Transcript Economic Capital and Risk Modeling

February 22, 2008 • Iowa Actuaries Club Session #2
Economic Capital and Risk
Modeling
Jeff Fitch, Senior Actuary - Corporate
Outline
• Principal’s Risk Metric and Economic Capital
Framework
• Lesson’s Learned from Principal’s Implementation
• Applications of Economic Capital models
• Emerging Industry Economic Capital Trends
2
Principal’s Risk Metrics and Economic
Capital Framework
• Background
– Where we were
– Where we are at now
– Looking forward
• My role in the process
3
Driving Forces & Objectives
• Better understanding of risk exposures and
incorporate into decision making process
• Improve our ability to measure and manage risk and return
• Appropriate capital level and capital allocation
• Competitive Pressures
• Economic Uncertainty
• Rating Agencies
• Board
4
Principal’s Economic Risk Metrics
3 Primary Risk Metrics
1. Earnings at Risk (EaR)
2. Embedded Value at Risk (EVaR)
3. Economic Total Asset Requirement
5
Earnings at Risk (EaR)
• Measures short-term volatility of GAAP Operating
Earnings
• Difference between:
– Best Estimate (baseline) GAAP Operating Earnings; and
– 90th percentile confidence level GAAP Operating Earnings
• Difference expressed as percent of Best Estimate
(baseline) GAAP Operating Earnings
• Time horizon of one year GAAP Operating Earnings
• New business included in projection
• Also look at GAAP Net Income
6
Earnings at Risk (EaR) Example
1 year EaR at 90th Percentile
• Run 1,000 scenarios of 1 year operating earnings
• Rank them from best to worst
• EaR is difference between Best Estimate and 900th
scenario
HYPOTHETICAL GAAP OE by Scenario
Best
Estimate
90%
EaR
7
Embedded Value (EV) and Embedded
Value at Risk (EVaR)
• Measures value of inforce business – doesn’t reflect
new business or intangibles (brand, reputation)
• Present Value of Distributable Earnings
• Embedded Value at Risk measures potential volatility
in value
– Difference between:
• Best Estimate (baseline) Embedded Value; and
• 90th percentile confidence level Embedded Value
8
Economic Total Asset Requirement
•
•
Economic Total Asset Requirement is the amount of assets needed to
cover our obligations at a given risk tolerance level over a specified
time horizon.
–
99.5% risk tolerance level for a AA rated company
–
30 year time horizon
Economic Total Asset Requirement =
Economic Reserves (cover obligations based on our
best estimate of claims plus a margin)
+
Economic Capital (cushion on top of Economic Reserves
to cover potential obligations from unanticipated adverse experience)
•
Our external Total Asset Requirement is equal to statutory regulatory
reserves plus rating agency required capital.
•
Trapped Capital is the difference between external Total Asset
Requirement and our Economic Total Asset Requirement.
9
Economic Total Asset Requirement (cont.)
Reconstruction of Economic Balance Sheet
10
Principal’s Economic Risk Metrics - Recap
Earnings at Risk
(EaR)
Embedded Value
At Risk
(EVaR)
Economic Total
Asset Requirement
Confidence
Limit
90% (1-in 10 year event)
90%
99.5%
Time Horizon
1 year
Life of Business
Life of Business
Metric
GAAP Operating Earnings
(also GAAP Net Income)
Embedded Value (EV) =
Present Value of
Distributable Earnings
Total Economic Asset
Requirement = Economic
Reserves plus Economic
Capital
Measures
Potential shortfall in
operating earnings relative
to baseline under relatively
adverse business &
economic conditions
Potential shortfall in
embedded value relative to
baseline under relatively
adverse business &
economic conditions
Total assets required to
ensure we can meet all
obligations with 99.5%
confidence
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Steps in quantifying Economic Capital
1. Identify and categorize risks
•
Credit
•
Market
•
Product / Pricing
•
Operational / Business
2. Quantify each risk individually
•
Deterministic Stress Test and / or stochastic modeling
3. Aggregate risks and capture any diversification
impact
12
Risk Hierarchy – Deeper Dive
Mortality Risk, for example, can be broken down into 4
components
1. Volatility – statistical mortality fluctuation
2. Level – misestimation of mortality mean
3. Trend – misestimation of mortality improvement
4. Calamity – 1 time spike mortality (flu pandemic)
13
Hypothetical Example of Risk Aggregation
R1
R2
R3
R4
Risk Type
Credit
Market
Underwriting
Operational
Undiversified Risk Measure
Diversified Risk Measure
Risk
measure
1,250
1,500
750
500
4,000
3,000 =
Correlation Matrix
Credit
Market
Underwriting
Operational
   RR
i
Diversification $ Benefit
1,000
Diversification % Benefit
25.0%
Cr
1
0.75
0
0.5
j
ij
i
Mkt
0.75
1
0
0.5
UW
0
0
1
0.25
Op
0.5
0.5
0.25
1
j
14
Top 10 Lessons Learned from Principal’s
Implementation
1. Importance of Quick Wins
2. Simplify
3. It isn’t all about modeling
4. Involve all parties in the process
5. Set up guiding principles up front
15
Top 10 Lessons Learned from Principal’s
Implementation (cont.)
6. Set up risk appetite and tolerances up front.
7. Not a project. Never really done.
8. Look at entire distribution of results (don’t focus only
on the downside)
9. Use lots of pictures
10. Communication, communication, communication.
16
Applications of Economic Capital Models
(if you build it they will come)
Initial Uses:
Medium Term Uses:
• Product / Business Unit
decision making
• Strategic Decision Making
• Hedging / Reinsurance
• Performance Measurement
• Internal Risk Reporting
• External Reporting
• Capital Allocation
Long Term Uses:
• Pricing
• Incentive Compensation
17
Emerging Industry Trends – Economic
Capital
Two methods have emerged as the most common:
1. Liability Run Off Approach
•
Level of starting assets needed to pay all future policyholder
obligations at a chosen confidence level
•
Approach used for RBC C3 Phase 2
2. One Year Mark to Market Approach
•
Level of assets needed to cover a fall in the market value of
net assets over a one-year time horizon at a chosen
confidence level
•
Approach used for Solvency 2
18
Lots of different variations in approaches
• Many decisions to make:
– Time Horizon
– Confidence Level
– What risks to include and how to measure
– Stochastic vs. Stress Testing
Many possible combinations!
19
One Year Mark to Market Approach
• Emerging as most common method to calculate
Economic Capital
• Driven by emerging solvency standards, particularly
in Europe (Basel II, Swiss Solvency Test, Solvency II)
• Consistent with emerging international accounting
and solvency standards
• US principles based approach for reserves and
capital is more of a liability runoff approach
– Although use of one year market-to-market for EC is
increasing in the US
20
One Year Mark To Market Approach Diagram
Normal Conditions
Stressed Conditions
MCEV
MV
Assets
MCEV
MV
Assets
MV
Liab
MV
Liab
Economic
Capital
Normal
Stressed
21
Is One Year Enough?
• Since our products have a long duration, how can
you capture the risk using a 1 year approach?
– You are still projecting your cash flows out to maturity and
factoring in the residual impact of that 1 year event.
– Confidence interval on a 1 year approach is likely higher
than a multi-year approach
• Ex: 99.95% instead of 99.5% for a AA Rated Company
• After one year company can likely recapitalize and
take other management action
22
Market Consistent Valuation
• Market price to transfer a liability between willing participants
• Applies capital market principles to liabilities
– No arbitrage (identical cash flows must have the same value)
• Uses risk neutral scenarios, discount at risk free rates
– Calibrated to current market conditions & prices
– Captures embedded options & guarantees
• Add an additional margin for non-hedgeable risks (Market Value
Margin)
– Percentile Method
– Cost of Capital Method
23
In a Market Consistent Embedded Value
Framework, selecting assets does not create value
Example:
Company has Capital of 25,
Borrows 75 at 4%, and
invests 100 in equities
expected to earn 8%
Assets
Liabilities
Capital
Day 1
100
75
25
One Year
Later
108
78
30
•
Using traditional EV techniques, the 30 might be discounted at say 9%,
giving a value of 27.5 on day 1.
•
Under MCEV the asset CFs are discounted at 8% and the liability CFs at
4%, giving a value of 25 on day 1.
•
The effective discount rate on capital is 20%.
•
The risk discount rate is an output of the MCEV valuation, and not an input.
•
Under a Market Consistent Framework you can’t take credit up front for
taking market risk.
24
Questions?
25