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Economic Capital CIA Seminar for the Appointed Actuary September 20, 2004 Speaker: Darryl Ivan.

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Presentation on theme: "Economic Capital CIA Seminar for the Appointed Actuary September 20, 2004 Speaker: Darryl Ivan."— Presentation transcript:

1 Economic Capital CIA Seminar for the Appointed Actuary September 20, 2004 Speaker: Darryl Ivan

2 CIA Seminar for the Appointed Actuary September 20, 2004 2 Agenda Capital (Bank Perspective): Importance & Types Economic Capital Definition Tenets Performance Measurement Risk Types and Attribution Methodology RBC Insurance: Economic Capital Development Distribution by Business & Risk

3 CIA Seminar for the Appointed Actuary September 20, 2004 3 Importance of Capital (Bank Perspective) The primary purpose of capital in a financial institution is to absorb risk. The absorption of risk is not just incidental to a bank’s business, but forms an integral part of the business itself.

4 CIA Seminar for the Appointed Actuary September 20, 2004 4 Types of Capital Book Capital Financial reporting Regulatory Capital Regulatory definition of capital Economic Capital Risk based attribution of capital

5 CIA Seminar for the Appointed Actuary September 20, 2004 5 Economic Capital Represents the total risk of RBC in one number and is a key measure of the RBC’s ability to withstand unexpected loss while enabling it to operate as a going concern. The amount of shareholder’s investment which is either at risk in a business or has already been utilized to purchase future earnings.

6 CIA Seminar for the Appointed Actuary September 20, 2004 6 Principles of Economic Capital Protect shareholders Equity is needed to guard against unexpected losses Covers all risks Consistent application of methodology across RBC More risk = more economic capital Capital should be attributed where risk is located

7 CIA Seminar for the Appointed Actuary September 20, 2004 7 Benefits of Economic Capital A robust economic capital framework provides management with an effective tool with respect to the following: Decision support and pricing Provide a consistent measure of profitability across the organization – performance measurement Effective allocation of capital resources Strategic development – quantify the shareholder value within each business activity Contributes to the assessment of bank’s capital adequacy

8 CIA Seminar for the Appointed Actuary September 20, 2004 8 Economic Capital Tenets: Attribution vs. Allocation ‘Attribution’ creates the right incentives for resources: Bottom-up measurement approach Robust measure of capital adequacy Accurate measure of risk vs. return ‘Allocation’ of equity is the distribution of ‘all’ available capital: Book or actual capital allocated top-down based on risk measures or regulatory requirements Ensures consistency with GAAP Cannot be used for capital adequacy, management and planning Incentives may not be aligned with economics

9 CIA Seminar for the Appointed Actuary September 20, 2004 9 Economic Capital Tenets: Solvency Standard AAAAAA Target Debt Rating Risk coverage as a function of target debt rating: Choosing a target capital level is driven by the institutions desired target debt rating. 99.997%99.95%99.65% Estimated risk coverage level (probability that capital and earnings will cover potential loss) Probability of default (approximate) 1 in 30,0001 in 2,0001 in 300 Time Horizon: 1 year

10 CIA Seminar for the Appointed Actuary September 20, 2004 10 Economic Capital Tenets: Solvency Standard Probability of loss Loss Rate 0% 100% Zero Losses Expected Losses Unexpected losses for which capital should be held Risk coverage level Level too expensive to hold capital 99.93%

11 CIA Seminar for the Appointed Actuary September 20, 2004 11 Economic Capital Tenets: Diversification EC for each risk type is calculated on a standalone basis. If stand-alone EC for each risk type was simply added, the sum would be significantly higher then RBC’s requirements at a given solvency standard. As a result, the benefits of diversification are calculated and attributed back to each BU. Diversification benefit is a function of the amount of risk and on the degree to which it is correlated with the other risks and businesses in RBC.

12 CIA Seminar for the Appointed Actuary September 20, 2004 12 Economic Capital Tenets: Book Value of Equity & Capital Management Capital you have vs. capital you require: ‘Capital you have’ is equal to common equity + retained earnings EC represents the ‘capital you require’ to maintain a common solvency standard The difference between EC and the book value of equity (either a net surplus or shortage) is held at the top of RBC Financial Group.

13 CIA Seminar for the Appointed Actuary September 20, 2004 13 Performance Measurement: Return on Equity (ROE) Economic Capital is the primary component for performance measurement, by defining risk/return relationship:

14 CIA Seminar for the Appointed Actuary September 20, 2004 14 Performance Measurement: Economic Profit (EP) EP measures business unit contribution to shareholder value EP measure strongly correlates to shareholder valuation EP = NIAT – Non-Recurring Items – Amortization of Intangible Assets – (Equity)*(Cost of Equity) Economic Capital

15 CIA Seminar for the Appointed Actuary September 20, 2004 15 Risk Types The identified risks for which RBC Financial Group calculates EC are: Credit Risk Market Risk Trading Market Risk Interest Rate Risk (Non-Trading Book) Operational Risk Business Risk Fixed Asset Risk Goodwill Risk Insurance Risks

16 CIA Seminar for the Appointed Actuary September 20, 2004 16 Attribution Methodology: Credit Risk Is the loss associated with a counterparty’s inability to fulfill its payment obligations, after taking into account recovery values when seeking to mitigate losses. Loss in market value due to deterioration in counterparty’s credit worthiness. A counterparty may be an issuer, debtor, policyholder, reinsurer or guarantor.

17 CIA Seminar for the Appointed Actuary September 20, 2004 17 Attribution Methodology: Credit Risk Primary drivers of credit risk: BRR; LGD; term to maturity; commitment status; UGD; product type Credit risk is calculated in three areas: Retail: credit cards, residential mortgages, lines of credit etc Capital rates applied against o/s balances Loan Book: commercial/corporate loans, public sector loans etc KMV Portfolio Model Trading Book CARMA Portfolio Model

18 CIA Seminar for the Appointed Actuary September 20, 2004 18 Attribution Methodology: Trading Market Risk Associated with trading activities resulting from market-making, positioning and sales, and arbitrage activities in the interest rate, foreign exchange, equity and commodity markets. Risk of unexpected loss occurring due to adverse changes in the market value of trading instruments. Market Risk Commodity RiskCurrency RiskInterest Rate RiskEquity Risk

19 CIA Seminar for the Appointed Actuary September 20, 2004 19 Attribution Methodology: Trading Market Risk Calculated using a combination of: Internal Models Approach: proprietary VaR model Standardized Approach: BIS Standardized Measurement Method Internal model approach to phase out standardized approach

20 CIA Seminar for the Appointed Actuary September 20, 2004 20 Attribution Methodology: Interest Rate Risk The potential adverse impact on RBC’s economic value due to changes in interest rates and interest rate volatility. Categories of IRR are: Neutral Position ALM Discretionary Foreign Basis Option

21 CIA Seminar for the Appointed Actuary September 20, 2004 21 Attribution Methodology: Business Risk Risk of loss due to variances in volume, price and cost caused by competitive forces, regulatory changes, reputational and strategic risk (primarily uncontrollable risks). Benchmarking indicates that attribution of capital for both business and operational risk is best practice. Factor determined annually applied against annualized gross revenues to arrive at economic capital for business risk.

22 CIA Seminar for the Appointed Actuary September 20, 2004 22 Attribution Methodology: Operational Risk Risk of direct or indirect loss resulting from inadequate or failed processes, technology, human performance, or from external events (primarily controllable risks). Determined annually using a number of approaches including benchmarking and earnings volatility. Currently RBC is working towards implementing a Loss Distribution Approach for determining operational risk capital.

23 CIA Seminar for the Appointed Actuary September 20, 2004 23 Attribution Methodology: Fixed Asset Risk The potential for the value of fixed assets to be less then its net book value at any time. Implicit assumption is that the depreciation schedule represents expected loss and capital is required for unexpected loss. Fixed asset classes include: real estate; computers; capital software development costs etc Publicly traded firms with large investments in each respective fixed asset class were used as proxies to derive fixed asset risk factors.

24 CIA Seminar for the Appointed Actuary September 20, 2004 24 Attribution Methodology: Goodwill Risk Goodwill is an asset that arises when the purchase price paid for an acquisition is higher than the value of the net assets acquired. The value of goodwill is based on earning capacity. Where these earnings do not materialize, a lower then expected return on invested capital is incurred, which translates into a loss of shareholder value. RBC Financial Group attributes 100% equity to goodwill.

25 CIA Seminar for the Appointed Actuary September 20, 2004 25 RBC Insurance: Economic Capital Development Align RBC Insurance with the rest of RBC Financial Group from an economic capital perspective. Move from a top-down approach to a bottom-up approach. Identification of risks: Those risks where current methodologies exist (e.g. credit, market etc) Risks unique to RBC Insurance (e.g. mortality, morbidity, lapse, P&C, IRR/reinvestment risk etc) Challenges: Management buy-in Actuarial support & model development for insurance specific risks Adjustment for liability conservatism Educating the ‘bankers’

26 CIA Seminar for the Appointed Actuary September 20, 2004 26 Distribution by Business (YTD Q3 04)

27 CIA Seminar for the Appointed Actuary September 20, 2004 27 Distribution by Risk (YTD Q3 04)


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