June Economic Capital for Life Insurers - Robert Chen

Transcription

1 Economic Capital for Life Insurers Robert Chen FIA FIAA June Economic Capital for Life Insurers - Robert Chen

2 Contents What is economic capital Economic capital management Pitfalls in building an economic capital model Concluding remarks 2 Economic Capital for Life Insurers - Robert Chen

3 What is economic capital Firm Name/Legal Entity Economic Capital for Life Insurers - Robert Chen

4 What is economic capital Sufficient surplus to cover potential losses, at a given risk tolerance level, over a specified time horizon. SoA Practice Guide on Economic Capital 4 Economic Capital for Life Insurers - Robert Chen

5 What is economic capital Sufficient surplus to cover potential losses, at a given risk tolerance level, over a specified time horizon. SoA Practice Guide on Economic Capital How long has this idea been around? Centuries Actuaries have always calculated reserves Reserves => solvency Implies sufficient surplus for covering potential losses 5 Economic Capital for Life Insurers - Robert Chen

6 What is economic capital Sufficient surplus to cover potential losses, at a given risk tolerance level, over a specified time horizon. SoA Practice Guide on Economic Capital So what s new? Traditional reserves doesn t say anything about how certain New economic capital allows you to say: the level of reserves will ensure that the company will remain solvent for 5 years with 99% probability 6 Economic Capital for Life Insurers - Robert Chen

7 What is economic capital Why do we want to know about probabilities? Internally Key management information Shareholders have known the expected return But they also want to know the level of risk Shareholders want to manage the risk / return trade-off Externally Key measure of financial strength Rating agencies Benchmark company s probability of insolvency with corporate bond ratings Regulators Increasingly using probability of insolvency to set regulatory capital requirement (ICA in UK) Economic Capital Assessment is a vital component of integrated risk managemet 7 Economic Capital for Life Insurers - Robert Chen

8 What is economic capital Evolution of life office economic capital Net premium reserving Traditional deterministic discounted cash flow method Conservative assumptions No specific allowance for risks other than investment and mortality Factor based RBC Specify drivers for various risks Apply factors to the drivers to determine allowance for each risk Often used by regulators Holistic economic capital calculation Model includes policyholder behaviour and management strategy Stochastic simulation to determine required capital Increasingly used by life companies for internal capital management 8 Economic Capital for Life Insurers - Robert Chen

9 What is economic capital 2 Components of Capital Assets Liabilities Required by stakeholders 1. Passive Capital Regulators Customers Rating agencies Lenders Financial intermediaries Passive Capital Capital External constraint Breach of passive capital => unable to transact business on normal terms 9 Economic Capital for Life Insurers - Robert Chen

10 What is economic capital 2 Components of Capital Liabilities Provision against 2. Active Capital Assets Passive Capital Active Capital Capital Market risks Claims risks New business strain Future growth in passive capital Internal requirement Level based on risk / return preference of shareholders 10 Economic Capital for Life Insurers - Robert Chen

11 Economic capital management Firm Name/Legal Entity Economic Capital for Life Insurers - Robert Chen

12 Economic capital management Liabilities External Constraints Assets Risk / Return preference Company Strategy Passive Capital Active Capital Capital Capital Requirement 12 Economic Capital for Life Insurers - Robert Chen

13 Economic capital management Understand status quo Set risk limits Optimise capital Monitor, adjust, analyse Understand status quo How are we looking? A diagnosis What would happen if we kept doing what we do now? Look at risk measures based on the company as it stands Asset portfolio Liability portfolio Portfolio & demographic experience Economic outlook (may be stochastic) Management strategy Clarifying management strategy may be the most difficult (and useful) step 13 Economic Capital for Life Insurers - Robert Chen

14 Economic capital management Understand status quo Set risk limits Where are we willing to go? Establish boundaries for the solutions Set risk limits Optimise capital Monitor, adjust, analyse External constraints Regulator Rating agencies Other insurer s practices Policyholders values Internal constraints Availability of capital Infrastructure Management capability 14 Economic Capital for Life Insurers - Robert Chen

15 Economic capital management Understand status quo Set risk limits Some crucial questions Set risk limits What time horizon do we use? How do we measure risk? What level of risk can we tolerate? Answers need to come from the board level Optimise capital Monitor, adjust, analyse Time horizon Amount of time it takes for the company to un-wind its position Asset Liability Management Depends on size and flexibility of company 15 Economic Capital for Life Insurers - Robert Chen

16 Economic capital management Understand status quo Set risk limits Optimise capital Monitor, adjust, analyse Set risk limits Answers need to come from the board level How to measure the risk Quantitative Hard measures, e.g. probability of ruin, VaR, RAROC Qualitative Soft measures, e.g. competitor actions Need to be A suite of measures that cover key drivers of the business Aligned with shareholder s view of risk Easily determined, understood, and communicated What level of risk can we tolerate? Consistent with internal / external constraints What is actually achievable? Consistent with management objectives (e.g. AA rating) Result: a clearly articulated risk statement 16 Economic Capital for Life Insurers - Robert Chen

17 Economic capital management Understand status quo Optimise capital Status quo may not fit in the risk limits Set risk limits Optimise capital Monitor, adjust, analyse Need to evaluate alternative strategies to ensure Risk is within tolerance Return is maximised for the level of risk Conduct what-if tests Determine risk drivers Examine effectiveness of alternative strategies Perform cost-benefit analysis of alternative strategies 17 Economic Capital for Life Insurers - Robert Chen

18 Economic capital management Understand status quo Set risk limits Optimise capital Alternative strategies need to be Practical Build on existing strengths Specific to the causes of the suboptimal risks and returns Optimise capital Monitor, adjust, analyse Every company is unique Optimal means different things to different companies Solutions are unique to each company Short list of practical strategic alternatives for the Board s consideration 18 Economic Capital for Life Insurers - Robert Chen

19 Economic capital management Understand status quo Monitor, adjust, analyse Chosen strategy needs to be robust Set risk limits Infrastructure to support the management framework Regular monitoring of risk measures Specific responsibility of risk limits (e.g. appointment of CRO) Optimise capital Monitor, adjust, analyse Continual refinement of model and framework Take advantage of new insights, new technology Reflect changes in company s circumstances Reflect changes in capital allocation between companies at the group level Not a one-off exercise: it s a new way of empowered management 19 Economic Capital for Life Insurers - Robert Chen

20 Pitfalls in building an economic capital model Firm Name/Legal Entity Economic Capital for Life Insurers - Robert Chen

21 Ingredients of an economic capital model Asset data Liability data Expense Scenarios Credit Scenarios Economic Scenarios Forex Scenarios Demographic Scenarios Other Scenarios Asset Model Liability Model Management Strategy Company Model Policyholder Behaviour Market risk measures Credit risk measures Insurance risk measures Operational risk measures Group risk measures Liquidity risk measures 21 Economic Capital for Life Insurers - Robert Chen

22 Pitfalls in building a model Too complicated too quickly A model has three roles Uncover questions Answer questions Understand risk drivers Model does not need to be complicated to uncover questions Recommended approach Build a simple model Look at results Understand results, uncover the big issues Refine modelling to Analyse the issues in more depth test effectiveness of solutions Model building is a journey of discovery Too much haste is a lost opportunity 22 Economic Capital for Life Insurers - Robert Chen

23 Pitfalls in building a model Losing the big picture Economic capital management is macro management on a company level Decisions are made on a company level, not a policy level Adopt a model structure that directs attention away from detail Invaluable to ensure modellers and managers see the company in the same way Pursuit of a perfect model leads to unnecessarily complicated model More difficult to maintain More difficult to modify to test alternative solutions Takes much longer to develop Slower to run (speed is very important for stochastic runs) Much less than perfect Requires practical experience and understanding of business to differentiate between Key features Unnecessary detail 23 Economic Capital for Life Insurers - Robert Chen

24 Pitfalls in building a model Inappropriate assumptions Traditional actuarial investigations Deterministic assumptions Modern actuarial investigations Stochastic assumptions Functional relationship between assumptions Investment return assumptions Key component of model Lack of arbitrage-free and market consistency can affect choice of strategy Demographic assumptions (e.g. lapse assumption) Evidence of economic driven dynamic lapsation of products carrying interest rate guarantees Scarce data to determine the relationship between interest rates and lapse rates Overseas experience can be used as reference 24 Economic Capital for Life Insurers - Robert Chen

25 Pitfalls in building a model Over-reliance on the model Model is built by human May well contain errors Always perform reasonableness tests on results Companies normally wish to test many strategies Not likely to need to test every strategy through the model Results of many strategies are predictable Likely to be able to filter many strategies based on general reasoning Not base business decisions purely on quantitative measures Qualitative measures (e.g. competitor s reaction) is also important They may affect specification of management / behavioural models They need to be investigated before quantitative measures are calculated 25 Economic Capital for Life Insurers - Robert Chen

26 To conclude Firm Name/Legal Entity Economic Capital for Life Insurers - Robert Chen

27 What is economic capital Sufficient surplus to cover potential losses, at a given risk tolerance level, over a specified time horizon. SoA Practice Guide on Economic Capital Level of economic capital is conditional: Risk tolerance level Time horizon Aggressiveness of strategy 27 Economic Capital for Life Insurers - Robert Chen

28 Successful economic capital management Successful economic capital management depends crucially on A realistic risk tolerance level Risk measures tailored to the business Clearly articulated risk management policy Suitable quantitative model Combination of technical and business knowledge Organisational infrastructure to promote risk management Well-informed senior management capable of using the new tools Buy in from management / head office Buy in from operation units / business units 28 Economic Capital for Life Insurers - Robert Chen

29 Thank you and Enjoy the Journey Robert Chen A soft copy of this presentation will be available at 29 Economic Capital for Life Insurers - Robert Chen

30 Member of 30 Firm Name/Legal Economic Capital Entity for and Life Legal Insurers Copy - Robert Chen 2005 Deloitte Actuarial 2003 and Deloitte Insurance Firm Touche Name/Legal Solutions Tohmatsu Entity (HK) Ltd.