Casualty Actuaries in Europe
Spring 2013 Meeting
Internal Model Uses
Laurence Dunkling
31st May 2012
Why build an Internal Model?
If building an Internal model is so expensive, what use is it going to be?
Article 118
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.
UK FSA Internal model approval process thematic review findings (February 2011)
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.
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.
Internal Data
FP&A Initial
Business Plan
Internal Model
External Models
Natural Catastrophe
Model
Economic Scenario
Generator
Credit Simulations
Historic Data
Technical
Provisions
Reinsurance
contract info
Financial
information
Exposure data
Credit risk data
Reinsurance
Credit risk data
Model Output
and Results
including
SCR and MCR
reporting
Calculation Kernel
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 – 29th January letter
Capital Management
• Mergers and acquisitions
• Legal entity restructuring
• Maintaining credit ratings
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 Measure vs Return Measure
3,064,000
3,062,000
3,060,000
Risk Measure (Capital)
3,058,000
3,056,000
3,054,000
3,052,000
3,050,000
3,048,000
3,046,000
3,044,000
43,000
44,000
45,000
46,000
47,000
48,000
Return Measure (Profit)
49,000
50,000
51,000
Risk Adjusted Return
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 Adjusted Return =
= Underwriting Profit/Loss
Net Income
–
+ Net Investment Income – Tax
Cost of Capital
-
(Cost of Capital Rate x Capital)
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:
AIG Europe – Proposed Risk Appetite Framework
AIG PC – Risk Appetite
Statement
1) Board Level – Risk
Appetite
OPERATIONAL
RISK
2) RCC Level – Risk
Specific Tolerances and
Limits (1:200)
1) Reins Prog Failure
2) Breach of U/W
Authorities
3) Failure of IT
Systems
CREDIT
RISK
Credit Risk
Aggregations
Top 3 Op Risk
Scenarios
MARKET
RISK
MM Cat
Risk
Terrorism
Concentration
Zones
NAT Cat
Risk
5 Most Material
Perils
Reserve
Top 5 Volatile
Risk
Reserve Risk LoB’s
Top 5 Volatile
Premium Risk
LoB’s
Prem
Risk
INSURANCE
RISK
Ratings
Target
IR Risk
FX Risk
Equity Risk
Spread Risk etc
Adverse
Stress
Scenario
Entity Level
Aggregate
Risk
(1:7 & 1:200)
3) RCC Level –
Risk Metrics
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
Target Risk
Profile
AIG Europe Ltd Risk Appetite Framework –
RCC Risk-specific Tolerances/Limits (£,000)
Risk
Limit
Risk Tolerance
Current
+10%
+20%
0 to +9.9%
+10% to +19.9%
Greater than 20%
Entity Risk Profile
Aggregate Risk
Risk
Tolerance
Level 1 Risk Appetite (Entity
Level Risk Tolerances and
Limits)
Risk
Limit
1:7
1:200
AIG Europe – Proposed Risk Appetite Framework
AIG PC – Risk Appetite
Statement
1) Board Level – Risk
Appetite
Risk Profile
PREMIUM RISK
Standalone
1:200
Risk
Tolerance
Risk
Limit
-731,963
Risk Profile
RESERVE RISK
Standalone
1:200
Risk Profile
MAN MADE CAT RISK
Standalone
1:200
Risk
Tolerance
Risk
Limit
Risk
Tolerance
1:200
1) Reins Prog Failure
2) Breach of U/W
Authorities
3) Failure of IT
Systems
2) RCC Level – Risk
Specific Tolerances and
Limits (1:200)
Risk
Limit
-1,077,833
Risk Profile
NAT CAT RISK
Standalone
Ratings
Target
CREDIT
RISK
INSURANCE
RISK
Entity Level
Aggregate
Risk
(1:7 & 1:200)
OPERATIONAL
RISK
Adverse
Stress
Scenario
Top 3 Op Risk
Scenarios
Risk
Limit
MARKET
RISK
1:200
Risk
Tolerance
Credit Risk
Aggregations
Risk Profile
Operational Risk
Standalone
MM Cat
Risk
Risk
Limit
Top 5 Volatile
Premium Risk
LoB’s
1:200
Risk
Tolerance
IR Risk
FX Risk
Equity Risk
Spread Risk etc
Risk Profile
Credit Risk
Standalone
Terrorism
Concentration
Zones
1:200
1:200
Risk
Limit
Prem
Risk
Risk
Tolerance
NAT Cat
Risk
Risk Profile
Market Risk
Standalone
Risk
Limit
5 Most Material
Perils
Risk
Tolerance
Reserve
Top 5 Volatile
Risk
Reserve Risk LoB’s
Risk Profile
Insurance Risk
Standalone
Risk
Tolerance
Risk
Limit
Level 2 Risk Appetite (Risk
Specific Tolerances and
Limits)
3) RCC Level –
Risk Metrics
Business Planning
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
BECR  100 %  ExpCat  InvInc  CoCapital
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 scenarios
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.
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 Premium
Expected Recoveries
Expected Loss
100
70
30
Reduction in entity 1 in 200 year losses
Cost of Capital Rate
Cost of capital saving
500
10%
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?
2000
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 provides
more capital benefit in
the 1st year as the
number and severity of
claims are unknown.
600
Once the first year is passed,
reinsurance will provide
protection on adverse reserve
deterioration.
600
1400
120
400
300
80
480
2013
2014
200
60
320
240
40
160
2015
2017
Net retention 2016
Cession to reinsurance
100
20
50
80
10
40
2018
Gross
2019
2020
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
Hedge USD Exposure
Base Portfolio
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.