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STRESS EVENTS - RESILIENCE VERSUS CAPITAL
EFFICIENCY
Hermann Pohlchristoph, CFO Reinsurance
Sun City, June 11th 2012
Financial Management often means to manage
opposing targets
Stakeholders have different requirements in terms of security and financial return.
Low results volatility
Liquidity
Regulators
Analysts
Return
High returns
Investors
Performance of share
price
Equity
Resilience against
stress events
Clients
Capital efficiency
Every company needs to find and maintain the right equilibrium.
State-of-the-art risk management processes should ensure a sustainable value
creation to shareholders while protecting the balance sheet of a company
against extraordinary shock events.
2
Agenda
1. A regulator’s view on capital adequacy: Solvency II
2. A shareholder’s view: optimizing resilience and capital efficiency
3. Limits of models and how to cope with it
Solvency II – Fuelling a global trend towards
risk-based supervision(?)
Influence of Solvency II on other supervisory regimes
Evidence of the trend
Various supervisory regimes
aiming for recognition under
Solvency II ("equivalence"), e.g.
Bermuda, Switzerland and
South Africa.
IAIS – International Association of Insurance
Supervisors
COMMON FRAMEWORK FOR THE SUPERVISION OF
Adjustments of risk-basedcapital-type models in USA
and Canada.
INTERNATIONALLY ACTIVE INSURANCE GROUPS
Multilateral framework aiming for worldwide coherence
of supervision among global insurance companies.
Harmonization
No separate framework.
Convergence
No additional supervision.
Planned adaption of Solvency
II, inter alia in Japan, Israel
and Mexico.
Convergence towards a common framework to be expected in the medium term.
Solvency II motivates the insurance industry to fully adopt
stringent risk-based economic steering
Changes compared to Solvency I
3 pillars of Solvency II
1 Quantitative
2 Qualitative
3 Transparency
Solvency
requirements
Supervisory
process
Market
transparency
Standard
approach or
internal model
Efficient risk
management
and control
Disclosure
requirements
to strengthen
market discipline
Enterprise risk management to replace the traditional
accounting-based focus, facilitating a stringent
economic and holistic approach to managing risks
 Principle-based (in contrast to
Solvency I rules)
 Economic and market-consistent
valuation of all material risks
 Reinsurance and other risk
mitigation instruments fully
applicable under Solvency II
(no more 50% cap on non-life
reinsurance)
 Some issues remain, especially
with regard to non-proportional
reinsurance
 Consideration of diversification
effects
 Investment risks are comprehensively taken into account
In the past, success was measured by combined ratio and investment income –
in the future, the focus will be on return on risk capital
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Divergence in opinion between European regulators and the
insurance industry at Level 2 (selected issues)
Level 1
European regulators & insurance industry
European regulators and the insurance industry agree on a Level 1 Framework Directive that represents an
adequate compromise which must be respected as a basis for Level 2 consultation process.
Level 2/3
Pillar 1
European regulators perspective
Insurance industry perspective
 Increased capital requirements in general.
 More balanced treatment of all risk categories,
especially within market risk (e.g. spread risk).
 Full allowance of diversification in risk margin.
 No consideration of diversification between solo
entities of a group in risk margin.
 Very strict rules for 3rd country equivalence.
 Preference for a discretionary approach for
countercyclical premium.
 More flexibility towards 3rd country equivalence.
 Rule-based approach for countercyclical
premium to make adjustments more predictable.
Pillar 2
 Strict requirements for the approval process for
internal models.
 Approval of internal models to be an achievable
option without incurring excessive costs.
Pillar 3
 Comprehensive reporting requirements to permit
efficient supervisory review.
 Content and degree of detail of reporting
requirements excessive, leading to high costs.
The current stage of Level 2 discussion indicates a level of restriction which goes
beyond the intentions of the Framework Directive.
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The impacts of Solvency II will change the insurance sector
Some general assumptions
1.
Capital
requirements
will rise…
 Identification and evaluation of all relevant risks
 Long term products will require more capital (more volatile)
2.
…and Available
capital too
 Assets and Liabilities will be evaluated by a "market value approach"
 The available capital will rise but the volatility will be higher in time
3.
Risk
management &
transparency
 Better qualitative processes for risk steering/control
 Use of quantitative models for an overall risk modelling
 Value proposition of risk transfer is measurable
4.
Asset Risk
 An aggressive asset allocation will not compensate any more technical losses –
higher risk capital for venturous asset allocation
 Reduction of volatile asset categories
5.
Product
adaptations
 Actual products are put to test (risk capital intensive?)
 New products will appear (less risk capital intensive)
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Advantages of reinsurance solutions
Criterion
Reasons
Capital
strength and
rating of
reinsurer
 Rating and capital strength of
reinsurers are differentiating criteria
Advantages of
reinsurance
solutions
 Effective and available independent of capital market access
Capital
management
by reinsurance
 Capital management as an additional driver for reinsurance
 Explicit consideration of reinsurance
credit risk through a deduction from
capital relief (see chart1)
 Faster and more flexible than capital market solutions
 Reinsurance available to all insurance segments and provides highest confidentiality
 Comparison of internal cost of capital with the cost of reinsurance (cost of capital +
administration cost + counterparty risk) will be possible and will influence decisions
Solvency II will lead to transparency in risk capital relief and will make the added
value of reinsurance much more visible.
1
Chart based on QIS5 technical specifications.
Agenda
1. A regulator’s view on capital adequacy: Solvency II
2. A shareholder’s view: optimizing resilience and capital efficiency
3. Limits of models and how to cope with it
Aiming for higher target capitalisation – Management
intervention much more responsive than supervisory scheme
Munich Re actions1
>140%
Excellent capitalisation
MRCM
Solvency II
Solvency ratio adjusted
for capital repatriation
 Capital repatriation
 Increased risk-taking
 Holding excess capital to
meet external constraints
100%–140%
Comfortable capitalisation
80%–100%
Adequate capitalisation
 Tolerate and monitor
 (Partial) suspension of
capital repatriation
Regulatory actions2
Munich Re solvency ratio
140%
245%
Actual solvency
ratio
100%
175%
80%
140%
100%
<80%
Below target capitalisation
 Risk transfer
 Scaling down of activities
 Raising of (hybrid) capital
1
2
35%
2008
Based on Munich Re capital model (MRCM): 175% of VaR 99.5%.
Based on Solvency II calibration: VaR 99.5%.
2009
2010
2011
35–100%
Below target capitalisation
 Obligation to submit a
comprehensive and
realistic recovery plan
 Insurer to take necessary
measures to achieve
compliance with the SCR
<35%
Insufficient capitalisation
 Obligation to submit a
short-term realistic
finance scheme
 Regulator may restrict or
prohibit the free disposal
of insurer's assets
 Ultimate supervisory
intervention: Withdrawal
of authorisation
Elements of Munich Re’s Enterprise Risk Management
Risk strategy
Clear limits indicate
precise signals for the internal & external world
and define the framework for operative actions
Risk identification
& early warning
Risk steering
Intelligent system consisting
of triggers , limits und
measures …
In cooperation
…with responsible
management actions
Risk
steering
ERM
Cycle
Risk
modelling
Risk identification and
early warning
Necessity for
comprehensive overview
but with special focus
on main issues
Risk modelling
Central competition factor
in the right balance
between flexibility and stability
Risk-based
incentive systems
and sustainable responsibility
Sound risk governance
and effective risk
management functions
Risk management culture as solid base
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Strategic Risk Management Framework of Munich Re
Category
Risk criteria
Measure
Criteria's objective
Whole
portfolio
criteria
Financial strength
 ERC
 Rating
 Solvency
Safeguarding sufficient
excess capital and limiting
frequency of negative
economic results of
Munich Re's entire risk
portfolio.
Supplementary
criteria
Avoiding financial distress
Negative economic
earnings tolerated
every 10 years
 Peak risk management
 Individual
 Longevity
nat cat perils  Financial
 Terrorism
sector limit
 Pandemic
VaR limits as % of
AFR or limit for
maximum
exposure
Limiting losses from
individual risks or
accumulation exposure
and liquidity risks that
could endanger Munich
Re's survival capability.
Individual risk
limits in absolute
value
Limiting risks that could
sustainably damage the
trust of stakeholders in
Munich Re
 ALM limits
 Liquidity
Other
criteria
E.g.: 



Counterparty-credit risk
Single risks
Alternative investments
Non-investment-grade
investments
ERM objective
addressed
Maintaining Munich
Re's financial
strength, thereby
ensuring that all
liabilities to our
clients can be met
Protecting and
increasing the
value of our
shareholders'
investment
Safeguarding
Munich Re's
reputation, thus
perpetuating future
business potential
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Risk Management Culture
Steering based on economic principles
Risk strategy
• Define the risk appetite
• Set limits and budgets for peek exposures
• Calculate adequate risk capital per segment
Business planning
Planning parameter take the underlying
risk into account:
•RoRaC targets
•Allocated risk capital
•Budgets and limits
Pricing
Pricing parameter take the underlying risk
into account:
•RoRaC targets
•Risk capital loadings
•Budgets and limits
Performance evaluation and incentive system
Achieved RoRaC and economical value added are parts of the incentive system
The “return on risk” idea is deeply implemented in every business decision
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Annual planning of business units as an application for scarce
resources (economic risk capital)
Service
• Controlling department provides necessary data, processes and systems for an efficient
business planning exercise.
Support
• Support of business units throughout the planning by dedicated controllers
(especially explanation of input parameters like economic risk capital or yield curves).
• Challenging of the calculation of economic risk capital by the business units.
Challenging
• Challenging of the ambition level and achievability of the plan by the controlling department.
• Discussion of critical points between business and controlling units.
Assessment
of plans
• Business units „apply“ in form of a business plan for scarce resources (economic risk
capital, staff), which are to be approved by the board of management.
• The board of management receives an independent assessment of the business plans
from the controlling department, incl. recommendations on the approval and allocation of
scarce resources.
Evaluation
of success
• Assessment of target/plan achievement by the controlling department.
• Value Added und RoRaC as fundamental KPIs.
• Variable compensation linked to plan achievement.
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Munich Re: Low volatility in shareholder returns with a
volatile business model through efficient capital management.
Efficient deployment of capital over time.
High shareholder returns1 with low volatility.
% Total shareholder return (p.a.)
Volatility of total shareholder return (p.a.)
CAGR: 12.4%
• Volatility in single years is a function of
the reinsurance business model.
• This has to be dealt with prudent risk and
capital management.
1
2
Dividend yield2 (%)
Annualised total shareholder return defined as price performance plus dividend yield over the period from 1.1.2005 until 29.2.2012; based on Datastream total return
indices in local currency; volatility calculation with 250 trading days per year. Peers: Allianz, Axa, Generali, Hannover Re, Swiss Re, Zurich Financial Services.
Dividend divided by year-end share price.
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21.07.2015
Agenda
1. A regulator’s view on capital adequacy: Solvency II
2. A shareholder’s view: optimizing resilience and capital efficiency
3. Limits of models and how to cope with it
Resilience to shock events
- 2011 as a real-life stress test (I)
Severe weather,
tornados
USA, 20–27 May /
22–28 April
Earthquake,
tsunami
Japan, 11 March
Wildfires
Canada, 14–22 May
Floods
Thailand, Aug.–Nov.
Floods
USA, April–May
Floods, flash
floods
Australia, Dec.
2010–Jan. 2011
Hurricane Irene
USA, Caribbean 22
Aug.–2 Sep.
Earthquakes
New Zealand,
22 Feb. / 13 June
Major loss events
Geophysical events
Climatological events
Meteorological events
 2011 saw for the reinsurance segment
of Munich Re a combined ratio of
113.6% of which 32.5% were due to
large losses (28.8% nat cat).
 Largest single losses were EQ Japan
(€1.5bn), EQ Christchurch (€1.3bn) and
the Flood in Thailand (€0.5bn).
Hydrological events
2011 Nat Cat events…
 Proved the value of risk modeling and active exposure management despite the inevitable problem of
model uncertainty.
 Confirmed the need to continuously revise and enhance underlying models.
 Emphasized again the necessity for sufficient profitability thresholds to sustainably write Cat business.
 Shed a special spotlight on the issue of CBI claims in the industrial primary insurance market.
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Resilience to shock events
- 2011 as a real-life stress test (II)
10-year German Bund yield1
–113 bps
Credit spreads1,2
+145 bps
EURO STOXX 501
–17%
Several countries downgraded in the course of 2011.
Historically low interest rates for „secure“ government bonds.
General high volatility in the financial markets.
• 2011 underlines the need for a limited risk-appetite and a high degree of
diversification on the asset side .
• Especially as “risk-free assets” virtually ceased to exist.
• Despite the turmoil Munich Re managed to achieve a RoI of ~ 3.4%.
1
Change between 31.12.2010 and 31.12.2011. 2 IBOXX EURO Corporate vs. BofAML German Government 7–10 years.
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Limits of mathematical models for business decisions... (I)
Changed jurisdiction
Dependency on assumptions
Model changes
Example: Motor UK
•Motor claims in UK used to be
paid as a lump sum.
•Jurisdiction started to move
towards periodical payments
(PPOs), even retrospectively.
•As a consequence, the
inflation and investment risk is
transferred from the insured to
the (re-)insurance company.
Example: Longevity
One risk in life insurance is the
average life expectation in an
insured portfolio.
Example: RMS11
•RMS, one of the leading risk
modeling companies,
introduced in 2011 a revised
model for US wind exposures.
• As a consequence of the
changes, the modeled loss
expectation for several US
exposures increased.
Example: Pandemic
Only scarce empiric data is
available on pandemic risks.
Sensitivity of changed
assumptions can be material
and can change the overall
assessment of a book of
business.
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Limits of mathematical models for business decisions...(II)
Trend risks
Example: Bodily injury
•Calculated risk capital of
„long-tail“ lines of business
(too?) low on a regular basis.
•Biggest losses of the
insurance industry happened
to be in exactly this class of
business (Workers comp,
Motor, Asbestos).
•Are trend risks, which
manifest slowly, correctly
captured in the models?
Immanent weaknesses
Example: Allocation of
economic risk capital
•The allocation of the groupwide modeled economic risk
capital to business units /
single contracts follows a
mathematical algorithm.
• Results of this algorithm can
never fully reflect reality (the
more granular - the more
incorrect)
And now...?
Does the systematic
consideration of risk in
controlling systems create
any benefit at all?
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Consequences of model insufficiencies for decision
making
• Principles of economic KPIs must be understood by decision makers – also with respect to the
Communication
& Transparency
immanent insufficiencies.
• However, the general question has to be clearly answered: an approximation of reality is clearly
better than not considering the risk factor at all.
• Value Added und RoRaC should not be taken as the only truth.
Sense of
proportion
• Especially for management incentives, there should be a sense for
proportion (however, in both directions).
• Not every „scientific“ finding on risk measurement has to be immediately incorporated in
Stability of
models
performance measurement.
• For every change in methodology it has to be assessed, if the initiated management impulse is
really intended. Implementation of a gatekeeper function for model changes is advisable.
• Regular review and „benchmarking“ of risk modeling results.
Monitoring
•
Annual monitoring of input parameters by the controlling department.
•
Discussion of findings with business units.
Mathematical models and KPIs do not supersede common sense and
entrepreneurial intuition.
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Let‘s dare an outlook what the future will hold for the
insurance industry...
• Local regulations will become more and
more aligned.
• Globally, the valuation of risks will follow
economic and market consistent
approaches.
• Regulation will become in tendency more
(and maybe too) onerous.
Financial Crisis
• The lessons learned will lead in many cases
to a changed assessment of risks.
• Especially the crisis in the banking sector
and the sovereign debt crisis revealed
severe problems in risk models.
Success Factors
Internal Reactions
External Developments
Regulation
• Decreasing appetite for
risky bets on assets
(incl. sovereign ratings).
• Increased levels of
diversification.
• Higher focus on
underwriting profitability
will be key.
• The pure existence of
internal models does not
prevent negative
surprises. A prudent
balance of models and
common sense is key.
Only if the industry draws the right conclusions, the stock markets and
investors will appreciate the development.
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