Risk Based Capital for Life Insurers

1
Risk Based Capital for Life Insurers

• Nick Dumbreck
• Invicta Actuarial Society
• 1 March 2007

2
Agenda

• Drivers behind risk-based capital
• Individual Capital Assessment
• Solvency II
• Economic Capital

3
The traditional regulatory balance sheet
4
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

5
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

6
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

7
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 ß ? higher share
  price
• Rating agencies

8
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 capitalmay be recognized by regulators
  as the minimum regulatory capital requirement,
  superseding any other regulatory requirements
• SP 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 Poors
9
Agenda

• Drivers behind risk-based capital
• Individual Capital Assessment
• Solvency II
• Economic Capital

10
The UK framework regulatory valuation
Market value of admissible assets
Free Capital LTICR RCR Mathematical
reserves
11
The UK framework
Pillar 1 basis (twin peaks approach)
Realistic assets
Free capital Risk capital margin Realist
ic liability
Admissible assets
Free capital WPICC LTICR RCR Statutory
reserves other liabilities
WP firms only (gt500m)
12
The UK framework
Pillar 1 basis (twin peaks approach)
WPICC set to equalise free capital
Realistic assets
Free capital Risk capital margin Realist
ic liability
Admissible assets
Free capital WPICC LTICR RCR Statutory
reserves other liabilities
WP firms only (gt500m)
13
The UK framework
Pillar 2 basis
Pillar 1 basis (twin peaks approach)
Realistic assets
Free capital ICG ICA Realistic liability
Realistic assets
Free capital Risk capital margin Realist
ic liability
Admissible assets
Free capital WPICC LTICR RCR Statutory
reserves other liabilities
Total assets needed
WP firms only (gt500m)
14
The UK framework
Pillar 2 basis
Pillar 1 basis (twin peaks approach)
Realistic assets
Free capital ICG ICA Realistic liability
Realistic assets
Free capital Risk capital margin Realist
ic liability
Admissible assets
Free capital WPICC LTICR RCR Statutory
reserves other liabilities
Total assets needed
WP firms only (gt500m)
15
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

16
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 must 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

17
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 99.5th percentile
Tail VaR (average VaR in tail)
18
ICA model
Classify risk
19
Calculating capital requirements A popular
method
1. Calculate base balance sheet
2. Recalculate base balance sheet in scenarios to
get capital for each risk
Correlation Matrix
3. Apply aggregation formula
20
Risk aggregation in the ICA

• The most common approach for life insurers is to
• Derive 99.5th percentile stress for each risk
• Calculate 99.5th 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
• Non-life insurers typically consider 98.5th
  percentile over 3 years or 97.5th percentile over
  5 years using a DFA model

21
The correlation matrix
Aggregate capital figure
59 Square root of sum of squares
47
Warning correlations for example only
22
FSA ICA review process
Submission request
Initial review
FSA initial view
Further data supplied
Discussion with firm
Formal ICG letter
23
The Use Test

• Strengthening of the link between risk and
  capital management is seen as important
• Demonstrate to supervisors that it is
  sufficiently embedded in the companys overall
  decision making processes
• Demonstrate Board and senior management
  involvement/ responsibility

24
Agenda

• Drivers behind risk-based capital
• Individual Capital Assessment
• Solvency II
• Economic Capital

25
Solvency II reform

• Risk-based regulatory framework for all insurers
  based in EU
• Harmonise standards across the EU to create level
  playing field
• Moving to a single lead supervisor in Europe for
  large groups
• Technical advisor to European Commission CEIOPS
• Proposals must be accompanied by impact
  assessment
• Framework Directive expected to be finalised in
  2007
• Due for implementation in 2010 (perhaps
  optimistic?)
• Some regulators already adopting risk-based
  framework in advance, e.g. FSA (UK), BPV
  (Switzerland), Finansinspektionen (Sweden)

Solvency II will significantly change the
European insurance solvency system
26
ICA vs Solvency II

• ICA
• Alongside Solvency l approach
• Full value of assets included
• Best estimate liabilities
• Capital requirement based on internal model
• Confidence level 99.5 VaR
• No public disclosure

• Solvency II
• Replaces Solvency I
• May be asset eligibility and admissibility
  restrictions
• Best estimate plus risk margin
• Standard alternative to internal models
• 99 tail VaR considered as an alternative (but
  99.5 VaR now looking more likely)
• More disclosure

27
Solvency II framework
Market value of assets
Free capital Adjusted SCR SCR Risk
margin Best estimate liability
MCR
28
Solvency II framework (cont.)
29
Agenda

• Drivers behind risk-based capital
• Individual Capital Assessment
• Solvency II
• Economic Capital

30
What is Economic Capital?
Actual capital The capital actually
available Required regulatory capital The
capital a company must have to be
solvent Allocated or Economic Capital The
capital a company should have to achieve its
goals

• ICA and Solvency II driven by regulators
• Economic Capital driven by companies own desire
  to manage risks better to gain competitive
  advantage and maximise shareholder value
• Some differences in approach between ICA,
  Solvency II and Economic Capital, but many
  components of the capital models are similar

Ultimate goal is to improve risk management
31
Lack of agreement over the best approach
Confidence level
Time horizon
Discount rate
Risk measure
32
Will companies move in the same direction?
Trends Market consistent valuations Modelling
management actions and policyholder behaviour One
year time horizon VaR risk measure
Some consensus emerging
33
The embedded Economic Capital framework
Data
Model
EC
Analysis of results
34
The current Economic Capital framework
Risk appetite
Board
Senior mgt
Reporting
Approval
Reporting
Data
Model
EC
Risk limits
Asset alloc.
Sales
Analysis of results
Expense control
Reinsurance
Capital allocation
Pricing
Performance attribution
RORAC
35
Barriers to implementation

• No regulatory pressure - delays in implementation
• Lack of resources
• Scepticism about value of Economic Capital
  framework
• Data availability and integrity
• Successful implementation into management
  decision-making

36
What improvements are envisaged for the risk
management process in the next 1-2 years?
Source Watson Wyatt Risk Management Survey 2005
Still some way to go before companies gain full
benefits from Economic Capital approach
37
Conclusion

• In the UK the ICA regime has laid much of the
  groundwork for
• Solvency II
• Shape of Solvency II starting to emerge but
  plenty of work still to be done on finalising the
  details
• Neither system represents the last word in
  sophistication, but each is a considerable
  improvement on the regime it replaces
• Implementing risk based capital requires a lot of
  actuarial resource
• Economic Capital evolving as an important risk
  measurement and decision making tool to gain
  competitive advantage

Risk-based capital models are becoming the norm!
38
Risk Based Capital for Life Insurers

• Nick Dumbreck
• Invicta Actuarial Society
• 1 March 2007