L959-02-107 Risk Based Capital: Convergence of Banking and Insurance Risk Management Thomas C....

L959-02-107

Risk Based Capital:Convergence of Banking and Insurance Risk Management

Thomas C. Wilson, Managing Director, Head Finance and Risk PracticeRamy Tadros, Senior Job Manager, Insurance Practice

C O N F I D E N T I A L

The Actuarial ProfessionFinance and Investment Conference 2003Edinburgh, June 22-23

L959-02-107

CONFIDENTIALITY

Our clients’ industries are extremely competitive. The confidentiality of companies’ plans and data is obviously critical. Mercer Oliver Wyman will protect the confidentiality of all such client information.

Similarly, management consulting is a competitive business. We view our approaches and insights as proprietary and therefore look to our clients to protect Mercer Oliver Wyman interests in our presentations, methodologies and analytical techniques. Under no circumstances should this material be shared with any third party without the written consent of Mercer Oliver Wyman.

Copyright © 2003 Mercer Oliver Wyman

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Mercer Oliver Wyman

• Strategic management consulting focused on financial services

• 650 individuals, 500+ professionals

• Offices in New York, London, Frankfurt, Zurich, Toronto, etc.

• Created by merger with Mercer Management Consulting FIG

RetailBanking

Corporate &Commercial

Banking

CapitalMarkets& Asset

Management

Insurance

Corporate Strategy

Finance & Risk

Insurance Actuaries

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Contents

1. Risk Capital Measurement Practices

2. Risk Management Practices

3. Risk Capital and Value Management

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Risk Capital Definition

Risk Capital

Credit RiskMarket

RiskOperational

RiskBusiness

RiskInsurance

Risk

LifeP&C Non-CAT

P&CCAT

Counter-party Risk

TransferRisk

Trading Risk

ALM Risk

“Definition”:Ex ante assessment of . . .• Maximum possible loss• Within a confinable interval• Over a defined time horizon

Aggregation

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Implementation and Use of Economic Capital

Aegon Allianz Aviva AXA Fortis ING Generali Lloyd’s of London Munich Re Prudential Royal & Sun Alliance Swiss Life Swiss Re Winterthur Zurich

Insurers Covered

% Respondents

0%

10%

20%

30%

40%

50%

60%

Not at all In Development

Piloted Once

Used Operationally

Used as Major Tool

1997

2002

Source: Mercer, Oliver, Wyman Survey

Current Use of Economic Capital . . .

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Capital Benchmark – Group Level (Including Insurance)

Risk Type Range (%) Average (%) N

Credit Risk 29-77 51 8

Market Risk 1-40 18

Operational Risk 6-23 13

Business Risk 5-36 14

Insurance Risk 0.01-12 4

Banc Sabadell Barclays BSCH CIBC Credit Suisse Group Den Danske Deutsche Bank Dresdner Bank Fortis Nordea Rabobank Royal Bank of Canada San Paolo IMI Standard Chartered Toronto Dominion UBS Unicredito Westpac

Banking Groups Covered


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Capital Benchmark - Insurance Operations Only

70 - 90% Financial Market Risk

<10% Insurance Risk <5% Credit Risk

10 - 25% Operational & Business Risk


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Evolving Regulatory Standards Support Use of Economic Capital:EU Solvency II Proposals

PROPOSED INSURANCE SOLVENCY PRINCIPLESPROPOSED INSURANCE SOLVENCY PRINCIPLES

1. Minimum capital requirements

1. Minimum capital requirements

2. Supervisory review of internal capital adequacy2. Supervisory review of internal capital adequacy

3. Market discipline3. Market discipline

Two levels of capital– Minimum safety level– Target level

“Standardised Approach”

“Internal Model Approach”

Group solvency requirement taking account of additional risks at group level.

Other prudential rules (assets and liabilities)

Insurers must assess, and supervisors review, solvency relative to their risk profile and hold sufficient capital for their risks

Quality of required internal risk and capital measures/controls should be proportional to size and riskiness of insurer

Regulators will intervene at an early stage if capital levels deteriorate

• Improved disclosure of– Capital structure

(including ‘realistic free assets’)

– Risk measurement and management practices

– Risk profile– Capital adequacy

• Potentially, market-based charging of insurers for their “risk of failure”

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Management Practices Support Use of Economic Capital

Corporate Level

Transaction or ‘tactical’ level

Impact on Corporate Strategy– Business portfolio composition– Relative growth

Impact on financial & capital management– Group capitalization– Capital attribution and capacity allocation– Reinsurance optimization

Asset/liability management Improved risk profile transparency

– Board-level reporting– External reporting, e.g. rating agency, etc.

Improved product pricing and customer relationship management discipline

Improved limit structures and control mechanisms

Improve risk capacity allocation

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Best Practice: Dynamic, Multi-year Framework

Asset Shares

Capital

Assets

Cash-flow projection

over the next 25 years

Accounting Perspective

Economic Perspective

Stochastic cash-flow projections:– Equity returns– Bond returns Credit risk Interest rate risk

– Dynamic policyholder behaviour

Management actions:– Bonus declarations – Asset mix– Dividend and capital policies

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Risk Capital Measurement Issues

General parameter definition– Definition, e.g. max loss, shortfall risk, survival probability, etc.– Confidence interval– Time horizon, e.g. one year, multi-year

Risk coverage, especially– Operational risk– ‘Business risk’, etc.

Measurement approach, e.g. – Accounting vs. mark-to-market– Run-off versus on-going business

Stochastic model parameterization– Financial markets, e.g. ‘arbitrate free’ vs economic, asset return models for

equity markets, interest rates, credit spreads/defaults– Modeling customer behavior– Modeling own behavior, e.g. asset mix, crediting/bonus rate policies, new

business, etc.

Aggregation techniques

Attribution techniques, e.g. proportional, marginal, covariance, etc.

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AAA Calibration

BBBCalibration

Years Years

2003

2005

2007

2009

2011

2013

2015

2017

2019

2021

2023

2025

2027

2003

2005

2007

2009

2011

2013

2015

2017

2019

2021

2023

2025

2027

Mean

Dynamic Profile of Required Shareholder Support

Expected Required Capital Injection

A Calibration

25-Year Probability of Requiring Shareholder Support = X %

Cumulative Probability of RequiringShareholder Support

Internal Models Allow for a Dynamic View of Capital Requirements . . .

Cumulative Probability of Default(Asset Share Basis)

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Probability of Fund Insolvency Over the Run-Off Period

Base Case Smoothing to +/-10% of CV

No further RBreduction

Full Smoothing -pay current

illustrated TBs

Lapse Rate Halved Lapse Rate Doubled Reduction in EBR attrigger points

Bonus Declaration Policyholder lapse behaviour Asset switching

Probability of Default

. . . and Test the Impact of Management’s Discretion Around Bonus Declaration and Asset Switching Rules

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Impact of Investment Returns on Projects Shareholder Transfers

10th Percentile

30th Percentile

70th Percentile

90thPercentile

Mean

Annual Shareholder Cashflows Investment

Returns

From a Shareholder Perspective, the Tools Can Provide the Basis for The Quantification of Fair Value

Distribution of PV of Shareholder Transfers

PV of Shareholder Transfers

Mean of Distribution(Adjusted Embedded Value)

Time

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Contents




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Risk Management Framework - Five Components

Committees2) STRUCTURE/ORGANIZATION• Line, staff and committee structure• Policies & procedures; roles &responsibilities;

limits & authorities, performance metrics, incentives

4) INFORMATION & REPORTS• Standardized reports to support control & decision making• Underlying reporting processes, information and systems

5) MEASUREMENT METHODS• Detailed methods and approaches• Risk, capital and economic performance

1) RISK STRATEGY/PHILOSOPHY

Supporting strategic decisions:• Is risk profile consistent with optimum

EVA-based business strategy?• Is risk profile consistent with

economic and financial solvency standards?

• Are assets optimally invested relative to liabilities?

Fiduciary responsibilities:• Is risk profile well understood and

within limits?• Are risks appropriately structured,

priced and underwritten?

STRATEGY IMPLEMENTATION

3) MANAGEMENT PROCESSESCORPORATE CALENDAR JAN APR JUL OCT AD HOC

EVA & Ecap plans X

Ecap/risk resource allocations (e.g. NatCat) X

Internal/external retrocession strategies X

Balance sheet capital, funding & liquidity plans X X

Accounting parameters X

Reserving standards, parameter selection X

New products and lines of business X X X X X

Underwriting guidelines X X X X

Large transactions X X X X X

SAA X X X

TAA X X X X

Internal/external audit recommendations X X

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Example Risk Management Organization:European Reinsurer

Supervisory Board

Group ExecutiveCommittee

Business Unit CEO

Business Segment CEO

Group CFO

BU CFO

Board Committees, e.g. • Finance Committee• Audit Committee

Corporate Committees, • Executive Committee• Capital & Capacity Comm• Finance Committee• Product Mgmt Comm • Underwriting Comm• SAA Committee• TAA CommitteeCorporate Networks, e.g.• Risk Management • Finance Network

SAA Staff

STRATEGIC FOCUS

TACTICAL FOCUS

Group CEO

LE Board

BU/LE Committees, e.g. • Reserving Committee• Audit CommitteeBU CRO

Board Comm • Finance • Audit

Group CRO

Group CIO

What risk organization?- Group, business unit risk structure?- Line, staff, committee, network?- Composition & staffing?- Responsibilities, authorities, performance metrics, incentives?

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DECISIONS JAN APR JUL OCT AD HOC

Capital & Risk Committee - Risk Strategy & Control

Review/approve EVA & Ecap plans X

Review/approve Ecap/risk resource allocations (e.g. NatCat) X

Review/approve internal/external retrocession strategies X

Review current risk profile against strategy and limits X X X X

Finance Committee - Risk & Financial Solvency

Review/approve balance sheet capital, funding & liquidity plans X X

Review/approve internal/external retrocession implementation X X

Review/approve accounting 'judgement' parameters X

Review/approve reserving standards, parameter selection X

A/L Committees - Focus on SAA/TAA

Review/approve strategic asset allocation X X X

Review/approve tactical asset allocation X X X X

Product Management Committee

Review/approve new products and lines of business X X X X X

Review/approve underwriting guidelines X X X X

Underwriting Committee

Approve large transactions above LE authorities X X X X X

Audit Committee

Review internal & external audit & op risk recommendations X X

Example Corporate Calendar - Standing Agendas: Standing Agenda

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Example Reporting Framework - Group SAA Report A4 vertical 12-15 pages enhanced, excluding appendix

Annual, enhanced form, for Board Finance Committee Ad-hoc, if required by market/insurance developments or

significant change in liability profile

TABLE OF CONTENTS

1. Executive Summary

2. SAA Recommendation– SAA Performance to date– MD&A Recommendation– Current Positions

Assets Liabilities Net

– Scenarios Financial Scenarios Business Plan Scenarios Re-positioning scenarios

– Financial & Economic Impact (NAV, NPAT, Ecap, etc.)– Final SAA Recommendation, including Group limits

3. Local Implementation

– Current positions– Recommended positions, including LE tactical limits

4. Review of Satellite Portfolio policy (ad hoc)

5. Review of limit structure, investment guidelines (ad hoc)

6 Next steps

7. Appendix

Report designed to support specific decisions within well defined decision processes

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Contents




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Management Practices Support Use of Economic Capital

Impact on corporate strategy– Business portfolio composition– Relative growth

Impact on financial/capital management– Overall corporate capitalization– Improved capital attribution– Improved capacity allocation

Improved risk profile transparency/Board reporting

Improved product pricing and customer relationship discipline

Improved limit structures/control mechanisms

Improved risk capacity allocation

Level Value Drivers/Issues

Group Holding

Company

Wholesale Investment

Banking

Ass

et

Man

agem

ent

Pri

vate

B

anki

ng

Domestic Commercial and Retail

Insu

ran

ce

Corporate Banking

Tra

din

g

Inve

stm

ent

Ban

kin

g

Ass

et

Man

agem

ent

Pri

vate

B

anki

ng

Co

mm

erci

al

Co

nsu

mer

P&

C In

sura

nce

Life Insurance

High Impact

Low Impact

Corporate Level• “Strategic”• “Financial”

Business Level• “Operational”

‘Product’ Level• “Tactical”

Driving business behavior consistent with transaction economics

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Integration Into Strategic Decisions

Which three measures are most used by your institution for strategic planning and decision making?

Source: CFO/CRO Survey 2002, Banks only

All InsuranceEarnings and earnings growth 1 1Revenue and revenue growth 2 3Cost or cost/income ratios 3 2Return on book capital 4 4Return on risk capital 5 6Market share 6 4Embedded Value 7 6Market Value 7 6Other 7 10Shareholder or intrinsic value 10 9

0% 10% 20% 30% 40% 50% 60% 70% 80%

Accurately reflects business economics

Level of detail

Transparency with respect to key drivers

Link between internal metrics (e.g. Raroc)and share value

Accurately reflects shareholder asopposed to other perspectives (e.g. debt

holders)

Generally accepted

All Insurance

How satisfied are you with regards to the following aspects of your performance

measurement framework?

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Integration Into Strategic Decisions

What prevents economic capital from being as important as it could?

Which areas of performance measurement could be most improved?

0% 20% 40% 60% 80% 100% 120%

Complexity of measure

Accuracy of measure

Instability of the metric

Reconciliation w ith f inancials

Not understood

Reconciliation w ith value

Earnings or grow th more important

ECAP not a constraint

Management acceptance

Other

All Insurance0% 20% 40% 60% 80% 100%

How revenue is recognized

How costs are recognized and allocated

How credit losses are estimated andexpensed

How insurance losses are estimated andreported

How capital is measured and attributed

How the cost of capital is calculated

Other

All Insurance

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Common Issues in Driving a Value-Creation Culture

Strategic and Financial Management – Strategic priorities typically not articulated in manner which is actionable and measurable– Performance metrics

Not measured accurately Not aligned to value creation, too detailed and/or too high-level, not understood, and/or not accepted

– Critical financial management processes not optimized to focus management on tough decisions and concrete actions, or not providing proper and timely information for effective decision making Strategy development processes Planning & budgeting processes LOB performance tracking and review processes Capital allocation and risk assessment processes

– Structural alignment between responsibility, authority and performance metrics

Organizational Alignment– Incentives and performance management aligning financial rewards and value creating results and

behaviors– Communication and education of how the organization creates value and how it cascades down to

individuals/teams

Cultural Change – Readiness and willingness to change– Commitment to change from senior leaders through front-line employees

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Different Performance

0.00

1.00

2.00

3.00

4.00

5.00

6.00

1995 1996 1997 1998 1999 2000 2001 2002

Average TSR

Maximum Top Quartile Average Bottom Quartile Minimum

Total Shareholder Return S&P US Index 1995-2002

Time to double: >7 yrs

Time to quadruple:

5 yrs

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Value Driven at a High Level by M/B Multiple, RoE

0

50

100

150

200

250

300

350

400

1 2 3 4 5 6 7 8 9 10 11

Years

Percent

* Assumes 33% dividend rate

M/B=1.0; RoE=12%*

M/B=1.5; RoE=12%*

M/B=1.5; RoE=15%*

Time to Double

Shareholder Value Model

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Understanding M/B Multiple for Insurance Companies

0

1

2

3

4

5

6

7

0 1 2 3 4 5 6 7

Actual M/B

Predicted M/B

EMPIRICAL EVIDENCEINTRINSIC VALUE THEORY

* Steady state residual income model

Cost of Capital

Growth

PerceptionGap

Excess Returns

ACTUAL VS. PREDICTED M/B SELECTED FINANCIAL INSTITUTIONS

MB

ROE - CoCCoC - g1 + +=

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Issues Between Internal & External Metrics

DRIVER ISSUES

Adjusted NetIncome

• Measure of operating effectiveness– Adjusted for risk (e.g. expected losses, claims development, provisions, etc.)– Measured on an economic/cash, not accounting, basis

(e.g. goodwill, npv vs accrual, etc.)

Growth (g) • Ability to grow earnings relative to capital base

Economic Capital • Capital available, fully allocated– Including excess capital– Appropriate for target rating and leverage ratio

– Attributed based on economic risk

• Allocated based on– Risk requirements– With acquisition adjustments

Cost of Capital(CoC)

• Differentiated costs of capital, reflecting– Risk of business– Target rating and leverage ratio

Perception Gap • Difference between market value and full-information, full confidence intrinsicvalue – managed via disclosure

PerceptionGap

MB

RoE - CoCCoC - g1 + +=

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Focus on Financial Management

Key requirements

Linking shareholder value directly to business unit drivers

Multi-period framework to capture growth

Economic perspective as opposed to accounting but reconcilable to financial statements

Key requirements

Recognition of external environment and macro trends

Clear link between plan and strategy for achieving plan

Value contract/balanced score card focused on value and tailored to individual business

ExternalValue

Metrics

Internal IntrinsicValue Metrics

Balance Sheet andIncome Statement Drivers

Business-Level Value Drivers

• Analysis of strategic position- Market growth/margin context and trends- Strategic position analysis

• Detailed business unit plans- Projected finances linked to intrinsic value- Concrete KPI objectives to support plans- Balance sheet/capital plans- Headcount targets

• Tailored Value Contract/ Balanced scorecard

M/B, P/E impact

Valuation of parts

Economic adjusted financial statements

# customers, avg balance, etc.

CLEARLY ARTICUALTED STRATEGY & TARGETS

TOP-DOWNPERFORMANCE METRICS

STRATEGIC PLAN

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Focus on Financial Management

MANAGEMENT PROCESSES

DECISION ORGANIZATION

INCENTIVES BASED ON ECONOMIC METRICS

Key requirements Corporate level organizational alignment

– Management structure Executive committee, OC, OCEO Strategic Business Unit definition

and leadership– Management committees

Business unit alignment: Decision making and responsibilities, e.g. distribution/ production

Corporate

SBUs

Functional Management Units

Focused initiativesFocused initiatives

Corporate Strategy & Targets

Group & BUStrategic Plans

Macro view of growth,

sector attractiveness

Micro view of value

of existing business, products,customers

Group & BU 3 Year Operational

Strategic Plans

RevenueCostsCapitalValue

Year 1

Year 2

Year 3

Budget

-

10,000

(...

(...

(... -

100

2

00

300

Bonus

RM Portfolio Value Creation

- 0 +

Key requirements Formal processes leading to ‘linked

chain’– Strategy development– Planning processes– Performance evaluation processes– Management and resource

allocation processes Informal processes

– Advisor, Partner, Controller

Key requirements Leveraged/meaningful incentives Linked to value creation and limited

number of key value drivers Compensation horizon consistent

with value creation horizon

Client Example:RM Bonuses vs.

RM Portfolio Value Creation

Committees

L959-02-107 Risk Based Capital: Convergence of Banking and Insurance Risk Management Thomas C....

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