Economic Capital, IFRS and Solvency 2
From a Book to a Market-based management of Life
Insurance Companies?
October 16th, 2006
Jean-Bernard Caen – DEXIA Head of Economic Capital
<This document presents the point of view of its author, which may differ from DEXIA’s.
It supports an oral presentation and is incomplete without it.
This support is protected by copyright laws..>
© JB Caen, 2006 & +
1
at a glance
 “A European Banking Group, World Leader in Public Finance”
•
•
Resulting from the merger of 4 institutions in France, Belgium, Luxembourg and US
Credit exposure reaches 715b€ (900b$), 2/3 in Europe, and 1/3 in the USA
 A diversified Financial Group
•
•
•
•
A Retail network in Benelux and Turkey
Investment Management Services in Luxembourg
Insurance activities in Belgium
Capital Market activities
 Highly profitable
•
•
© JB Caen, 2006 & +
Net Income reached 2.0b€ (2.5b$) in 2005, 20% ROE
Market Capitalization is 24b€ (30b$) – well in the top 20 European banks
2
Context of the presentation
 The context of this presentation is that of a European Insurance Company, wholly
owned by a larger Financial Institution
•
2005: Life premiums 3.3b€ (4.1b$) and non-life 0.4b€ (0.5b$); Reserves 9b€ (11b$).
 Economic Capital status
•
•
A full Economic Capital model, covering all risks and the group consolidated – including the
Insurance subsidiary – is up and running
Disclosure by business line in the Quarterly Activity Report.
 IFRS status
•
•
IFRS has been applied since January 1st, 2005
IFRS 1 for the insurance (assets at fair value, but most liabilities are not)
 Regulatory status
•
•
Solvency 1 currently active but its constraint is weak
Solvency 2 official “Framework Directive” is expected in July 2007
 Full test number 2 (QIS2) feed-back expected by October 2006
 As a consequence, the Companies will anticipate the changes
 Full application by 2010?
© JB Caen, 2006 & +
3
Key messages
 REGULATORY and ACCOUNTING referentials are converging
towards an ECONOMIC, market-driven framework.
 This will lead to deep changes :
•
Cultural and strategic changes
•
A pricing policy more coherent with strategy and value creation
•
Improved products quality for the customers
•
More effective use of capital
•
Higher returns to shareholders
 A challenging but rewarding process
•
© JB Caen, 2006 & +
Lets get prepared!
4
From Book Value to Economic Value
Economic Value
Management
“True risk profile”
Future
Internal models
IFRS 2
IFRS 1
Standard solvency 2
formula
Ratings agencies model
Historical GAAP
© JB Caen, 2006 & +
Current
Solvency I
5
Economic Capital: What for ?
 To manage two opposite pressures
PRESSURE OF SHAREHOLDERS FOR AN
INCREASED RETURN ON CAPITAL
Search of Profitability
Reduce capital usage
CAPITAL
Increase capital backup
Search of Safety
PRESSURE OF REGULATORS FOR A BETTER
PROTECTION OF POLICY HOLDERS AND
RATINGS AGENCIES FOR BOND HOLDERS
© JB Caen, 2006 & +
6
Maximal value creation requires
optimal capital allocation
High
1
Areas of
Excellence
2
5
Capital
Allocation
Expected
Return
6
4
Competitors
Arena
Low
Low
3
Aggregate Risk
High
√ Capital allocation supports long term value creation
√ Explicit allocation of long term resources
√ Supporting allocation requires to weight risk against return
√ This requires a neutral and transverse metrics for measuring risks
© JB Caen, 2006 & +
7
The Economic Capital (ECAP) logic
impacts a large number of processes
 ECAP measures risks, it is a neutral metrics across all risks and all activities




Comparison of risks
Performance assessment
Pricing
Compensation
ECAP usage
 Allocating ECAP explicits the budget of risk, the resources for business
development, and the expected profit
 Strategic planning
 M&A
 Investments and divestitures
ECAP demand
 The “Available Financial Resources” is the supply of capital against which
ECAP can be compared
 Dividend policy
 Shares buy back
 Capital raising
© JB Caen, 2006 & +
ECAP supply
8
ECAP potential benefits are huge
 ECAP creates value
•
Better strategic development decisions
•
Improved tactical management, product definition, resources allocation
•
Incentives in line with shareholders interests
 ECAP brings in higher returns
•
Effective pricing policy
•
Effective reinsurance policy
•
Effective internal funds transfer pricing
 ECAP reduces risk
•
Identification and management of concentration effects
•
Identification and management of embedded options
•
Disclosures transparency reduces risk for shareholders
 The sooner the better
•
Learning process is long and implies cultural changes
•
Improved vision and skills is all the more beneficial when competitors stay behind
© JB Caen, 2006 & +
9
Numerical example: What excess capital?
Historical balance sheet
Assets
Liabilities
Bonds
100 Provisions
Equity
100 Beneficiary participation
Own funds
130
30
40
ECAP
Excess
Capital
40
0
For equity, ECAP is assessed at
40% of value; no risk for bonds
-> Just the right level of own funds!
200
Assets
Bonds
Equity
© JB Caen, 2006 & +
200
Liabilities
100 Provisions
150 Beneficiary participation
Own funds
Equity reserve
250
ECAP
130
30
40
50
250
Excess
Capital
When the value of equity raises
60
-20
-> RECAPITALIZE ?!
10
But implementing ECAP will require managers to cope
with volatility – and they don’t like it
 Economic or market-based approach implies more volatility
•
Seldom understood as early warning systems
 Managers prefer stability
•
They work day-to-day with regulators, ratings agencies and accountants
•
And they have to produce masses of documents, analysis and explanations
 To make life easier, each major management functions (accounting,
communication, risk management,…) fight to impose its view of the universe
•
In systems, organization, communication … and decision-making
 The executive management maintains a subtle equilibrium between these –
to often - antagonist forces
•
Because each one is necessary
 IF ONLY THEY WOULD CONVERGE!...
© JB Caen, 2006 & +
11
Currently each referential has its own objective and logic
Increasingly sophisticated risk management tools
Regulators
Ratings agencies
Shareholders and
the Management
Board
Defend the interest of…
Policy holders
Debt holders
Shareholders
Are searching for…
Limits to the ability
to take risk
Solvency
Return
Put limits in terms of…
Minimum
regulatory capital
Minimum ratio of
accounting capital
to regulatory capital
for a given rating
Return volatility i.e.
Economic Capital
Expect management to…
Add capital
Add capital
Maximize value
creation
© JB Caen, 2006 & +
12
What level of capital should the Company have?
 From the shareholders / Management Board viewpoint
•
•
•
What minimum capital to avoid failure?
 In the context of sharing both risks and return with policy-holders
What sharing of profits and risks?
 In France, the law implies that policy holders must receive at least 85% of profits
 In Belgium, no such law exist
 Up to where risk can be carried by policyholders and return be collected by
shareholders?
What excess capital?
 To fuel development, hefty dividends and share buy-back
 What decision without an Economic Capital framework?
 From the regulators viewpoint
•
•
© JB Caen, 2006 & +
Banking regulators: Is the Company part of a larger group?
 What capital under Basel 2 Pillar 2?
Insurance regulators: Compliance with Solvency 2?
 Posture regarding ratings agencies?
 Solvency 2 VaR-type logic is very close to the Economic Capital logic
13
From Statutory Equity to Available Financial Resources
Statutory balance sheet
Statutory Equity vs. AFR
Economic balance sheet
IFRS 2
IFRS 1
Solvency 2
Towards an Economic Capital framework
Uncovered
Capital
. Local regulations
. Tax and statutory based
© JB Caen, 2006 & +
Presentation concept by Mercer Oliver Wyman
. Internal steering
. Economic risk and performance
measurement framework
14
Solvency 2 is the European effort for pushing Insurance
Companies towards using an Economic framework
 It follows Solvency 1, issued in 2002
 It benefits from existing models
•
Financial Assessment Framework FTK (NL), Swiss Solvency Test (CH), FSA Model (UK),
National Association of Insurance Commissioners (USA), German Insurance Undertakings
GDV (D), Jukka Rantala Model (Former chairman of Solvency 2 Working group),…
 It joins efforts currently undertaken in other parts of the world:
Australia
•
Insurance Reform Act (APRA).
Canada
•
The Office of the Superintendent of Financial Institutions Canada (OSFI) Minimum Continuing
Capital and Surplus Requirement (MCCSR) for Life Insurance Companies and Minimal Capital
Test (MCT) for Federally Regulated Property and Casualty Insurance Companies.
Singapore
•
Risk-based Capital Framework for Insurance Business (MAS).
© JB Caen, 2006 & +
15
The structure of Solvency 2 offers
many similarities with Bâle 2
Three same pillars as Basel 2
Quantitative rules
Supervisory review process
• Technical provisions regime
• Minimum capital requirements
• Investments rules
• Internal control
• Rules for assessing assets value • Risk management
• Explicit list of risks
• Corporate governance
• Risk assessment constraints
• Opening toward internal models
Pillar 1
© JB Caen, 2006 & +
Pillar 2
Market discipline
• Minimum public disclosures
in order to reinforce market
discipline
• Transparency
Pillar 3
16
How will Solvency 2 clear the path
from a statutory to economic framework?
 Solvency 2 will require an economic assessment of technical provisions
 Solvency 2 will define 2 levels of solvency, both based upon the economic
risks of the Company
•
Minimum Capital Requirement (MCR). Below that level sanctions are immediate.
•
Solvency Capital Requirement (SCR). Acts as a target, consolidated.
 Should be considered as a minimum for Companies targeting a good rating.
 Solvency 2 will explicit risk aversion
•
The Solvency Capital Requirement should be equal to a one year 99,5% global VaR
 Roughly equivalent to a BBB-/BBB rating
© JB Caen, 2006 & +
17
Technical provisions assessment under Pillar I
 Today there are a variety of technical provisions assessments regimes
depending on the country
•
And various explicit – or implicit – levels of risk aversion
•
In France:
 4% of Mathematical Provisions for guaranteed products + 1% of Unit-Linked products.
 Pillar I will homogenize technical provisions assessments and risk aversion levels
•
Technical provisions will have to be assessed as the NPV of future cash-flows, with a prudent
stance
 “Prudently” meaning either 75th percentile (regulators preference) or best estimates,
that is NPV actualized at risk free rate + cost of capital (Companies preference)
 The QIS underway should clarify the options.

Coherent with the future calculation of provisions such as required by IFRS “phase 2”
(liabilities in fair–value)
 Difficult and ambitious challenge
© JB Caen, 2006 & +
18
The major risks facing a Life Insurance Company
 Typically, European Life Insurance Company have two major activities, with
different risk profiles
•
Unit-linked funds
 The Company acts as an asset manager
 Risk and return are both held by policy holders
 The Company bears the operational risks
•
Euros-denominated funds
 The Company legally guarantees a minimum return on assets
 Both risks and return are shared between the Company and the policyholders
 Assessing a global VaR requires to identify and measure the risks, and
aggregate them
•
Market risk: Assets value volatility and Assets : Liabilities mismatches
•
Credit risk: Bonds ratings changes and concentration
•
Operational risks
 For solvency 2, the major challenges concern the market risk of assets
(volatility of market value) and the relationship between assets and liabilities

Same challenges as for setting up an Economic Capital framework!
© JB Caen, 2006 & +
19
Asset and liability risks are closely linked
 They cannot be treated independently
 One given asset allocation may generate a very high or a very low global risk
depending upon the nature of the liability
•
such as the nature and level of guarantees and the characteristics of the options given to the
policy-holders
 Moreover, part of the profit and part of the risk are transferred to policy holders
•
Sharing rules are not necessarily explicit
•
But even if it is, it leaves many axis of freedom to manage it
 Surplus reserves, some of which is not disclosed, can be used

 to improve the yield served to the customer
 to offer fat dividends to shareholders
 or kept for future uses
With IFRS, fair-value of reserves are disclosed as most assets are classified in “Available For
Sales” reserves.
© JB Caen, 2006 & +
20
Profit and risk sharing
 The Insurance specificity is that the policy holder bear a part of the risks (i.e.
of the capital)
•

Which part is usually not explicit for easier management of the trade-off between financial
and commercial goals
Managing Insurance risks is managing one big ALM
•
But share- and policy-holders do not have the same risk aversion and expected return
 Defining a profit sharing rule is the backbone for modeling Insurance ALM
•
It will form the back-bone of sound economic management
© JB Caen, 2006 & +
21
Numerical example: What profit and risk sharing with
policy holders?
Assets
Bonds
Equity
Liabilities
100 Provisions
150 Beneficiary participation
Own funds
Equity reserve
250
Profit and risk are shared with policy holders 50/50
Assets
Liabilities
Bonds
100 Provisions
Equity
150 Beneficiary participation
Own funds
250
Profit and risk are shared with policy holders 20/80
Assets
Liabilities
Bonds
100 Provisions
Equity
150 Beneficiary participation
Own funds
130
30
40
50
250
130
55
65
ECAP
Excess
Capital
60
-20
ECAP &
surplus
Excess
30
30
25
35
ECAP &
surplus
Excess
48
12
22
38
High ROE (56%), but as risk is fully
carried by shareholders, the need for
recapitalization appears quickly
THAT QUICKLY?!
No, IFRS includes the equity reserves
in the perimer -> Excess capital is 30
Lower ROE (38%), but sharing the
risk (and the profit) with policyholders
safeguards much own funds
250
130
70
50
ROE decreases (20%) when a still
larger chunk of the profit (and risk)
is transferred to policy-holders
-> what optimal profit sharing?
250
© JB Caen, 2006 & +
250
22
ALM issues differ from those of a bank
 Insurance: Pack of options against lower than market guaranteed rates
•
Bank: Duration gap
 Insurance: Naturally exposed to raise in interest rates
•
Banks: Naturally exposed to decrease in interest rates
 Insurance: A large chunk of risks is on the liability side
•
Banks: Most risks are on the asset side
 Insurance: Yields are defined afterwards (subordinated model)
•
© JB Caen, 2006 & +
Banks: Yields are usually defined beforehand
23
The level of solvency capital will depend upon
the quality of the risk assessment
 Basically, the more precise and robust the risk models are, the less
regulatory capital will be required
 By default, one standard formula
•
Applicable to all companies, simple, based upon existing data
•
Solvency capital = R1 * K1 + R2 * K2 + R3 * K3…
 Ri are risk factors
 Ki are risk weightings
 Then replaced, globally or step by step, by an internal model
•
© JB Caen, 2006 & +
Assessing 1 year VaR 99,5%
24
Treatment of asset risks and ALM in the standard formula
Three steps
 1. Assess a solvency capital (SCR) for individual categories of risks
•
Price risk of equity: depending upon the volatility of their market value
•
Price risk of bonds: depending upon the potential changes of the issuers solvency
•
Interest rate risk, depending upon the spread in duration between assets and liabilities
 2. Correct individual SCRs depending on the potential risk absorption by
policy-holders surplus
•
These are the « K » factors
 3. Aggregation of risks is additive
•
A prudential approach that does ignore all benefits of diversification
© JB Caen, 2006 & +
25
Internal models
 The standard formula should remain more capital intensive than internal models
 Whatever the parametric solution retained for the standard formula (which aim
is to remain simple), it will hardly grasp the inherent complexity of Insurance
Companies assets – liabilities relationship.
•
On the asset side: Derivatives, structured products,…
•
On the liability side: Minimum interest rate guarantee, outflow and transfer options (many of
which are influenced by policy holders changes in behavior),…
 Options…options…options
•
Understanding and modelling the options is a tough challenge … but unavoidable.

Under IFRS, all derivatives – including embedded derivatives – must be accounted for at their
fair- / market-value
 Almost all Companies now have an ALM model that can be enhanced
•
To include options, derivatives and structured instruments
•
To power energy intensive Monte-Carlo type simulations
•
To make it easier and safer to use, with an audit trail,…
© JB Caen, 2006 & +
26
Implications include renovating pricing policy
 Internal models will be required to relax the regulatory constraint on capital

And also to assess internal economic capital, coherent with ratings target

And to make adequate valuation of complex assets and liabilities, such as those requested
for disclosure under IFRS (and these valuations must pass the auditors tests…)
 Internal models will reveal unexpected risk hot spots
•
Capital cost of guarantees
•
« Out of the Money » options that become black holes at 99,5% interval of confidence
 This will lead to reviewing pricing policies
•
To adequately price guarantees and options
 And upgrading the usage of risk mitigation techniques
•
Reinsurance
•
Securitization
© JB Caen, 2006 & +
27
Proper articulation of the parallel referentials
with which the Company lives is key
ACCOUNTING
REGULATORY
ECONOMIC
Solvency
Capital
Economic Capital
Used
(risk measure)
Required
(by regulators, rating
agencies, planned
investments)
Accounting Equity
Minimum and
Solvency Capital
Requirements
Allocated Capital
Available Solvency
Capital
Available Financial
Resources (AFR)
Available
(maximum loss
coverage)
© JB Caen, 2006 & +
28
Conclusion: Irrigating the organisation with an Economic
Capital framework will be a competitive advantage
Risk
Management
Accounting
Back Office
Economic Capital
and
SOLVENCY 2
Business
Units
Financial Planning
and Control
Front Office
Thank you for your attention
© JB Caen, 2006 & +
29