‚— According to a 2009 Pimco study:
09/21/2010
Correlation to S & P 500
Corr elation Early 90s
Correlation Early 2008
S & P 500
1
1
High-Yield Bonds
20% -30%
80%
International stocks
30% -40%
70%
Real Estate
30%
60% -70%
Commodities
0%
-20% -30%
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Correlation: Implications In times of crisis, negative correlation benefit between
asset classes disappears. “When people start buying an asset, the act of them diversifying ultimately makes the asset less of a diversifier .” Pimco’s Head of analytics Rule: total diversification benefit should not be above 30%
Solvency II QIS4: 31% CROF: 21% Swiss Solvency Test: 24%
Ultimately, correlation assumptions should determined
by linking back to your own company’s ERM processes. 09/21/2010
Enterprise Risk Advisory LLC
Stress Testing: Complimentary Approach Regulatory Approach: QIS5 risk shocks by type of risk:
Some examples: Global Equity: 39% & volatility Up: 10% additive Property: 25%, low compared to recent US experience! Spread Widening, AA-rated, 4yr: 10.4%
Management Approach: Prospective scenario modelling with a top down approach Historical perspective:
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Ex. 2008 credit crunch Similar risk events at other firms, in other industries Enterprise Risk Advisory LLC
Management Implications of EC: Use it!
Investment decisions: existing and new Product development Strategic decisions: probably the most important of all Corporate finance decisions: financial leverage Hedging strategies: use it within the treasury department Solvency II regulatory proposal: “…widely used and plays an important role in the course
of conducting an insurer's regular business, particularly in risk management. " 09/21/2010
Enterprise Risk Advisory LLC
Solvency II ORSA & EC Pillar II requirement: Own Risk & Solvency Assessment Goal is to demonstrate “sound and prudent management of the
business and assess overall solvency needs.” In other words, is risk management – including EC – aligned with your strategies and internal risk and control processes? Demonstrate that! Useful references: Bermuda Monetary Authority: “Opportunity to align management
and regulatory reporting & encourage sound risk management practices within the jurisdiction.” CEIOPS: Preliminary views on the definition and importance of the ORSA as a management tool, requirements and guidance:
09/21/2010
Alignment of risk profile, risk tolerance, risk strategy Enterprise Risk Advisory LLC
Capital and Liquidity of EC Types of required capital: expressed in Tiers in Solvency II Tier 1: most secure and liquid, permanent
shareholder’s equity and inforce cash flows
Tier 2: revaluation reserves, general provisions, hybrid like
instruments and subordinated term debt, callable equity, group support, letters of credit, unpaid shares, Max. 50% Tier 3: Hybrid capital, subordinated loans, Max. 15%
Liquidity New explicit requirement since the 2008 crisis The insurance industry should be concerned about assessing explicitly liquidity risk and liquid capital instead of trying to do it indirectly through the debate over liquidity premium in valuation reserves. Not in line with best EC/ERM practices. 09/21/2010
Enterprise Risk Advisory LLC
EC Emerging Risk: Systemic risk “The risk of disruption to the flow of financial services that is (i)
caused by an impairment of all or parts of the financial system; and (ii) has the potential to have serious negative consequences for the real economy.“ (IMF) “Treat systemic risk as an emerging risk” Dave Ingram, SVP Willis Re Some insurers are already considered “ systematically relevant institutions”: Aegon, Allianz, Aviva, Axa, Swiss Re and Zurich, not any US insurer? (Financial Stability Board) "Most insurers will be impacted by systemic risks, but only a few insurers can contribute to creating systemic risk" - Dr Shaun Wang Does insurance create systemic risk? Emerging consensus is NO But insurance business will be impacted by systemic risk events.
(Bennett, AAA)
09/21/2010
Enterprise Risk Advisory LLC
SOCIETY OF ACTUARIES
2010 Valuation Actuary Symposium (September 2010) Session Topic:
Introduction to Economic Capital
Competency:
External Forces & Industry Knowledge
Expected Attendance
Session:
All Sessions 5,255
36 TS 109
This Session
Actual Attendance
4,818
98
Number of responses
2,317
29
Return rate (# of resp./actual att.)
48%
30%
Overall rating of this session
3.88
3.93
Provided you with practical technical information
4.12
4.30
4.30 4.12
Will enable you to make better business decisions
3.99
4.04
4.04 3.99
Prepared you to impact industry-wide changes
3.82
3.88
Knowledge of Subject
4.27
4.50
4.50 4.27
Effectiveness of Delivery
3.89
4.50
4.50 3.89
2
0
4.27
4.32
3.89
3.78
2
0
4.27
4.23
3.89
3.96
2
0
Knowledge of Subject
4.27
4.00
4.00 4.27
Effectiveness of Delivery
3.89
4.50
4.50 3.89
2
1
Knowledge of Subject
4.27
4.22
Effectiveness of Delivery
3.89
3.85
2
1
3.33
2.95
Did you chose this session based on the Competency addressed during this session? % Yes
53%
61%
61% 53%
Did this session meet your expectations in terms of how it addressed this Competency? % Yes
65%
65%
65% 65%
All Sessions
1
Overall Rating Learning Experience
2
Indicate your level of agreement with the following. This session:
David Hopewell, FSA, MAAA
Number of participants indicating presenter included commercial promotion in presentation
Presenter Effectiveness1
David S. Graham, Knowledge of Subject FSA, MAAA, CERA Effectiveness of Delivery Number of participants indicating presenter included commercial promotion in presentation
Michael C. Hayes, Knowledge of Subject FSA, MAAA Effectiveness of Delivery Number of participants indicating presenter included commercial promotion in presentation
Michel Rochette, FSA
Number of participants indicating presenter included commercial promotion in presentation
Hans J. Wagner, FSA, MAAA
Number of participants indicating presenter included commercial promotion in presentation
Rate the level of audience interaction for this session Competency
1
3.93 3.88
3.88 3.82
0 2 4.32 4.27 3.78 3.89 0 2 4.23 4.27 3.96 3.89 0 2
1 2 4.22 4.27 3.85 3.89 1 2 2.95 3.33
1
The rating scale used: Excellent (5), Very Good (4), Good (3), Fair (2), Poor (1), and N/A (no value).
2
The rating scale used: Strongly Agree (5), Agree (4), Neither Agree nor Disagree (3), Disagree (2), Strongly Disagree (1), and N/A (no value).
Speakers are compared to an overall speaker average regardless of the order of presentation.
Evaluation Tips to keep in mind when reviewing the responses: Numerical evaluations tend to give you a pretty good feeling for how well the attendees responded to the session as a whole. Scores in the range of 3 to 5 are considered successful programs. Written comments come from people who may have a strong opinion, therefore they tend to be very good or very bad. Repetitive comments that point to the same theme could be an indication of an area you may want to capitalize on in the future or work on for future presentations. Perception Solutions, Inc.
www.perceptionsolutions.com 10/18/2010
SOCIETY OF ACTUARIES
2010 Valuation Actuary Symposium (September 2010) Session Evaluation (Participants' Comments) Session 36 TS 36 TS 36 TS
36 TS
Overall Comments Regarding This Session David Graham: You have great knowledge & info, but please slow down in your delivery - it was hard to catch all that you were saying. Mr. Wagner seemed to mostly discuss Solv. II, not EC. Pretty good. The structure of session was good. It provided sufficient coverage on what is an Economic Capital? What does it look like based on examples? Also, how it ties to other regulatory requirement such as Solvency II & IFRS. Very good overview - nice balance of material. Particularly liked the more specifications around the companies' EC Models.
Perception Solutions, Inc.
www.perceptionsolutions.com 10/18/2010
Comments- 1