Governance of Uncertainty/Risk & US ORSADAVID SANDBERG

FSA, MAAA, CERA

September 17, 2015

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Governing The Businesses of Uncertainty

• Banking – (Uncertain Assets)• Savers money loaned away. Liability is a known

quantity. Assets are not certain• Manage risk not paid back + liquidity risk of

savers. Biggest risk = assets not there when savers want them

• Engine for growth via risk• Time horizon = daily balancing

• Insurance – (Uncertain Liabilities)• Money invested in bonds & managed so funds

sufficient to meet future promises. • Liability is uncertain, but assets are known• Ensure safety• Time horizon = quarterly to decades

• Exchanges – Price Stabilization & Speculation

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All Intersect in The Financial Market Today

Central

Bank

Markets

Net Stable Funding Ratio

Liquidity Coverage Ratio

No Domestic Credit Risk

Banking/Trading Book Option

Going-Concern Contingent Capital

Low-Trigger Contingent CapitalAdditional Capital Buffers

Counter Cyclical Premium

Matching Adjustment

No EUR Credit Risk

Equity Dampener

Lack of diversification across jurisdictions

Sovereign

Banks

Sovereign Bonds

Toxic Assets

Market influence, e.g. via prohibition of short selling, buying up of government bonds, etc.

Moral Suasion

Hold to Maturity

Approaches, IAIS ICP 14

Transfer of illiquid assets from

banks to insurers and pension funds

in exchange for liquid assets

Markets with

impaired price

finding function

Insurance regulation geared to

support banks and sovereigns

Lowered asset quality, lower reserves / technical

provisions; disincentives to sell assets with declining

market values, lower market liquidity

Taking on of banking

debt, CoCos etc.Ultimate Forward Rate

Solvency

II, etc

BSCBBasel

II/III

SIFI

Liquidity, Cash

IAIS

IASB

Expropriation of Pension Funds

Sovereign Bonds

Moral Suasion

Moral Suasion

Banking

SIFIs

Liq

uid

ity T

ran

sfo

rmati

on

s

Lo

ng

-Term

Fin

an

cin

g

Co

mp

eti

tive D

isad

van

tag

e

Liq

uid

ity T

ran

sfo

rmati

on

s

Basel II

I / S

olv

en

cy II

EM

IR, D

od

d-F

ran

k A

ct

Basel II

I

Liquidity pumps

Dir

ect

Bailo

ut

SIFI Designation

Pre

fere

nti

al

investm

en

t in

SIF

Is

Growth of SIFIs due to funding advantage and being Too

Big To Fail, Too Big to Prosecute and Too Big to Supervise

Low Interest Rate Policies

Central banks issuing and buying

sovereign bonds, Quantitative Easing,

Outright Monetary Transactions etc.

Closer link between

sovereigns and central

banks

Neglect

Conflicts of

interests

Pension

Funds

Insurers

Inefficient capital

allocation

Decline due to competitive

disadvantages and low-

interest rate environment

Lobbying power

Government Guarantee

Sovereign Bonds

Full Diversification within Conglomerates

Lo

we

r co

st o

f ca

pita

l

(~5

0 t

o 1

00

bp

)

Repo Facilities

Pension

Funds

InsurersInsurance

SIFI

Insurers

Insurance SIFI RegulationNo preferential

IAIS /

ComFrame

Inve

stm

en

t

Increasing protectionism

Enhanced supervision, resolution, higher loss absorption capacity

Offshore

Jurisdiction

De-facto control

Capital Flows

Rating

AgenciesPressure Rating Uplift

Sovereign Rating

Protectionist measures: Capital flow restrictions, trade barriers, hurdles for foreign investment, etc.

Competing

Jurisdiction

Capital Flows

Closure via

supranational

agreements

Offshore

Jurisdiction

Currency Wars

Capital Transfers to SIFI Banks: ~500bn Annually

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Pillar One & Three Pillar Two

Governing the Drivers of Insurance Value

Value of Put Option

Value of Firm

Value of Tangible Assets

Value of Liabilities

Value of Default Put

Option

Manage-ment or

Franchise Value

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Source: Babbel/Merrill, Journal of Risk & Insurance 2005

Capital as Governance Tool

• Nuance for Insurance Capital• Assets in excess of liabilities to invest or to

return to shareholders (traditional shareholder view) plus

• Required buffer for uncertainty for additional policyholder protection (regulator & policyholder view)

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Shortcomings of Capital

• Amortized Cost• Does not capture cost of the underlying

guarantees – the heart of insurance• Uses history to project future values

• Market Value• Uses todays pricing of risk to value all

future risks. • Good for assessing cost to hedge all risks,

but volatility is exaggerated

• All Reported Numbers are Approximations – Inherent Uncertainty in Liability Valuation Methods (and some assets)

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What is the Important Problem?

• What Pillar 2 (ERM) processes and tools can be used to sustain the Balance Sheet before Pillar 1 indicates the “ship is sunk”.• And, are they robust or smoke and mirrors?

8

Company Tools

1. Reliance on (and use of) experts (especially actuaries), with those from a profession being, perhaps, the most valuable

2. Organizational structures such as groups

3. Reinsurance, both proportional and non-proportional - to mitigate risk and to act as a form of capital

4. Hedging and asset liability management techniques

5. Enterprise Risk Management (ERM) concepts such as emerging risk identification, risk appetites, limits and controls

6. Capital focused on addressing needs in excess of regulatory balance sheet requirements

Company Tools

7. Models, including both external vendor models and internal models (e.g., catastrophe models and economic capital models)

8. Internal model control and validation procedures

9. Stress testing

10. Responsible pricing, product design and inforce management

11. Voluntary disclosures to both shareholders and policyholders

12. Traditional corporate management processes such as disaster recovery, strategic planning, compensation philosophy and market positioning.

OECD Paper on Governance

1. Identifies all the “Shoulds”

2. How to Tell the Gold from a Potemkin Village?

3. What is “Sound” Risk Management vs. Ineffective Bureaucracy?

4. How to apply so shareholders and/or regulators can tell if there is effective governance?

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Actuarial Profession Addresses Potemkin Village Issues

1. How to measure and report on Financial Risks – Book written over a decade ago

2. How to Assess Sustainability and Soundness of Processes for:

1. ERM

2. Governance of Models

3. Understanding the value, uncertainties and shortcomings of each measurement and mitigation option

4. Three Lines of Defense

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Risk Book Topics

• Wave 1 (Ready for On-Line Early Fall)• Catastrophe Risk (ICP 13)• Non-Proportional Reinsurance (ICP 13)• Professional Standards (ICP 14)• Operational Risk (ICP 13,15-17,23,25)• Actuarial Function (ICP 8)

• Wave 2 (Ready for On-Line by Mid-Fall/Winter)• Regulatory (and Management) Tools • Stress Testing (ICP 8,16-17)• Group Structure and Consequences (ICP 23 etc.)• Intra-Group reinsurance (ICP 8,9,15-17,23,25)• ORSA and ERM (ICP 16)• Financial Statements

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Future Topics

• Wave 3 (Ready for On-Line by Q1 2016?)• Overview, Executive Summary and Integration

• Governance of Models (ICP 17)

• One Year vs. Multi Year Valuation (ICP 14,16,ICS etc)

• Resolution (of insolvencies) (ICP 17, 26, FSB Key Attributes)

• ALM (ICP 15)

• Marketing/Distribution Risk

• Wave 4 (Timing Uncertain)• Use of Derivatives

• Communicating Uncertainty

• Materiality & Proportionality

• Policyholder Behavior/Management Actions

• Visualizing/Identifying Risk Interlinkages

• ???

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ERM Tools = Holistic Set

• Powerful new Tools

• Caution =

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US ORSA – Quo Vadis?

• How will recent NAIC focus on Group Capital calculations impact legal entity ORSAs?

• Will supervisory colleges make efficient or redundant use of ORSAs?

• Will ASB adopt a Standard for Actuaries involved in preparing or reviewing an ORSA?

AUDIENCE QUESTIONS

1) How many here are part of a Group Supervisory Framework?

2) How has the ORSA impacted the role of risk in your organization?A. Reduced your role with more paperwork to be done?B. No impact?C. Increased your presence at both the board and operational

levels?

3) Who owns the preparation and review (including discussion) or the ORSA?

4) What is the relationship, if any, between the ORSA and the appointed actuary discussions by the board?

The Evolution of the ORSA(Canadian Edition)

Stephen Manly, FSA, FCIA, FRM

Office of the Superintendent of Financial Institutions, Canada

September 17, 2015

Agenda

The ORSA process

ORSA – General Observations

General Feedback to Insurers

Evolution of the ORSA

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ORSA and ERM Framework

The Own Risk and Solvency Assessment is the process by which an insurer assesses its capital needs. The ORSA should be used to establish or change an insurer’s internal target

OSFI’s Corporate Governance Guideline states: “A FRFI [federally regulated financial institution] should

have a Board-approved Risk Appetite Framework that guides the risk-taking activities of the FRFI.”

ORSA is one tool used by an insurer to guide risk-taking activities. ORSA is focused on risk identification and solvency, while ERM focuses on the management of risk towards a well-defined risk appetite

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Evolution to ORSA

Dynamic Capital Adequacy Testing (DCAT) Required by OSFI since 1992 for Life insurers (1998 for P&C insurers) Driven by a recognition of the retrospective and static nature of capital

requirement rules Standards for DCAT set by CIA (Canadian Institute of Actuaries), not by OSFI

Internal Capital Target Setting OSFI Guideline A-4 for insurers effective Jun 2011 (revised Jan 2014)

Stress Testing OSFI Guideline E-18 (effective Dec 2009) Outlines OSFI’s expectations with respect to enterprise-wide stress testing

framework for all federally regulated financial institutions

4

Key Elements in ORSA

Comprehensive identification and assessment of risks

Relating risk to capital

Board oversight and senior management responsibility

Monitoring and reporting

Internal controls and objective review

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Importance of the Approach to ORSA

Key point: ORSA is a process

The ORSA report and Key Metrics Report (KMR) are only outputs of the process. They document the ORSA process

Three approaches: Compliance exercise Communication or risk summary Description of process and conclusions

The approach taken can influence the usefulness of the ORSA process

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Agenda

The ORSA process

ORSA – General Observations

General Feedback to Insurers

Evolution of the ORSA

7

ORSA Benchmarking

Preliminary review of more than 125 Life and P&C ORSA reports focused on characteristics: Expectations from Guideline E-19

Approaches used by insurers

Qualitative assessment

Key Metrics Report filing

Observations are broadly similar in the P&C and Life industries

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ORSA: Link to internal targets

0%

25%

50%

75%

100%

Reportidentified theinternal target

Internal targetidentified =KMR ratio

% o

f O

RSA

Rep

ort

s

ORSA reports generally identify the insurers’ internal target

However, operating level and Tier 1 internal capital target (for life insurer) usually not discussed in the report

Insurers are not using the ORSA to establish their internal target

Many insurers kept their internal target at pre-2014 levels but without explanation on how it tied to the ORSA

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ORSA: Risk identification Most insurers have not yet fully incorporated their ORSA process as part of their

ERM or strategic planning

No standard definition of risk categories Insurance risk:

In some cases catastrophe risk or reserving is a separate risk category Some definitions include reinsurance risk

Credit risk: In many cases it is strictly reinsurance counterparty credit Sometimes includes policyholder and broker counterparty credit risk Other definitions are investment based

Market risk: FX risk may be included in market risk or as a separate category

Materiality assessment determines whether a risk category is aggregated into a broader category or separated out

Implications: adding up and comparing own capital by risk categories at an industry level may not be meaningful.

10

ORSA: Life risk identification

11

ORSA: Life insurers own capital

12

ORSA: Quantification methodology

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0%

25%

50%

75%

100%

VaR TVaR/CTE Unspecified

% o

f O

RSA

Rep

ort

s

P&C Life Total

DCATs, MCCSRs, and models (VaR, CTE) often referenced but not always explained how they integrated

Some ORSAs provide a good overview of methodologies or provide a reference of the supporting documentation

Stress testing own capital

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0%

25%

50%

75%

100%

Seve

re S

cen

ario

s

Var

yin

g Sc

enar

ios

% o

f O

RSA

Ow

n C

ap

ita

l

Proportion of own risk capital # of reports

Very few reports (~13%) include any own capital for stress testing scenarios

Some reports include a number to bring ORSA capital to the internal target level. Usually labelled a compliance amount under other or as a separate risk line.

Severity (confidence level)

15

Diversification methodology

16

ORSA: Diversification Credit

17

ORSA: Risk processesReferences to various documents

The majority of the insurers:

ERM process

Policies related to risk

Risk appetite/tolerances

DCAT

Half of the insurers:

Emerging risk process

Capital fungibility

Some of the insurers:

Reverse stress testing process

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ORSA: General Observations

Examples of future planned enhancementsDevelopment/enhancement of modelMore research understanding risk profileOperational riskAggregation/diversification benefitsStress testingBetter integration with ERM and business planning

The ORSA reports at a glance: A number of reports are descriptive in nature From 4 pages to over 200 pages

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Agenda

The ORSA process

ORSA – General Observations

Feedback for Insurers

Evolution of the ORSA

20

Superintendent’s remarks "I understand that many companies are interested in our feedback on the

assessments that they have shared with us. Having seen the broad range of ORSAs, we at OSFI are well positioned to provide you with recommendations for improvement, and to compare your practices with those we see as the best in the industry.”

“And while we are well positioned to do all of that, we are not going to.”

“Why not? Because our overriding goal is to keep the “Own” in ORSA. If we started making specific suggestions to individual companies, we would, inadvertently, start substituting our judgment for yours. Of course we could try to reduce the impact of our comments by noting that they are only suggestions, that you are not obliged to follow our recommendations, that your ideas might well be beter than ours, and so on. But I don’t think insurers ever forget, even for a moment, that we are the supervisor. And so comments that would be perceived as suggestions if they were made by anyone else come across as requirements if we make them.”

Source: Remarks by Superintendent Jeremy Rudin to the 2015 Property and Casualty Insurance Industry Forum, Cambridge, Ontario, June 4, 2015 (http://www.osfi-bsif.gc.ca/Eng/osfi-bsif/med/sp-ds/Pages/jr20150604.aspx

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Supervisory use

The ORSA process is the insurer’s own assessment of their capital needs. The report documents that process

Supervisors may use the information in the report or supporting documentation in understanding of the institution

The ORSA report is viewed in a manner similar to other internal management reports of the insurer. For example: risk appetite investment management report the insurer’s risk dashboard

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Supervisory feedback

Supervision may come back to the insurer if:

Clear inconsistency with Guidelines A-4 or E-19 expectations E.g. ORSA process is not used to set internal target

Inconsistency in reporting between the KMR and ORSA report E.g. Numbers do not align

No annual process to update the ORSA

An objective review plan has not been identified

Methodological concerns with the internal target setting E.g. methodologies around diversification, etc.

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General feedback to insurers The ORSA report is the documentation of an insurer’s risk

identification and own capital assessment processes. Therefore OSFI will not comment on the:

Structure of the report

Specific risks identified General content of the report

Relating risk to own capital Quantification assessments within the report are not required

(should be documented somewhere within the process) but it may be useful to a Board or Chief Agent

If the ORSA report includes a quantitative assessment, it should reconcile with the data in the KMR

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The ORSA process to set targets

The ORSA process is expected to establish the internal target

The ORSA quantification assessment should establish the internal target.

If there is a change of internal target, OSFI may be assessing the adequacy of the revised internal target and may need to review the methodology of the quantitative processes.

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Common industry questionsQ1: How does ORSA interact with Guideline A-4: Regulatory Capital and Internal Capital Targets?

Q2: Does the requirement to have the internal target greater than 150% apply before or after a stress scenario?

Q3: What are OSFI’s views with respect to having an economic capital model as a basis for setting internal capital targets?

Q4: How does OSFI intend to gain comfort in the internal capital targets derived from ORSA economic models?

Q5: How does OSFI reconcile and/or measure an internal target that is derived from ORSA economic models to a capital ratio calculated using standard MCT factors?

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Key Metrics Report The Key Metric Report is an OSFI requirement Template should not be modified.

All figures should be consistent with any figures included in the ORSA report (KMR is a summary of how the insurer has related their risks to capital).

Appropriate information, such as location in the ORSA report or supporting documents, should be given in the Methodology and References section.

Needs to be submitted within 30 days of the ORSA report being discussed with the Board (Chief Agent).

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Key Metrics Report

Top 4 Regulatory and ORSA risks in terms of capital are the same but not necessarily ranked in the same order.

Most of the KMR’s had deficiencies in their filing.

Often the amounts in the ORSA report do not reconcile to the numbers in the KMR.

The internal target identified in the report is sometimes different than the ratio on the KMR.

OSFI’s KMR template was modified or adapted by some insurers.

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Key Metrics Reports

Summary of the results of the insurer’s ORSA process for determining own capital needs and internal target(s).

Insurer is allowed to redefine the respective risk categories based on their unique risk drivers and business needs.

For aggregation/diversification credits used, reference to supporting documents is expected.

KMR must be filed annually with the Lead Supervisor.

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2015 Key Metrics Reports (KMR)

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Agenda

The ORSA process

ORSA – General Observations

Feedback for Insurers

Evolution of the ORSA

31

Evolution of the ORSA

ORSA introduced in 2014

Room for continuous improvement

Elements and processes will need to mature

May take several years to achieve a mature process

Supervisory expectations will be related to size, nature and complexity of the insurer

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Questions ???

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