Effective Computer Presentations

1
Economic Capital (EC) ERM Symposium, CS
1-B Chicago, IL April 26-27, 2004 Hubert
Mueller, Tillinghast Phone [phone]   
Value/
Capital
2
Overview
EC Measurement and Allocation
Uses of EC
EC vs. Rating Agency or Regulatory Capital
3
Determining EC involves an analysis of the risk
profile for a selected risk tolerance level
sufficient surplus capital to cover potential
losses, at a given risk tolerance level, over a
specified time horizon
4
EC typically covers both financial and
non-financial risks
Results of a 2002 SOA Survey
5
When determining EC, various risk tolerance
measures are used
Results of a 2002 SOA Survey Conditional
Tail Expectation (or TVAR)
6
There are a variety of approaches in use for
measuring EC

• Full economic scenarios
• Stress testing
• Factor tables
• Stochastic models (risk free / real world)
• Mean-Variance-Covariance model
• Credit risk methods
• Option pricing (Black Scholes)
• Includes operational risk (increasingly)

7
Many companies calculate EC on both a total
company and a LOB basis
Source SOA/Tillinghast Risk Capital Management
Seminar (March 2003)
8
Various methods are in use for allocating EC

• Diversification benefit
• Results from combining products with different
  risk profiles
• Allocating EC at the enterprise level
• Diversification benefit goes to corporate segment
• Allocating EC to business segments
• Diversification benefit stays at LOB
• Allocating EC for pricing purposes
• Generally, simplified formulas are used

9
Typical Approaches used in allocation of EC

• By risk measure (e.g. VAR, TVAR, ECOR)
• Based on exposure
• Based on exposure times default probability
• Based on loss simulations
• Based on incremental capital

10
Example
11
Best Practices

• Including both financial and non-financial risks
• Determining EC as the difference between required
  assets and MV of liabilities (or Embedded Value)
• Allowing for diversification benefit
• For pricing, LOB is held at EC level
• Excess of regulatory capital over EC (if any) is
  leveraged through the use of reinsurance or LOC,
  typically at a lower cost

12
Typically, the diversification benefit resides at
the corporate level
Diversification Benefit
13
Overview
EC Measurement and Allocation
Uses of EC
EC vs. Rating Agency or Regulatory Capital
14
Many companies use EC to determine and manage the
right level of capital
Source SOA/Tillinghast Risk Capital Management
Seminar, March 2003
15
There are many other uses of Economic Capital
all requiring stochastic analyses

• Solvency II (IAA Working Party)
• OSFI regulation for segregated funds
• C-3 Phase II capital model
• Proposed STAT reserves for variable annuities
• GAAP SOP 03-1 requires explicit reserves for
  guarantees
• Variable annuity risk profiles and hedging
  analysis
• Pricing and risk management
• Measuring Economic Value
• Measuring exposure to catastrophic events

16
Solvency II Overview

• Three-pillar approach to supervision
• All types of risks are to be included
• Total balance sheet approach
• Requires use of appropriate risk measures, and an
  appropriate time horizon
• Need to allow for risk management
• Company-specific approaches recommended
• Capital requirements should be market-efficient
• Encouragement of best practices
• Expected to be effective by 2005?

17
Various activities in the U.S. marketplace
require life insurers to improve their stochastic
modeling capabilities

• New capital requirements according to C-3 Phase
  II RBC proposal
• New reserving requirements (STAT/GAAP)
• Pricing of guarantees (GMDB, GMWB, GMAB, GMIB)
  within VA contracts
• Analysis of current risk exposure for guarantees
  on EIAs, VAs and UL products
• Analysis of credit risk on assets backing
  interest-sensitive business

18
C3 Phase II proposed modeling standard for
required capital on variable annuities

• Model Assets begin with Starting Assets equal to
  Statutory Reserves (or a best estimate based on a
  roll forward from prior quarter reserves)
• Model Surplus is defined as Model Assets less
  Cash Surrender Value (proxy for reserve
  liability) Starting Surplus generally positive
• For each scenario, compute its Additional Asset
  Requirement (AAR)

19
C3 Phase II required capital (continued)

• AAR for scenario (i) is added to Starting Assets
  Total Asset Requirement (TAR)
• TAR(i) Starting Assets AAR(i)
• Stochastic process is repeated N times
• C3-Phase II capital TAR _at_ CTE(90) - Statutory
  Reserves
• Alternative Factor Method is possible
• Implementation is expected for year-end 2004

20
Illustrative Capital Requirements for Variable
Annuities under C3 Phase II (bps of AV)
Source Tillinghast
21
Proposed STAT Reserves for Variable Annuities

• Stochastic modeling of risk exposure
• Using CTE (65), i.e. average of worst 35 of
  outcomes
• Alternative factor method is possible
• Expected to cause reserve volatility
• Implementation expected for 2005

22
New GAAP Reserves for Guarantees (SOP 03-1)

• Stochastic modeling of cost of guarantees
• Scenarios should be consistent with DAC EGP
  calculations
• Additional reserve required if guarantees
  in-the-money
• PV (excess benefits) / PV (reserves)
• Will cause reserve volatility
• Effective since 1Q04

23
Example Creating risk profiles for VA guarantees
24
ExampleHedging the Tail Exposure Case Study
(Gain) Loss as of Fund Value
25
Overview
EC Measurement and Allocation
Uses of EC
EC vs. Rating Agency or Regulatory Capital
26
Regulators use capital to determine a companys
financial solvency
INSOLVENT
27
EC vs. Regulatory / Rating Agency Capital

• Companies internal EC models are designed to
  reflect proprietary risks
• Company-specific, tailored to risks
• Prospective method
• Regulatory capital (RBC) is generally based on
  industry factors
• Not company-specific
• Formulaic method, retrospective
• Reconciliation through rating agencies?
• Historically, a retrospective view
• Current trend towards evaluating capital
  requirements based on proprietary models

28
All major rating agencies have recently come out
with enhanced capital adequacy models

• Standard Poors capital model (FPC) applies an
  EC approach
• AM Best has enhanced their BCAR model to allow
  for correlation of risks
• Moodys is coming out with a new capital adequacy
  model as well
• Allows for correlation of different risk factors
  as well