Conflicts in ALM across different capital regimes

Transcription

1 19 April 2011 Conflicts in ALM across different capital regimes Robert Waugh Managing Director, Standard Chartered April 2011

2 Disclaimer This communication is issued by Standard Chartered Bank ( Standard Chartered or we ), a firm authorised and regulated by the United Kingdom s Financial Services Authority. It is not directed at Retail Clients in the European Economic Area as defined by Directive 2004/39/EC neither has it been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. It is for information and discussion purposes only and does not constitute either an offer to sell or the solicitation of an offer to buy any security or any financial instrument or enter into any transaction. Information contained herein, which is subject to change at any time without notice, has been obtained from sources believed to be reliable. While all reasonable care has been taken in preparing this communication, no responsibility or liability is accepted for any errors of fact, omission or for any opinion expressed herein. Standard Chartered may not have the necessary licenses to provide services, offer products or distribute research in all countries or such provision of services, offering of products or distribution of research may be subject to the regulatory requirements of each jurisdiction and you should check with your relationship manager or usual contact. No representation is made that the information contained herein is appropriate for use in all locations, or that any products, investments and/or services discussed herein are available or appropriate for sale or use in all jurisdictions, or by any investors or counterparties. You are advised to exercise your own independent judgment (with the advice of your professional advisers as necessary) with respect to the risks and consequences of any matter contained herein. We expressly disclaim any liability and responsibility for any losses arising from any uses to which this communication is put and for any errors or omissions in this communication. SCSNAI or an affiliate may have positions or act as a market maker in securities or financial instruments mentioned herein and may also act as advisor or lender to an issuer mentioned herein. Additional information is available upon request. This communication is not for distribution to any person or to any jurisdiction in which its distribution would be prohibited. Do not invest in investment products unless you fully understand and are willing to assume the risks associated with them. Copyright 2011 Standard Chartered Bank / Standard Chartered Securities (North America) Inc. All rights reserved. All copyrights subsisting and arising out of these materials belong to Standard Chartered Bank and may not be reproduced, distributed, amended, modified, adapted, transmitted in any form, or translated in any way without the prior written consent of Standard Chartered Bank. In China, this communication is distributed by Standard Chartered Bank (China) Limited, which is regulated by the China Banking Regulatory Commission. In Hong Kong, this communication is distributed by Standard Chartered Bank (Hong Kong) Limited. In Korea, this communication is distributed by Standard Chartered First Bank Korea Limited which is regulated by the Financial Supervisory Service. In Malaysia, this communication is distributed by Standard Chartered Bank Malaysia Berhad. In the United Arab Emirates, Standard Chartered Bank is regulated by the Dubai Financial Services Authority. In the United States this communication is distributed by Standard Chartered Securities (North America) Inc. ( SCSNAI ) a member of Financial Industry Regulatory Authority ( FINRA ) and Securities Investor Protection Corporation ( SIPC ). 2

3 Standard Chartered Bank Pension and Insurance ALM Solutions Team Located in Hong Kong Advise on ALM transactions Insurance liabilities Regulatory and Economic capital Quantitative risk management Robert Waugh Managing Director CM Solutions Phone: Mobile: Fax: /F Two International Finance Centre 8 Finance Street, Central Hong Kong Robert joined Standard Chartered to build up the solutions business for Insurance & Pensions. He brings a wealth of experience servicing clients in Asia for over 2 years and previously helping European insurers with their Solvency II hedging. He has over 10 year experience in quantitative modeling of fixed income, credit and equity products. During the last 6 years he has been devoted to the insurance client segment looking into regulatory capital optimization withn an economic capital framework, with particular attention to the Variable annuity market. Prior to Standard Chartered Robert worked for ABN Amro in both Hong Kong and London. Before joining the financial services industry Robert was an academic physicist and completed his PhD in Particle Physics. Ken Su Director CM Solutions Phone: Mobile: Fax: Ken.Su@sc.com 12/F Two International Finance Centre 8 Finance Street, Central Hong Kong Ken, a UK qualified actuary, has recently joined Standard Chartered Bank to work on ALM solutions for pensions and insurance clients. With 10 years of actuarial experience gained from European insurance companies and global actuarial consultancies, he brings a wealth of life and pension industrial ALM knowledge to the bank. Prior to Standard Chartered Ken worked for Barrie and Hibbert, a financial risk management consultancy and lead their business activities in the Greater China region. Before relocating to Asia in 2008, Ken worked for UK insurers in product pricing, EEV reporting, ALM and capital management. Ken holds a first class degree from LSE and a master in actuarial management, with distinction, from Cass Business School. 3

4 Asset and Liability Management

5 Key Components in ALM One of the key challenges of ALM is to define a coherent framework where various strategic investment strategies can be analysis and optimize 1. Liabilities Participating or Non- Participating Regular or Single Premium Valuation methodologies Market Consistent ALM B 2. Assets Available/admissible assets universe Liquidity and maturity Expected yields, volatility and return distributions Real World Accounting IFRS Local GAAP Tax implications 4. Statutory Capital Not same as economic Arbitrage might be possible Need to meet/target solvency ratio to stay in operation 3. Economic Capital True capital position Client internal EC framework Market Consistent one year VaR Return on Economic Capital 5

6 Rethinking Efficient Frontier Define risk and return measure is a first step in achieving efficient frontier. Insurance ALM require much more sophisticate approach in thinking efficient frontier Traditional Assets Manager Approach Focus on return Beating the benchmark But is this achieving financial objectives for key stakeholders? ALM Approach Insurers ultimate goal is to earn return on capital for its stakeholders Capital = Assets Liabilities Key question is what risk and return measures 6

7 Which risk and return measures? Statutory, Accounting or Economic basis for ALM decision Reported earnings follow the rules and principles of accounting. The results do not always create measures consistent with underlying economics. However, corporate management s performance is generally measured by accounting income, not underlying economics. Therefore, risk management strategies are directed at accounting, rather than economic performance. - Enron in-house risk management handbook It is easy to focus on reporting numbers but basic ALM should always start with underlying economics 7

8 Smarter ALM Process? My experience of the marketing ALM products to insurers with ALM. Risk Governance ALM Capital Measurement Investment Performance Measurement Risk Management Process Risk Budgeting Strategic Asset Allocation 8

9 Mismatch and Conflicts

10 Capital Regimes Misalignment of capital Hong Kong and China Duration mismatch in assets and liabilities do not induce higher capital requirement Assets only investment return benchmark for local insurers Non-Solvency II insurers likely to take significant higher duration mismatch risks E.g. China Life Group annual report states they will negotiate for more floating rate (instead of fixed term) deposit this year SII insurers likely to loss out from in a rates hiking environment if duration fully match Take risks with lower capital requirement by using option based strategies RBC countries, apart from Taiwan, do penalize duration mismatch SII / fair hedging approach help reduce local statutory capital requirement Consideration need to be made on impact on IFRS, interaction with statutory liability measurement Countries Hong Kong Statutory Capital Regime Required Minimum Solvency Margin Hold more capital for duration mismatch No Thailand RBC Yes Singapore RBC Yes Malaysia RBC Yes China Required Minimum Solvency Margin Method to assessment of duration gap n/a MV Base Factor Base MV Base Taiwan RBC No n/a No Korea RBC Yes n/a Factor or MV base 10

11 Solvency problems in all directions? Insurers may experience solvency problems under both higher and lower rates. How can this be? Higher Rates Lower Rates Statutory capital resources will fall when rates rise Fixed income assets will fall in value Statutory liabilities will stay mostly constant Fair Value capital resources will fall when rates fall Assets have a shorter duration than liabilities Both rise in value, but liabilities quicker Issue How do we change the behavior of the statutory liabilities without impacting the capital? Issue How do we close the duration gap and manage convexity? 11

12 Conflicts in ALM Created by RBC without fair value discount curve RBC regime regulations encourage risk management but can create challenges for insurers want to do risk management Rick Based Capital Capital requirement is a function a risk taken Lower capital requirement for lower duration mismatch Encourage better ALM as capital saving can be significant Singapore Cashflow 10 Year, use Singapore Government yield 10<Cashflows<15, interpolate SGS Yield and Long Term Risk Free Discount Rate (LTRFDR) Cashflows 15, use LTRFDR Problems created by discount rate Usage of average market spot rates mean the effective dollar duration of liabilities are lower than its economic duration Not responsive to movement in rates Similar to book value liabilities Strategies to close economic duration gap, although reduce risk based capital requirement, but may actually induce more statutory surplus volatility and more problems for solvency LTRFDR, which is a slow moving average of 10 & 15 year government bonds Thailand Discount rate use zero coupon yield of government bonds with equal duration For longer cash flow, use longest dated government bond (e.g. For 34 year cash flows, the 30 year is used) To avoid market volatility use max (spot, average) 12

13 EU Solvency II Discount Rate QIS5 - Curves Definition of risk free rate Unconditional Forward Rate (UFR) Extrapolation method gives stable long term rate Based on swap, not government, with removal of credit risk Spread locks remove basis risks between assets & liabilities Usage of UFR to extrapolate yield curve stabilize long term discount rate Asian curves Major Asian currencies curve are provided HKD business discount at HKD rates Adjustment can be a significant if previous practice use USD assets to back HKD liabilities Liquidity premium 0%, 50%, 75% and 100% of LP depending on types of liabilities Purchase illiquid but low credit risk assets to match illiquid liabilities: Secured funding Negative basis Mitigate swap spread risk by spread locks Covered bonds Source: EIOPA, Bloomberg 13

14 EU Capital Requirement Interest Rate Risk Fair Value Approach One year concept and not run-off Less concern about precise cashflow matching Dollar duration hedging instead of cash-flow replications Hedging against predefined interest rate stress scenarios (up and down) Duration (Delta) hedging may not be sufficient Convexity (Gamma) need to be consider Incentive to use low /zero cost swaptions strategies to hedge predefined rates scenarios Lack of long duration assets means static hedging instruments not available for Asian currencies Need regular rebalancing to maintain hedge effectiveness Care should be taken for yield curve extrapolation technique (which assume stable long term rates over time) versus SCR stress scenarios Source: EIOPA, SCB 14

15 Thailand and Solvency 2 Credit Risk Standard Model Using the standard default risk and recovery rates from QIS5 one can calculate the implied capital charge for credit. Group Reporting At a group level capital must be held according to Solvency 2 For A- rating and 20Y 10.3% capital is held Thailand in not OECD Local Reporting At a local level capital must be held according to Thai regulations For Thai Government bonds 0% capital is held Managing Basis Mismatch between regulations Take credit risk onshore Remove credit risk at group 15

16 Final Thoughts Conflicts arise when setting the performance indicators Risk and return measurements will always conflict but economic basic should not be forgotten Risk and return do go hands in hands No guilt in running a risk exposure, as long as risk is rewarded Moving from Solvency I to RBC framework may encourage better risk management But regulations need to be more principle base to influence insurers to practice and preach Solvency II may argue to be a burdensome for European insurers But if economic capital is the right framework, it should be more like an opportunity 16