Lessons from the ICAS regime for UK insurers Nick Dumbreck President, Institute of Actuaries University of Kent, 6 September 2007
Agenda Individual Capital Assessments (ICA) Review by the regulator Board involvement Current issues and future developments
The traditional regulatory balance sheet Assets Free capital Required capital Liabilities Assets Admissibility limits Possibly reflected at book value Liabilities Discounted at a constant rate of interest and ignores the time value of any policyholder options or guarantees Required capital Generally relatively insensitive to the true riskiness of the business
Problems with traditional approach Overall probability of failure difficult to assess Does not reflect time value of options and guarantees Ignores some sources of risk entirely Accrued terminal bonus (in excess of valuation margins) treated as free capital Does not reflect concentration/diversification of risk
Main sources of risk 1 The obvious ones Market risk (1) - change in interest rates - fall in value of equities/property Credit risk - risk of default on corporate bonds Insurance risk - change in mortality rates (gradual) - temporary increase in mortality (epidemic) - change in lapse rates
Main sources of risk 2 The less obvious ones Market risk (2) - increase in credit spreads - increase in volatility Liquidity risk - potential loss if assets need to be realised quickly Operational risk - expense levels - IT system failure - mispricing risk - regulatory risk - fraud, theft Group risk
Why has risk-based capital become so important? Changes in economic conditions e.g. lower interest rates causing guarantees to bite Equitable Life Stakeholder influence Regulators Protection of policyholders Promote good risk management Shareholders Protect and create value Good risk management lower β higher share price Rating agencies
Rating agencies views Moody's We are already moving towards adoption of risk-based measures We will work with firms on their internal capital models and incorporate results into our ratings Standard & Poor's economic capital may be recognized by regulators as the minimum regulatory capital requirement, superseding any other regulatory requirements S&P will continue to develop robust processes of evaluating companies economic capital processes to better inform our overall view of financial strength Rating agencies are beginning to expect firms to have operating Economic Capital models Source: Moody's and Standard & Poor s
The UK framework regulatory valuation Market value of admissible assets Free Capital LTICR RCR LTICR Factor-based approach RCR Prescribed falls in market values Mathematical reserves
The UK framework Pillar 1 basis (twin peaks approach) Free capital Free capital WPICC Admissible assets LTICR RCR Realistic assets Risk capital margin Statutory reserves + other liabilities Realistic liability WP firms only (> 500m)
The UK framework Pillar 1 basis (twin peaks approach) Free capital WPICC set to equalise free capital Free capital WPICC Admissible assets LTICR RCR Realistic assets Risk capital margin Statutory reserves + other liabilities Realistic liability WP firms only (> 500m)
The UK framework Pillar 1 basis (twin peaks approach) Pillar 2 basis Free capital Free capital Free capital WPICC ICG Admissible assets LTICR RCR Statutory reserves + other liabilities Realistic assets Risk capital margin Realistic liability Realistic assets ICA Realistic liability Total assets needed WP firms only (> 500m)
The UK framework Pillar 1 basis (twin peaks approach) Pillar 2 basis Free capital Free capital Free capital Admissible assets WPICC LTICR RCR Statutory reserves + other liabilities Realistic assets Risk capital margin Realistic liability Standard model Realistic assets Internal model ICG ICA Realistic liability Total assets needed WP firms only (> 500m)
Realistic liability Includes discretionary as well as guaranteed payments Term structure of discount rates, based on risk-free yields Stochastic modelling of options and guarantees/replicating portfolio approach Allows for management/policyholder actions
The Individual Capital Assessment (ICA) The ICA is a self-assessment by the insurer of the amount of capital needed to ensure that there is "no significant risk that its liabilities cannot be met as they fall due" Each insurer has had to prepare an ICA at least annually from 31 December 2004 All material risks are considered explicitly (including market, credit, liquidity, insurance, operational and group risks) There is no requirement to publish the ICA
ICA capital requirement Defined for ICG purposes as 99.5% confidence level over one year that assets will be equal or greater than liabilities Mean Std Deviation VaR 99.5 th percentile Tail VaR (average VaR in tail)
ICA model Collect data Identify material risks Classify risk Market Credit Liquidity Insurance Operational Group Quantify risk Actions to reduce risk Set capital requirements
Calculating capital requirements A popular method 1. Calculate base balance sheet Base m Assets 1200 Liabilities 1000 Surplus 200 Correlation Matrix 2. Recalculate base balance sheet in scenarios to get capital for each risk Equity down Assets Liabilities Surplus Equity Capital 40 m 1000 840 160 3. Apply aggregation formula Equity Int. Prop Credit Eq vol Eq 1.0-0.2 0.5 0.5 0.7 Int. -0.2 1.0-0.1 0.3 Prop. 0.5-0.1 1.0 0.2 0.5 Cred 0.5 0.3 0.2 1.0 Eq vl 0.7 0.5 1.0 Mort Lps -0.5 0.1-0.4 Op 0.6-0.1 0.2 0.2 0.5 Interest Property Credit Equity vol 10 5 5 10 Mort Lapse Op -0.5 0.6 0.1-0.1 0.2 0.2-0.4 0.5 1.0 1.0 1.0 Mortality Lapse 5 10 ICA 2 Ci + = ρijcic j Operational Total 15 100
Risk aggregation in the ICA The most common approach is to: Derive 99.5 th percentile stress for each risk Calculate 99.5 th percentile capital required for each risk separately Aggregate to derive total capital required using a "correlation matrix formula" approach Adjust as necessary for any weaknesses in approach
The correlation matrix Capital (C i ) Eq Int. Prop. Cred Eq vl Mort Lps Op Equity 40 Equity 1.0-0.2 0.5 0.5 0.7-0.5 0.6 Interest 10 Int. -0.2 1.0-0.1 0.3 0.1-0.1 Property 5 Prop 0.5-0.1 1.0 0.2 0.5 0.2 Credit 5 Credit 0.5 0.3 0.2 1.0 0.2 Equity imp. vol 10 Eq vol 0.7 0.5 1.0-0.4 0.5 Mortality 5 Mort 1.0 Lapse 10 Lapse -0.5 0.1-0.4 1.0 Operational 15 Op 0.6-0.1 0.2 0.2 0.5 1.0 Total 100 2 Aggregate capital figure = C + = 59 i ρ ij C ic j C 2 i Square root of sum of squares = = 47 Warning: correlations for example only
Agenda Individual Capital Assessments (ICA) Review by the regulator Board involvement Current issues and future developments
FSA ICA review or?
Objectives of the ICAS regime To provide insurers with an incentive to improve risk management To reinforce the responsibility of senior management to manage a firm s capital in line with its risks To assist the regulator to assess the overall adequacy of a firm s capital
FSA ICA review process Formal ICG letter FSA ICA panel Possible discussion Further data supplied Discussion with firm FSA initial view Written questions Initial review Submission request
Individual capital guidance (ICG) First round of reviews completed on target by 30 June 2007 Non-life Average ICG 18% in excess of firm s ICA in 2005, 10% in 2006/7 Life Average ICG 14% (stable over time) Range 0% to 70%, excluding outliers
Main sources of ICG Non-life Operational risk including model validation and understanding Lack of supporting evidence for assumptions (e.g. volatility of underwriting risks, correlations under stressed conditions) Life Operational risk (again) Aggregation (non-linearity, stressed correlation assumptions) Quality of capital resources Credit risk
Other review issues (1) Assets/ liabilities l Value of non profit (life) l Service companies l Intra-group reinsurance l Value of illiquid assets l Management actions l Transferability of capital l Avian flu pandemic (life) Stresses l Lapse stress tests (life) l Appropriateness of stresses l Reinsurer credit risk (non-life)
Other review issues (2) l Mortality/longevity offset Aggregation l Scenario analysis l Management actions Process l Small ICA team / lack of documentation l Board/NED involvement/ understanding l Use test
Individual capital guidance A firm must notify FSA if it fails (or expects to fail) to maintain cover for ICG and explain either: What action it intends to take to increase the capital resources; or What modifications it feels is necessary to the ICG
Target capital risk appetite Risk appetite often linked to ICA: Higher confidence level and/or different time horizon Ability to cover ICA after pre-defined shocks Percentage coverage for the ICA Absolute amount of cover for the ICA
Economic capital confidence levels of European insurers 4 3 European regulatory benchmark 1 in 200 1 in 3333 Number of firms 2 1 1 in 1000 1 in 2000 1 in 5000 0 99.50% 99.60% 99.75% 99.80% 99.90% 99.95% 99.97% 99.98% 99.99% Economic capital confidence level Source: Chief Risk Officer Forum "Principles for Regulatory Admissibility of Internal Models" (June 2005)
Agenda Individual Capital Assessments (ICA) Review by the regulator Board involvement Current issues and future developments
Understanding the ICA How well does the Board understand the ICA calculation? AFHs Board members 5% 11% 49% Very well Very well 21% Well Reasonably Slightly 3% Well Reasonably Slightly 63% Not at all Not at all 49% Source: Watson Wyatt 2006 ICA survey
Board training Has the Board had specific training on the ICA? 100% 90% 80% 70% 47% 29% 60% 50% 40% 30% 20% 53% 71% No Yes 10% 0% AFH Board Source: Watson Wyatt 2006 ICA survey
Reporting the ICA How frequently is the ICA reported? AFHs Board members 100% 80% 60% 40% 20% 0% 50% 39% 11% 100% 80% 60% 40% 20% 0% 13% 37% 19% 31% Other Annually Half-yearly Quarterly Monthly Other Annually Half-yearly Quarterly Monthly Too infrequent for use as an effective control? Source: Watson Wyatt 2006 ICA survey
Board involvement to make an effective individual contribution every board member should maintain at least a minimum level of understanding of all key issues and processes within the business the level of board understanding of riskbased capital methods was patchy FSA Insurance Sector Briefing: Risk Management in Insurers (November 2006)
Agenda Individual Capital Assessments (ICA) Review by the regulator Board involvement Current issues and future developments
Current issues credit spreads Spread of corporate bond yields over gilt/swap yields comprises: Allowance for default risk Risk-aversion premium Liquidity premium How much credit can be taken for the risk aversion premium in the realistic valuation of liabilities? How much of any spread widening represents additional default risk?
Current issues - how good are the models? Completeness and accuracy of input data Modelling methods and assumptions Aggregation methods Governance and controls Thoroughness of validation Analysis of sources of profit/loss Sensitivity to assumption changes
Building models for risks Risk type Market Credit Insurance Operational Correlations Liquidity Most common methodology Statistical model Statistical model Quantitative & qualitative Scenario testing Expert opinion & quantitative Scenario testing Comments Fit distribution to historical data or use economic scenario generator Fit distribution to limited historical data or use 3 rd party model Limited data so greater uncertainty, mortality often uses expert views Some use of databases, but mainly internal scenario analysis or factors Quantitative for market risks, largely qualitative for other risks Historical and prospective scenarios
Current issues - scenario testing GENPRU Carry out stress and scenario testing (GENPRU 1.2.42R) INSPRU Carry out stress and scenario testing (INSPRU 7.1.69G) Consider a range of scenarios that could give rise to such a loss (INSPRU 7.1.73G) FSA We place great importance on this and expect ICA submissions to be supported by scenarios ABI Guidance Firms that do not consider combination scenarios as inputs to their capital assessments are likely to need strong arguments to justify this approach. GN46 Scenarios may be used to give additional comfort as to the accuracy of an ICA calculated using other methods
Current issues impact on strategy Liability management Hedging Reinsurance Outsourcing Product development and pricing Volume and mix of new business Dividend distribution Assessment of potential acquisition targets
Conclusions from the ICA Unit linked and protection business need less capital With profits and annuity business often have higher capital requirements ICA is significantly higher the MCR for non-life firms Aggregation, tail events and operational risk are challenging areas But overall improvement in risk management
The future (as seen by the FSA) Extend ICG to diversified groups Better coordination between ICA review and ARROW risk assessments Better integration with enterprise risk management and Solvency II
The embedded ICA Approval Board Reporting Risk appetite Reporting Senior mgt Data Model ICA Risk limits Asset alloc. Capture Validation Change control Analysis of movement Expense control Sales Reinsurance Capital allocation RAROC Performance attribution Pricing
The current ICA Approval Board Reporting Risk appetite Reporting Senior mgt Data Model ICA Risk limits Asset alloc. Capture Validation Change control Analysis of movement Expense control Sales Reinsurance Capital allocation RAROC Performance attribution Pricing
How close are we to the FSA s ideal? Are we nearly there yet? Still some way to go
Lessons from the ICAS regime for UK insurers Nick Dumbreck President, Institute of Actuaries University of Kent, 6 September 2007