Post on 17-May-2018
17th17th
7 – 10 November 2010 Sheraton Mirage, Gold Coast
Using Internal Capital Models to Better Articulate Risk Appetite and
Measure Risk Tolerance
Karl Marshall, Quantium
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Outline of presentation• Introduction to Internal Capital Models
(ICMs)• A global picture of ICMs• Measuring risk tolerance• Articulating risk appetite
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
ICM is a stochastic budget
Deterministic budget set around here
Distribution of profit
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Journey towards integrated ICMs
Basic risk profiling
Asset-liability management
High-level stress testing
Stand-alone DFA
modelling
Integrated ICM and
ERM
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
ICMs have a number of key elementsUnderwriting risk
Reserving risk
Catastrophe risk
Reinsurance structure
Asset mix and strategy
Credit risk
Operational risk
Dependency structure
Economic Scenario Generator (ESG)
Simulation engine
Stochastic P&L
Stochastic BS
Stochastic cashflows
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
ICMs align well with proposed MCRUnderwriting risk
Reserving risk
Catastrophe risk
Reinsurance structure
Asset mix and strategy
Credit risk
Operational risk
Dependency structure
Outstanding claims insurance risk capital charge
Premium liabilities insurance risk capital charge
Insurance concentration risk capital charge
Asset risk and asset concentration risk capital charges
Asset risk and asset concentration risk capital charges
Operational risk capital charge NEW
CHANGED
CHANGED
Asset risk correlation matrix and aggregation benefit NEW
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Insurance risk easily largest contributor
0%
10%
20%
30%
40%
50%
60%
70%
80%
Insurance risk Market risk Operational risk Credit risk Group risk
Attribution by risk category
Source: FSA Insurance Sector Briefing: ICAS – Lessons learned and looking ahead to Solvency II (Oct 2007)
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
There are many uses for ICMs
ICM
Risk tolerance
and appetite
Capital
Target prof it
margins
P&L volatility
RI structuring
Investment strategy
Business planning
Attribution
Regulatory capital
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Global ICM landscape: Australia• Internal model-based MCR
an option since 2002• Not compulsory but
encouraged where possible• 3 large insurers approached
APRA to use ICMs for regulatory capital
• Punching above its weight
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Global ICM landscape: New Zealand• Introducing a new solvency
regime – ‘APRA lite’• No option for an internal
model-based MCR• NZ insurers with large
Australian parents have ICMs
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Global ICM landscape: UK and Europe• UK currently requires insurers
to conduct internal capital assessments (ICAs)
• Solvency II a ‘sea change’• Allows a prescribed basis,
internal model or hybrid• Solvency II will be a key global
driver of change
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Global ICM landscape: US• ICMs not required by
regulators• Traditionally the domain of
large insurers / reinsurers• Following GFC, more interest
in the role that ICMs can play• Indirect impact of Solvency II• The sleeping giant?
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Global ICM landscape: Asia• Wide range of approaches to
regulation• Risk-based capital regulation
common• ICMs starting to emerge but
not for regulatory capital• Some Asian regulators
considering use of ICMs
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Global ICM landscape is changing• General trend is one of
increased use of ICMs• Driven by the developed world• Solvency II likely to materially
drive global trends over the next 10 years
• When will the US catch up with rest of developed world?
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
What is risk appetite?• Risk appetite incorporates
– Capacity for risk– Desire for risk– Tolerance for risk
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Risk appetite has many dimensions1. Expected profit
– Drives market expectations– Business planning and short-term strategy
2. Likely outcomes– Probability profit will diverge from
expectations not small3. Adverse tail outcomes
– Drive maximum risk tolerance– Focus of capital requirements
1
2
3
Distribution of profit
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
…. and many thresholds1. Expected profit not achieved2. Profit warning to market / shareholders3. Loss in financial year - dividend not covered4. Capital below internal minimum target5. Capital < soft regulatory minimum6. Capital < hard regulatory minimum7. Technical insolvency
Distribution of profit
5
12
3
4
6
7
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Risk profile improved using ICMs• A better understanding of drivers of risk using ICMs can lead to an improved risk profile
– Reducing tail risks– Increasing upside risk– Decreasing downside risk– Refining profile of BAU risks
E1 E2
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Boards ask questions on risk toleranceWhat is the
probability that our capital will fall
below the MCR?
What are the key risks that we are
exposed to?
What is the volatility of our
retained exposure to catastrophes?
How much of our assets should we invest in equities?
What is the chance that we won’t make a
profit this year?
If we go insolvent, what are the likely
causes?
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
These can be answered using ICMs• Example: Distribution of net profit over different time horizons
0%
5%
10%
15%
20%
25%
30%Distribution of Net Profit After Tax by Time Horizon
One year profit Three year profit Five year profit99th percentile 90th percentile 80th percentile
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
These can be answered using ICMs• Example: Distribution of net outstanding claim payments
0%
2%
4%
6%
8%
10%
12%
14%
16%Distribution of Net Outstanding Claim Payments
75th percentile
80th percentile
90th percentile
95th percentile
99th percentile
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
These can be answered using ICMs• Example: Probability of impairment for different investment
strategies
0.0%
2.5%
5.0%
7.5%
10.0%
12.5%
1.50 1.75 2.00 2.25 2.50 2.75 3.00
Prob
abili
ty o
f cap
ital f
allin
g be
low
thre
shol
d
Starting capital as a multiple of opening MCR
Probability of Impairment - 1.2 x MCR Threshold
Current investment strategy SHF assets - no equities
SHF assets - 30% equities (optimal?) SHF assets - 100% equities
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
These can be answered using ICMs• Example: Distribution of insurance risk outcomes and
attribution
Mean 75% 90% 95% 99%
Attr
ibut
ion
of c
laim
cos
ts
Percentile
Attribution of Claim Costs - Underwriting and Reserving Risk
Past claims - economic inflation Past claims - SI inflationPast claims - uninflated claim payments Future claims - economic inflationFuture claims - SI inflation Future insurance loss - attritionalFuture insurance loss - large Future insurance loss - natural hazard
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Articulation of risk appetite not one statement
Risk appetite
Capital management
plan
Business plan and strategy
Probability of adequacy of insurance liabilities
Reinsurance management
strategy (REMS)
Investment strategy and
mandate
Risk management
strategy (RMS)
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Capital Management Plan (CMP)• Key vehicle for risk tolerance statements• Particularly those derived using ICMs• Consider operating capital range, including
– Minimum Capital Adequacy Multiple– Maximum Capital Adequacy Multiple
• Risk tolerance statements can attach to minimum and maximum
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
CMP risk tolerance statements• Risk tolerance can consider 3 dimensions
– A risk threshold, e.g. 1.2 x MCR– A time horizon, e.g. 1 or 5 years– An x% probability of falling below risk
threshold at any point over time horizon
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
Investment strategy• Strategic asset allocation (SAA) should be
considered in context of adopted risk tolerance
• Various SAAs can be modelled and impact on risk tolerance and profit volatility considered
• Investment policy should refer to risk appetite and risk tolerance
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
REMS• REMS considered in context of adopted risk
tolerance• Program structure, limits and retentions are
elements of risk tolerance• Retentions/MER expressed in many ways
– % of net assets– return period– % of projected profits– in context of risk tolerance statements
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
RMS• RMS is the most appropriate vehicle for
aggregation of risk appetite and tolerance statements
• Pull all of the elements together– CMP– RMS– Investment strategy and policy
7 – 10 November 2010 Sheraton Mirage, Gold Coast
17th
ICMs and APRA capital changes• Proposed APRA MCR effectively imposes
an artificial risk profile on an insurer• This risk profile may not be closely related
to the true risk profile• ICMs much better at determining risk
profile• If MCRs increase, ICMs have a role to
play in setting target capital multiples