Risk Management Best Practices 2004

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Risk Management Best Practices 2004

• David Ingram, FSA, FRM, PRM

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• The savvy corporate leader uses risk management
  as both a sword and a shield.
• John S. Hunkin, CEO, Canadian Imperial Bank of
  Commerce

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Presentation

• Brief Overview of Risk Management Best Practices
  for Insurance Companies
• Risk Capital
• Product Risk Margins

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Risk Management Best Practices for Insurance
Companies

• Board Senior Management are Responsible for
  Risk Management
• Senior management understands all firm
  activitiesand understands the basis of the Risk
  Management system
• Authority and responsibility are clearly
  definedand risk measurement and management are
  independent from risk taking functions
• All material risks are identified and
  measuredExposures are aggregated and management
  attends to largest exposures

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Risk Management Best Practices for Insurance
Companies

• There are risk limits for all material risks and
  a system for enforcing the limits that is part of
  an internal control system that is relevant to
  the risks of the firm
• The firm has staff with sufficient expertise to
  perform the risk management functions and
  adequate systems support
• Risk surplus is allocated to business units and
  products and is used for capital budgeting
  purposes
• Stress testing is a part of the risk management
  process

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Risk Management Best Practices for Insurance
Companies

• New products and ventures trigger consideration
  of potential new risks and new risk management
  procedures
• Financial reporting allows management to view the
  risk adjusted returns of business units, products
  and activities.
• Product pricing and rate setting reflects the
  risk adjusted return.
• The firm has a process for quickly resolving
  identified risk management weaknesses

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Shield Sword

• Risk Surplus
• Product Risk Margins

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Risk Surplus

• Need for Risk Surplus
• Calculation of Risk Surplus
• Allocation of Risk Surplus
• Uses of Risk Surplus

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Need for Risk Surplus

• Management needs to balance between returns and
  risks
• Need to identify and quantify risks inherent to
  the company
• Need to measure performance consistently and make
  strategic decision
• Capital is a buffer against unexpected losses
• Link between the level of risks assumed and the
  level of capital held
• Not desirable to over-capitalize
• Efficient use of capital to achieve optimal RoE
• How much capital is needed for the assumed risks?

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Regulatory Surplus Requirements

• Migrating to an Economic Capital basis
• Banking Basel II
• Internal Models Advanced Modeling Approach
  (2007)
• Insurance
• UK CP195 ICAS
• Resiliency Tests
• Implementation 2005

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Purpose of CP195

• Reserving Capital
• Covers with profits business
• Ensure firms can cover, to an adequate degree of
  certainty, expected contractual liabilities and
  discretionary payments

• Stress Scenario
• Designed to test overall adequacy of its
  financial resources
• One of the inputs to the giving of individual
  capital guidance

• Reporting
• New reporting proposals
• In particular covering with profits

Timetable offices disclosing realistic position
for year ends on or after September 2004!
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From 1 January 2005, UK Life insurers should

• Maintain overall financial resources adequate to
  ensure that there is no significant risk that
  liabilities cannot be met as they fall due
• Have systems and procedures in place for
  assessing that the financial resources are
  sufficient
• Identify major sources of risk in certain
  categories
• Carry out stress and scenario tests appropriate
  to the major risks identified

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Realistic Reserving
Initially 20 Offices now up to 95 Coverage by
size
First Performed In June 2002
Additional Offices in subsequent exercise
Realistic Balance Sheet
Public at Year Ends on or after 30 Sep 2004
Returns private at outset (remain so for interim)
Six Monthly Realistic Reporting
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Acceptable Methods of Calculating Realistic
Liabilities

• Asset Share
• Prospective or Bonus Reserve approach

Realistic WP Reserves

• Smoothing
• Enhancements
• Guarantees
• Future Charges

Adjustments
Realistic Liabilities

• Market Consistent
• Sophisticated and robust methods
• Weighted deterministic available but not
  favoured

Market Consistent
PPFM

• Reflected in modelling
• Treating customers fairly

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Illustration of revised Twin Peaks approach
Excess admissible assets
Risk Capital Margin (RCM)
Future profits on NP business
Other required capital
WPICC
Required capital to be held in With-profits fund
Realistic Liabilities
Long-Term Insurance Capital Requirement (LTICR)
Resilience Capital Requirement
Mathematical Reserves
Admissible Assets in With-profits fund
Required Financial Resources
Regulatory Peak
Realistic Peak
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• WPICC With Profits Insurance Capital Component
• EC Enhanced Capital

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Issues for Capital Assessment

• Applies to all companies whatever size
• Guidance on Capital Models very low
• Waivers, in particular, will be dependent on a
  reviewed model
• Likely results will be an addition to ECR (say
  25) because of
• operational risk
• volatility of investment return
• extreme events
• Aggregation of group capital will need analysis
  in non life and life groups

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(No Transcript)
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UK Resiliency Tests

• Equity 10 to 25 drop in equity markets
• Interest rise in all rates of 20 of long term
  government bonds
• Real Estate 10 - 20 fall in values
• Credit 100 rise in credit spread

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Regulatory Surplus Requirements

• EU Solvency II
• Agreement in Principle to use Economic Capital
• Implementation 2007
• US Canada
• Internal Models Approach for
• Equity product guarantees
• Implementation Canada 2003
• US 2004 or 2005

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Definition of Economic Capital

• Economic capital is defined to be
• the amount of capital required to meet potential
  losses at a given level of risk tolerance over a
  specified time horizon.

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Further Definition

• Capital
• Loss
• Risk Tolerance
• Time Horizon

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Capital

• Current funds per financial statement
• Present Value of Future Funds needed to provide
  for losses
• Excess of MV of Assets over MV of Liabilities

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Loss

• Cash Loss
• Accounting Loss
• MV / Economic Loss

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Risk Tolerance

• Management / Board
• Rating Agency
• Market Customers
• Market Investors
• Debt vs. Equity
• Regulator

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Time Horizon

• 1-year
• intermediate (2 10 year)
• Entire product horizon

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Choice of US Regulators

• Capital Current Book Capital
• Loss Decrease of Book Capital below zero
  (Greatest)
• Risk Tolerance 90 CTE
• Time Horizon 30 years

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Calculation of Economic Capital

• Example Variable Annuities
• Stochastic Scenarios for Market Returns
• Profit Projection Model
• Rank Scenarios
• Distribution of Results
• Economic Capital at Tolerance

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Economic Capital Calculation
4. Distribution
3. Rank
5. Tolerance
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Allocation of Economic Capital

• How to allocate diversification benefits?
• Proportionate
• First in
• Last in
• Corporate

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Economic CapitalConclusions

• World-wide regulatory movement to Economic
  Capital
• Improves Risk based decision making
• Calculations require sophisticated models

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Risk Management SwordProduct Risk Margins

• How Do Companies Look at Risk for their products?
• How do they tell whether they are receiving
  adequate margin for the risks they are taking?

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Pricing For Risk Survey

• Conducted August September 2002
• SOA Risk Management Task Force listserve and
  Product Development Section Members were asked to
  participate
• 351 Responses

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RMTF Pricing Risk Survey
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Capital Allocation (24)

• Capital Requirement relates to Risk of Failure
• Therefore Cost of Capital is seen as Risk Charge
• 55 use RBC Multiple
• 26 use Internal Formula
• 17 use Economic Capital

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Assumption Stress Testing (24)

• Stress Testing of key assumptions
• Judgment Method 60
• Worse Lapse, expense/inflation, claims,
  investment experience - 18
• Confidence Intervals 21
• Adjust premiums if unusually high (or low) impact
  of Stress Tests

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Risk Adjusted Profit Target

• Hurdle Rate varies according to the risk of the
  product
• 2/3 use judgment to determine adjustments
• 1/3 use a formula
• Examples of Adjustment Formula
• Risk Adj Hurdle Rate Base Rate f s
• Where f is the risk return trade-off
• And s is the standard deviation of expected PV of
  profits
• RAHR Corp HR f (s sc )
• Where s c is the corporate average standard
  deviation of PV of profits

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Stochastic Scenario Analysis

• Can be used to develop ä for Risk Adjusted Profit
  Target
• Can use optimization techniques to maximize
  return within risk constraints
• Constraint could be
• duration mismatch maximum
• Maximum 99 percentile loss

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Stochastic Scenario Analysis

• Key Metric
• Percentiles 30
• Problem Scenario Analysis - 16
• Like Assm Stress Testing
• Conditional Tail Expectation 16
• Mean/Variance Analysis 13
• Efficient Frontier 8

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Assumption PAD

• Set based on
• Analysis of Recent Experience 50
• Industry Standard 27
• Stochastic Scenario Analysis 19
• Canadian PfAD (Industry Standard)
• Look at
• High Margin Release from risk for reserves
• low margin Fair risk charge

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Canadian PfAD
Expense high margin 10.0 low margin
2.5 Lapse high margin140 -60 low margin
110 -90

• Mortality
• Margin per 1000
• high margin 15/ex
• low margin 3.75/ex
• Interest
• High Margin 2
• Low Margin .5

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Market Risk Pricing

• Fixed Income Security
• PricePV of Cashflows at Risk Free Rate
• - Charge for expected losses
• - Charge for risk
• Risk Charge is a charge for volatility
  uncertainty of the timing and severity of losses

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Example

• Corporate Bond Yield 7.00
• Risk Free Rate 6.00
• Expected Defaults Losses 0.25
• Risk Charge 0.75

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Credit Loss Experience
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Net Return
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Insurance Pricing

• Theoretical Concept whoever keeps the
  volatility keeps the risk charge
• Practice Insurance companies charge for
• Expected Losses
• General volatility
• Capital Requirements
• Pass along risk charge in excess of amounts
  needed to pay for general volatility Capital
  Reqs
• Keep actual volatility

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Product Risk Margins

• Can Take Many Forms
• Issues with
• Comparability to Market Margins
• Comparability between products and risks

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Final Conclusions

• Risk Management is a many faceted discipline
• Best Practice for Risk Management is not Static
• Best Practice Company will always be seeking to
  improve their Risk Management