Casualty Actuaries in Europe Spring 2013 Meeting Internal Model Uses Laurence Dunkling 31 st May 2012

Why build an Internal Model? If building an Internal model is so expensive, what use is it going to be?

Article 118 Use test Insurance and reinsurance undertakings shall demonstrate that the internal model is widely used in and plays an important role in the following: (1) their system of governance, referred to in Articles 41 – 49, in particular (a) their risk-management system as laid down in Article 43 and their decision-making processes; (b) their economic and solvency capital assessment and allocation processes, including the assessment referred to in Article 44. In addition, insurance and reinsurance undertakings shall demonstrate that the frequency of calculation of the Solvency Capital Requirement using the internal model is consistent with the frequency with which they use their internal model for the other purposes covered by the first paragraph. The administrative or management body shall be responsible for ensuring the on-going appropriateness of the design and operations of the internal model, and that the internal model continues to appropriately reflect the risk profile of the insurance and reinsurance undertakings concerned.

Model Use in Practice Used means “widely used in and plays an important role in” The internal model is not intended to be the driver of all business decisions, but it should contain a consistent view of risk of all areas that could have a financial impact on the insurance entity. What we were looking for 5.1 We were looking for examples of how firms could demonstrate that the internal model is widely used in and plays an important role in their system of governance. UK FSA Internal model approval process thematic review findings (February 2011)

Model Use in Practice The model (as defined by Solvency II) is wider than just the calculation kernel. The model can be used without reference to the calculation kernel at all.

Categorisation of Uses Five categories of uses identified i.Capital Management ii.Portfolio Management iii.Risk Management iv.Reinsurance Management v.Investment Management

Capital Management Capital models can be used to set capital. Alternative to setting capital using a model under Solvency II is to use the standard formula. Standard formula is a factor based approach and can be used by all insurance entities. This ‘one size fits all’ approach means that it has to be calibrated to meet the capital requirements of even the least diversified of entities. Capital derived from an approved model is likely to have be significantly lower than standard formula requirements. Source : E&Y European Solvency II survey

Capital Management PRA currently allowing Solvency II models to be used in the ICA + assessments ‘We believe that we have now developed an approach (referred to as ‘ICAS+’ as shorthand) that provides a practical solution – available to both life and non-life firms – consistent with our current regulatory approach and which allows firms to continue to make progress towards Solvency II. We consider ICAS+ to be most appropriate for those IMAP firms subject to an ICAS review to the end of 2014, and firms should discuss with their supervisor the timing and content of their reviews. Firms are reminded that they are not obliged to enter the two-phase approach, and it is not a condition for IMAP review or approval’ Julian Adams – 29 th January letter

Mergers and acquisitions Legal entity restructuring Maintaining credit ratings Capital Management

Portfolio Management Significant commercial benefits can be gained by understanding the business risks, thus enabling management to more efficiently target and address those risks (e.g., from a resource allocation perspective). The internal model provides a consistent view of the interaction between risk, capital and value across different types of businesses and geographies. Using economic capital allows insurers to quantify risk and better understand their capital utilization. The internal model is a valuable tool in developing a strategy that increases profitability, while also reducing risk. It affords an opportunity to apply a common currency to the measurement of risk, value and capital across the organization and provide an objective measure for evaluating business decisions. Using the internal model makes it easier for insurers to identify strategies that increase diversification. This will allow them to reduce capital requirements or to address capital intensive classes of business in order to release capital for other profitable risk-taking activities. Furthermore, this may reduce the overall cost of holding such capital. A company may also consider reducing a risk exposure via reinsurance, securitization or hedging arrangements.

Risk/Reward Trade-off

Risk Adjusted Return Risk Adjusted Return = Net Income – Cost of Capital = Underwriting Profit/Loss + Net Investment Income – Tax - (Cost of Capital Rate x Capital) One of the most important uses of the model is in the performance measurement. A risk adjusted return has been agreed where insurance results are adjusted to take into account the amount of capital required to write the business. The model is used to allocate capital to each of the lines of business within Europe, so it’s important for profit centers to ensure that the risks modelled for their business is accurate, otherwise their RAP results may be inappropriate.

Risk Appetite ‘We observed that the majority of respondents settled on a set of measures that, while variations on a theme, were common to most organisations. These measures, in nearly all cases, were different return periods derived from the same Expected Probability (EP) curve’ Source : Grant Thornton – Risk Appetite – A Market Study

Risk Appetite The Risk Appetite Framework is now structured in three levels:

Risk Appetite The Entity Level Aggregate Risk and lower level risk appetites are set out below. Risk Tolerance and Risk Limits have been set for each to build a framework of escalation and management action following movements in the AIG Europe Risk Profile. The framework has two facets: 1.Monitor Risk Profile against Appetite on a quarterly basis, in line with runs of the ECM 2.Alignment of Strategic Business Planning/Point in time Strategic Decisions with Risk Appetite Level 1 Risk Appetite (Entity Level Risk Tolerances and Limits) Level 2 Risk Appetite (Risk Specific Tolerances and Limits)

The capital model and the business plan are closely linked. Regulatory capital is set at the level required to meet the risks of the business plan. Throughout the business planning process the internal model is used in various ways Break Even Combined ratios are sent out to countries/profit centers Portable tools have developed using model output that allows management to assess the potential risk based return from various scenarios. Once draft plans are developed, the model can be updated to assess any changes to capital requirements or any breach of risk appetite. Business Planning

Stress and scenario testing is also conducted on the business plans as part of a risk assessment report. The model can quantify likelihood of meeting plan and then results from various scenarios such as stagflation can be derived. A Reverse Stress Test is conducted using the tail simulations from the model output. This allows management the ability to make contingency plans as well as being an additional validation of the model results. Business Planning – stress and scenarios

Risk Management Risk committees In medium to large-sized firms with more complex business models, those that were better prepared had formalised individual risk committees (insurance risk, investment risk, etc) reporting to an overall executive risk committee. Typically, chairs of the individual risk committees were members of the overall executive risk committee. The CRO (or equivalent) was also a member of the executive risk committee and had overall responsibility for risk within the organisation. The committee had defined reporting responsibilities to the executive committee, CEO, board risk committee and board. While we saw many variations within this structure, the key was that the firm has a thorough understanding of risk at an entity-wide level, as well as by risk category, and that the appropriate messages are communicated to and acted on by the board in a timely fashion. UK FSA Internal model approval process thematic review findings (February 2011)

Risk MI Standardised model output is used to inform the relevant risk officers of the standalone and diversified risks relating to their risk type. Model output will also be used to in production of key performance indicators, key risk indicators and risk ranking reports. Results from Profit and Loss attribution is also produced. Model output is reported through the Insurance/Credit/Market/Operation/Aggregation and Reinsurance committees and the key issues reported up to the Risk and Capital Committee.

Risk Management Natural Catastrophe Exposure The model requires detailed information as to the potential losses caused by natural catastrophes. Running this through the catastrophe model requires granular information about the exposures. Output from the catastrophe model can be relayed to the underwriters to use when assessing the risks of new accounts. It can also be used to monitor concentrations of risks to ensure RAP positive business is being written. Regular reporting ensures that appropriate allowance for the potential costs of natural catastrophe losses are included. Improvements in data quality result in better understanding of risks, business planning, lower capital requirements and a reduction in the price of reinsurance.

Risk Management and Pricing The model is not used directly in pricing insurance products other than in the setting of a maximum combined ratio. However, some non insurance related solutions do have explicit cost of capital loads. Business where the insurance entity fronts for another entity (usually a captive) and the risk is a credit risk and loss portfolio transfers use model output to ensure that the cost of capital is covered in the pricing.

Reinsurance Management Reinsurance and capital are closely linked. Reinsurance can be considered as an alternative to capital. All reinsurance treaty renewals have been assessed using the model. The capital reduction resulting from the treaty can be compared to the cost of the reinsurance. Example : RI Premium100Reduction in entity 1 in 200 year losses 500 Expected Recoveries 70Cost of Capital Rate10% Expected Loss 30Cost of capital saving 50 The key to the analysis is to ensure that not just the immediate benefit of reinsurance is assessed, but also the future capital benefit that will result due to a lower reserve risk. The analysis of future capital benefit distinguishes between credit for Excess of Loss treaties and credit for quota share reinsurance.

Capital requirement How is the capital projected? By calculating the capital needed as a percentage of the remaining reserves at the end of each year. The reserves are assumed to follow the payment patterns derived by actuarial

Reinsurance Management Prior to the development of the capital model, reinsurance purchase was decided by global profit centers. Analysis from the capital model has revealed that much of the reinsurance purchased is not capital efficient. All reinsurance is effective when viewed on a stand alone basis, but at the entity 1 in 200 losses not all reinsurance is necessarily triggered and many lines are not benefitting from their reinsurance purchase. As a result of having an aggregated model, the benefits of aggregate stop loss and reserve adverse development cover are being considered.

Investment Management The Internal Model projects a large number of possible scenarios of how the AEL assets and liabilities might behave in the future. Each model run only considers the actual asset portfolio; however, when evaluating our investment performance and considering possible alternative asset portfolios, it is useful to have a comparison of results between different asset portfolios. The Asset Allocation Analysis Tool allows the user to input a set of asset portfolios, and provides figures that illustrate how investment returns from these portfolios compare with each other and with the current asset portfolio. The Tool produces a broad range of output on various asset-related risks such as interest rate risk, credit spread risk and foreign exchange rate risk. These risks can be measured taking into consideration the interaction between assets and liabilities. This can help quantify benefits that can arise from proper asset-liability management, such as matching assets and liabilities in terms of duration and currency exposure.

Investment Management Proposed Portfolio 1 Base Portfolio Hedge USD Exposure

Data Improvements Why is data so important?Helps make business decisions Demonstrates results Supports audit and control Internal Model success The comic series, Batman, featured a villain named the Actuary: (Detective Comics #683-4 (March–April 1995)): A mathematical genius who applies formulae to aid the Penguin in committing crimes.