1. Linking Risk & Return under Solvency 2 Christopher Chappell Association of Financial Mutuals London, February 2013

2. Agenda TopicIssue ORSA & ERMContext Linking business strategy and risk strategy How practically can I use them interactively? Performance measurementLots of performance metrics, so how do I make decisions? Risk appetiteHow do I generate risk appetite statements? Operationalising risk appetiteHow do I set risk limits / budgets?

3. Strategic risk management Which risks do we want to take and why? How much risk do we want to take? Business strategy What are our competitive advantages? Are we generating value for our members? Emerging risk mgt What are the threats & opportunities to our business? Are events likely to invalidate our model? What is the plan to manage threats? What are the triggers? Solvency & capital management How much capital do we need to hold in each entity? How do we manage risk-taking? Risk & capital models What risks do we face? What is the range of potential impacts? How do our risks interact? Strategic planning Products & pricing Governance & controls Performance mgt Capital mgt Reporting Strategic Approach Enterprise risk and capital management framework Embedded through business processes Culture How do we behave in managing our business?

4. Linking Risk & Return Linking the risk strategy and the business strategy

5. Articulate the business model  The business model  Outlines what the business does, and  How it makes money doing it  Helps stakeholders to  Understand where the return is expected to come from, and  The sort of risks the business is expected to take.

6. Qualitative risk strategy/risk appetite statements Overarching principles: We do not wish to take unrewarded risks We do not want to take risks that are not consistent with the delivery of our strategy as an insurer. We will take on risks dependent on the expected return exceeding the cost of capital We will charge a price for accepting risk that seeks to optimise our risk/reward profile and that fully reflects the cost of taking that risk By risk category - market risk:  The Group has no appetite for market risk exposures except where exposures arise as a consequence of core strategic activity (principally as a consequence of exposure of revenue streams to market risks).  Business units are expected to limit market risk exposures by matching the features of liabilities to features of assets.  Exposures may be incurred where there is an overriding business need and specific appetites will be established as necessary.

7. Example evidencing challenge Business strategyImplications for Risk and Return Validating strategic alignment …… We have appetite for taking [xxxx] risk as we believe that we can achieve [return] on this risk We do not want to take [xxxxx] risk as we believe the upside to be limited. Questions as to how strategies align or may appear mis-aligned

8. Linking Risk & Return Establishing performance measures and risk appetite statements

9. Context of risk and return Return Risk Target risk appetite Target return Impact of balancing multiple appetite statements. Zone bounded by target tolerances controlled by limits

10. Risk-adjusted ‘primary’ performance measures Risk-Adjusted Return on Lifetime Economic Capital (RARLEC) RARLEC is a measure of how much value is generated for members relative to the risks being taken on Simple way of ranking products when making capital allocation decisions EVNB/PV(ECap) Economic value of new business (EVNB) is the EVC at point of sale of a policy Economic Value Creation (EVC) EVC is a measure of value created less the explicit cost of holding the required economic capital Cost of capital used is not the same for all products / projects Capital allocated reflects diversification benefits If EVC is greater than zero, value has been generated for members Franchise value = Net assets + Present value of potential transfers to members from in-force business + Goodwill for new business member value- add capability Other metrics (constraints)  Payback period  Distributable cash  New business strain  IFRS profit  Solvency II profit  …….

11. Common risk appetite dimensions Dimensions Capital Earnings Liquidity Franchise value Brand & reputation Definitions  Buffer above regulatory diversified Solvency Capital Requirement (SCR) in a 1-in-10 event  Pre-defined 1-in-10 event results in, at worst, zero Group operating profit  Coverage of liquid assets over net cash flows in a 1-in-10 shock event  Reflection of how our brand is perceived by our major stakeholders, e.g. customers, employees & regulator 1 2 3 4 Operational & capability  Tracking events that could occur and result in operationally being unable to deliver the strategic plan BAU cash flows In a stressed scenario  Ability to meet BAU cash outflows on a day-to-day basis

12. Linking Risk & Return Operationalising risk appetite

13. Risk category Regulatory capital requirement Economic Capital target (140% coverage) Amber trigger level (170% coverage) Total10001400 (=1000 * 1.4)824 (=1400 / 1.7) Financial500700412 - Equity 100 140 83 - Interest rate 400 560 329 Business300420246 Operational200280165 The target capital level has been established at 140% of the SCR Amber trigger level established at the capital position of being able to cover 170% SCR. RAG for each risk proportionately allocated from central target SCR multiples are implied solvency levels and therefore risk capital limits are inverted Then refine to assess how RAG statuses should change to reflect earnings risk appetite and risk strategy output Limits move over year in line with plan numbers Setting risk limits using risk appetite

14. Risk category Regulatory capital requirement Economic Capital target (140% coverage) Amber trigger level (170% coverage) Total10001400 (=1000 * 1.4)824 (=1400 / 1.7) Financial500700412 - Equity 100 140 83 - Interest rate 400 560 329 Business300420246 Operational200280165 The target capital level has been established at 140% of the SCR Amber trigger level established at the capital position of being able to cover 170% SCR. Setting risk limits using risk appetite Risk category Marginal contribution (base) Marginal contribution (scenario) Total 45%48% Financial 75%80% - Equity 60% 62% - Interest rate 45% 50% Business 25%24% Operational 60%63% Scenario: business operating at the upper red limit for particular risk type Scenario tests whether limits reasonably protect diversification benefit

15. Linking Risk & Return Summary

16. Summary : linking risk and reward under Solvency 2  Performance metrics have explicit allowance for risk that is appropriately costed  This means creating value greater than zero is creating value for shareholders  Define primary metrics and identify other metrics that act as constraints  Risk appetite is multi-dimensional  It focuses on what the Board is concerned about in running the business  Derived from stakeholder expectations  Capital risk appetite and risk limits link together  Limits set to preserve benefit of diversification  Economic (risk) capital is allocated appropriately to those products that create the risk exposure  Ensures products are charged appropriately for capital usage  Projections of the risk profile are appropriate as business mix and volume change  Ensures the assessment of return from taking risk is appropriately allocated to products to ensure we grow the right parts of the business

17. Questions and comments? Christopher Chappell E-mail: cichappell@live.com