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Economic Capital and Risk Modeling February 22, 2008 Iowa Actuaries Club Session #2 Jeff Fitch, Senior Actuary - Corporate.

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Presentation on theme: "Economic Capital and Risk Modeling February 22, 2008 Iowa Actuaries Club Session #2 Jeff Fitch, Senior Actuary - Corporate."— Presentation transcript:

1 Economic Capital and Risk Modeling February 22, 2008 Iowa Actuaries Club Session #2 Jeff Fitch, Senior Actuary - Corporate

2 Outline Principals Risk Metric and Economic Capital Framework Lessons Learned from Principals Implementation Applications of Economic Capital models Emerging Industry Economic Capital Trends 2

3 Principals Risk Metrics and Economic Capital Framework Background –Where we were –Where we are at now –Looking forward My role in the process 3

4 Driving Forces & Objectives Better understanding of risk exposures and incorporate into decision making process Improve our ability to measure and manage risk and return Appropriate capital level and capital allocation Competitive Pressures Economic Uncertainty Rating Agencies Board 4

5 Principals Economic Risk Metrics 3 Primary Risk Metrics 1.Earnings at Risk (EaR) 2.Embedded Value at Risk (EVaR) 3.Economic Total Asset Requirement 5

6 Earnings at Risk (EaR) Measures short-term volatility of GAAP Operating Earnings Difference between: –Best Estimate (baseline) GAAP Operating Earnings; and –90 th percentile confidence level GAAP Operating Earnings Difference expressed as percent of Best Estimate (baseline) GAAP Operating Earnings Time horizon of one year GAAP Operating Earnings New business included in projection Also look at GAAP Net Income 6

7 Earnings at Risk (EaR) Example 1 year EaR at 90 th Percentile Run 1,000 scenarios of 1 year operating earnings Rank them from best to worst EaR is difference between Best Estimate and 900 th scenario 7

8 Embedded Value (EV) and Embedded Value at Risk (EVaR) Measures value of inforce business – doesnt reflect new business or intangibles (brand, reputation) Present Value of Distributable Earnings Embedded Value at Risk measures potential volatility in value –Difference between: Best Estimate (baseline) Embedded Value; and 90 th percentile confidence level Embedded Value 8

9 Economic Total Asset Requirement Economic Total Asset Requirement is the amount of assets needed to cover our obligations at a given risk tolerance level over a specified time horizon. –99.5% risk tolerance level for a AA rated company –30 year time horizon Economic Total Asset Requirement = Economic Reserves (cover obligations based on our best estimate of claims plus a margin) + Economic Capital (cushion on top of Economic Reserves to cover potential obligations from unanticipated adverse experience) Our external Total Asset Requirement is equal to statutory regulatory reserves plus rating agency required capital. Trapped Capital is the difference between external Total Asset Requirement and our Economic Total Asset Requirement. 9

10 Economic Total Asset Requirement (cont.) Reconstruction of Economic Balance Sheet 10

11 Principals Economic Risk Metrics - Recap Earnings at Risk (EaR) Embedded Value At Risk (EVaR) Economic Total Asset Requirement Confidence Limit 90% (1-in 10 year event)90%99.5% Time Horizon1 yearLife of Business MetricGAAP Operating Earnings (also GAAP Net Income) Embedded Value (EV) = Present Value of Distributable Earnings Total Economic Asset Requirement = Economic Reserves plus Economic Capital MeasuresPotential shortfall in operating earnings relative to baseline under relatively adverse business & economic conditions Potential shortfall in embedded value relative to baseline under relatively adverse business & economic conditions Total assets required to ensure we can meet all obligations with 99.5% confidence 11

12 Steps in quantifying Economic Capital 1.Identify and categorize risks Credit Market Product / Pricing Operational / Business 2.Quantify each risk individually Deterministic Stress Test and / or stochastic modeling 3.Aggregate risks and capture any diversification impact 12

13 Risk Hierarchy – Deeper Dive Mortality Risk, for example, can be broken down into 4 components 1.Volatility – statistical mortality fluctuation 2.Level – misestimation of mortality mean 3.Trend – misestimation of mortality improvement 4.Calamity – 1 time spike mortality (flu pandemic) 13

14 Hypothetical Example of Risk Aggregation 14

15 Top 10 Lessons Learned from Principals Implementation 1.Importance of Quick Wins 2.Simplify 3.It isnt all about modeling 4.Involve all parties in the process 5.Set up guiding principles up front 15

16 Top 10 Lessons Learned from Principals Implementation (cont.) 6.Set up risk appetite and tolerances up front. 7.Not a project. Never really done. 8.Look at entire distribution of results (dont focus only on the downside) 9.Use lots of pictures 10.Communication, communication, communication. 16

17 Applications of Economic Capital Models (if you build it they will come) Initial Uses: Product / Business Unit decision making Hedging / Reinsurance Internal Risk Reporting Medium Term Uses: Strategic Decision Making Capital Allocation Performance Measurement External Reporting Long Term Uses: Pricing Incentive Compensation 17

18 Emerging Industry Trends – Economic Capital Two methods have emerged as the most common: 1.Liability Run Off Approach Level of starting assets needed to pay all future policyholder obligations at a chosen confidence level Approach used for RBC C3 Phase 2 2.One Year Mark to Market Approach Level of assets needed to cover a fall in the market value of net assets over a one-year time horizon at a chosen confidence level Approach used for Solvency 2 18

19 Lots of different variations in approaches Many decisions to make: –Time Horizon –Confidence Level –What risks to include and how to measure –Stochastic vs. Stress Testing Many possible combinations! 19

20 One Year Mark to Market Approach Emerging as most common method to calculate Economic Capital Driven by emerging solvency standards, particularly in Europe (Basel II, Swiss Solvency Test, Solvency II) Consistent with emerging international accounting and solvency standards US principles based approach for reserves and capital is more of a liability runoff approach –Although use of one year market-to-market for EC is increasing in the US 20

21 One Year Mark To Market Approach Diagram 21

22 Is One Year Enough? Since our products have a long duration, how can you capture the risk using a 1 year approach? –You are still projecting your cash flows out to maturity and factoring in the residual impact of that 1 year event. –Confidence interval on a 1 year approach is likely higher than a multi-year approach Ex: 99.95% instead of 99.5% for a AA Rated Company After one year company can likely recapitalize and take other management action 22

23 Market Consistent Valuation Market price to transfer a liability between willing participants Applies capital market principles to liabilities –No arbitrage (identical cash flows must have the same value) Uses risk neutral scenarios, discount at risk free rates –Calibrated to current market conditions & prices –Captures embedded options & guarantees Add an additional margin for non-hedgeable risks (Market Value Margin) –Percentile Method –Cost of Capital Method 23

24 In a Market Consistent Embedded Value Framework, selecting assets does not create value Example: Company has Capital of 25, Borrows 75 at 4%, and invests 100 in equities expected to earn 8% Using traditional EV techniques, the 30 might be discounted at say 9%, giving a value of 27.5 on day 1. Under MCEV the asset CFs are discounted at 8% and the liability CFs at 4%, giving a value of 25 on day 1. The effective discount rate on capital is 20%. The risk discount rate is an output of the MCEV valuation, and not an input. Under a Market Consistent Framework you cant take credit up front for taking market risk. 24

25 Questions? 25


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