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Economic Capital CIA Seminar for the Appointed Actuary

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Presentation on theme: "Economic Capital CIA Seminar for the Appointed Actuary"— Presentation transcript:

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

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 September 20, 2004 CIA Seminar for the Appointed Actuary

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. September 20, 2004 CIA Seminar for the Appointed Actuary

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

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. September 20, 2004 CIA Seminar for the Appointed Actuary

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 September 20, 2004 CIA Seminar for the Appointed Actuary

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 September 20, 2004 CIA Seminar for the Appointed Actuary

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 September 20, 2004 CIA Seminar for the Appointed Actuary

9 Economic Capital Tenets: Solvency Standard
Risk coverage as a function of target debt rating: Choosing a target capital level is driven by the institutions desired target debt rating. AAA AA A Target Debt Rating Estimated risk coverage level (probability that capital and earnings will cover potential loss) 99.997% 99.95% 99.65% Probability of default (approximate) 1 in 30,000 1 in 2,000 1 in 300 Time Horizon: 1 year September 20, 2004 CIA Seminar for the Appointed Actuary

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

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. September 20, 2004 CIA Seminar for the Appointed Actuary

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. September 20, 2004 CIA Seminar for the Appointed Actuary

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

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 September 20, 2004 CIA Seminar for the Appointed Actuary

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 September 20, 2004 CIA Seminar for the Appointed Actuary

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. September 20, 2004 CIA Seminar for the Appointed Actuary

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 September 20, 2004 CIA Seminar for the Appointed Actuary

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 Interest Rate Risk Currency Risk Equity Risk Commodity Risk September 20, 2004 CIA Seminar for the Appointed Actuary

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 September 20, 2004 CIA Seminar for the Appointed Actuary

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 September 20, 2004 CIA Seminar for the Appointed Actuary

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. September 20, 2004 CIA Seminar for the Appointed Actuary

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. September 20, 2004 CIA Seminar for the Appointed Actuary

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. September 20, 2004 CIA Seminar for the Appointed Actuary

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. September 20, 2004 CIA Seminar for the Appointed Actuary

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’ September 20, 2004 CIA Seminar for the Appointed Actuary

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

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


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