Michel Rochette, MBA, FSA, PhD Student2010 Valuation Actuary Symposium

ChicagoSeptember 21th 2010

Topics Purpose and principles of any capital framework

Modelling issues:

Diversification: correlation assumptions

Stress testing

Management implications:

Use test and ORSA

Capital types and liquidity

Emerging issues

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Purpose of an EC framework ¨ Risk management system of an insurer for the

analysis of the overall risk situation of the insurance undertaking, to quantify risks and determine the capital requirement on the basis of the company specific risk profile¨ CEA Groupe Consultatif

Required capital is assessed in light of:

available capital & other financial resources

enterprise risk management processes

strategic goals & risk appetite

regulatory requirements

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Principles: EC Development All material risks should be covered: links to ERM and emerging risks Models must be appropriate for the scale and complexity of the firm Models must be dynamic and flexible Models must be embedded in the financial, strategic and operational

processes: Use Test in Solvency II Governance of models development:

Board/top management oversight and involvement documentation of models, limitations & changes internal controls over development: auditable independent review: More than peer review

Others: consistency between valuation and EC models: valuation framework input data verifiable and controllable validation and calibration

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Correlation: Proposals Correlations exist at different levels: (CRO Forum, Dec. 2009, QIS5)

Between legal entities for Solvency II: zero because of the non-fungibility of capital and the non recognition of group capital support

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Some risk factors Corr. Coefficients

Equity/IRR 50%(D)/0%(U)

FX/IRR 25%

Default/Equity 25% CROF,QIS475% QIS5

Default/IRR 50%(D)/0%(U)

Correlation: Crisis Dependent According to a 2009 Pimco study:

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Correlation to S & P 500 Corr elation Early 90s

CorrelationEarly 2008

S & P 500 1 1

High-Yield Bonds 20% -30% 80%

International stocks 30% -40% 70%

Real Estate 30% 60% -70%

Commodities 0% -20% -30%

Correlation: Implications In times of crisis, negative correlation benefit between

asset classes disappears.

“When people start buying an asset, the act of them diversifying ultimately makes the asset less of a diversifier .” Pimco’s Head of analytics

Rule: total diversification benefit should not be above 30% Solvency II QIS4: 31%

CROF: 21%

Swiss Solvency Test: 24%

Ultimately, correlation assumptions should determined by linking back to your own company’s ERM processes.

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Stress Testing: Complimentary Approach Regulatory Approach:

QIS5 risk shocks by type of risk:

Some examples:

Global Equity: 39% & volatility Up: 10% additive

Property: 25%, low compared to recent US experience!

Spread Widening, AA-rated, 4yr: 10.4%

Management Approach:

Prospective scenario modelling with a top down approach

Historical perspective:

Ex. 2008 credit crunch

Similar risk events at other firms, in other industries

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Management Implications of EC: Use it! Investment decisions: existing and new

Product development

Strategic decisions: probably the most important of all

Corporate finance decisions: financial leverage

Hedging strategies: use it within the treasury department

Solvency II regulatory proposal: “…widely used and plays an important role in the course

of conducting an insurer's regular business, particularly in risk management. "

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Solvency II ORSA & EC Pillar II requirement: Own Risk & Solvency Assessment

Goal is to demonstrate “sound and prudent management of the business and assess overall solvency needs.”

In other words, is risk management – including EC – aligned with your strategies and internal risk and control processes? Demonstrate that!

Useful references: Bermuda Monetary Authority: “Opportunity to align management

and regulatory reporting & encourage sound risk management practices within the jurisdiction.”

CEIOPS: Preliminary views on the definition and importance of the ORSA as a management tool, requirements and guidance: Alignment of risk profile, risk tolerance, risk strategy

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Capital and Liquidity of EC Types of required capital: expressed in Tiers in Solvency II

Tier 1: most secure and liquid, permanent shareholder’s equity and inforce cash flows

Tier 2: revaluation reserves, general provisions, hybrid like instruments and subordinated term debt, callable equity, group support, letters of credit, unpaid shares, Max. 50%

Tier 3: Hybrid capital, subordinated loans, Max. 15%

Liquidity New explicit requirement since the 2008 crisis The insurance industry should be concerned about assessing

explicitly liquidity risk and liquid capital instead of trying to do it indirectly through the debate over liquidity premium in valuation reserves. Not in line with best EC/ERM practices.

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EC Emerging Risk: Systemic risk “The risk of disruption to the flow of financial services that is (i)

caused by an impairment of all or parts of the financial system; and (ii) has the potential to have serious negative consequences for the real economy.“ (IMF)

“Treat systemic risk as an emerging risk” Dave Ingram, SVP Willis Re Some insurers are already considered “ systematically relevant

institutions”: Aegon, Allianz, Aviva, Axa, Swiss Re and Zurich, not anyUS insurer? (Financial Stability Board)

"Most insurers will be impacted by systemic risks, but only a few insurers can contribute to creating systemic risk" - Dr Shaun Wang

Does insurance create systemic risk? Emerging consensus is NO But insurance business will be impacted by systemic risk events.

(Bennett, AAA)

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