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Deloitte & Touche Risk-Adjusted Capital Management CAS/SOA ERM Symposium July 30, 2003 Sim Segal, FSA, MAAA Senior Manager Deloitte & Touche.

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Presentation on theme: "Deloitte & Touche Risk-Adjusted Capital Management CAS/SOA ERM Symposium July 30, 2003 Sim Segal, FSA, MAAA Senior Manager Deloitte & Touche."— Presentation transcript:

1 Deloitte & Touche Risk-Adjusted Capital Management CAS/SOA ERM Symposium July 30, 2003 Sim Segal, FSA, MAAA Senior Manager Deloitte & Touche

2 2 Agenda  What is capital management?  The capital management process and its evolution  Practical application of capital management  Keys to success

3 3 Deloitte & Touche Capital has two components Capital is wealth ”used” or ”available for use” in the production of more wealth. American Heritage Dictionary

4 4 Deloitte & Touche Assets Total Capital = Required + Available Used Required capital Available capital Total capital Liabilities Available for use

5 5 Deloitte & Touche Capital management is managing both required and available capital Required capital management Available capital management Maintain available capital at optimal level, balancing: a) Future growth needs b) Drag on returns c) Capital flexibility Maximize risk-based capital performance measure, within constraints

6 6 Deloitte & Touche Capital management is managing both required and available capital Required capital management Maximize risk-based capital performance measure, within constraints Maintain available capital at optimal level, balancing: a) Future growth needs b) Drag on returns c) Capital flexibility Focus of today’s discussion Available capital management

7 7 Deloitte & Touche Agenda  What is capital management?  The capital management process and its evolution  Practical application of capital management  Keys to success

8 8 Deloitte & Touche The Capital management process has five steps 1. Define required capital 2. Allocate required capital 3. Select a capital measure to evaluate performance 4. Set a hurdle rate 5. Maximize capital measure, within constraints

9 9 Deloitte & Touche Capital management has evolved in the insurance industry 1. Required Capital2. Capital Allocation3. Capital Measure4. Hurdle Rate Zero (ignored in pricing) Multiple of RBC (Statutory) Multiple of RBC plus accounting adjustments (GAAP, but Stat-based) Value-at-Risk (VaR) (GAAP) Company level Segment level Line of business or product line level Policy level  Customer level  Producer level Internal Rate of Return (IRR) Return on Investment (ROI) Return on Equity (ROE) Return on Capital (ROC) Benchmark Long-Term Weighted Average Cost of Capital (WACC) WACC based on dynamic risk-free rate WACC based on dynamic risk-free rate and dynamic risk premium Embedded Value (EV) or Fair Value (FV)

10 10 Deloitte & Touche Agenda  What is capital management?  The capital management process and its evolution  Practical application of capital management  Keys to success

11 11 Deloitte & Touche Example: Public Multiline Financial, Inc. Step 1: Define required capital

12 12 Deloitte & Touche Downgrade by rating agency Action by state insurance department Economic ruin Loss of competitive standing ? ? ? ? ? ? ? Required capital is risk-based... but what risk is being addressed?

13 13 Deloitte & Touche Required capital addresses multiple risks related to disparate constituencies Regulatory Capital Rating Agency Capital Benchmark Capital Economic Capital Total Required Capital To avoid regulatory action To maintain current debt or financial strength ratings To maintain a given probability of avoiding ruin To match the capital level of a key competitor

14 14 Deloitte & Touche Example: Public Multiline Financial, Inc. Step 1: Define required capital Required capital is Value-at-Risk (VaR), using a one-year time horizon and a 99.9% confidence level

15 15 Deloitte & Touche Loss Rate Probability Confidence Level 95% 99% 99.9% Illustrative Value-at-Risk (VaR) is based on a stochastic analysis of economic ruin Value-at-Risk Capital

16 16 Deloitte & Touche Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital

17 17 Deloitte & Touche Allocating capital further down in the organization facilitates more decision-making Strategic decisions, e.g.:  Growth  Market exit Tactical decisions, e.g.:  Pricing  Mix of product portfolio Transactional decisions, e.g.:  Retention efforts  Cross-selling  Producer compensation decisions Policy Product Policy... Product... Policy Segment...

18 18 Deloitte & Touche Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital Capital is allocated down to the product level

19 19 Deloitte & Touche Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital Step 3: Select a capital measure to evaluate performance

20 20 Deloitte & Touche Each capital measure offers a unique focus  ROI emphasizes rate of return  ROE measures efficiency of usage of equity capital  ROC illustrates the ability to generate earnings per dollar of total capital  EV quantifies the dollar contribution to shareholder value

21 21 Deloitte & Touche Case study: ROE-based compensation has disadvantages vs. EV-based compensation Hurdle rate = 15% SituationROE-based* planEV-based plan Value is created: Management in a 20% ROE line of business decides to add a 16% ROE project PenalizedRewarded Value is destroyed: Management grows a 12% ROE business RewardedPenalized * Compensation plan based on ROE and earnings

22 22 Deloitte & Touche Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital Step 3: Select a capital measure to evaluate performance Capital measure is Embedded Value (EV)

23 23 Deloitte & Touche Embedded Value (EV) Value of surplus Value of inforce business Discounted value of distributable earnings from inforce business* Distributable surplus * Includes target surplus Embedded Value (EV) is a function of distributable earnings / surplus from inforce

24 24 Deloitte & Touche Adjusted statutory net income * Target surplus released (consumed) * Adjusted to replace investment income on surplus with investment income on target surplus Distributable earnings reflects changes in total surplus and target surplus

25 25 Deloitte & Touche Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital Step 3: Select a capital measure to evaluate performance Step 4: Set a hurdle rate

26 26 Deloitte & Touche The hurdle rate is management’s estimate of its risk-return position on the efficient frontier Return Risk RfRf mm RmRm ? ? 0 X X

27 27 Deloitte & Touche Hurdle rate setting methods involve tradeoffs between simplicity, accuracy and stability MethodSimplicityAccuracyStability of Measure BenchmarkingEasiestPoor Long-term weighted average cost of capital (WACC) Moderately complex ModerateFair WACC based on dynamic risk-free rates Moderately complex HighGood WACC based on dynamic risk-free rates and dynamic risk premium Most complex HighestBest

28 28 Deloitte & Touche Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital Step 3: Select a capital measure to evaluate performance Step 4: Set a hurdle rate Hurdle rate is WACC based on dynamic risk-free rates, with uniform hurdle rates throughout the enterprise

29 29 Deloitte & Touche Example: Public Multiline Financial, Inc. Step 1: Define required capital Step 2: Allocate capital Step 3: Select a capital measure to evaluate performance Step 4: Set a hurdle rate Step 5: Maximize capital measure, within constraints

30 30 Deloitte & Touche Dynamic modeling clarifies potential impact of projects on embedded value (EV)

31 31 Deloitte & Touche Constraint of maintaining the RBC ratio is more complex when using Value-at-Risk (VaR) Required capital (VaRC) 1.0 B Available capital 0.3 B Required capital (200% RBC) 1.2 B Available capital 0.1 B Statutor y GAAP

32 32 Deloitte & Touche Summary: practical applications of capital management Strategic:  Manage stock analysts, e.g., reveal under-valued businesses  Strategic planning, e.g., project capital needs, quantify impact on capital ratios  Risk management, e.g., estimate probability of ruin and impact on stock price Tactical:  Funding decisions, e.g., identify stock repurchase opportunities  Risk-return tradeoff decisions  Identifying highest value-added projects  Asset-liability management (ALM)  Provide incentive compensation aligned with increasing value

33 33 Deloitte & Touche Agenda  What is capital management?  The capital management process and its evolution  Practical application of capital management  Keys to success

34 34 Deloitte & Touche Keys to success  Define required capital with deference to all key constituencies  Allocate capital as far down in the organization as possible  Select a capital measure that aligns with your goals  Align incentive compensation with the capital measure  Avoid fallacy of the “correct” hurdle rate  Manage constraints carefully while maximizing capital measure  Employ a disciplined process to setting or changing assumptions  Provide management with the tools to understand the impact of decisions on the capital measure

35 35 Deloitte & Touche CAS/SOA ERM Symposium July 30, 2003 Sim Segal, FSA, MAAA Senior Manager Deloitte & Touche Risk-Adjusted Capital Management Thank You!


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