Enterprise Risk Management For Insurers and Financial Institutions

Enterprise Risk Management For Insurers and Financial Institutions
David Ingram CERA, FRM, PRM From the International Actuarial Association

Course Outline 1. INTRODUCTION - Why ERM?
2. RISK MANAGEMENT FUNDAMENTALS – FIRST STAGE OF CREATING AN ERM PROGRAM 3. RISK ASSESSMENT AND RISK TREATMENT - ACTUARIAL ROLES 4. ADVANCED ERM TOPICS

Risk Assessment & Risk Treatment
Actuarial Roles 3.1 Types of Risks 3.2 Risk Models 3.3 Risk Treatment Options – ALM 3.4 Risk Treatment Options – Hedging 3.5 Risk Treatment Options – Reinsurance 3.6 Risk Treatment Options – Capital Markets 3.7 Risk Treatment Options – Risk Design 3.8 Risk Treatment Options – Diversification 3.9 Risk Treatment Options – Avoid/Retain 3.10 Choosing a Primary Risk Metric 3.11 Uses of multiple Risk Models 3.12 Using Economic Capital for ERM 3.13 Capital Management & Allocation

3.1 Types of Risks Systematic v. Specific Traded v. Non-Traded
Paid to Take v. Not Paid to Take Market, Credit, Insurance, Operational

Systematic Risk vs. Specific Risk
Flood – Systematic Risk -everyone gets wet Bucket of water thrown by your brother – Specific risk – only you get wet Insuring one House – Systematic or Specific? Insuring thousands of houses – Systematic or Specific?

What are risk management Techniques for Specific Risk?
_____________

What are Risk Management Techniques for Systematic Risk?
_____________

What happens with a group of specific risks?

3.2 Risk Models Cause / Effect - Outcome Outcome – Frequency/Severity
Closed Form v. Single Scenario v. Monte Carlo Stress v. Scenario Sensitivity

Cause Effect - Outcome Typical Life Insurance Actuarial Model
Model follows the steps taken over the life of an insurance contract following a tree branching logic Policy Issue, continue to next year (1 – q - w) Death & Claim in first year (q) Lapse or surrender the contract (w) Repeat – year after year Outcome = PV of three paths for each year

Outcome – Frequency/Severity
Model commonly used for non-life insurance and for financial market instruments Past observations of frequency and severity of outcomes used to parameterize statistical models of future outcomes

Closed Form v. Single Scenario v. Monte Carlo
Close Form models one step calculations usually depend upon assumption of distribution of outcomes (normal or log normal) that have formulaic outcomes Black Sholes Single Scenario Also one step (the one scenario) Using either CEO or OFS Monte Carlo (stochastic) model Multi scenario Often do not presume to know distribution of outcomes

Stress v. Scenario Stress Test Redo calculation changing one parameter
Scenario Test Adjust all parameters to reflect a fictional total world Includes interactions of factors and dependencies in the assumed situation

3.3.0 Risk Treatment Process
May vary significantly with each major risk category Depending on Nature of Risk Assessment Capabilities Relationship with Risk Takers Knowledge & Experience of Staff

Components of Risk Treatment Process
Risk Identification Measuring & Monitoring System Risk Assessment & Communication Establishment of Risk Limits & Standards Risk Treatments Enforcement of Limits & Standards Risk Learning

Risk Identification Within a broad category Need to know which sub categories of the risk can be treated together And which need to be treated separately

Measuring & Monitoring System
Measures of risk v. Key Risk Indicators Existing v. Future Manual v. Automated Quantitative v. Qualitative

Risk Assessment & Communication
Need to establish regular schedule of assessment Assessments must be communicated at several levels in the organization Operational Levels Management levels Management MUST have discussions with subordinates about the risk positions

Establishment of Risk Limits & Standards
Limits = How large, How much, How many, Authorities Limits must be quantitative Also may use Checkpoints Standards For how things are to be done Treatments permitted/ required

Risk Treatments Avoid Reduce Offset Transfer Retain & Provision

To set Standards Ask the best person in a function what needs to be done to “get it right” Ask supervisors what information that they need to be able to tell that things are being done “right” Standards also apply to documentation and recordkeeping

Enforcement of Limits & Standards
Assessment & Communication systems need to include comparison of risk positions to limits And adherence to standards Must clearly establish what will happen if limit or standard is violated Might depend on seriousness of breach Hard limits v. Soft Limits

Risk Learning Internal External Backwards Forward
About Losses, Risk Assessment, Risk Treatment Processes Internal External Backwards Forward

Credit Risk Treatment Traditional Credit Risk Treatment Standards for
Underwriting Authorities Collateral, Coverage Limits & Enforcement Limits by credit quality, Size of Position Authority Limits Active Workout with Risk Learning

“Modern” Credit Risk Treatment
Credit VaR risk model & Aggregate limits Gives aggregate portfolio view of Credit Risk Allows trade-offs within aggregate limits Use of credit derivatives to offset excessive specific or aggregate risk levels

Insurance Underwriting
Traditional Risk Control Mechanism for Insurance Standards for Underwriting Authorities Insurable Interest Limits & Enforcement Limits by quality, Amount of Coverage Authority Limits Active Claims management with Risk Learning

3.3 Risk Treatment Options – ALM
Interest Rate Risk Treatment Crediting Rate Matching Cashflow Matching Duration Matching Advanced ALM Economic Capital Limits & Reporting

Crediting Rate Matching
Portfolio Rate New Money Rate Investment Year Rates Mismatched crediting rates can lead to large harmful cashflows

Cashflow Matching Project out expected cashflows from liabilities
Project out expected cashflows from assets Identify major gaps where there is a large difference between the projected cash outflow and inflow in a future year Make plans to fill those gaps (usually on asset side for insurers) Targeting future asset purchases Targeting asset sales & repurchases

Duration Matching Duration is sensitivity of value to a change in interest rate Also equal to PV of time weighted cashflows Sum of PV(t x Cft) Focus on DA v. DL Set Limit for abs(DA – DL) Usually ½ to 1 year

Duration Matching Most Insurers adjust assets to match duration of liabilities First step is to assess expected DL for a new product Set DA target for new cashflow Second step is to set schedule for assessment of portfolio DA & DL

Duration Matching If assessment reveals excessive abs(DA – DL) gap then will plan to: Adjust DA target for future cashflows Sell some assets and purchase others to change DA Purchase derivatives Macro or Micro Hedge

ALM – Advanced Duration matching only works well if interest rate moves are Small Similar for all durations Advanced methods take care of: Larger movements (Convexity) Non-parallel shifts (Key Rate Durations)

Convexity Change in Duration with change in interest rates
Second derivative of value with respect to a change in interest Duration measures slope of the value plot If Value Plot is a curve, then slope is only accurate measure for very small moves

Key Rate Durations Change in value with change in rate at a specific duration For example, 5 year rate only Matching Key Rate Durations allows protection against yield curve twists

3.4 Risk Treatment Options – Hedging
Financial Market Risk Treatment Derivative Instruments used for Hedging Futures Put & Call Options Swaps Derivatives are often low cash outlay Usually means that derivatives involve significant leverage

Example of Financial Market Risk
Product – Index Annuity Feature – Product promises the greater of 80% of stock market growth Floor interest Rate on 90% of funds On a specified maturity date To match without derivatives would require insurer to invest twice 80% In Stock Fund 90% in Bonds For a total of 170% of deposit

Hedging Methods Cashflow Hedging Works like Cashflow matching in ALM
Purchase derivatives that have strike dates where there are potential cash mismatches Most firms use this method to manage Index Annuities Invest 90% of deposit in fixed income Use other 10% to buy Option contracts tied to Equity market Adjust participation percentage (80%) based upon cost of Options Strike Date3 for Options is maturity date Of Index Annuity Contract

Hedging Methods Delta Hedging
Is fundamentally the same idea as Duration Matching Delta is change in price (value) per change in an underlying (usually a market index) Delta hedging often uses derivatives with extremely different term to hedge obligations Delta hedges are only good for a very short time period (usually a day) Delta Hedges must be rebalanced every day

Delta Hedging Index Annuity
Buy bonds to cover interest guarnatees Delta hedging ignores interest rate risk Then determine Delta of liabilities Plus Delta of existing hedges Purchase new derivatives that will bring Delta of assets + hedges to be within tolerance for difference from liabilities

Hedging Methods Get Definitions Greeks
Greeks are partial derivatives of Prices with change in various factors Gamma Vega Tau Get Definitions

Hedging Index Annuity with Greeks
Investments can be any mixture of bonds and stocks Greeks will determine adjustments needed with derivatives to match all of the risk characteristics

Custom Hedging Can purchase custom hedge contracts from a bank that have terms tailored to your specific need If using custom hedges, would expect very low amount of rebalancing needed Hedges are tied to market indices – not to actual liabilities

Favorable Unfavorable Cashflow Hedging Delta Hedging Greeks Custom
Hedging Programs Favorable Unfavorable Cashflow Hedging Easy to understand & Control Lock in protection Inflexible Difficult to adjust Can be costly Delta Hedging Can produce low cost hedging program Single Metric – easy to control Works well in normal market conditions Requires sophisticated models & derivative trading abilities Requires that derivatives are always available and always reasonably priced Ignores risk of jump and other risks Greeks Can provide protection that is effective in normal & abnormal markets Requires highly sophisticated models and derivative trading capabilities Can result in high amount of trading to balance many Greeks Custom One step hedging process May not work as expected Custom hedge is illiquid – usually must sell back to same bank May be costly

3.5 Risk Treatment Options – Reinsurance
Insurance & Financial Market Risk Treatment Reinsurance is broadly similar to Custom hedges just described Usually much more customized than Custom hedges Reinsurers will usually promise to offset some portion of an insurers exact claims experience

Types of Reinsurance Facultative v. Treaty
Proportional v. Non-Proportional Per Risk v. Per Occurrence v. Aggregate

Facultative v. Treaty “Facultative” reinsurance applies to a single insurance contract “Treaty” reinsurance applies to all contracts in a defined block

Proportional v. Non-Proportional
Proportional reinsurance: the reinsurer takes a defined percentage of all losses Non-proportional reinsurance: the reinsurer only takes losses that exceed some threshold Almost always subject to a maximum limit Threshold may be on per risk, per occurrence, or aggregate basis

Per Risk v. Per Occurrence v. Aggregate
Types of loss threshold for non-proportional reinsurance Per Risk: threshold applies to losses from each insurance policy Per Occurrence: threshold applies to total loss from each specific event (for example, each hurricane or earthquake) Aggregate: threshold applies to total loss from a specific time period

Reinsurance Advantages: Disadvantages
Customized to take exact aspect of risk that insurer wants to lay off Available through a market of firms globally Disadvantages Cost and availability of specific covers varies widely Need to be concerned about credit quality of reinsurer Sometimes for many, many years

Actuarial Analysis of Reinsurance Decision
Quantify frequency & severity of insurance losses Apply terms of various reinsurance options Compare cost / benefit and Risk/Reward tradeoffs Evaluate options in light of company goals in order to determine best strategy

Strategies for Managing Underwriting Risk
Remove Cancel policy or exit LOB Pro: eliminates future risk Con: also eliminates opportunity for profit Reduce Stringent UW & claims management Pro: leverage company expertise Con: competitive forces are outside company control Reinsure Purchase reinsurance Pro: customized hedge Con: cost of risk transfer Retain Live with the risk Pro: retain profit opportunity Con: risky; requires supporting capital

Determining Reinsurance Needs
Increase Risk Capacity Provide Stability Surplus Relief Provide U/W Expertise Facilitate Withdrawal from Business Business Strategy Growth X LOB Focus Financial Position Limited Asset Liquidity Limited Surplus

Functions Served by Different Types of Reinsurance
Increase Risk Capacity Provide Stability Surplus Relief Provide U/W Expertise Facilitate Withdrawal from Business Facultative X Proportional Treaty Non- Proportional Treaty

Reinsurance Advantages: Disadvantages
Customized to take exact aspect of risk that insurer wants to lay off Available through a market of 50 to 100 firms globally Disadvantages Cost and availability of specific covers varies widely Need to be concerned about credit quality of reinsurer Sometimes for many, many years

3.6 Risk Treatment Options – Capital Markets
Securutization of Firm Risks Use of General Capital Markets products (ILW)

Capital Markets Options for Insurance Risks
Two broad Capital Markets Solutions to Risk Securitize & Sell your own risk on the Capital Markets Buy Capital Markets Instruments that offset a risk that you have

Securitize your Risk Advantages: Covers your exact risk
Pricing may be better than reinsurance Capacity can be higher than reinsurers Disadvantages Market might balk at any non-standard aspects of your risk Large fixed cost of securitization Market appetite varies widely for insurance

Buy Capital Markets instruments to offset your risk
There are some instruments – usually related to insurance cats that have been created by banks or (re)insurers Mortality Cat Bonds Industry Loss Warrents Usually, these are bonds where principle is not repaid if trigger event occurs Trigger event is usually very large catastrophe

3.7 Risk Treatment Options – Risk Design
Life Insurance Annuities Health Insurance Property Insurance Casualty Insurance

Risk Design – Life Insurance
Increasing Insurance Amount To limit underwriting anti-selection High Premium Levels For Guaranteed Options Assumed high degree of anti-selection Offsetting Insurance & Investment Risks If investments perform poorly, must buy more insurance Explicit in UL product

Risk Design - Annuities
Deferred Annuities Surrender Charges Market Value Adjustments (fixed) Investment restrictions (variable) Immediate Annuities Limited or no Withdrawal options

Health Specific ERM Concerns
Underwriting controls-- centralized authorizations required for larger cases Avoiding Anti-Selection--being one of several health options offered by employer could invite anti-selection Experience monitoring--ability to slice and dice claim experience and trend, monthly, down to segment/geography/product Diversification—(Large Accounts, small accounts, by location, public/private). Provider contract renewal (for example – staggering renewals). Assessing counterparty credit risk of providers, especially those accepting capitated risk. Stress scenario modeling: Bioterrorism, Pandemic

POLICY CONTRACTS As Risk Treatment Tool
ELEMENTS OF AN INSURANCE POLICY – Declarations Page(s) Coverage Part(s) Definitions General Provisions Exclusions – General  Additional Coverages  Conditions  Duties After an Accident or Loss Excluded Property  Excluded Perils 

POLICY CONTRACTS … OCCURRENCE & CLAIMS-MADE
Policies written to cover losses two ways: Occurrence Basis – Pays for losses that occur during the policy period. Claims Made – Pays for losses reported during the policy period Due to nature of Claims Made policies, they are written with either: Extended Reporting Provision, or Retroactive Date Provision Both extend the “period” during which losses may be reported and covered

BASIC Reinsurance CONTRACT TYPES
Facultative or Treaty Individual Risk Entire Book of Business Excess or Pro Rata Limit and Retention Proportional Sharing of Loss 66

“BUSINESS” PROVISIONS
Business Covered Line(s) of business In force, new and renewal Exclusions What isn’t covered Territory Where can the risks be located or policies written KNOW THIS – questions # 2, 6, 11, 18 Question # 6 – What article specifies what Policies will be covered by the Contract? a) commencement and termination, b) access to records, c) business covered, d) territory? Answer = c Question # 11 – One reason for the Exclusions Article is ….. a) to exclude business which the Reinsurer is unwilling to reinsure, b) to exclude business which is unreinsurable, c) to exclude business which has not been insured, d) to exclude losses from ever happening. Answer = A Question # 18 – An exception to an exclusion is covered under the reinsurance contract. Answer = True Question # 2 – The Territory Article establishes the geographical area within which risks must be located or policies must be issued to be subject to the contract. Business Covered: Might also identify MGA. Exclusions: Establishes lines of business, risks types or activities that are not covered under the reinsurance. Reasons for excluding: Business not contemplated in the rating of the reinsurance premium. Business the Reinsurer isn’t willing to reinsure. Business which is unusually hazardous. Exceptions to exclusions (write-backs) Territory 67 67

COVERAGE PROVISION “Coverage” Article establishes the Reinsurer’s liability to the Company for the subject business: Excess – Retention and Limit Quota Share or other Pro Rata – Percentage of Cession The Basis of Coverage is defined. For example, on an XOL contract the Basis of Coverage is “each loss occurrence” or “each risk,” etc. Coverage basis also often addresses assignment of losses, (previously known as the “Accounting Basis” article) 68 68

COVERAGE PROVISIONS Definitions – Excess vs. Pro Rata
Commencement and Termination Definitions – Excess vs. Pro Rata ECO/XPL LAE/DJ UNL – excess only Loss Occurrence – Property vs Casualty KNOW THIS – Questions 4, 13, 19 Question # 13 – Assume that a contract contains the following wording. Which of the following best summarizes the termination provisions under this Contract as described in the wording? a) Cutoff only, b) Runoff only, c) Automatic cutoff with the Company’s option to runoff, d) Automatic runoff with the Company’s option to cutoff. Answer = D Question # 4 – The term “ultimate net loss” is used only in pro rata contracts. Answer = False Question # 19 – A typical definition of “Ultimate Net Loss” might include: a) ECO, b) LAE, c) XPL, d) all the above Commencement and Termination Addresses the coverage of losses/claims after the termination or expiration of the contract. Methods are runoff & cutoff, with various options for election. Will address handling of premiums based on accounting basis. Ultimate Net Loss: Excess contracts only – explain why Will identify various loss components to be included in UNL. 69 69

COVERAGE PROVISIONS Other Reinsurance – Inuring vs Underlying
Reinstatement Warranties Notice Of Loss and Loss Settlements KNOW THIS – WARRANTY – Question #16 – If one party breaches a warranty, the other party may render the Contract null and void back to inception. Answer = True 70 70

“MONEY” PROVISIONS Three Types of Accounting Basis Accident Year
Calendar Year Underwriting Year KNOW THIS – Question # 17 – If the Reinsurer asks you how losses and premium are being reported under an XOL (Excess of Loss) contract, you should look in what article to find the answer? a) Service of Suit, b) Federal Excise Tax, c) Commencement and Termination, d) Accounting Basis. Answer = D Accident Year (a.k.a. Losses Occurring during) The matching of all losses occurring (regardless of when reported) during a given 12 month period with all premium earned (regardless of when written) during same period. Ultimate results cannot be finalized until all losses are settled. Losses Occurring During (Inforce New and Renewal or New and Renewal basis). Calendar Year The matching of losses incurred (not necessarily occurring) within a given 12 month period (usually 1/1-12/31) with all premium earned within same period. Incurred losses will include change in IBNR. Underwriting Year (a.k.a. Policy year Accounting, Pool Year, Risks Attaching) The segregation of all premiums and losses attributable to policies having an inception/renewal date within a given 12 month period. Premiums and losses matched during reinsurance term. Similar to Accident Year as Ultimate results cannot be finalized until all losses are settled. 71 71

3.8 Risk Treatment Options – Diversification
Diversification among risks Diversification between risks Correlations v. Dependencies

Diversification of Like Independent risks
If rate of claim is q, amount of claim is C, number of insured is N Expected claims = NqC Standard Deviation of Claims amount is Square Root {Nq(1-q)}C

Independent Like Risks
Expected Std Dev COV 1 10 99 995% 5 50 222 445% 100 315 315% 500 704 141% 1,000 995 99% 5,000 2,225 44% 10,000 3,146 31% 50,000 7,036 14% 100,000 9,950 10% 500,000 22,249 4% q=.01 C=1000

Combining Unlike Risks
Dependent = Add Ranked Values Fully independent = Square Root(A2 + B2) if both are Normally distributed

Unlike Risks Risk 1 Risk 2 Dependent Independent 5% -6 -18 -24 -19 15%
-0 25% 3 2 5 4 35% 6 7 13 10 45% 9 12 21 15 55% 11 18 29 65% 14 23 37 27 75% 17 28 45 33 85% 20 36 56 41 95% 26 48 74 55

Correlation v. Dependencies
Correlation is a mathematical term Can calculate correlation between finger length and car ownership Dependency is a statement about the fundamental relationship between things Net Wealth and Car ownership Correlations can be found for things with no conceivable dependency

Copulas General Mathematical technique for combining two random variables that are partially dependent Gaussian Copula Non-Gaussian Copula Some non-Gaussian Copulas will allow higher dependence in the tails of the distribution Which is popular to more closely fit with reality

3.9 Risk Treatment Options – Avoid/Retain
Operational Risks Holding Capital for Retained Risks

Operational Risks Usually a firm is not paid to take Operational Risks
So most firms will choose to avoid Operational Risks If unavoidable, to minimize them Using cost benefit to choose how to lminimize

Operational Risk Definition Identifying Risks Assessing Risks
Risk Control Risk Transfer & Reduction Case Studies

Operational Risk “the risk of loss, resulting from inadequate or failed internal processes, people and systems, or from external events”. Basel

Operational Risks (a partial listing)
Regulatory Changes Tax Changes Governance Problems Industry reputation Company reputation Information systems risks Legal risks Financial Reporting Risk Outsourcing Inadequate Controls Process inefficiencies Business strategy risks Political risk Terrorism Natural Catastrophe Misselling Fraud Insourcing

Operational Risk Measurement
Measurement is not the most important aspect of operational risk management Operational Risk Management Process: Identify Risks Classify risks by frequency and severity Develop plans and strategies for controlling high frequency and high severity risks

Risk Management Continuum (Harvard University)
Proactive Management Anticipate Risks Central Oversight / Assurance Active Management Timely Response Governance / Compliance Standards Understanding and Evaluation of Risks Reactive Crisis Management Protection of Reputation Decreased Crisis Response Improved Services Improved Work Place

Compliance Paradigm Shift (Harvard University)
From To Informal Policies Limited Oversight Reactive Fragmented Limited Involvement People Orientation Ad Hoc Formal Policies Senior Level Oversight Anticipate, Prevent, Monitor Focused, Coordinated Everyone is Involved Process Orientation Continuous Activity

Basel Prescribed Methodology
Banks should implement a sound process to identify in a consistent manner over time the events used to set up a loss database and to be able to identify which historical loss experiences are appropriate for the institution and represent the current and future business activities. Banks should develop rigorous conditions under which internal data would be supplemented with external data, as well as the process of ensuring relevance of this data for their business environment.

Operational Risk Tracking
Need Standard List of Risks Need to Track Losses Exposures Process should be similar to mortality studies for Life Insurers

Operational Risk Management
Control Systems Internal audit Back-up and Redundancy Insurance Compliance monitoring Process improvement

Categories of Operational Risk
Clients, Products & Business Practices Fraud, Theft, Unauthorized Activity Execution & Processing Errors Employment & Safety Physical Asset Suitability, breach of fiduciary duties, sales practices Unauthorized transactions, money laundering, fraud Execution errors & systems failures Wrongful dismissal, harassment, workers comp & related legal liability Natural Disasters and human-instigated acts of damage

Case Study Misselling Risk
Risk Description Occurs during Sales Process Improper Illustrations Misrepresentation of Policy Provisions Misrepresentation of Company intentions regarding non-guaranteed elements Loss occurs when Incorrect expectations are not met by company policyholder obtains redress via regulator or courts

Misselling Risk Risk Assessment Isolated cases Systematic Misselling
Frequency – Low to Medium Severity – Low to Very Low Systematic Misselling Frequency – based on economic & competitive conditions Severity – Very High

Misselling Risk Risk Management Options Transfer – Insurance Coverage?
Offset – Not Applicable Manage - Controls Avoid – Improve Procedures

Misselling Controls & Improved Procedures
Culture Training Clear Marketing Materials, Illustrations & Contracts Supervision Monitoring In Depth Review Random Triggered Complaints Turnover Spot Checking

Case Study Equity Linked Product Execution
Risk Description Occurs with client directed transactions processing lags corrected with backdating of transactions company has gain or loss with each backdated transaction Original thinking – gains & losses would cancel Actual findings – direction of client fund movement tends to create more losses than gains with extreme market movements volumes increase, delays increase and losses increase

Equity Linked Product Execution
Risk Assessment Frequency – Very High Severity – Low

Risk Management Options Transfer – Insurance, Hedging Offset – Possibly Manage – Controls Avoid – Improve Procedures

Insurance Option Insurer will require improvement in procedures & controls Hedging Option buy hedge contracts to offset losses from late processing may want to use if cost of improved processing & controls is very high

Controls & Improved Procedures Monitoring processing lag Set targets for max daily lag Review cases with longest lags Monitoring losses Review losses with supervisors Review Processes look for avoidable delays in processing enhance technology & training Special attention to larger transactions Develop standards for overtime vs. delays empower management to make decisions

Risks to Avoid Most firms will have certain risks that they will always AVOID Important to explicitly document these Either in Standards or Limits

Retained RIsks Insurers and Banks are usually in the business of retaining some risks as their primary business Important for each to appropriately provision for the risks that are retained Reserves + Capital

Total Asset Requirement (TAR) approach to provisioning
Risk area calculated the Total amount of assets needed to pay off risks with desired confidence interval (for example 99.5% under Solvency 2) – This is TAR Reserves are held for expected losses plus prudent margin (as required) Capital requirement is then TAR - Reserves

3.10 Choosing a Primary Risk Metric
Ruin v. Volatility Short Term v. Long Term Other Risk Aspects

Ruin v. Volatility Ruin = Large and usually unlikely loss potential
99.5%tile loss – Solvency 2 Volatility = Fluctuations in earnings Standard Deviation of distribution of probable earnings or 90%tile loss

Ruin v. Volatility Reasons to Choose Ruin Reasons to Choose Volatility

Short Term v. Long Term Short Term Long Term 1 year – Solvency 2
Multi Year Until finall run-off of liabilities - US

Short Termv. Long Term Reasons to Choose ST Reasons to Choose LT

Other Aspects of Risk

3.11 Uses of multiple Risk Models
Risk & Light Full Risk Profile

Law of Risk & Light There is a danger that whatever risks you ignore will accumulate in your firm.

Full Risk Profile Risk Profile is your distribution of Risks
By Risk Type By Business Area By Region With Other important risk aspects

Other Risk Aspects Can determine Risk Profile by Measurement
Or by Queary Ask Underwriter to note whether each case has High, Medium, Low data integrity risk

3.12 Using Economic Capital for ERM
Loss Controlling EC Provides common metric for exposures & Limits Risk Trading EC Provides common standard for risk margins Risk Steering EC provides common metric for macro risk reward

3.13 Capital Management & Allocation
Risk Steering Overall Capital Target Capital Allocation (retrospective) Capital Budgeting Process (prospective)

Capital Target Base Target plus Security

Base Target DIRECT REFERENCE TO RATING AGENCY
Target the level of capital that supports the desired rating according to the exact rating agency capital model. Advantages Rating agency model widely used / thoroughly vetted Offers greater certainty on capital portion of the rating Disadvantages Uses broad industry average risk factors Inaccurate unless firm replicates industry average risk per exposure Actual capital held by similar firms with target rating may vary from Rating Agency guidelines; adjustments reduce this to a modified peer comparison method

Base Target INDIRECT REFERENCE TO RATING AGENCY
Using an internal company risk model, target Economic Capital level at an exceedence probability consistent with default rate for desired rating. Advantages Reflects management knowledge of the risks of the firm At least one rating agency (S&P) has stated that it will eventually incorporate internal capital models into ratings decisions Disadvantages Effort of developing a full internal risk model Work required to validate the model to the satisfaction of both internal and external users Probabilities related to A and AA rating levels are extremely low (0.02% and 0.008% per one Moody's study); in almost no case is there enough data to reliably calibrate a model to those probability levels

BUFFER CAPITAL There are often dire circumstances associated with failure to maintain minimum rating agency capital; therefore, most firms establish a safety buffer. At one extreme is a firm that plans to maintain its rating through a 1-in-500-year catastrophe loss scenario (99.8th percentile). In contrast, another firm believes it will be possible to access the capital markets about once every five years to replenish capital after moderate losses, and therefore sets a buffer at the 80th percentile loss. Most firms, whether they directly calculate a buffer or not, fall somewhere in the 1-in-10 to 1-in-20 range (90th to 95th percentile).

Capital Economic Risk Capital Face Capital Free Capital
Amount needed to support particular probability of loss event over a time period i.e. 95% probability of maintaining solvency over 5 years Face Capital Additional amount needed to satisfy regulators, rating agencies, board and stock analysts Free Capital Actual capital in excess of above

Reasons for Allocating Capital
Pricing Reflecting cost of capital in premiums, expense charges and interest rates Financial Reporting Determining ROE (RAROC) Capital Budgeting Determining who gets the scarce resource

Allocating Risk Capital
Total Firm Risk Capital is usually less than total risk capital for each unit Diversification Benefit Correlation Benefit How can the overlap be allocated?

Allocating Risk Capital
First, calculate Risk Capital for each unit separately Three general methods for allocating overlap: Proportionate Marginal Corporate

Proportionate Allocation
Multiply each unit’s separate Risk Capital Calculation by ratio of overlap to sum of separate risk capital calculations

Marginal Allocation Order of calculation is key
“Base” Unit gets overlap “Other” Units get overlap Marginal Factors by risk category

Corporate Each unit holds full separate Risk Capital
Corporate unit “holds” the overlap (Could be coordinated with Face Capital and Free Capital)

Proportionate Allocation
Pros Easy to explain & understand Easy to calculate Can be seen as fair / impartial Cons No recognition of source of correlations

Marginal Allocation “Base” Unit gets overlap
Pros Helps to “feed the franchise” Recognizes that “Base” unit creates the opportunity for overlaps Cons Makes it difficult for new Unit to get started Ignores fact that “Other” units are necessary for overlap to exist

Marginal Allocation “Other” Units get overlap
Pros May give newer units a pricing advantage Recognizes that “Other” units create the new situations that lead to overlaps Cons Is another way that the “Other” units are subsidized by “Base” unit Encourages shift of business to the new unit

Marginal Allocation Marginal Factors by Risk
Pros Allocates some of overlap to each business unit that contributes Cons Difficult to explain Factors difficult to develop

Face Capital Allocation
Methods of Allocations Offset against “Overlap” and use overlap allocation techniques Corporate keeps Face Capital

Free Capital Retained Earnings approach Profits Released approach
Units keep what they earn regardless of short term needs usually a long term expectation of need Sometimes followed by international firms where moving capital is difficult Profits Released approach all free capital flows to corporate for re- allocation

Investing Capital Many firms let unit management determine investment strategy for assets backing capital Firm can use investment strategy as a major Risk Management tool Can be especially effective if all capital is used may want to use a “transfer pricing” approach to allocate investment results back to units

Enterprise Risk Management For Insurers and Financial Institutions

Similar presentations

Presentation on theme: "Enterprise Risk Management For Insurers and Financial Institutions"— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

Enterprise Risk Management For Insurers and Financial Institutions

Similar presentations

Presentation on theme: "Enterprise Risk Management For Insurers and Financial Institutions"— Presentation transcript:

Similar presentations

About project

Feedback