The Rating Agency View of Capital Modelling Simon Harris Team Managing Director European Insurance September 2007
Agenda The importance of risk and capitalisation in the rating process Moody s approach to evaluating risk management capabilities What is good ERM? How Moody s incorporates internal capital models into the rating process Observations on Model evaluation to date 2
Rating Agency View : The Importance of Risk Management and Capitalisation Moody s published refined Insurance Rating Methodologies in September 2006 Identifies the key factors that contribute to the level of an insurers (Financial Strength) Rating. In addition reasons why the factor is important metrics that we use to look at the factor the relevant importance of that factor within the overall rating Capitalisation (stand-alone) contributes 10-15% to our idealised rating approach Risk Management a below the line adjustment 3
Rating Agency View : The Importance of Risk Management and Capitalisation 4
Rating Agency View : The Importance of Risk Management and Capitalisation What we need capital to do Absorb unfavourable deviations in results Satisfy regulatory requirements / avoid regulatory pressure or intervention Be at a level sufficient to enable business expansions and / or enable business strategy (e.g. asset / reinsurance / liability policy) Simplified rating methodology metrics 5
How does Moody s assess Risk Management? Risk Management Assessment Framework published March 2007 Moody s ratings have always reflected management s risk control culture and capabilities Risk Management Assessments introduce a more transparent and formalised framework Best practice quantification for each element of Risk Management 6
Moody s Risk Management Assessments (RMA s) Separate RMA process for larger institutions Deepening of Moody s understanding of an issuer Evolving process Recently carried out a number of RMA s with large European Insurance Groups Participation of risk specialists in rating committees Risk management capabilities qualitatively weighted against other rating drivers Explicit identification of influence of risk management on credit where appropriate RMA reports discuss all aspects of risk management for a particular industry or in some cases company 7
Moody s Risk Management Assessments (RMA s) Risk Governance 1. Risk governance at board and executive management level 2. Risk management organization and its influence Risk Management 1. Risk control processes 2. Risk appetite and limit setting 3. Risk mitigation Risk Analysis and Quantification 1. Risk quantification 2. Risk monitoring and reporting Risk Infrastructure and Intelligence 1. Risk infrastructure 2. Risk intelligence 8
Observations From European Insurance RMA s Governance CRO role reporting to Board or CEO Management incentives aligned (at least in part) to risk adjusted measures Established committees covering all major risks Clear ownership of all risks Coordination of activity between business unit, risk unit and internal audit Risk staff embedded in business units Distinct Risk Committee CRO reports to CEO Explicit Risk Appetite reviewed and reported to Board 9
Observations from European Insurance RMA s Risk Management Risk appetite established both on a capital and an earnings basis Risk practices become part of everyday life e.g. new product approval, limit breaches Control, limit and approval processes well established especially for market and credit risks Effective mitigation plans executed or in place for appetite breaches Clear risk appetite targets at Group level Risk mitigation techniques evaluated and proposed at risk owner level 10
Observations from European Insurance RMA s Analysis & Quantification Significant investment in internal models Comprehensive approach to market, credit and interest rate risk Greater focus on difficult to quantify risks: Operational / Catastrophe / Emerging Longevity/mortality improvement Data systems become more closely aligned to risk management needs Well established internal model examines majority of material business risks 11
Observations from European Insurance RMA s Infrastructure & Intelligence Board receives timely, regular and effective risk management information Internal models used more prominently Embedding of output into regular reporting cycle Focus on difficult to quantify risks: Operational Catastrophe Emerging Longevity improvement Provision at high level of timely, relevant, digestible risk information 12
How Moody s Assess Capitalisation? Rating Methodologies stipulate simplified global metrics that we use currently We are also incorporating Groups Internal Capital Models into our analysis (we will not develop our own internal stochastic model) 13
Moody s Internal Capital Model Analysis Why should Moody s care about internal models? Potential for greater insight than established capital measures Regulatory and economic views are converging Asset-liability mismatches highlighted Focus on large franchise-damaging losses instead of everyday risks Models provide basis for understanding the effectiveness of risk mitigation activity Views of relationships and trade-offs between different risks Provide the essential link between risk management and strategic objectives 14
Moody s Internal Capital Model Analysis Rapid developments mean that the opportunity for Moody s to perform analysis of company internal models has vastly increased Robust internal models becoming increasingly common amongst major insurance players Actual and anticipated regulatory change driving developments in this area Model sophistication increasing and company specific features often significant Track record of use and testing being established Such is the pace of change that, for large companies especially, absence of such a capability could soon be a credit negative 15
Moody s Internal Capital Model Analysis Company specific nature means individual analysis of internal models essential Product terms and conditions can vary significantly within a market (guarantees, surrender values, XS levels, risk coverage) Risk profile within certain lines can vary significantly by target market Data profile dependent upon historic sales and persistency experience Policyholder behaviour and claims experience will differ between companies In Moody s view internal capital models now offer the richest source of information about insurance company capitalisation 16
Moody s Internal Capital Model Analysis Consequently Moody s has recently begun to carry out detailed assessments of company internal models Areas of investigation include: Use and coverage of model Systems and controls around model Methodology and assumptions Risk distributions, stress tests and correlations Results analysis 17
Use and coverage of model Use-test : Model outputs should be used to aid decision making at different levels of the firm Overall capital adequacy Risk-adjusted performance and capital allocation decisions Use of model should be embedded in the business culture Good buy in from business unit heads Regular interactions between risk modellers and businesses Same data sources as wider risk management Model coverage should be high Majority of business should be modelled Model should be scalable and extendible to new businesses 18
Systems and controls Testing should be robust and extensive Internal testing procedures External review or sign off Procedures should be defined and maintained Clear and up to date documentation Change control & model run processes Integrated systems and recognised software Track record of results Several run cycles Analysis of change Public disclosure 19
Methodology & Assumptions No prescribed methodology but Moody s expects: Common sense and prudence be used where necessary Latest technical advances are reflected where possible VAR methods with some use of stochastic techniques becoming the standard Assumptions should reflect underlying experience Quality of internal experience investigations important Robust allowance for management and policyholder behaviour, especially in times of stress (in particular persistency and asset mix) 20
Risk distributions, stress tests and correlations Considerable subjectivity due to need to assume extreme events makes this a difficult area Nevertheless Moody s will assess: Appropriateness of distributions for risks Stress tests relative to assumed time horizon and confidence level Reasoning behind assumed correlations Evidence of scenario testing and allowance for any non linearity is also important 21
Results analysis Moody s will form a view on the capital adequacy implied by the model Baseline results assessed in context of model study Adjustments identified due to perceived strengths or weaknesses of model Results modified based on existing stress/scenario tests wherever possible This outcome will be fed into the overall rating committee process and, over time, is expected to outweigh more traditional capitalisation measures 22
Conclusions Capitalisation and Risk Appetite/Risk Management are important, although not overpowering, elements to Moody s analysis of insurers Risk Management will be assessed using our Risk Management Assessment framework (comparison to best practice ) Moody s will increasingly integrate group s internal capital models into our analysis Absence of a strong risk infrastructure backed up by a sophisticated capital model is currently a clear differentiator for insurance groups 23