Enterprise Risk Management For Insurers and Financial Institutions

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EnterpriseRisk ManagementFor Insurers and
Financial Institutions

• David Ingram
• CERA, FRM, PRM

From the International Actuarial Association
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Course Outline

• 1. INTRODUCTION - Why ERM?
• 2. RISK MANAGEMENT FUNDAMENTALS FIRST STAGE OF
  CREATING AN ERM PROGRAM
• 3. RISK ASSESSMENT AND RISK TREATMENT - ACTUARIAL
  ROLES
• 4. ADVANCED ERM TOPICS

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Risk Assessment Risk Treatment

• Actuarial Roles
• 3.1 Types of Risks
• 3.2 Risk Models
• 3.3 Risk Treatment Options ALM
• 3.4 Risk Treatment Options Hedging
• 3.5 Risk Treatment Options Reinsurance
• 3.6 Risk Treatment Options Capital Markets
• 3.7 Risk Treatment Options Risk Design
• 3.8 Risk Treatment Options Diversification
• 3.9 Risk Treatment Options Avoid/Retain
• 3.10 Choosing a Primary Risk Metric
• 3.11 Uses of multiple Risk Models
• 3.12 Using Economic Capital for ERM
• 3.13 Capital Management Allocation

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3.1 Types of Risks

• Systematic v. Specific
• Traded v. Non-Traded
• Paid to Take v. Not Paid to Take
• Market, Credit, Insurance, Operational

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Systematic Risk vs. Specific Risk

• Flood Systematic Risk -everyone gets wet
• Bucket of water thrown by your brother Specific
  risk only you get wet
• Insuring one House Systematic or Specific?
• Insuring thousands of houses Systematic or
  Specific?

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What are risk management Techniques for Specific
Risk?

1. _____________
2. _____________
3. _____________

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What are Risk Management Techniques for
Systematic Risk?

1. _____________
2. _____________
3. _____________

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What happens with a group of specific risks?
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3.2 Risk Models

• Cause / Effect - Outcome
• Outcome Frequency/Severity
• Closed Form v. Single Scenario v. Monte Carlo
• Stress v. Scenario
• Sensitivity

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Cause Effect - Outcome

• Typical Life Insurance Actuarial Model
• Model follows the steps taken over the life of an
  insurance contract following a tree branching
  logic
• Policy Issue, continue to next year (1 q - w)
• Death Claim in first year (q)
• Lapse or surrender the contract (w)
• Repeat year after year
• Outcome PV of three paths for each year

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Outcome Frequency/Severity

• Model commonly used for non-life insurance and
  for financial market instruments
• Past observations of frequency and severity of
  outcomes used to parameterize statistical models
  of future outcomes

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Closed Form v. Single Scenario v. Monte Carlo

• Close Form models
• one step calculations
• usually depend upon assumption of distribution of
  outcomes (normal or log normal) that have
  formulaic outcomes
• Black Sholes
• Single Scenario
• Also one step (the one scenario)
• Using either CEO or OFS
• Monte Carlo (stochastic) model
• Multi scenario
• Often do not presume to know distribution of
  outcomes

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Stress v. Scenario

• Stress Test
• Redo calculation changing one parameter
• Scenario Test
• Adjust all parameters to reflect a fictional
  total world
• Includes interactions of factors and dependencies
  in the assumed situation

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3.3.0 Risk Treatment Process

• May vary significantly with each major risk
  category
• Depending on Nature of Risk
• Assessment Capabilities
• Relationship with Risk Takers
• Knowledge Experience of Staff

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Components of Risk Treatment Process

• Risk Identification
• Measuring Monitoring System
• Risk Assessment Communication
• Establishment of Risk Limits Standards
• Risk Treatments
• Enforcement of Limits Standards
• Risk Learning

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Risk Identification

• Within a broad category
• Need to know which sub categories of the risk can
  be treated together
• And which need to be treated separately

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Measuring Monitoring System

• Measures of risk v. Key Risk Indicators
• Existing v. Future
• Manual v. Automated
• Quantitative v. Qualitative

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Risk Assessment Communication

• Need to establish regular schedule of assessment
• Assessments must be communicated at several
  levels in the organization
• Operational Levels
• Management levels
• Management MUST have discussions with
  subordinates about the risk positions

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Establishment of Risk Limits Standards

• Limits How large, How much, How many,
  Authorities
• Limits must be quantitative
• Also may use Checkpoints
• Standards
• For how things are to be done
• Treatments permitted/ required

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Risk Treatments

• Avoid
• Reduce
• Offset
• Transfer
• Retain Provision

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To set Standards

• Ask the best person in a function what needs to
  be done to get it right
• Ask supervisors what information that they need
  to be able to tell that things are being done
  right
• Standards also apply to documentation and
  recordkeeping

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Enforcement of Limits Standards

• Assessment Communication systems need to
  include comparison of risk positions to limits
• And adherence to standards
• Must clearly establish what will happen if limit
  or standard is violated
• Might depend on seriousness of breach
• Hard limits v. Soft Limits

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Risk Learning

• About Losses, Risk Assessment, Risk Treatment
  Processes
• Internal
• External
• Backwards
• Forward

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Credit Risk Treatment

• Traditional Credit Risk Treatment
• Standards for
• Underwriting
• Authorities
• Collateral, Coverage
• Limits Enforcement
• Limits by credit quality, Size of Position
• Authority Limits
• Active Workout with Risk Learning

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Modern Credit Risk Treatment

• Credit VaR risk model Aggregate limits
• Gives aggregate portfolio view of Credit Risk
• Allows trade-offs within aggregate limits
• Use of credit derivatives to offset excessive
  specific or aggregate risk levels

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Insurance Underwriting

• Traditional Risk Control Mechanism for Insurance
• Standards for
• Underwriting
• Authorities
• Insurable Interest
• Limits Enforcement
• Limits by quality, Amount of Coverage
• Authority Limits
• Active Claims management with Risk Learning

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3.3 Risk Treatment Options ALM

• Interest Rate Risk Treatment
• Crediting Rate Matching
• Cashflow Matching
• Duration Matching
• Advanced ALM
• Economic Capital
• Limits Reporting

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Crediting Rate Matching

• Portfolio Rate
• New Money Rate
• Investment Year Rates
• Mismatched crediting rates can lead to large
  harmful cashflows

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Cashflow Matching

• Project out expected cashflows from liabilities
• Project out expected cashflows from assets
• Identify major gaps where there is a large
  difference between the projected cash outflow and
  inflow in a future year
• Make plans to fill those gaps (usually on asset
  side for insurers)
• Targeting future asset purchases
• Targeting asset sales repurchases

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Duration Matching

• Duration is sensitivity of value to a change in
  interest rate
• Also equal to PV of time weighted cashflows
• Sum of PV(t x Cft)
• Focus on DA v. DL
• Set Limit for abs(DA DL)
• Usually ½ to 1 year

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Duration Matching

• Most Insurers adjust assets to match duration of
  liabilities
• First step is to assess expected DL for a new
  product
• Set DA target for new cashflow
• Second step is to set schedule for assessment of
  portfolio DA DL

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Duration Matching

• If assessment reveals excessive abs(DA DL) gap
  then will plan to
• Adjust DA target for future cashflows
• Sell some assets and purchase others to change DA
• Purchase derivatives
• Macro or Micro Hedge

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ALM Advanced

• Duration matching only works well if interest
  rate moves are
• Small
• Similar for all durations
• Advanced methods take care of
• Larger movements (Convexity)
• Non-parallel shifts (Key Rate Durations)

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Convexity

• Change in Duration with change in interest rates
• Second derivative of value with respect to a
  change in interest
• Duration measures slope of the value plot
• If Value Plot is a curve, then slope is only
  accurate measure for very small moves

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Key Rate Durations

• Change in value with change in rate at a specific
  duration
• For example, 5 year rate only
• Matching Key Rate Durations allows protection
  against yield curve twists

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3.4 Risk Treatment Options Hedging

• Financial Market Risk Treatment
• Derivative Instruments used for Hedging
• Futures
• Put Call Options
• Swaps
• Derivatives are often low cash outlay
• Usually means that derivatives involve
  significant leverage

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Example of Financial Market Risk

• Product Index Annuity
• Feature Product promises the greater of
• 80 of stock market growth
• Floor interest Rate on 90 of funds
• On a specified maturity date
• To match without derivatives would require
  insurer to invest twice
• 80 In Stock Fund
• 90 in Bonds
• For a total of 170 of deposit

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Hedging Methods

• Cashflow Hedging
• Works like Cashflow matching in ALM
• Purchase derivatives that have strike dates where
  there are potential cash mismatches
• Most firms use this method to manage Index
  Annuities
• Invest 90 of deposit in fixed income
• Use other 10 to buy Option contracts tied to
  Equity market
• Adjust participation percentage (80) based upon
  cost of Options
• Strike Date3 for Options is maturity date
• Of Index Annuity Contract

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Hedging Methods

• Delta Hedging
• Is fundamentally the same idea as Duration
  Matching
• Delta is change in price (value) per change in an
  underlying (usually a market index)
• Delta hedging often uses derivatives with
  extremely different term to hedge obligations
• Delta hedges are only good for a very short time
  period (usually a day)
• Delta Hedges must be rebalanced every day

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Delta Hedging Index Annuity

• Buy bonds to cover interest guarnatees
• Delta hedging ignores interest rate risk
• Then determine Delta of liabilities
• Plus Delta of existing hedges
• Purchase new derivatives that will bring Delta of
  assets hedges to be within tolerance for
  difference from liabilities

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Hedging Methods

• Greeks
• Greeks are partial derivatives of Prices with
  change in various factors
• Gamma
• Vega
• Tau

Get Definitions
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Hedging Index Annuity with Greeks

• Investments can be any mixture of bonds and
  stocks
• Greeks will determine adjustments needed with
  derivatives to match all of the risk
  characteristics

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Custom Hedging

• Can purchase custom hedge contracts from a bank
  that have terms tailored to your specific need
• If using custom hedges, would expect very low
  amount of rebalancing needed
• Hedges are tied to market indices not to actual
  liabilities

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Hedging Programs Favorable Unfavorable
Cashflow Hedging Easy to understand Control Lock in protection Inflexible Difficult to adjust Can be costly
Delta Hedging Can produce low cost hedging program Single Metric easy to control Works well in normal market conditions Requires sophisticated models derivative trading abilities Requires that derivatives are always available and always reasonably priced Ignores risk of jump and other risks
Greeks Can provide protection that is effective in normal abnormal markets Requires highly sophisticated models and derivative trading capabilities Can result in high amount of trading to balance many Greeks
Custom One step hedging process May not work as expected Custom hedge is illiquid usually must sell back to same bank May be costly
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3.5 Risk Treatment Options Reinsurance

• Insurance Financial Market Risk Treatment
• Reinsurance is broadly similar to Custom hedges
  just described
• Usually much more customized than Custom hedges
• Reinsurers will usually promise to offset some
  portion of an insurers exact claims experience

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Types of Reinsurance

• Facultative v. Treaty
• Proportional v. Non-Proportional
• Per Risk v. Per Occurrence v. Aggregate

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Facultative v. Treaty

• Facultative reinsurance applies to a single
  insurance contract
• Treaty reinsurance applies to all contracts in
  a defined block

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Proportional v. Non-Proportional

• Proportional reinsurance the reinsurer takes a
  defined percentage of all losses
• Non-proportional reinsurance the reinsurer only
  takes losses that exceed some threshold
• Almost always subject to a maximum limit
• Threshold may be on per risk, per occurrence, or
  aggregate basis

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Per Risk v. Per Occurrence v. Aggregate

• Types of loss threshold for non-proportional
  reinsurance
• Per Risk threshold applies to losses from each
  insurance policy
• Per Occurrence threshold applies to total loss
  from each specific event (for example, each
  hurricane or earthquake)
• Aggregate threshold applies to total loss from a
  specific time period

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Reinsurance

• Advantages
• Customized to take exact aspect of risk that
  insurer wants to lay off
• Available through a market of 50-100 firms
  globally
• Disadvantages
• Cost and availability of specific covers varies
  widely
• Need to be concerned about credit quality of
  reinsurer
• Sometimes for many, many years

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Actuarial Analysis of Reinsurance Decision

• Quantify frequency severity of insurance losses
• Apply terms of various reinsurance options
• Compare cost / benefit and Risk/Reward tradeoffs
• Evaluate options in light of company goals in
  order to determine best strategy

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Strategies for Managing Underwriting Risk

• Remove
• Cancel policy or exit LOB
• Pro eliminates future risk
• Con also eliminates opportunity for profit
• Reduce
• Stringent UW claims management
• Pro leverage company expertise
• Con competitive forces are outside company
  control

• Reinsure
• Purchase reinsurance
• Pro customized hedge
• Con cost of risk transfer
• Retain
• Live with the risk
• Pro retain profit opportunity
• Con risky requires supporting capital

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Determining Reinsurance Needs
Increase Risk Capacity Provide Stability Provide Surplus Relief Provide U/W Expertise Facilitate Withdrawal from Business
Business Strategy Growth X X X
Business Strategy LOB Focus X X X X
Financial Position Limited Asset Liquidity X X
Financial Position Limited Surplus X X X
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Functions Served by Different Types of Reinsurance
Increase Risk Capacity Provide Stability Provide Surplus Relief Provide U/W Expertise Facilitate Withdrawal from Business
Facultative X X
Proportional Treaty X X X
Non-Proportional Treaty X X X
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Reinsurance

• Advantages
• Customized to take exact aspect of risk that
  insurer wants to lay off
• Available through a market of 50 to 100 firms
  globally
• Disadvantages
• Cost and availability of specific covers varies
  widely
• Need to be concerned about credit quality of
  reinsurer
• Sometimes for many, many years

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3.6 Risk Treatment Options Capital Markets

• Securutization of Firm Risks
• Use of General Capital Markets products (ILW)

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Capital Markets Options for Insurance Risks

• Two broad Capital Markets Solutions to Risk
• Securitize Sell your own risk on the Capital
  Markets
• Buy Capital Markets Instruments that offset a
  risk that you have

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Securitize your Risk

• Advantages
• Covers your exact risk
• Pricing may be better than reinsurance
• Capacity can be higher than reinsurers
• Disadvantages
• Market might balk at any non-standard aspects of
  your risk
• Large fixed cost of securitization
• Market appetite varies widely for insurance

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Buy Capital Markets instruments to offset your
risk

• There are some instruments usually related to
  insurance cats that have been created by banks or
  (re)insurers
• Mortality Cat Bonds
• Industry Loss Warrents
• Usually, these are bonds where principle is not
  repaid if trigger event occurs
• Trigger event is usually very large catastrophe

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3.7 Risk Treatment Options Risk Design

• Life Insurance
• Annuities
• Health Insurance
• Property Insurance
• Casualty Insurance

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Risk Design Life Insurance

• Increasing Insurance Amount
• To limit underwriting anti-selection
• High Premium Levels
• For Guaranteed Options
• Assumed high degree of anti-selection
• Offsetting Insurance Investment Risks
• If investments perform poorly, must buy more
  insurance
• Explicit in UL product

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Risk Design - Annuities

• Deferred Annuities
• Surrender Charges
• Market Value Adjustments (fixed)
• Investment restrictions (variable)
• Immediate Annuities
• Limited or no Withdrawal options

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Health Specific ERM Concerns

• Underwriting controls-- centralized
  authorizations required for larger cases
• Avoiding Anti-Selection--being one of several
  health options offered by employer could invite
  anti-selection
• Experience monitoring--ability to slice and dice
  claim experience and trend, monthly, down to
  segment/geography/product
• Diversification(Large Accounts, small accounts,
  by location, public/private).
• Provider contract renewal (for example
  staggering renewals).
• Assessing counterparty credit risk of providers,
  especially those accepting capitated risk.
• Stress scenario modeling Bioterrorism, Pandemic

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POLICY CONTRACTS As Risk Treatment Tool

• ELEMENTS OF AN INSURANCE POLICY
• Declarations Page(s)
• Coverage Part(s)
• Definitions
• General Provisions
• Exclusions General ?
• Additional Coverages ?
• Conditions ?
• Duties After an Accident or Loss
• Excluded Property ?
• Excluded Perils ?

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POLICY CONTRACTS OCCURRENCE CLAIMS-MADE

• Policies written to cover losses two ways
• Occurrence Basis Pays for losses that occur
  during the policy period.
• Claims Made Pays for losses reported during the
  policy period
• Due to nature of Claims Made policies, they are
  written with either
• Extended Reporting Provision, or
• Retroactive Date Provision
• Both extend the period during which losses may
  be reported and covered

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BASIC Reinsurance CONTRACT TYPES

• Facultative or Treaty
• Individual Risk
• Entire Book of Business
• Excess or Pro Rata
• Limit and Retention
• Proportional Sharing of Loss

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BUSINESS PROVISIONS

• Business Covered
• Line(s) of business
• In force, new and renewal
• Exclusions
• What isnt covered
• Territory
• Where can the risks be located or policies
  written

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COVERAGE PROVISION

• Coverage Article establishes the Reinsurers
  liability to the Company for the subject
  business
• Excess Retention and Limit
• Quota Share or other Pro Rata Percentage of
  Cession
• The Basis of Coverage is defined. For example, on
  an XOL contract the Basis of Coverage is each
  loss occurrence or each risk, etc.

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COVERAGE PROVISIONS

• Commencement and Termination
• Definitions Excess vs. Pro Rata
• ECO/XPL
• LAE/DJ
• UNL excess only
• Loss Occurrence Property vs Casualty

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COVERAGE PROVISIONS

• Other Reinsurance Inuring vs Underlying
• Reinstatement
• Warranties
• Notice Of Loss and Loss Settlements

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MONEY PROVISIONS

• Three Types of Accounting Basis
• Accident Year
• Calendar Year
• Underwriting Year

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3.8 Risk Treatment Options Diversification

• Diversification among risks
• Diversification between risks
• Correlations v. Dependencies

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Diversification of Like Independent risks

• If rate of claim is q, amount of claim is C,
  number of insured is N
• Expected claims NqC
• Standard Deviation of Claims amount is
• Square Root Nq(1-q)C

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Independent Like Risks
N Expected Std Dev COV
1 10 99 995
5 50 222 445
10 100 315 315
50 500 704 141
100 1,000 995 99
500 5,000 2,225 44
1,000 10,000 3,146 31
5,000 50,000 7,036 14
10,000 100,000 9,950 10
50,000 500,000 22,249 4

• q.01 C1000

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Combining Unlike Risks

• Dependent Add Ranked Values
• Fully independent Square Root(A2 B2) if both
  are Normally distributed

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Unlike Risks
Risk 1 Risk 2 Dependent Independent
5 -6 -18 -24 -19
15 -0 -6 -6 -6
25 3 2 5 4
35 6 7 13 10
45 9 12 21 15
55 11 18 29 21
65 14 23 37 27
75 17 28 45 33
85 20 36 56 41
95 26 48 74 55
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Correlation v. Dependencies

• Correlation is a mathematical term
• Can calculate correlation between finger length
  and car ownership
• Dependency is a statement about the fundamental
  relationship between things
• Net Wealth and Car ownership
• Correlations can be found for things with no
  conceivable dependency

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Copulas

• General Mathematical technique for combining two
  random variables that are partially dependent
• Gaussian Copula
• Non-Gaussian Copula
• Some non-Gaussian Copulas will allow higher
  dependence in the tails of the distribution
• Which is popular to more closely fit with reality

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3.9 Risk Treatment Options Avoid/Retain

• Operational Risks
• Holding Capital for Retained Risks

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Operational Risks

• Usually a firm is not paid to take Operational
  Risks
• So most firms will choose to avoid Operational
  Risks
• If unavoidable, to minimize them
• Using cost benefit to choose how to lminimize

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Operational Risk

• Definition
• Identifying Risks
• Assessing Risks
• Risk Control
• Risk Transfer Reduction
• Case Studies

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Operational Risk

• the risk of loss, resulting from inadequate or
  failed internal processes, people and systems, or
  from external events. Basel

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Operational Risks(a partial listing)

• Regulatory Changes
• Tax Changes
• Governance Problems
• Industry reputation
• Company reputation
• Information systems risks
• Legal risks
• Financial Reporting Risk
• Outsourcing

• Inadequate Controls
• Process inefficiencies
• Business strategy risks
• Political risk
• Terrorism
• Natural Catastrophe
• Misselling
• Fraud
• Insourcing

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Operational Risk Measurement

• Measurement is not the most important aspect of
  operational risk management
• Operational Risk Management Process
• Identify Risks
• Classify risks by frequency and severity
• Develop plans and strategies for controlling high
  frequency and high severity risks

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Risk Management Continuum(Harvard University)
Proactive Management Anticipate Risks

• Central Oversight / Assurance

Active Management Timely Response

• Governance / Compliance Standards

• Understanding and Evaluation of Risks

Reactive Crisis Management

• Protection of Reputation

• Decreased Crisis Response

• Improved Services

• Improved Work Place

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Compliance Paradigm Shift(Harvard University)
From
To

• Informal Policies
• Limited Oversight
• Reactive
• Fragmented
• Limited Involvement
• People Orientation
• Ad Hoc

• Formal Policies
• Senior Level Oversight
• Anticipate, Prevent, Monitor
• Focused, Coordinated
• Everyone is Involved
• Process Orientation
• Continuous Activity

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Basel Prescribed Methodology

• Banks should implement a sound process to
  identify in a consistent manner over time the
  events used to set up a loss database and to be
  able to identify which historical loss
  experiences are appropriate for the institution
  and represent the current and future business
  activities.
• Banks should develop rigorous conditions under
  which internal data would be supplemented with
  external data, as well as the process of ensuring
  relevance of this data for their business
  environment.

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Operational Risk Tracking

• Need Standard List of Risks
• Need to Track
• Losses
• Exposures
• Process should be similar to mortality studies
  for Life Insurers

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Operational Risk Management

• Control Systems
• Internal audit
• Back-up and Redundancy
• Insurance
• Compliance monitoring
• Process improvement

90
Categories of Operational Risk

1. Clients, Products Business Practices
2. Fraud, Theft, Unauthorized Activity
3. Execution Processing Errors
4. Employment Safety
5. Physical Asset

• Suitability, breach of fiduciary duties, sales
  practices
• Unauthorized transactions, money laundering,
  fraud
• Execution errors systems failures
• Wrongful dismissal, harassment, workers comp
  related legal liability
• Natural Disasters and human-instigated acts of
  damage

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Case Study Misselling Risk

• Risk Description
• Occurs during Sales Process
• Improper Illustrations
• Misrepresentation of Policy Provisions
• Misrepresentation of Company intentions regarding
  non-guaranteed elements
• Loss occurs when
• Incorrect expectations are not met by company
• policyholder obtains redress via regulator or
  courts

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Misselling Risk

• Risk Assessment
• Isolated cases
• Frequency Low to Medium
• Severity Low to Very Low
• Systematic Misselling
• Frequency based on economic competitive
  conditions
• Severity Very High

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Misselling Risk

• Risk Management Options
• Transfer Insurance Coverage?
• Offset Not Applicable
• Manage - Controls
• Avoid Improve Procedures

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Misselling Controls Improved Procedures

• Culture
• Training
• Clear Marketing Materials, Illustrations
  Contracts
• Supervision
• Monitoring
• In Depth Review
• Random
• Triggered
• Complaints
• Turnover
• Spot Checking

95
Case Study Equity Linked Product Execution

• Risk Description
• Occurs with client directed transactions
• processing lags corrected with backdating of
  transactions
• company has gain or loss with each backdated
  transaction
• Original thinking gains losses would cancel
• Actual findings direction of client fund
  movement tends to create more losses than gains
• with extreme market movements volumes increase,
  delays increase and losses increase

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Equity Linked Product Execution

• Risk Assessment
• Frequency Very High
• Severity Low

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Equity Linked Product Execution

• Risk Management Options
• Transfer Insurance, Hedging
• Offset Possibly
• Manage Controls
• Avoid Improve Procedures

98
Equity Linked Product Execution

• Insurance Option
• Insurer will require improvement in procedures
  controls
• Hedging Option
• buy hedge contracts to offset losses from late
  processing
• may want to use if cost of improved processing
  controls is very high

99
Equity Linked Product Execution

• Controls Improved Procedures
• Monitoring processing lag
• Set targets for max daily lag
• Review cases with longest lags
• Monitoring losses
• Review losses with supervisors
• Review Processes
• look for avoidable delays in processing
• enhance technology training
• Special attention to larger transactions
• Develop standards for overtime vs. delays
• empower management to make decisions

100
Risks to Avoid

• Most firms will have certain risks that they will
  always AVOID
• Important to explicitly document these
• Either in Standards or Limits

101
Retained RIsks

• Insurers and Banks are usually in the business of
  retaining some risks as their primary business
• Important for each to appropriately provision for
  the risks that are retained
• Reserves Capital

102
Total Asset Requirement (TAR) approach to
provisioning

• Risk area calculated the Total amount of assets
  needed to pay off risks with desired confidence
  interval (for example 99.5 under Solvency 2)
  This is TAR
• Reserves are held for expected losses plus
  prudent margin (as required)
• Capital requirement is then TAR - Reserves

103
3.10 Choosing a Primary Risk Metric

• Ruin v. Volatility
• Short Term v. Long Term
• Other Risk Aspects

104
Ruin v. Volatility

• Ruin Large and usually unlikely loss potential
• 99.5tile loss Solvency 2
• Volatility Fluctuations in earnings
• Standard Deviation of distribution of probable
  earnings or
• 90tile loss

105
Ruin v. Volatility

• Reasons to Choose Ruin

• Reasons to Choose Volatility

106
Short Term v. Long Term

• Short Term
• 1 year Solvency 2
• Long Term
• Multi Year
• Until finall run-off of liabilities - US

107
Short Termv. Long Term

• Reasons to Choose ST

• Reasons to Choose LT

108
Other Aspects of Risk
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3.11 Uses of multiple Risk Models

• Risk Light
• Full Risk Profile

111
Law of Risk Light

• There is a danger that whatever risks you ignore
  will accumulate in your firm.

112
Full Risk Profile

• Risk Profile is your distribution of Risks
• By Risk Type
• By Business Area
• By Region
• With Other important risk aspects

113
Other Risk Aspects

• Can determine Risk Profile by Measurement
• Or by Queary
• Ask Underwriter to note whether each case has
• High, Medium, Low data integrity risk

114
3.12 Using Economic Capital for ERM

• Loss Controlling
• EC Provides common metric for exposures Limits
• Risk Trading
• EC Provides common standard for risk margins
• Risk Steering
• EC provides common metric for macro risk reward

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3.13 Capital Management Allocation

• Risk Steering
• Overall Capital Target
• Capital Allocation (retrospective)
• Capital Budgeting Process (prospective)

118
Capital Target

• Base Target plus
• Security

119
Base Target DIRECT REFERENCE TO RATING AGENCY

• Target the level of capital that supports the
  desired rating according to the exact rating
  agency capital model.
• Advantages
• Rating agency model widely used / thoroughly
  vetted
• Offers greater certainty on capital portion of
  the rating
• Disadvantages
• Uses broad industry average risk factors
• Inaccurate unless firm replicates industry
  average risk per exposure
• Actual capital held by similar firms with target
  rating may vary from Rating Agency guidelines
  adjustments reduce this to a modified peer
  comparison method

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Base Target INDIRECT REFERENCE TO RATING AGENCY

• Using an internal company risk model, target
  Economic Capital level at an exceedence
  probability consistent with default rate for
  desired rating.
• Advantages
• Reflects management knowledge of the risks of the
  firm
• At least one rating agency (SP) has stated that
  it will eventually incorporate internal capital
  models into ratings decisions
• Disadvantages
• Effort of developing a full internal risk model
• Work required to validate the model to the
  satisfaction of both internal and external users
  
• Probabilities related to A and AA rating levels
  are extremely low (0.02 and 0.008 per one
  Moody's study) in almost no case is there
  enough data to reliably calibrate a model to
  those probability levels

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BUFFER CAPITAL

• There are often dire circumstances associated
  with failure to maintain minimum rating agency
  capital therefore, most firms establish a safety
  buffer.
• At one extreme is a firm that plans to maintain
  its rating through a 1-in-500-year catastrophe
  loss scenario (99.8th percentile).
• In contrast, another firm believes it will be
  possible to access the capital markets about once
  every five years to replenish capital after
  moderate losses, and therefore sets a buffer at
  the 80th percentile loss.
• Most firms, whether they directly calculate a
  buffer or not, fall somewhere in the 1-in-10 to
  1-in-20 range (90th to 95th percentile).

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Capital

• Economic Risk Capital
• Amount needed to support particular probability
  of loss event over a time period
• i.e. 95 probability of maintaining solvency over
  5 years
• Face Capital
• Additional amount needed to satisfy regulators,
  rating agencies, board and stock analysts
• Free Capital
• Actual capital in excess of above

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Reasons for Allocating Capital

• Pricing
• Reflecting cost of capital in premiums, expense
  charges and interest rates
• Financial Reporting
• Determining ROE (RAROC)
• Capital Budgeting
• Determining who gets the scarce resource

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Allocating Risk Capital

• Total Firm Risk Capital is usually less than
  total risk capital for each unit
• Diversification Benefit
• Correlation Benefit
• How can the overlap be allocated?

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Allocating Risk Capital

• First, calculate Risk Capital for each unit
  separately
• Three general methods for allocating overlap
• Proportionate
• Marginal
• Corporate

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Proportionate Allocation

• Multiply each units separate Risk Capital
  Calculation by
• ratio of overlap to sum of separate risk capital
  calculations

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Marginal Allocation

• Order of calculation is key
• Base Unit gets overlap
• Other Units get overlap
• Marginal Factors by risk category

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Corporate

• Each unit holds full separate Risk Capital
• Corporate unit holds the overlap
• (Could be coordinated with Face Capital and Free
  Capital)

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Proportionate Allocation

• Pros
• Easy to explain understand
• Easy to calculate
• Can be seen as fair / impartial

• Cons
• No recognition of source of correlations

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Marginal AllocationBase Unit gets overlap

• Pros
• Helps to feed the franchise
• Recognizes that Base unit creates the
  opportunity for overlaps

• Cons
• Makes it difficult for new Unit to get started
• Ignores fact that Other units are necessary for
  overlap to exist

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Marginal AllocationOther Units get overlap

• Pros
• May give newer units a pricing advantage
• Recognizes that Other units create the new
  situations that lead to overlaps

• Cons
• Is another way that the Other units are
  subsidized by Base unit
• Encourages shift of business to the new unit

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Marginal AllocationMarginal Factors by Risk

• Pros
• Allocates some of overlap to each business unit
  that contributes

• Cons
• Difficult to explain
• Factors difficult to develop

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Face Capital Allocation

• Methods of Allocations
• Offset against Overlap and use overlap
  allocation techniques
• Corporate keeps Face Capital

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Free Capital

• Retained Earnings approach
• Units keep what they earn
• regardless of short term needs
• usually a long term expectation of need
• Sometimes followed by international firms where
  moving capital is difficult
• Profits Released approach
• all free capital flows to corporate for
  re-allocation

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Investing Capital

• Many firms let unit management determine
  investment strategy for assets backing capital
• Firm can use investment strategy as a major Risk
  Management tool
• Can be especially effective if all capital is
  used
• may want to use a transfer pricing approach to
  allocate investment results back to units

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