Economic Capital

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INTEGRATED MANAGEMENT OF RISK AND CAPITAL
Internal Capital Modeling as a Decision-Making Platform
FROM REGULATORY TO RATING -AGENCY TO ECONOMIC CAPITAL
Regulators and Rating Agencies Agree on Importance of ERM
• ORSA as an internal tool:
• Requires (re)insurance enterprises to adequately assess their own short- and
long-term risks
• “Own funds” necessary to cover the identified risks and uncertainties
•Methodology used to determine solvency needs
• ORSA as a tool for the supervisory authorities:
• Enables the regulators to evaluate the insurer’s risk profile, risk management
practices, and approach to capital management
• Internal capital models to complement standard SCR
Risk Mgmt / ERM Review (Rating Agencies)
• Higher-rated insurers are expected to have better risk mgmt and stronger capital
• ERM is the link between risk-taking and capital
• (S&P) Internal capital modeling to supplement RBC
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INTEGRATED MANAGEMENT OF RISKS AND CAPITAL
ORSA (Solvency II, NAIC SMI) and SCR:
S&P has been reasonably successful in “rating” insurers’ ERM:
• Risk governance and culture, including the Board’s oversight, ERM
organization and committees, risk tolerances/appetite/limits, risk
coordination and communication (reporting and dashboards), and
risk objectives in incentive compensation.
• Risk controls: insurance risks (underwriting, pricing, reserving, risk
transfer), investment risks, asset-liability management, liquidity
management, counterparty/credit and operational risks.
• Risk aggregation, concentrations and contagions.
• Risk analytics/modeling.
• Emerging-risk management.
• Strategic risk management (SRM): The insurer‘s framework for value
creation through controlled risk-taking; balancing short- and longterm objectives; integrated management of risk and capital; capital
allocation under the economic, rating-agency and regulatory
constraints.
S&P EXPERIENCE: CONDUCTING ERM REVIEWS SINCE 2006
Can an External Observer Evaluate the Strength of ERM?
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Analytics in (Re)Insurance Decision-Making
Quantification and
Aggregation
Desired Risk Profile
Risk-Vs.-Reward
INTEGRATED MANAGEMENT OF RISKS AND CAPITAL
Risk Limits
(& other controls)
Risk Tolerance(s)
Beginning
Balance
Sheet
Economic Scenario
Generator
GDP, Inflation, Yield Curve,
Equity Prices…
Assets
Coupons, Dividends,
Sales, Reinvestments
& Valuation
Insurance Risk
Scenario Generator
Exposures, Premiums,
Expenses, Losses (incl. Cat),
Adverse Reserve Development
Operational and Strategic Risks
Cash Flows
Income
Statement
Ending
Balance
Sheet
TVaR1% VaR0.5%
Liabilities
Payments,
Outstanding,
& Valuation
ECM: INTEGRATED STOCHASTIC RISK-VS.-CAPITAL MODELING
DFA as a Platform for Economic Capital Analyses
Insurance risks (underwriting/pricing and reserving risks) are typically modelled
within homogeneous groupings (e.g. new Homeowner’s business written in
Florida, or Excess Workers’ Compensation loss reserves, etc.), usually as
aggregate-loss or severity/frequency loss probability distributions.
•Important issues to consider:
• Parameter uncertainty (model risk), especially for low frequency / high severity
risks (such as catastrophes, liability/“tort” shocks, etc.)
• Complex dependency structure for insurance risks
•The projected valuations of the reserves are affected by economic scenarios:
•Claim-cost inflation is correlated with general inflation
•Discounting under the path-specific (future) yield curve
•Reserving risk reflects regulatory regime; e.g. Solvency II’s market-value (risk) margins
•Underwriting cycle and systemic events (e.g. tort reform) may result in (positive)
correlation across insurance risks
UNDERWRITING/PRICING AND RESERVING RISKS
ECONOMIC CAPITAL MODELING (DFA)
Simulating Insurance-Specific Scenarios
•A simplified approach: rank-order correlation or copulas
•Difficult to parameterize
•May miss the interdependencies with asset risks
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In evaluating the health of the future balance sheet, DFA “marks to model”
all assets and liabilities relative to the future macro-economic environment
simulated by an ESG (particularly, under the yield curve in each simulated
scenario). This common environment naturally “correlates” the projected
economic valuations of the assets and liabilities. This is particularly
important for longer-tailed (e.g. Liability) businesses, as both their assets
and liabilities tend to be especially sensitive to these macro-economic
variables.
• P&C (non-Life) actuaries tend to pay less attention to market and asset
risks
• Important issues to consider:
• Parameterization, testing and validation;
ESG IN ECM’S DEPENDENCY STRUCTURE
ECONOMIC CAPITAL MODELING (DFA)
Economic Scenario Generator (ESG)
• Alignment of projected macroeconomic scenarios with the management’s
own views (the “use test”);
• ESG-based portfolio analytics and investment decision-making;
• “Holy Grail”: Stochastic multi-line, multi-year underwriting-cycle and claimcost inflation model.
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Internal Capital Models (DFA)
Integrated, fully stochastic model.
All plausible risks can be explicitly
incorporated to determine the
targeted amount of capital that would
assure ongoing solvency.
Explicit modeling of key risk interdependencies; coupled with
correlations or copulas. Extreme
events and systemic dislocations
reduce the benefit of diversification.
Capital Adequacy: The amount of
current assets sufficient (relative to
the desired rating) to assure ongoing
solvency over a one-year period under
the aggregate impact of all
stochastically generated scenarios.
vs.
S&P Capital Model
Factor-based approach; factors are
stochastically calibrated.
Target capital – as affected by market,
credit, operational, underwriting and
catastrophic risk.
Credit for diversification recognized for
correlations in the tail, but at a lower
value than observed in the industry
(e.g. 50% haircut).
Capital Adequacy: Present value of the
expected economic losses in surplus
measured over the expected duration
of the assets and liabilities and
observed over a one-year period for
the stress scenario corresponding to
the desired rating.
INTERNAL CAPITAL MODELS ARE BETTER SUITED TO SUPPORT SRM
Internal Models Vs. Regulatory and Rating-Agency Models
ECM AND STRATEGIC DECISION-MAKING
EC = (minimum) capital sufficient – to a pre-defined security
standard – to meet the insurer’s obligations even under
extremely adverse outcomes associated with various risks of an
enterprise. (a.k.a. “Risk Capital”)
• EC is a capital-at-risk indicator and a capital-adequacy
constraint
DEMYSTIFYING THE EC
ECONOMIC CAPITAL MODELING (DFA)
How Is EC Calculated?
• Means different things to different people (e.g. in-force only, or with
one year of new business)
• Highly sensitive to the selected metric (e.g. one-year VaR99.5%; other
metrics are also popular, e.g. TVaR98%)
• Highly prone to model risk (since it is based on modeling
rare/extreme events)
• It is usually based on a one-year solvency target, and thus only
partially reflects long-term creation of value (e.g. from strategic
decisions)
• Tends to disregard mgmt actions, such as capital mgmt, changing
reinsurance strategy, changing investment allocations, etc.
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• Highly sensitive to the selected metric (e.g. one-year VaR99.5%; other
metrics are also popular, e.g. TVaR98%)
• Highly prone to model risk (since it is based on modeling
rare/extreme events)
• Means different things to different people
DEMYSTIFYING THE EC
EC = (minimum) capital sufficient to offset future businessenvironment adversities, and assure the payment of .
• EC is a capital-at-risk indicator and a capital-adequacy
constraint
ECONOMIC CAPITAL MODELING (DFA)
Economic Capital (EC)
• It is usually based on a one-year solvency target, and thus only
partially reflects long-term creation of value (e.g. from strategic
decisions)
• Tends to disregard mgmt actions, such as capital mgmt, changing
reinsurance strategy, changing investment allocations, etc.
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• Even as a constraint, VaR-based EC is insufficient. Additional
constraints may be needed to help contain the loss given
insolvency (the risk to policyholders)
DEMYSTIFYING THE EC
Frequently, practitioners refer to “optimizing economic
capital”.
• EC is not an objective function (target to achieve, or to
optimize). It’s just a capital-at-risk indicator and a capitaladequacy constraint!
ECONOMIC CAPITAL MODELING (DFA)
EC in Decision-Making (cont.)
• E.g. in addition to imposing a constraint on the probability of
insolvency, a model may also seek to constrain the average loss given
insolvency
• Other metrics are needed to reflect the creation of value within an
insurance enterprise
• RoE
• Multi-year book-value growth
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(here FX is the cumulative probability distribution)
• Co-x-TVaR is indicative of the product’s contribution to the tail risk to
capital
•(It is unclear how to chose a )
•Many insurers continue to use VaR-based EC as the basis for capital
allocation, which raises many concerns:
• VaR is not a coherent risk measure
• VaR tends to focus too far in the tail
DECISION-MAKING APPLICATIONS OF DFA
Capital allocation is a widely used and powerful application of DFA.
•TVaR is a popular tail-risk measure used to allocate capital to
individual business segments (i), since:
ECONOMIC CAPITAL MODELING (DFA)
Capital Allocation
•Very sensitive to model risk (especially parameter-estimation risk)
•Smaller contributors to overall risk would tend to not register on the VaR
“radar”
•VaR cannot adequately address the value created by risk transfer
(reinsurance)
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• Value protection: allocation of risk capital to the product (or
individual insurance contract) reflects the product’s
(contract’s) potential claim on risk capital
• Value creation: the minimum (“permissible”) price should be
such that the expected cash flows (incl. the cash “trapped” by
allocated risk capital) generate an IRR consistent with the
return-on-capital target.
• E.g. if RoE is the target, then the cash flows should factor in the
attributed interest expense, taxes, etc
• On the other hand, interest expenses and taxes should be
ignored if the pre-tax return-on-available-capital is the target
DECISION-MAKING APPLICATIONS OF DFA
ECONOMIC CAPITAL MODELING (DFA)
Capital Allocation as a Pricing Tool
• While all capital-allocation methodologies try to reflect a
product’s contribution to the potential depletion of capital,
they may produce dramatically different results, and thus
cause divergent views on the product’s profitability
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Integrated Mgmt of Risk &
Capital
Regulatory, RatingAgency and Economic
Capital
Capital Mgmt
- Amount
- Structure
- Share Buybacks
- Excess Capital Position
Capital Attribution
and Risk-Adjusted
Profitability
Risk vs. Reward in
Decision-Making
Strategic Opportunities
RAC, RoRAC, RARoC
Risk-based (adjusted)
profitability targets
Enter/Exit LOB
Improved Risk
Selection
M&A
- Predictive Modeling
Risk-Adjusted Price
- Data Mining
Portfolio Optimization
- Right-sizing LOBs/segments
- Cat. portfolio optimization
- Risk-transfer optimization
- Asset portfolio optimization
Balancing Objectives
- Short-Term vs. Long-Term
- Growth vs. Stability
- Shareholders vs. Policyholders
INTERNAL MODELS: TACTICAL OR STRATEGIC?
Other
Tactical and Strategic Applications
Strategic Risk Management
“STAIRWAY TO HEAVEN”
Risk Measurement and Analytics Play Pivotal Role in ERM Evolution
Risk Models:
Value
Creation
Through ERM
Economic Capital, DFA, ESG,
Stochastic Reserving, etc.
High
Integration
into DecisionMaking
Medium
Integrated
Management
of Risk &
Capital
Quantification
KRI
Loss Control
&
Mitigation
Low
Compliance
Risk control; protection of balance sheet
and earnings
Industry standard in
the last 5-10 years
Risk/reward optimization
Today
Industry standard in
the next 5-10 years
EVOLUTION OF ENTERPRISE RISK MANAGEMENT
Strategic
Role
• U.S. RE Analytics is a consulting arm of U.S. RE. Using the most sophisticated, ever
evolving risk analysis tools, we identify, quantify and combine all factors
consequential to the financial strength of our insurance clients.
SPEAKER
About U.S. RE Analytics
• ERM Consulting
• Regulatory requirements and rating-agency expectations
• Integrated management of risk and capital / Economic Capital Modeling
• www.usre-analytics.com
• Our staff of analysts, actuaries and senior executives with real world experience in
management can help you chart a course to protect and grow your business.
• About the speaker: Vlad Uhmylenko is an expert in risk management, financial
and actuarial modeling, mathematics, and Decision Theory. He is Managing
Director at U.S.RE Analytics where he leads Enterprise Risk Management,
Economic Capital Modeling, and broker-support consulting. Before joining U.S. RE
Analytics, he was Director-Enterprise Risk Management at Standard & Poor’s
where he led ERM analytics on Property-Liability (P&C) insurance and reinsurance
companies. Earlier, he spent 12 years at Aon in various risk management
consulting roles. He holds advanced degrees in Mathematics and Finance, and his
main area of analytical expertise is Decision-Making under Uncertainty, which
includes Capital Modeling, Dynamic Financial Analysis, and Program Optimization.
•[email protected]
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