RISK MANAGEMENT OF A FINANCIAL CONGLOMERATE

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RISK MANAGEMENT OF A FINANCIAL CONGLOMERATE A
challenge for the actuaries?
Luc Henrard Chief Risk Officer,
Fortis Enterprise Risk Management symposium
Chicago, April 26-27, 2004
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Overview

1. Introduction
2. Measurement of risks
3. Differences Insurance and Banking
4. Food for thought Role of the actuary
5. Conclusion

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1. INTRODUCTION
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1.1. External and internal constituencies want
a clear understanding of risks
Risk versus Capital
Risk versus Return

• Creditors
• Regulators
• Rating Agencies

• Shareholders
• Analysts

Executive Committee
Shareholders have entrusted the board with their
capital They dont want to lose it They expect
a decent return or optimal use of their
capital They dont want any surprises They
penalise volatility
Regulators demand that risks are well managed (to
avoid tax-payer bail-outs) Depositors/policyholde
rs expect safety of their savings and
investments Rating agencies will only give high
ratings to institutions able to measure and
manage risk
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Example in Life Insurance

• Question in the traditional model
• Given set of liabilities what is the optimal
  strategic asset allocation strategy.
• Question in the risk model
• Given my constraints in capital, what is the best
  use of this capital
• More risky asset mix and if yes, equities, credit
  or should the company strive for more
  conservative investment policy and try to invest
  the capital for (more) growth? If yes, what type
  of business?
• New development in product design Insurance
  savings products merely packaging of capital
  market commodities such that residual market
  risk and related capital for insurance companies
  is low

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1.2. A Bancassurance group faces a wide
range of risks
NB In this fairly arbitrary classification,
insurance risk is the residual risk you have on
the liability side when you have stripped
out all of the investment risk.
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Ordering of risks Consumption Economic Capital
at Fortis
RELATIVE CAPITAL CONSUMPTION (illustrative)
Credit Risk capital is expected to be large for a
wholesale bank ALM is invariably the largest
consumer of capital in insurance companies
(especially in Life) given that Insurance Risks
diversify away in large portfolios The potential
duration mismatch in banking is proportional to
the book and sensitive to the options of lending
products, e.g. prepayment options for residential
mortgages Insurance risks (Mortality and
Underwriting) will diversify away substantially
in large portfolios because they are not
correlated with the other (financial) risks and
because a lot of the volatility is already
reserved for in the provisions Operating risks
are typically proportional to the fixed cost base
First order
Second order
Third order
Capital
100
0
Trading
ALM - Bank
Credit - Bank
Underwriting
ALM - Insurance
Operating - Bank
Credit - Insurance
Mortality/morbidity
Operating - Insurance
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2. Measurement of risks
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A Bancassurance group faces a wide range of risks
Illustrative
RISK
Operational Risk
Investment Risk
Insurance Risk
Credit Risk
Market Risk
Property Casualty Risks
Life Risks
Business Risk
Event Risk
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Step 1 Model each risk in terms of (earnings or
value) volatility and target debt rating
EARNINGS OR VALUE VOLATILITY
MEASUREMENT REQUIREMENTS

TAILPROBABILITIES
Probability of Outcome

• Shareholders to define the risk profile i.e. the
  confidence interval.

BBB
AAA
AA
A
0,01
0,03
0,07
0,30
Default probability

• All risk need to be adjusted forthe same
  capitalization horizon (Basel 2 Recommendation
  one-year horizon)

Earnings or Value
Mean
0
KBBB
KA
KAA
Capital required to achieve rating Economic
capital
KAAA
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Step 2 Look at the capital consumption and
define a corridor for solvency capital
MM
Actual lt- capital
FairValue
Amount of equity capitalheld to protect
againsteconomic and statutoryinsolvency
Economic Capital

• Amount of capital required to protect the
  company against statutory insolvency.
• Acts as a floor, which triggers takeover by
  the regulators.
• Based on rules of thumb that do not reflect real
  economic risk of the business.

Regulatory capital --gt
-
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Step 3 Look at the risk/return Framework
Accounting view RoA / RoE Regulatory view
RoRE RARORACEconomic view (Basel 3?
Solvency 3 ?) RAROC RORAC
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Example Risk return frameworkAlternative
investment strategies for Group life product
Profit sharing based on book yield underlying
bonds
Change in Fair Value(1 yr period)
Increasing bond duration
ALM EC / Technical Provision
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Consequence we need to develop an alternative
Economic Measure for Solvency capital.

• Needed discussion between experts (actuaries and
  non-actuaries) on pragmatic economic solvency
  measure
• Developments of risk based measures (NAIC
  RBC/Solvency II)
• Consistency in taxonomy and terminology between
  Bank and Insurance regulators
• Regulators and rating agencies to familiarize
  with the way banks/insurance companies measure
  economic solvency based on real measurement of
  risk no fixed rules of thumb. Only then
  financial institutions can start managing risks
  and capital

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3. Differences Insurance and Banking
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3.1. Actuaries and bankers have evolved
different approaches and terminology
Banking Insurance
Terminology Expected loss Rating Master scale VaR RARORAC Economic capital Claims Mortality tables Embedded Value/Fair Value Reserves/Solvency/Risk based capital
Focus Risk One year Expected outcome Multi year
Weaknesses Insufficient use of statistics Customer behavior Insufficient use of modern Finance theory Little use of transfer pricing (ALM)
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3.2. The purpose of an economic capital/solvency
project is to arrive at the capital
requirements of the Group based on the
risks taken.
REGULATORY CAPITAL
AGENCY DRIVEN CAPITAL
ECONOMIC CAPITAL
ACTUAL CAPITAL


Amount of capital required


Amount of capital the


Amount of capital required


Amount of equity capital or
to protect the Group
rating agencies expect in
to protect the Group
Embedded Value actually
against
statutory
order to feel comfortable
against
economic
held to protect the Group
insolvency over a one-year
giving Fortis a AA rating
insolvency (over a one-year
against
economic
and
time-frame
time-frame)
statutory
insolvency over a
one-year time-frame


Based on undifferentiated


Based on relatively


Reflects real risks taken in


Accounting result
rules of thumb that do not
undifferentiated rules of
the sense of unexpected
expanded definition
reflect the real economic
thumb (bank), and/or
movements in the value of
includes hidden reserves
risks of the business and
simple models (insurance)
assets and liabilities and
usually based on
on the confidence interval


Not formulaic other
(relatively) public
management wishes to
factors such as quality of
information
tolerate
management and


Designed to protect policy
likelihood of Government


Designed to be a tool for
holders and creditors
bail-out are also
management
considered


Acts as a floor, which
triggers takeover by the
regulators
BARE MINIMUM CAPITAL
CAPITAL YOU ARE
CAPITAL YOU OUGHT TO
CAPITAL YOU ACTUALLY
YOU MUST HAVE
EXPECTED TO HAVE
HAVE
HAVE
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Example different forms of capital life insurance
company
Surplus Regulatory Capital
Additional Prudency
Required Regulatory Solvency Capital
Expected Liabilities
Balance Sheet Reserves/Provisions
Solvency Capital
Required Economic Solvency Capital
Expected Liabilities
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3.3. How to bridge the GAP ?
Basel 2 Requirementsfor Banks Statutory Reservesfor InsuranceCompanies Economic Capitalconsumed by aBancassurer
Confidence interval A?/BBB ? None Shareholder's decision
Base Line Statutory solvency Statutory solvency Economic solvency
Valuation Statutory Statutory Fair value
Risk type coverage excludes Business risk as well as most of the ALM risk (the Banking Book) Excludes Event Risk All risk types
Diversification ? ? Yes
Market risks are highly correlated with credit
risk. It is not the case however for operational
risk. The existing European insurance capital
requirements assume some average level of
correlation within one licensed entity. In
case several such entities form part of an
insurance group, any additional diversification
(e.g. geographic diversification) are ignored.
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Leeway for regulatory arbitrage
Example CAPITAL REQUIREMENTS FOR A RATED
CREDIT RISK

• EU Life Insurance
• Treat as an investment (no explicit focus on
  credit risk)
• Implicit asset risk charge 3 outstanding

• US Insurance PC (NAIC RBC)
• 0.3-1.0 for investment grade credit

TODAY

• Banking Regulation (BIS I)
• 8 (minimum 4 must be Tier 1)

• Banking Regulation (FDIC)
• US Banks also subject to prompt corrective
  action (PCA) requirements

• END INVESTORS
• No capital requirements

• BIS II will bring regulatory requirements much
  closer to Economic Capital, decreasing banks
  incentives for regulatory arbitrage, although
  some will remain among lower quality credit
  (BB-BBB)
• More risk sensitive requirements is also
  observed in the insurance industry (Solvency II)
• Definition of Regulatory capital still differs
  between banking and insurance.

TOMORROW
CONCLUSION
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4. Food for thought Role of the Actuary
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Actuaries in a risk management process

• Traditionally Actuaries focused on technical
  insurance risks (mortality, disability, PC
  claims risks, etc).
• Today the actuaries perspective includes the
  whole risk taxonomy
• Integration of ALM and Actuarial departments
• Shift from traditional solvency to Risk based
  solvency measures

This has consequences for the academic actuarial
curriculum transition to curriculum all-round
financial risk manager integration actuarial
science, (mathematical) finance, econometrics
financial markets, etc
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..and the use of current models in a risk
framework

• In order to do risk modeling current models (e.g.
  Embedded Value models) have to be dynamized
• From policy-to-policy to model points
• Full integration with asset side of the balance
  sheet
• Stochastic simulations
• Risk adjusted cash flows
• Calculations with the dynamized model
• Economic Capital/Solvency calculations
• Fair Value type computations
• Development of robust Economic Solvency Framework
  in the light of Solvency II and link to pricing

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possible consequences for the actuarial
profession

• Actuarial and other financial experts have to
  educate the external constituencies re the
  economic risk picture
• For bank-insurance groups how can
  diversification-netting benefits be explained to
  rating agencies?
• This has consequences for the academic actuarial
  curriculum transition to curriculum all-round
  financial risk manager integration actuarial
  science, (mathematical) finance, econometrics
  financial markets, etc

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5. CONCLUSION
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Conclusions

1. We need a more rational and appropriate framework
   for responding in an appropriate manner to the
   issues and opportunities raised by the
   convergence of the Banking and Insurance
   models.- Role of the actuary crucial- Current
   models (e.g. Embedded Value) have to be turned
   into risk models.
2. It is only in this spirit of co-operation and
   mutual willingness to learn from each other that
   we will reap the full benefits of convergence.
3. Basel 2/Solvency 2 is a necessary condition to
   reach that objective uniform economic solvency
   framework ? Still quite a lot of issues to be
   discussed.
4. Internal reporting ? external reporting.
5. Integration of the major regulators (Bank
   Insurance Stock exchange).