LRM Sample Detailed Study Manual

Transcription

1 LRM Sample Detailed Study Manual You have downloaded a sample of our ILALRM detailed study manual. The full version covers the entire syllabus and is included with the online seminar. Each portion of the detailed study manual is available in PDF with a clickable table of contents. Each reading (and sub-chapters if applicable) are also bookmarked in the PDF for ease of navigation in your favorite desktop, tablet, or smartphone PDF viewer. If you have additional questions about the detailed study manual or any aspect of the exam, please me. Zak Fischer, FSA, CERA, MAAA zak@theinfiniteactuary.com

2 LRM Detailed Study Guide Sample LRM-120: LIPF Section 14.4 Asset/Liability Matching The Innite Actuary, LLC 1

3 Kailan Shang and Zhen Chen (March 2012) Overview of This Reading This paper explains the role of a risk appetite framework in eective risk management and how the risk appetite framework can be used to make more informed strategic decisions It also explores how an insurer s risk appetite should be embedded in areas of strategic planning including: Asset allocation New business budgeting Capital allocation Liquidity management Performance measurement The concepts in this paper are at a level above certain core quantitative concepts on the LRM syllabus like duration analysis. The perspective in this paper is at more of a 10,000 foot view of the company. Some of the concepts liken ALM and duration analysis will be more meaningful after you complete the syllabus and learn more about those items in other readings. Key topics for the exam include: Dening risk appetite Focuses of a risk appetite framework Three levels in a risk appetite framework Quantitative vs. Qualitative measures Understanding and analyzing the Risk/Return Prole Chart Validating your model with backtesting Steps to set up a risk appetite framework Constraints a global company faces Describing risk categories in terms of risk appetite and risk limit Approaches to quantify the diversication benet Strategic Asset Allocation (SAA) vs. Tactical Asset Allocation (TAA) Return objectives vs. Risk considerations Describing the Capital Market Line (CML) and its disadvantages and alternatives RAROC vs. MCEV Ways to allocate capital Components of required liquidity 2018 The Innite Actuary, LLC 2

4 Three types of performance measurements Two approaches to calculate MCEV Calculating MCEV for the three dierent business functions Decomposing MCEV Executive Summary Questions to ask before making decisions: What s the company s competence in the market? Are the decision makers familiar with the risks involved? This includes the tail risks and understanding their potential impact Is the company capable of surviving extreme events? Risk appetite: Articulates the level of risk a company is prepared to accept to achieve its strategic objectives Represents the willingness and ability to take risks Requires eort to understand the constraints and the ability to assume risk A gradual process to be updated from time to time if: you enter new markets enter new business have a new understanding of risk assumed Risk appetite frameworks: Helps management understand a company s risk prole Find an optimal balance between risk and return Nurtures a healthy risk culture in the organization Explains the risk tolerance of the company both qualitatively and quantitatively Qualitative measures: Species major business strategies and business goals that set up the direction of the business and outline favorable risks Quantitative measures: Provides concrete levels of risk tolerance and risk limits Critical to implement eective risk management 2018 The Innite Actuary, LLC 3

5 Risk Appetite, Risk Tolerance and Risk Limit Setting 3 Definitions of Risk Appetite 1. The total risk exposure an organization will undertake to achieve its objectives 2. Total impact of risk an organization is prepared to accept in the pursuit of its strategic objectives 3. Maximum amount of risk a company is willing to accept in pursuit of its mission/objectives/plans Focuses of a Risk Appetite Framework 1. Protect and create value for the business Describes risk within quantitative measures Facilitates the analysis of the risk/return trade-o Helps senior management make informed decisions to maximize the risk-adjusted return for the shareholder 2. Ensures the consistency between risk appetite and risk limits Rating agencies and investors care about if the risk appetite is aligned wit the risk limits being set for business operations 3. Integrates into business strategy and corporate culture Acts as a guideline for risk-taking activities Facilitates risk identication and monitoring Rating Agency s View Rating agencies focus on assessing risk management practices when evaluating credit ratings Standard & Poor s view Risk appetite is an essential component for an enterprise risk management score of strong or above Expect insurers with strong ERM frameworks to have a well-dened risk appetite framework that: Supports the eective selection of risks Establishes the risks that the insurer wishes to acquire, avoid, retain, and/or remove Findings of the 2010 S&P report The nancial crisis exposed a number of weaknesses in insurers risk appetite framework Risks have been sought after that insurers may not fully understand 2018 The Innite Actuary, LLC 4

6 Insurers couldn t manage within their specied risk tolerances Risk limits were set but the limits didn t adequately reect their risk appetite or were poorly understood Important to integrate risk appetite into a company s strategy and culture To get a favorable ERM rating/credit rating, have a clean and formal linkage between risk appetite and strategic planning Risk Appetite in Solvency II Framework Solvency II framework emphasis on a risk-management system It should be eective and well integrated into the organizational structure and in the decision making processes Applies to both insurance and reinsurance People who run this system should be properly considered Good risk management practices links with meeting capital requirements Have capital requirements to survive a 1-in-200-year event Ruin occurs no more often than once in every 200 cases With a probability of at least 99.5% With the ability to meet their obligations to policyholders and beneciaries over the following 12 months CEIOPS view on an eective risk management system includes: A clearly dened and well documented risk management strategy includes: All objectives CEIOPS Committee of European Insurance and Occupational Pensions Supervisors Key principles Risk appetite Assignment of responsibilities across all activities of the undertaking Risk management strategy should be consistent with the overall business strategy Adequate written policies including: A denition and categorization of the risks faced by type Levels of acceptable risk limits for each risk type Implementing the risk strategy 2018 The Innite Actuary, LLC 5

7 Facilitating control mechanisms Taking into account the nature, scope, and time horizon of the business Current Practices of Insurance Companies Towers Perrin survey (2009) 84% expected to have a risk appetite statement document within 12 months 40% demonstrated consistency between risk appetite and risk limits Deloitte s fth Global Risk Management Survey (2007) 130 nancial institutions 16% did not have a statement of the rm s risk appetite Others had one approved Others had an informal statement not approved by the Board of Directors 42% of executives said their ERM program were well integrated with strategic planning Key ndings of survey using 2010 Annual Reports 22 insurance companies including 5 reinsurers Purpose was to explore risk appetite and its integration with strategic planning 68% clearly mentioned risk appetite framework as part of the risk management sections Capital adequacy was an important goal for those who didn t mention risk appetite in their annual report Both capital adequacy and earnings volatility were important for the companies that did mention risk appetite in their annual report 14 out of 15 companies that mentioned risk appetite framework said risk appetite played a role in strategic planning/business decisions 3 companies said risk appetite was considered when deciding asset allocation 10 companies said risk appetite was considered to maximize risk-adjusted returns 15 companies said risk appetite was considered in capital allocation All 15 companies that mentioned risk appetite framework said they had a risk limit and risk-monitoring processes was consistent with risk appetite Companies with risk appetite frameworks focus on protecting value and creating value from risk appetite 2018 The Innite Actuary, LLC 6

8 Risk Appetite Framework Traditional measures to manage business New business volume/market share Persistency rate Embedded value of existing and new businesses Appraisal value Operating prot Useful tools to analyze the impact of tail events Stochastic analysis Stress Testing Correlation analysis These tools discover the distribution and range of possible outcomes useful for senior management s strategic planning Risk Appetite Framework Risk appetite framework rst step Dene the organization s willingness and ability to take risk Based on the input from the board and senior executives Look at the company s unique situation to dene its risk appetite Risk appetite as a high-level view of risks Looks at what the insurer is willing to assume to pursue value The priority is to serve shareholders benets when dening the optimal level of risk Before setting risk appetite Have a clear picture of the market and the company s core competency This facilitates the decision on the type and magnitude of risk to be taken It will be consistent with business strategies and market situations Risk prole should satisfy constraints both other parties including: Regulators Rating agencies Policyholders 2018 The Innite Actuary, LLC 7

9 Debt holders Senior Management Employees External changes that have sped up the process of setting risk appetite: S&P requires a clear statement of risk appetite as a foundation for a strong or excellent ERM rating Solvency II requires insurers to explicitly consider their risk appetite Three detailed levels included in the risk appetite framework 1. Enterprise risk tolerance 2. Risk appetite for each risk category 3. Risk limit Enterprise risk tolerance Aggregate amount of risk the company is willing to take on Expressed in terms of: Capital adequacy Earnings volatility Credit rating target Represents the company s long-term target Should be revised only if there are fundamental changes to the company s nancial prole, market situation, and strategic objective Required by regulators, rating agencies, policyholders and debtholders Show little or no interest in the upside of risk taking Shareholders interested in the upside from risk taking and low earnings volatility Risk appetite for each category Allocate enterprise risk tolerance to risk appetite for specic categories and business activities Allocate company resources to areas where the company feels comfortable or has a competitive advantage Use platform, analytical tools, and conclusions to identify the risk-taking activities that have high-adjusted return Risk limit The most granular level used for business operation 2018 The Innite Actuary, LLC 8

10 Translates enterprise risk tolerance and risk appetite for each risk category into riskmonitoring measures Ensure consistency between risk limit and enterprise risk tolerance This helps realize the risk objective and maximizes risk-adjusted return Now we ll look at risk metrics that are used to set risk appetite for a given time horizon Quantitative Measures 1. Capital/equity at risk Used under local statutory/rating agencies/economic basis Maximum acceptable capital at risk would be X% of current available capital with a certain probability Alternative denition: With a proability of Y%, the company can still stand solvent 2. Earnings at risk (EaR) Used under local accounting/us GAAP/IFRS basis Maximum acceptable earning at risk would be X% of expected/target earning with a certain probability Alternative denition: With a probability of Y%, the earnings will be non-negative 3. Embedded value/market consistent embedded value Maximum acceptable decrease in EV/MCEV would be X% of expected/target EV/MCEV with a certain probability The quantitative measures mentioned above use Value at Risk (VaR) Tail Value at Risk (TVaR) (a.k.a. CTE) The average of all possible values above VaR A more conservative measure than VaR More appropriate measure than VaR for a variable with high skewness Qualitative Measures Credit ratings Lowest desired nancial strength rating or debt rating Risk preference Certain risks an insurer doesn t want to take Examples include underwriting business in regions with likely catastrophic events Franchise value 2018 The Innite Actuary, LLC 9

11 How much franchise value can be decreased due to: Publicity Poor reputation Regulatory intervention Enterprise Risk Tolerance Statement Here is an example of an enterprise risk tolerance statement Credit Rating Financial Strength Achieve and maintain an AA nancial strength rating of a global basis (S&P rating) Maintain a buer of more than 50% of one year s net income above the minimum capital requirement for the AA rating. Debt Rating Earnings at risk Achieve and maintain an A rating for senior unsecured debt The probability of negative IFRS/U.S. GAAP earnings for one year is leass than 5% Capital at risk The probability of a 15% loss of IFRS/ U.S. GAAP equity for one year is less than 0.5%. The probability of a capital deciency under the economic framework is 0.05% according to the target nancial strength rating The company has extremely high risk aversion to reputation risk Figure Illustrative Quantitative Risk Appetite Statement Measure Earnings at Risk Condence interval 95% Stressed metric IFRS/GAAP earnings Interpretation Potential negative IFRS earnings during a moderate stress scenario (i.e. 1 in 20 years) Measure Capital at Risk Condence interval 99.5% Stressed metric IFRS/GAAP equity Interpretation Potential 15% available capital reduction of net value during a severe stress scenario (i.e. 1 in 200 years) 2018 The Innite Actuary, LLC 10

12 Measure Condence interval Stressed metric Interpretation Economic Capital 99.5% (based on target nancial strength rating) Available economic capital Potential available economic capital < required capital during an extreme stress scenario (i.e. 1 in 2000 years) Risk Appetite and Business Analysis After dening risk appetite, quantify the risk/return prole and the constraints of the business this helps prevent exceeding the risk tolerance when making strategic decisions From Figure Risk Return Analysis Based on Capital at Risk Key interpretations: The area above the 6% minimum return line and to the left of the 15% vertical risk line is all within the company s risk limits The ideal position is where the utility function touches the ecient frontier This will generate 10% return on capital while taking the risk of a 13% reduction in available capital in a 1-in-200 year event (99.5% condence) Utility function reects company s risk aversion (convex U shape = risk averse) 2018 The Innite Actuary, LLC 11

13 Business units 1 and 3 are on the ecient frontier, so they are preferable to BU2 Might consider allocating capital from BU2 to BU1 or BU3 since BU2 is under-performing the ecient frontier (not earning sucient return for risk taken) Percentiles in Risk Measures Considerations when determining the percentile As the target credit rating ", the percentage used in risk measures " Dierent risk measures may use dierent percentiles TVaR is more conservative than VaR EaR and CaR may be dierent percentages during extreme events caused by systemic risk EaR and CaR may be the same percentages during normal conditions Tail events may change from time to time Return periods may change after big events. A return period of 200 years means year event Percentages may not change, but the severity of tail events need to be updated with new information Companies with dierent types of business usually view key tail events with dierent probabilities The deterministic stress events are critical Backtesting Backtesting Either based on historical experience or hypothesized events Make assumptions while assigning a probability of occurrence to certain events Design strategies to remain solvent when those stress events happen This can be more meaningful than trying to allocate a probability to those events The quantitative risk measures are very sensitive to economic assumptions They are also exposed to model risk A proper process is needed to test the measures against experience If there is no process to test then the measures are likely to be misunderstood, misused, or even manipulated One solution is to backtest the measures against reality at a less severe condence level Use 80% CaR and test against the experience in the past ve years 2018 The Innite Actuary, LLC 12

14 Use 99.5% CaR and test against N x 1-in-10-year event Pros and Cons of Backtesting Pros History repeats; helps us learn from history and adjust our view of the future Cons Backtesting of key assumptions could improve corporate strategic decisions such as: Ecient capital allocation to business lines Timing of exit plans Timing of rate adjustments Forward-looking view evolve quickly Especially true in highly uncertain world with more emerging risks Examples of extreme events aecting companies risk appetite and strategic decision Large earthquakes in Chile, Haiti, New Zealand, and Japan Industry leaders in catastrophic modeling backtested their model and released a new version with updated parameters Variable annuity (VA) market in Japan felt squeeze after 2008 VA market share decreased signicantly due to awareness of downside risks for insurers Sept. 11, 2011 terrorist attacks Global insurers and reinsurers invested more capital in aviation businesses Risk Governance and Risk Appetite Steps to set up a risk appetite framework 1. Bottom-up analysis of the company s risk prole 2. Interviews with the board of directors regarding the level of risk tolerance 3. Alignment of risk appetite with the company s goal and strategy 4. Formalization of the risk appetite statement with approval from the board of directors 5. Establishment of risk policies, risk limit and risk-monitoring processes consistent with risk appetite 6. Design and implementation of the risk-mitigation plan to be consistent with risk appetite 7. Communication with local senior management for their buy in 2018 The Innite Actuary, LLC 13

15 Ultimate goal of all risk management activities: Ensuring the risk-taking activities are consistent with risk appetite A risk limit system provides measures to monitor risk positions and making sure not to exceed the level of risk tolerance Constraints There are going to be constraints when making strategic decisions These should be set as lines that can t be crossed to remain consistent with risk tolerance Constraints a global company may face: Local statutory requirements: capital adequacy Group solvency requirements: capital adequacy Rating agency capital requirements Economic capital suciency IFRS/U.S. GAAP earnings volatility Embedded value earnings volatility Next, we ll look at the interaction between the constraints dened in risk appetite and strategic planning Risk Appetite for Each Risk Category and Risk Limit Market Risk Market risk appetite Reects constraints caused by risk-taking activities in: Interest rate risk Equity risk Foreign exchange risk Alternative investments Volatilities of the nancial market It should be mapped to: Asset allocation limits Foreign exchange (FX) limits 2018 The Innite Actuary, LLC 14

16 Fixed income securities duration limits Asset liability mismatch (ALM) limits Examples of how market risk appetite can be stated The company could not lose more than 10% of IFRS equity in a 1-in-200-year event The company will not participate in any strategy that bets on the direction and magnitude of the foreign exchange rate movement (currency hedging) or change in equity volatility (no buttery or straddle investment strategies) Buttery designed to payo if future volatility, current implied volatility Straddle Allows the holder to prot based on how much the price and the underlying security moves (in either direction) Requires buying/selling option or derivatives Dynamic Modeling is a key and dicult component in deriving a reasonable limit Dynamic management actions include: Investment strategy Policyholder dividend setting Credit interest rate setting Premium setting Dynamic policyholder behaviors include: Dynamic lapse Dynamic premium payment Credit Risk Credit risk consists of downgrade and default risks related to investment and reinsurance activities Example of Credit Risk appetite statement The company could not lose more than 5% of IFRS equity in a 1-in-200-year event The company will not invest in any bonds that have a credit rating below BBB Credit risk appetite is mapped into credit limits such as: Obligor limit Reinsurance counterparty credit rating limit Insurance Risk Insurance (Underwriting) Risk 2018 The Innite Actuary, LLC 15

17 Includes mortality, morbidity, lapse, and expense risks Impacts both the value of new business (VoNB) and the reserve of in-force business Example of Insurance Risk Appetite Statement The company can t lose more than 5% of IFRS equity in a 1-in-200-year event due to the insurance risk s impact on reserves The company can t lose more than 50% of VoNB in a 1-in-200-year event due to the insurance risk s impact on pricing Guidance to translate insurance risk appetite into risk limits: Rely on an existing experience monitoring framework Possible choices include A/E ratio and/or loss ratio Get the A/E ratio limit by stress testing under a 1-in-200-year event Monitor regular experience study results against the limit For expense risk, use a limit in terms of amount to monitor This approach may create practical issues for a company with diversied products Timing and eort for experience monitoring at the product level may be too much It can be challenging to set assumptions and a risk limit for new products or new product features May be more valuable as a tool to identify risk and adverse trends vs. setting a limit Here is an example of a risk limit and risk-monitoring report for insurance risk (from Figure ) Risk Metric for Insurance Risk Risk Limit Current Position A&H Loss ratio deviation from pricing +5% +7% A/E mortality rate for life 115% 108% A/E mortality rate for annuity 90% 94% A/E Lapse rate for non-lapse supportive 130% 135% A/E Lapse rate for lapse supportive 90% 95% Expense overrun $2.5 million $2.36 million *** A&H Loss Ratio and lapse rate exceed risk limit and need mitigation plan *** Catastrophe Risk Causes of higher catastrophic risk: Climate change Pandemics Growing number of natural disasters 2018 The Innite Actuary, LLC 16

18 Exposure to this risk can deplete a company s available liquidity quickly Company runs the risk of bankruptcy with sucient liquidity Example of appetite for catastrophe risk The company cannot lose more than 20% of IFRS equity in a 1-in-200-year event The company cannot lose more than 20% of IFRS equity if the 1918 Spanish u pandemic happens again Guidance to align catastrophic risk limit to risk appetite Use Net Amount at Risk (NAaR) Liquidity Risk It is the sum assured minus the reserve The additional amount that has to be paid in excess of what has been reserved Monitor real-time NAaR against the limit to prevent excessive risk exposure Issues insurers face during a catastrophic event High liquidity requirements Mass policy lapses due to disintermediation risk Credit rating downgrade Examples of liquidity risk appetite The company maintains liquidity for a 1-in-200-year event over a time horizon of three months The company maintains liquidity at the condence level of 99.5% while the liquidity cost to meet cash payments at the condence level of 995.% is less than 25% of capital. Further notes of the appetite for liquidity risk: The appetite will constrain investment choices The appetite indicates the level of liquid asset investment It is a major constraint A company may have to lower risk tolerance due to the devastating impact Concentration Risk Relates to the risks causes by a dominating position in a: Risk category Product line 2018 The Innite Actuary, LLC 17

19 Region Distribution channel Asset class Examples for concentration risk appetite The company has a natural diversication of geographic concentrations of insurance and political risks The company has a range of product oerings including both life and annuity products and thereby reduces exposure to concentrations of mortality or longevity risk. Guidance for concentration risk appetite It s an important element in strategic planning (i.e. developing business planning) Too much concentration puts a company in danger Use a good risk limit or risk-monitoring system to identify signicant deviations from the concentration risk appetite Terrorism Risk Terrorism Causes deaths, injuries, business interruption and adverse market movement Hurts the company s nancial strength and business Examples of appetite for terrorism risk The company cannot lose more than 20% of IFRS equity in a terrorism event. The company has a contingency plan in place for continuing business operations in the event of terrorism. Risk limit for terrorism risk Concentration of policyholders locations is the focus Get sucient reinsurance coverage to cap the maximum possible claim amount Operational Risk Appetite for operational risk Usually qualitative The company disallows any behaviors that will damage our reputation May not be translated to quantitative risk limit Ensured by company policy and/or internal control Examples include: 2018 The Innite Actuary, LLC 18

20 Brand management Anti-money laundering Compliance policies Diversification Benefit Diversication Benet: Diversify among risk categories, products and geographic regions Helps reduce aggregate level of risk A critical factor to determine the current risk prole with a bottom-up approach A critical factor to set the risk limit using the top down approach Important factor in economic capital management when considering: the high sensitivity to the assumption of dependency the magnitude in reduction of required economic capital Make a reasonable diversication assumption Keep it from manipulation Approaches to quantify diversication that incorporate a higher correlation of tail events: Correlation matrix approach Uses a correlation matrix Aggregates the value distributions of certain percentiles of dierent risk factors Copula approach Determines joint distribution based on marginal distributions and a copula function Allows better modeling of tail events where much higher correlations were seen than in normal circumstance Doesn t assume a linear correlation as used by the correlation matrix Structural scenario approach Uses stochastic global scenarios that include all the risk factors Incorporates correlations between risk factors in the stochastic scenarios Assesses asset and liability portfolios under scenarios to obtain a value distribution When to use the dierent approaches: Correlation matrix and copula approaches When determining the diversication benet among dierent categories and among geographic regions 2018 The Innite Actuary, LLC 19

21 Structural scenario approach When calculating the diversication benet among risk factors within each risk category and volatility under the market risk category Risk Appetite and Asset Allocation Strategic asset allocation (SAA) vs. Tactical asset allocation (TAA) Strategic asset allocation (SAA) Used to determine a long-term policy portfolio Reects the desired systematic risk exposure Tactical asset allocation (TAA) Species the allowable deviation from SAA Takes advantage of short-term market opportunities Examples of return objectives Minimum return Statutory rate set by actuarial assumptions to fund statutory reserve Choose the assets based on the duration matching strategy Enhanced margin Competitive return earned to fund a well-dened liability and a reasonable prot A surplus account usually has a riskier asset allocation to achieve higher returns Risk considerations Valuation concerns Adverse market movement leads to reduced surplus Risk exposure is limited to a safe capital adequacy level Cash ow volatility Low tolerance of income loss Reinvestment risk Duration and/or convexity match between asset and liability portfolios Credit risk Need to reduce credit risk by diversifying your portfolio Disintermediation risk Periods of large cash outows 2018 The Innite Actuary, LLC 20

22 When a high interest rate leads to more policy loan lapses This decreases the duration of the liability Regulatory and legal constraints about eligible investment Disadvantages of determining asset allocation without a clearly dened risk appetite No holistic thought of the relationship of risk and return No holistic though of the correlation of all the identied risks Advantages of using risk appetite to determine asset allocation Strategic allocation will help ensure the realization of both risk and return objectives There will be appropriate and dierent return objectives These can be set for individual segments to achieve the overall goal Ecient frontier and capital market line (CML) Requires a calculation engine that can support risk appetite analysis Derive ecient frontier(s) by running the engine, which considers dierent portfolios resulting in dierent returns for the level of risk taken Capital market line (CML) tangent to the ecient frontier and crosses the vertical return axis at the risk-free rate (i.e. earns the risk-free rate if zero risk is taken) CML / ecient frontier tangent point = theoretical optimal portfolio (optimal risk/reward combination) Reasons why the CML tangent portfolio may not be achievable Borrowing cost could be too high Optimal portfolio may require short selling, which insurers may not be allowed to do Investment income may be more volatile than the company desires May be impractical/impossible to solve for the optimal portfolio for a given set of risk combinations SAA can consider multiple risk measures based on risk appetite this will result in multiple ecient frontiers, which means dierent tangent risky portfolios to choose from This is a more holistic approach to risk Setting the risk appetite helps make sure alpha-seeking behaviors (TAA) will not put capital/earning positions at high risk Need to dene minimum returns, maximum risk limits, etc. to restrict TAA activities 2018 The Innite Actuary, LLC 21

23 Risk Appetite and New Business Budgeting New business budgets of certain return or value measures are prepared annually by insurance companies Commonly used traditional return and value measures don t fully and accurately consider the level of risk being taken Traditional embedded value of new business for life insurance Combined ratio for non-life insurers Combined Ratio Premium Losses Expenses Premium Alternative measures explaining the impact of new business on the future risk prole 1. RAROC Risk-adjusted return on capital Takes into consideration the expected prot and risk over the entire life of a policy Allows for a consistent comparison of activities across dierent types of risks and businesses RAROC PV(U/W Prot) + PV(Inv Income on Capital) (1 TaxRate) PV(Required Economic Capital) 2. MCEV where: PV(U/W Prot) = PV(Prem) PV(Claims) PV(AcqCosts) PV(Other Exp) Activities that generate RAROC in excess of the hurdle rate create value Market consistent embedded value Adjusts the approach of value measurement used by traditional embedded values of new business Considers the following: Costs of nonhedgeable risks Costs of options and guarantees oered in the insurance contracts Frictional cost of capital explicitly Activities that generate MCEV earnings in excess of target MCEV create value Risk Appetite and Capital Allocation Capital available to a rm is not unlimited 2018 The Innite Actuary, LLC 22

24 Should be employed to generate enough return for shareholders on a sustainable basis Level of required return is determined by the level of risk taken Need to allocate capital to dierent risk types, business lines, and business units Ways companies allocate capital Statutory framework models Rating agencies models Economic capital framework Risk appetite Statutory framework models Regulatory rules build conservatism in calculating reserves in specifying the amount of required capital needed to remain solvent Regulatory required capital frameworks vary across the world Adopt factor-based models where factors are prescribed by the regulator Inaccurate estimation of the risk exposure may happen due to the lack of required granularity in the models This may be improved by Solvency II and more principal-based reserve methods Is prescribed and can t reect the view of the board and senior management Rating agencies models Helps in understanding the requirement to maintain the target credit rating Model can t cater to all the idiosyncratic characteristics of the business Is prescribed and can t reect the view of the board and senior management Economic capital framework Chosen by many insurers for ecient capital allocation Addresses the disadvantages of using the statutory capital model or rating agencies capital model Provides a platform to compare and select business opportunities by: Dierent business lines Risk types Geographic regions 2018 The Innite Actuary, LLC 23

25 Not practical to rely on the economic capital framework alone Regulators and rating agencies will still constrain the company Risk appetite for capital allocation Considers the specics of the: Business Investors risk tolerance All the constraints Provides the guideline for capital allocation with the board s risk tolerance Capital allocation decisions are facilitated by: Explicit statement of the probability of loss Associated maximum loss amount Available Capital Versus Required Capital Action steps when comparing available capital and required capital If total available capital >>> total required capital Company can reduce the available capital by: Dividend payment to shareholders Share buyback Take up more business opportunities Increase the size of the business Increase the risk of the business If total available capital < the total required capital Company takes actions to increase available capital Raise additional capital from shareholders or the market vis issuing preferred stocks Company reduces the required capital Reduce the size of the business Reduce the risk of the business The Role of Diversification in Capital Allocation Diversication benets can arise in dierent places: Within a given product Diversication between dierent risk categories it is exposed to 2018 The Innite Actuary, LLC 24

26 e.g. between insurance risk and nancial risk Within a business unit Diversication among dierent products e.g. between life insurance products and annuity products regarding mortality risk and longevity risk Across dierent types of business at a higher level e.g. between general insurance business and nancial service business Guidance for capital allocation with diversication Available economic capital allocation to business units should be based on the required economical capital after diversication benets Give extra capital allocation for business units with signicant diversication benets Capital Fungibility Since they have relatively lower marginal cost of capital Guidelines on moving capital Subject to regulators approval Entities accumulate their retained earnings to build up capital One can pay the parent company in form of a dividend (this is the easy and normal way) Diversication benet is reduced if capital is not easy to transfer between entities Risk Appetite and Liquidity Management Liquidity: the ability to fund increases in assets and meet obligations as they come due Liquidity risk: the measure of probability that a company s cash resources will be insucient to meet current or future cash needs Losses during a liquidity event Transaction costs Interest payments on borrowings Market impact of re sale Bankruptcy costs This happens when mass lapses take place together with a credit rating downgrade Appetite for liquidity risk Denes the liquidity risk tolerance 2018 The Innite Actuary, LLC 25

27 Appropriates cash levels held in the company s asset allocation Often stated as The company maintains liquidity in a 1-in-200-year event over a time horizon of three months The company maintains liquidity at the condence level of 95% while the liquidity cost to meet cash payments at the condence level of 99.5% is less than 25% of capital Disadvantages of having liquidity risk management without a clear and stated guideline Leads to oversimplied rules Leads to an overconservative strategy Earn lower yield on liquid assets Underlying risk may not be identied Risks are caused by the liability structure and the exogenous market changes Liquidity management policies without risk appetite could include: Cash balance is no less than the maximum weekly cash payment in the past three months Cash balance is no less than Y times the maximum daily cash payment in the past month Liquid assets cannot be less than 50% of the total asset balance Liquidity quantitative statement should: Reect a bottom-up analysis to gure out the major liquidity requirements Identify risks that will increase the liquidity requirement signicantly Show the market impact on available liquidity Ways an appetite for liquidity risk constrains strategic planning: Planning for new business sales Quantify the impact on required liquidity Verify that the overall liquidity position remains consistent with the risk appetite Identify the new factors related to new business that may signicantly change the liquidity requirement Strategic capital management Impacted as decision makers need to uphold liquidity requirements Capital will need to be allocated to dierent risks, business units, and business lines Stategic asset allocation Under stress scenarios if immediate liquidation is required consider the: 2018 The Innite Actuary, LLC 26

28 Available Liquidity Liquidity of assets Likely liquidity costs Three tiers of asset classication for liquidity risk management Tier 1: Highly liquid Cash Government bonds Tier 2: Liquid Bond coupons and redemption Equity dividends Rental income Tier 3: Not liquid Required Liquidity Selling those assets or cash ows might lead to big market impacts and signicant liquidity costs Required liquidity: measures the required cash payment for a certain period in a severe event. (e.g. Three months = certain period and severe event = 1-in-200-year event) Components of required liquidity Credit rating downgrade impact Normal operational cash ow volatility Catastrophic risk Funding commitments Interest rate risk Adverse mortality and morbidity experience Correlation among the above factors Budget net cash ow (NCF) within the time horizon Now we ll go into each of these components so you ll be able to describe them Credit rating downgrade impact the additional cash payment requirement due to a credit rating downgrade Caused by overall market chaos or an idiosyncratic reason 2018 The Innite Actuary, LLC 27

29 Insurers face an unexpected mass lapse if downgraded Estimated based on past credit crisis experience Industry experience is used to estimate the impact if one s own experience is not available Normal operational cash ow volatility Use historical company data for this analysis Example: use weekly historical data of net cash ow to t a distribution Calculate the 99.5 percentile from historical data or from a tted distribution Distribution tting may capture tail events better when historical data is not long enough Adjust the historical data by excluding: The period when a credit rating downgrade occured When there there was a sharp increase in the interest rate Catastrophic risk (CAT risk) Stress test the business portfolio Use some extreme events that occurred before Calculate the required benet payment under those stress scenarios Funding commitments Examples include private equity investments or real estate investments Interest rate risk Assess the impact on: Products sensitive to interest rate risk Asset values where there s a signicant increase in the new money rate Expect to see increased lapse activity and a drop in asset value Additional liquidity requirements and realized losses will be created This is due to asset liquidation at a depressed price Adverse mortality and morbidity experience Actual claim experience may deviate signicantly from pricing assumptions Happens especially for: New markets New products New features added to existing products 2018 The Innite Actuary, LLC 28

30 Actual claim experience is an important component of required liquidity for start-up companies without much credible experience Correlation among the above factors Diversication benet is an important assumption when determining the appropriate required liquidity level Being too conservative! may hinder business Due to the cost of maintaining a high liquidity level Being too risky! may lead to position exceeding the risk tolerance Data to determine the appropriate correlation assumption: Detailed research based on market data Reference to industry standards (e.g. CFO forum, CRO forum, Solvency II) Peers Budget net cash ow (NCF) within the time horizon An oset of required liquidity for a mature company Unless there is signicant expansion that overwhelms the contribution from in-force business The reading shows a case study where a company creates a stochastic distribution of weekly net cash ow based on historical data To convert the weekly 99.5th percentile amount to a 3-month amount, they assume the cash ow follows a Wiener process (Brownian motion) q 3 months weeks per month on average weekly result This is the amount of cash to have available to sustain a 3-month liquidity event Risk Appetite and Performance Measurement The key to successfully implement and gain from a risk appetite framework is a healthy risk culture Get management to understand and buy into the risk culture Encourage people to think in terms of both return and risk when making business decisions Three types of performance measures 1. The gap between current prole and risk tolerance Makes sure the business is safe compared to its risk tolerance Can reect at top (group) level, risk category level, and/or risk limit level 2018 The Innite Actuary, LLC 29

31 2. Risk-adjusted return (RAROC) vs. expected RAROC 3. Risk-adjusted value: economic value added (EVA) vs. expected EVA EVA = earnings opportunity costs capital allocated Three levels measuring the gap between the current risk prole and risk tolerance 1. At the top level Compare the current risk prole against the enterprise risk tolerance Identify the major gaps Responsibility falls to the group level senior management 2. At the risk category Check the exposure for each risk category against risk appetite for a specic risk Risk committees are responsible Example: Credit risk committee evaluates the credit risk exposure Asset liability management committee is responsible for signicant deviations from the interest rate risk appetite 3. At the risk limit (or business execution level) Risk management committees and risk-taking departments are responsible for monitoring Example: Market risk management and the chief investment oce s performance scores will be deducted if the equity VaR exceeds the limit Diculties in embedding these performance measurements in the management s scorecard Determining the appropriate performance target Explaining the deviation of actual results from the target Management can t control the system risk and the nancial market movement It s not reasonable to penalize management for this Solution: Use a consistent, reasonable, and well-accepted performance measurement framework Banks have increasingly used economic prot measures such as RAROC and economic value added (EVA), which have the following advantages: Encourages senior management to take opportunity costs of capital into consideration Maximizes shareholder s value given their risk appetite Dierent functions within a company is responsible for various risk types 2018 The Innite Actuary, LLC 30

32 Function Risk Type Investment Achieving higher returns than expected ALM Minimize the gap between asset and liability portfolios Business management New business growth and gain and loss from nonnancial risk MCEV is a good candidate for measuring economic value Two approaches to calculate MCEV 1. Balance sheet approach 2. Earnings approach 1. Balance Sheet Approach 2. Earnings Approach Free Surplus MCEV Required Capital MCEV VIF FrCoC FrCoC MVA MVM CRNHR PVFP CEL MVL TVOG CEL-TVOG Tax Liability Tax Liability Important denitions: MCEV (PVFP FrCoC CRNHR {z TVOG) + ReqCap + Free Surplus } VIF MVA MVL + MCEV MVA = market value of asset (i.e. market value of balance sheet assets + MV of future earnings) FrCoC = frictional cost of capital (reects the taxation and investment costs on the assets backing required capital) MVM = market value margin CEL = current estimate of liability 2018 The Innite Actuary, LLC 31

33 MVL = market value of liability = CEL + Tax Liability + FrCoC + MVM VIF = value of in-force business = PVFP TVFOG FrCoC CRNHR Includes the impact of nonhedgeable, nonnancial risks, and nonhedgeable nancial risks Should be presented as an equivalent average cost of capital charge CRNHR = cost of residual nonhedgeable risks (= MVM) TVOG = also known as TVFOG = time value of nancial option and guarantees PVFP = present value of future prot of in-force business Guidance for MCEV framework The opportunity cost of allocated capital is considered as the cost of residual nonhedgeable risks (CRNHR) and frictional costs of capital (FrCoC) This is due to investment and double taxation costs CRNHR and FrCoC accounts for all future years cost of using capital For performance measurement, compare measurement period actual earnings cost vs. expected earnings cost over the For life insurers, EVA = MCEV earnings cost of capital * MCEV earnings = change of MCEV from the beginning to the end of the measurement period The goal now is to attribute EVA to three dierent functions (investment, ALM, and business management) Investment Manage an asset portfolio actively Do so as long as the resulting portfolio doesn t move outside the allowable range specied by TAA Target extra returns by positioning the portfolio based on market movement expectations Interest rate expects to go #!decrease the decrease and increase the duration of assets Pick up yields by investing in lower credit rating bonds EVA for the investment department EVA inv = extra investment income over SAA - cost of capital Business Management The business management function should focus on new business and nonnancial risks (e.g. Insurance and Operational risk) 2018 The Innite Actuary, LLC 32

34 Properties of a good benchmark 1. Mimics the liability characteristics as much as possible If the nancial market changes, then the liability portfolio will change in the same way 2. The replication is valid for a wide range of market situations 3. Its value is easy to track Replicating the portfolio of liability also called a risk-minimizing portfolio Uses the available liquid assets in the market to replicate the value and sensitivities of the liability More complicated due to additional risk-adjusted measures Needs to replicate the following: Cash ows Economic value (MVL) Sensitivities Earnings Value Capital Requirements under Statutory and the Rating Agencies frameworks Ensure the replicating portfolio doesn t deviate too much from the liability EVA for the business management function EVA bus = MCEV of new business + expected return on the replicating portfolio + experience G/L - cost of capital where: Cost of Capital is calculated as the cost of capital the required capital consistent with the risk appetite Use the maximum of statutory required capital, rating agency required capital, and economic capital EVA contributed by new business = calculate as MCEV of new business created during the period Asset Liability Management (ALM) The return on SAA over the return on a replicating portfolio of liability gets attributed to ALM 2018 The Innite Actuary, LLC 33

35 The dierence is caused by the mismatch between the asset and liability portfolios EVA ALM = return on SAA - return on replicating portfolio If you want to go from MVA to MVL and you want to see the responsibilities of dierent functions, remember this diagram: Figure 7.2 MCEV Decomposition Alpha-Investment Mismatch ALM MCEV MVA Non-nancial risk -business management SAA Replicating Portfolio MVL Setting the appropriate EVA target Be consistent with strategic planning Set the target = expected EVA. Do this once the strategic and business plans have been decided Evaluate the performance of dierent functions by comparing the Realized EVA vs. the Expected EVA Guidance to introduce a risk-adjusted measure to the performance scorecard to management Communicate with the management team Get their buy in and agreement on all the assumptions used to determine the EVA target Hold interactive workshops with senior management from business units and core departments This is necessary to help them understand EVA and the assumptions and calculation methods used 2018 The Innite Actuary, LLC 34

36 Giving them a full understanding allows people to accept linking it with compensation Management can make business decisions under a risk-adjusted return/value framework You will then have a long-term and benecial impact on business management and risk culture Conclusion Two perspectives on how a risk appetite framework can improve strategic planning 1. Embeds the risk perspective into decision making Reduces the chance of making bad and risky strategic decisions Which the company, the regulator, or the markets are not ready for 2. Analysis makes it easier for senior management to make better decisions Risk/reward tradeos Quantication of the impact on capital position and earnings 2018 The Innite Actuary, LLC 35