Economic Capital Modeling Implementation

Transcription

1 Economic Capital Modeling Implementation Yan Guo, Enterprise Risk Management, AIG Shanghai, China July 7 th, 2008 Asia-Pacific Risk and Insurance Association 12 th Annual Conference, Sydney

2 Outline I. Overview II. III. AIG s ECM Governance AIG s ECM Development and Key Applications Page 1

3 I. Overview Page 2

4 Why do we care about capital? We need capital to cover potential, unexpected losses within a target confidence level and timeframe. Capital inadequacy can lead to ratings downgrades. In the severest case, extreme capital deterioration and successive downgrades would to lead to economic insolvency (i.e., default). Assets Liabilities Capital or Equity Required Capital Excess Capital Cushion we need to maintain target ratings Page 3

5 Different Capital Models Cushion you have Cushion you need Various measures of required capital: Regulatory Capital GAAP Capital (accounting view) or Available Economic Capital (economic view) Capital Required Capital Excess Capital or Rating Agency Capital or Required Economic Capital Page 4

6 Economic Capital Key Goals The Economic Capital Project aims to answer several related questions: 1) How much capital is needed? Required Economic Capital (REC) 2) How much capital do we have? Available Economic Capital (AEC) 3) How much do we make on a risk adjusted basis? Return (EVA) 4) How do we optimally deploy capital? Capital Allocation Required Economic Capital Is defined as the amount of equity capital required to cover unexpected losses and to maintain a desired rating over a specified time horizon Is over and above the reserves held on AIG s balance sheet which are intended to cover expected losses Captures the risk and return profiles and the inter-relationships of all AIG businesses Available Economic Capital Is defined as the difference between the economic value of assets and the economic value of liabilities on the Economic Balance Sheet Provides a more accurate measure of AIG s financial strength Allows the inclusion of future profitability of in-force and new business on the Economic Balance Sheet Reflects AIG s unique businesses and management strategies Page 5

7 What is Available Economic Capital Available Economic Capital, or Available Capital, is the difference between the economic value of assets and the economic value of liabilities. It is an economic view of the balance sheet akin to a fair value concept, and could there fluctuate significantly from period to period as market condition changes. Economic Value of Assets Economic Value of Liabilities Available Economic Capital Economic Value of Assets Economic Value of Liabilities Page 6

8 What is Required Economic Capital? Required Economic Capital, or Economic Capital, is an assessment of capital required to cover potential, unexpected losses within a target confidence level and timeframe. AIG s Required Economic Capital (REC) is calculated to maintain a strong AA rating It consists of a Pillar I component that is based on probabilistic modeling at 99.95% and one-year time horizon, and, a Pillar II component that capture the capital fungibility constraints on firmwide diversification and stress testing add-on for unmodelable risks. Expected Loss (Reserve) Max 99.95% REC = Max Loss - Exp Loss Unexpected Loss Page 7

9 Required Economic Capital Overall Required Economic Capital (REC) at AIG, Inc = Sum of Standalone REC at BU/LE _ Pillar I Diversification Benefits among BU/LE + Capital Fungibility Div. Benefit Haircut Pillar II + Stress Testing Capital Requirement Add-on Page 8

10 REC vs. Other Required Capital Measures Required Economic Capital differs from other required capital measures, such as regulatory and rating agency capital requirements, which may not provide the most accurate reflection of actual business risks and diversification benefits. General Relationship of Required Capital Measures Regulatory Capital Varies based on target rating Rating Agency Capital The greater of Regulatory Capital and Rating Agency Capital Cost of Regulation and Ratings Required Economic Capital quantification of potential for capital relief current minimum capital we must have absent costs of regulation and ratings, Required Economic Capital represents the desired minimum capital we should hold Page 9

11 Balancing Multiple Views of Capital Longer Term Solutions Could Differ Markedly From Short Term Constraints AIG is actively preparing for the longer term expected convergence of capital requirements, but must continue to manage short-term needs according to existing operating constraints. Economic view is expected to prevail Ultimate convergence, but at different speeds Economic Rating Agencies EU Solvency US GAAP IFRS time Illustrative only, i.e. the lines are not representative of any specific case Page 10

12 Rating Agencies Four major rating agencies have indicated that they will, over time, incorporate ERM and ECM in the rating process. Standard & Poor s is developing a process for evaluating the economic capital (EC) models of insurers with ERM programs that have been viewed as strong or excellent Moody's expects best practice insurers to develop economic capital models based on sound principles and conservative assumptions to reflect the risk profile of their businesses Fitch believes reviewing insurers in-house models is a key part of capital analysis Prism provides a common ground to compare various insurers capital positions on a true economic basis A.M. Best will also expand the use of company-provided capital models in developing capital requirements within the rating evaluation process S&P, Jan. 31, 2007 Moody s, Mar. 22, 2007 Fitch, Apr A.M. Best, Mar. 5, 2007 Page 11

13 II. ECM Governance Page 12

14 AIG s Multi-Layered ERM Processes Credit Risk Management Market Risk Management Gen Ins. Risk Management Life Ins. Risk Management Op. Risk Management Liquidity Risk Management Each of the ERM functions focuses on systematic (non-diversifiable) risks Combination of centralized and decentralized processes that fit the business model (e.g. central oversight and built-up of local/business unit expertise) Regional ERM hubs in North America, Asia and Europe Mature risk governance structure since early 90 s ERM does not compensate for, but rather builds on, profit center RM Extensive use of stress scenarios that cut through all risk types (e.g. Pandemics) AIG s corporate philosophy has always encouraged full profit center accountability for risk management ERM has built on this unique risk culture Page 13

15 ERM Governance and Reporting Enterprise Risk Management Credit Risk Market Risk Insurance Risk Economic Capital Senior Management Committees Credit Risk Cross-Border Exposure Country Rating Review Financial Risk Foreign Exchange Derivatives L&RS RM General Insurance RM CEO Approval Process Capital Management Economic Capital Board of Directors Finance Committee & Operational Risk SOX CSFT ORM Forums CSFT/ TRC Audit Committee Page 14

16 ECM Governance Governance for ECM is built upon existing governance structures along organizational dimension and risk dimension. Business Dimension BU CFO/Chief Actuary responsible for data accuracy Consultation process is place to ensure various inputs/arguments are heard and considered Reach consensus or otherwise make decisions Life Ins. & Ret. Services Risk Management Group Group Risk Committee General Insurance Risk Management Group Business Units, Working Groups, Risk Management Activities Risk Dimension Risk manager responsible for each risk silo is also responsible for economic capital methodology for that risk consistent with how risk is being managed E.g. Chief Credit Officer signs off credit risk methodology Operational Risk Management Life Insurance Risk Management Credit Risk Management Economic Capital P&C Insurance Risk Management Market Risk Management Page 15

17 ERM Organization in Asia ex Japan AIG s Division Issues -Life - General - Financial Services - Asset Mgmt AIG Chief Risk Officer AIG Life Division, CFO ERM - Asia (ex Japan) Life Division Issues Credit Risk Mgmt Financial Mkt Risk Mgmt Regulatory Risk Mgmt Operations Risk Mgmt (inc. SOX) Insurance Risk Mgmt CSFT (NY) & TRC Economic Capital Center Business Continuity Planning ERM Asia has oversight responsibilities across all AIG businesses in Asia (ex Japan): Life and Retirement Services; General Insurance; Financial Services, Asset Management Division Local Chief Risk Officers in each business units have a Matrix Report to Regional Director of ERM Asia Page 16

18 Economic Capital Center in China The primary objective of the EC Center is to develop central EC expertise to support implementation across Asia (ex. Japan) business units. Models: Work with BUs on complex modeling issues Methodology: Technical guidance on methodology issues and financial statement reconciliation Education: Provide training and education to help BUs build local internal EC capabilities and expertise Started operations in May Currently 10 FTE and expect to have a team of FTE by 2008 Report to ERM Asia (ex Japan) Page 17

19 III. AIG s ECM Development and Key Applications Page 18

20 Economic Capital at AIG Core Principles AIG is taking a principles-based approach to develop its Economic Capital Models (ECM). Relevant Collaborative In line with how AIG manages its business and used for decision-making Joint venture between Corporate and BUs in all phases Comprehensive Covers all major risks, businesses, geographies Flexible Economic Value and Simulation- Based Integrates new products, M&A, divestitures, reorganizations, etc., in a timely fashion Addresses specific risks and returns of AIG s businesses, including diversification Page 19

21 Economic Capital: Business Relevance By focusing on business applications, AIG s economic capital modeling has leapfrogged many of the traditional approaches to EC Later 90's Early 00's AIG decided very early on to focus on business units/legal entities/profit centers, not just group. Banks Group European Insurers European Insurers' disclosures focus on group level:. Allianz. AXA. Generali. ING. Munich Re. Pru UK. Swiss Re Japan and Other ALICO AIG Edison AIG Star Life Foreign Life Insurance & Retirement Services Asia A6 APLO AIA China Nan Shan Philam AIRCO Life DLC AGL AGLA AIG Canada AIG Life & AI Life Domestic DRS AIG Annuity VALIC Sun America (Ex. GIC) Domestic General DBG Personal Lines UGC HSB 21st Century TRH General Insurance Foreign General AIG Capital Markets AIG FP Parent Financial Services Comm. Finance ILFC AIG CEF AIG Credit Consumer Finance AG Finance AIG CFG FSB Asset Management Asset Management Institutional AM (AIGGIG) Wealth AM (AIG Private Bank) Retail AM (SAAMCo, AIG Advisors) Spread-Based Investment SALIC (GIC) AIG MIP Asia Business Units Important for Capital fungibility Regulatory capital dialogue Understanding business Performance metrics fit for purpose Page 20

22 Risk Categories Risks are grouped into risk categories. For AIG these include Insurance Risk (further separated into Life Insurance Risk and P&C Insurance Risk), Credit Risk, Market Risk, and Operational Risk. AIG (Group, BU, or Product) Insurance Risk Credit Risk Market Risk Operational Risk Mortality/Morbidity Default Interest Rate Business Practices Policyholder Behavior Life Catastrophe Premium risk Rating Migration Recovery Exchange Rate Equity Alternative investment Controls & Compliance Systems & Disruption Execution & Process Reserve risk Aircraft Fraud P&C Catastrophe Commercial Real Estate Employment Practices Page 21

23 Stochastic Simulation Approach Scenario-based simulation or other advanced methods are generally used to calculate Required Economic Capital. Group, Business Unit or Product 1. Identify all the relevant risks Insurance Risk Credit Risk Market Risk Operational Risk 2. Develop loss distribution functions 3. Combine distributions Aggregation, Correlation 4. Measure and allocate required capital Expected Loss (Reserve) REC = Max Loss - Exp Loss Max 99.95% Page 22

24 Risk Aggregation Three Step Approach AIG s ECM uses a three step approach for ensuring that accumulations of risk are robustly estimated Hybrid Approach in ECM Within risk types, aggregation is performed using consistent scenarios (e.g. the different components of market risk) Between risk types, risks are aggregated using a correlation matrix / copula approach to reflect the impact of stress correlations and increased interconnectedness of risks Some of the aggregations (e.g. between market and credit) are increasingly being performed using a consistent scenario approach 4 Capital Mobility Insurance operations are regulated along legal entities by different jurisdictions with varying minimum risk based capital (RBC) requirements Restrictions on dividend payments to the parent and other capital flow constraints and tax considerations give rise to a further fungibility haircut to determine realizable diversification benefits 4 Stress Testing Bottom up stress tests (e.g. effect of a severe pandemic) are performed by simple addition of risk type effect, following detailed assessment of each category of loss (e.g. mortality, credit, interest rate and business interruption losses for pandemics) Provides a reality check on assumed modeled dependencies Page 23

25 Pillar II Stress Test In view of the large uncertainty surrounding the estimation of the yield curve extension in developing markets, AIG at the corporate level sets aside additional stress test capital for a parallel shift down in the yield curve 4.0% Yield Curve extension (Best Estimate and Stress Test) Extrapolated Best-estimate rates Pillar I and Pillar II REC Swap rate 3.5% 3.0% 2.5% 2.0% Observed Parallel shift of best estimate rates beyond tradable horizon Stress Test 1.5% 1.0% 0.5% Maximum tradable swap maturity 0.0% Term (years) REC (Pillar I) REC (Pillar II) Total REC Page 24

26 Key Applications Economic Capital will help drive better decision-making by providing a tool for various applications Opportunity Greater individual business unit risk retention / buy less reinsurance Increased operating efficiency / more financial flexibility More aggressive products evaluated on overall AIG portfolio risk effect vs. profit center Converge rating agency and economic views of excess capital positions Link management compensation to economic value creation Higher growth and profitability Optimize net Investment Income and total return Higher ROE Impact Higher margins Allows for more efficient redeployment of capital Allows measurement of risk adjusted business performance Page 25

27 AIG s Applications of EC Business Performance: Analysis of operating performance on a risk-adjusted basis using consistent measures across segments Capital and Asset Allocation: Quantitative tool to optimize asset allocation within AIG s global investment portfolio and allocate capital to businesses providing the most attractive risk-adjusted returns Capital Management: Methodology for optimizing AIG s capital structure and lowering the cost of capital, in part through utilization of capital markets to leverage AIG s capital base more efficiently Risk Management: Approach to analyze economic risks and benefits of investment strategies and risk mitigation through reinsurance and hedging programs Cost of Regulation and Ratings: Framework for analyzing the cost of maintaining capital to meet rating agency and regulatory standards for capital required to be held in excess of the economic capital required to support AIG s risk profile Product Development: Detailed approach to develop and price products to meet market demand and to maximize economic value added Management Compensation: Framework to incorporate the importance of maximizing economic value added into management compensation programs Source: AIG Investor Relations Website; February 2008 Page 26

28 Case Study: Strategic Asset Allocation for Asian Life Co. We evaluated alternative Strategic Asset Allocations (SAA) using our SRM framework, incorporating RBC requirements and GAAP earnings projections. 1 Efficient Frontier 3 RBC Impact Projected multi-year distribution of RBC ratios for portfolio SAAs Developed Risk and Return efficient frontier for each asset class as well as the portfolio SAAs 3 GAAP Earnings Volatility 2 Peer Group Analysis Projected multi-year distribution of GAAP & Economic earnings for portfolio SAAs Compared the risky asset allocations of Life Co. with that of its competitors 3 Projection of AEC & REC Projected multi-year distribution of Available Economic Capital & Required Economic Capital for SAAs Page 27

29 SAA: Efficient Frontier and Peer Group Analysis We evaluated the risk and return trade off for the portfolio SAAs and compared the asset allocation with that of its competitors Efficient Frontier Onshore Private Equity Return SAA1 SAA2 Real Estate Onshore Equity Fixed Income Peer Group Analysis Volatility BU Company A Company B Fixed Income 70.0% 65.0% 80.0% Onshore Listed Equity 14.0% 10.0% 10.0% Onshore Private Equity 1.0% 2.0% 0.0% Real Estate 15.0% 23.0% 5.0% Total 100.0% 100.0% 100.0% Page 28

30 Integrated SAA Model: RBC, GAAP and EC An integrated model enables a holistic approach to evaluate alternative SAAs, incorporating EC, RBC requirements and GAAP earnings volatility RBC Ratio USD in Millions Year 1 SAA1 SAA2 Projected RBC Ratios Year 3 SAA1 SAA2 90 th Pct 75 th Pct 25 th Pct 10 th Pct Year 5 SAA1 SAA2 SAA1 SAA2 SAA1 SAA2 SAA1 SAA2 Year 1 SAA1 SAA2 Projected GAAP Earnings Year 3 SAA1 SAA2 90 th Pct 75 th Pct 25 th Pct 10 th Pct Year 5 SAA1 SAA2 SAA1 SAA2 SAA1 SAA2 SAA1 SAA2 USD in Millions Projected Available Economic Capital Year 1 SAA1 SAA2 Year 3 SAA1 SAA2 90 th Pct 75 th Pct 25 th Pct 10 th Pct Year 5 SAA1 SAA2 SAA1 SAA2 SAA1 SAA2 SAA1 SAA2 The top and bottom of each box are the 75 th and 25 th percentiles, respectively The top and bottom of each line are the 90 th and 10 th percentiles, respectively Page 29

31 Economic Performance Measures In 2008, AIG plans to extend the model s applications by building on the work performed in 2007 for a wider range of businesses, segments, geographies and product lines. Commencing in 2008, the economic value added for each of AIG s business segments will be considered as an element, alongside other existing measures, in the evaluation of senior management performance. - AIG Investor Relations Website, February 2008 Page 30