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EnterpriseRisk ManagementFor Insurers and Financial Institutions

David IngramCERA, FRM, PRM

From the International Actuarial Association

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Course Outline

1. INTRODUCTION - Why ERM?

2. RISK MANAGEMENT FUNDAMENTALS – FIRST STAGE OF CREATING AN ERM PROGRAM

3. RISK ASSESSMENT AND RISK TREATMENT - ACTUARIAL ROLES

4. ADVANCED ERM TOPICS

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Risk Assessment & Risk Treatment

Actuarial Roles3.1 Types of Risks3.2 Risk Models3.3 Risk Treatment Options – ALM3.4 Risk Treatment Options – Hedging3.5 Risk Treatment Options – Reinsurance3.6 Risk Treatment Options – Capital Markets3.7 Risk Treatment Options – Risk Design3.8 Risk Treatment Options – Diversification3.9 Risk Treatment Options – Avoid/Retain3.10 Choosing a Primary Risk Metric3.11 Uses of multiple Risk Models3.12 Using Economic Capital for ERM3.13 Capital Management & Allocation

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3.1 Types of Risks

Systematic v. Specific

Traded v. Non-Traded

Paid to Take v. Not Paid to Take

Market, Credit, Insurance, Operational

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Systematic Risk vs. Specific Risk

• Flood – Systematic Risk -everyone gets wet

• Bucket of water thrown by your brother – Specific risk – only you get wet

• Insuring one House – Systematic or Specific?

• Insuring thousands of houses – Systematic or Specific?

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What are risk management Techniques for Specific Risk?

1) _____________

2) _____________

3) _____________

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What are Risk Management Techniques for Systematic Risk?

1) _____________

2) _____________

3) _____________

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What happens with a group of specific risks?

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3.2 Risk Models

Cause / Effect - Outcome

Outcome – Frequency/Severity

Closed Form v. Single Scenario v. Monte Carlo

Stress v. Scenario

Sensitivity

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Cause Effect - Outcome

Typical Life Insurance Actuarial Model Model follows the steps taken over the life of

an insurance contract following a tree branching logic

Policy Issue, continue to next year (1 – q - w) Death & Claim in first year (q) Lapse or surrender the contract (w)

Repeat – year after year Outcome = PV of three paths for each year

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Outcome – Frequency/Severity

• Model commonly used for non-life insurance and for financial market instruments

• Past observations of frequency and severity of outcomes used to parameterize statistical models of future outcomes

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Closed Form v. Single Scenario v. Monte Carlo

• Close Form models

– one step calculations

– usually depend upon assumption of distribution of outcomes (normal or log normal) that have formulaic outcomes

– Black Sholes

• Single Scenario

– Also one step (the one scenario)

– Using either CEO or OFS

• Monte Carlo (stochastic) model

– Multi scenario

– Often do not presume to know distribution of outcomes

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Stress v. Scenario

• Stress Test

– Redo calculation changing one parameter

• Scenario Test

– Adjust all parameters to reflect a fictional total world

– Includes interactions of factors and dependencies in the assumed situation

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3.3.0 Risk Treatment Process

• May vary significantly with each major risk category

• Depending on Nature of Risk

– Assessment Capabilities

– Relationship with Risk Takers

– Knowledge & Experience of Staff

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Components of Risk Treatment Process

– Risk Identification– Measuring & Monitoring System– Risk Assessment & Communication– Establishment of Risk Limits &

Standards– Risk Treatments– Enforcement of Limits & Standards– Risk Learning

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Risk Identification

• Within a broad category

• Need to know which sub categories of the risk can be treated together

– And which need to be treated separately

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Measuring & Monitoring System

• Measures of risk v. Key Risk Indicators

• Existing v. Future

• Manual v. Automated

• Quantitative v. Qualitative

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Risk Assessment & Communication

• Need to establish regular schedule of assessment

• Assessments must be communicated at several levels in the organization

– Operational Levels– Management levels

• Management MUST have discussions with subordinates about the risk positions

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Establishment of Risk Limits & Standards

• Limits = How large, How much, How many, Authorities

– Limits must be quantitative– Also may use Checkpoints

• Standards

– For how things are to be done– Treatments permitted/ required

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Risk Treatments

• Avoid

• Reduce

• Offset

• Transfer

• Retain & Provision

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To set Standards

• Ask the best person in a function what needs to be done to “get it right”

• Ask supervisors what information that they need to be able to tell that things are being done “right”

• Standards also apply to documentation and recordkeeping

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Enforcement of Limits & Standards

• Assessment & Communication systems need to include comparison of risk positions to limits

– And adherence to standards

• Must clearly establish what will happen if limit or standard is violated

– Might depend on seriousness of breach

– Hard limits v. Soft Limits

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Risk Learning

• About Losses, Risk Assessment, Risk Treatment Processes

– Internal– External– Backwards– Forward

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Credit Risk Treatment

Traditional Credit Risk Treatment

• Standards for– Underwriting

– Authorities

– Collateral, Coverage

• Limits & Enforcement– Limits by credit quality, Size of Position

– Authority Limits

• Active Workout with Risk Learning

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“Modern” Credit Risk Treatment

• Credit VaR risk model & Aggregate limits

– Gives aggregate portfolio view of Credit Risk

– Allows trade-offs within aggregate limits

• Use of credit derivatives to offset excessive specific or aggregate risk levels

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Insurance Underwriting

Traditional Risk Control Mechanism for Insurance

Standards for

• Underwriting

• Authorities

• Insurable Interest

Limits & Enforcement

• Limits by quality, Amount of Coverage

• Authority Limits

Active Claims management with Risk Learning

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3.3 Risk Treatment Options – ALM

Interest Rate Risk Treatment• Crediting Rate Matching

• Cashflow Matching

• Duration Matching

• Advanced ALM

• Economic Capital

Limits & Reporting

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Crediting Rate Matching

Portfolio Rate New Money Rate Investment Year Rates

Mismatched crediting rates can lead to large harmful cashflows

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Cashflow Matching

1) Project out expected cashflows from liabilities

2) Project out expected cashflows from assets

3) Identify major gaps where there is a large difference between the projected cash outflow and inflow in a future year

4) Make plans to fill those gaps (usually on asset side for insurers)

Targeting future asset purchases Targeting asset sales & repurchases

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Duration Matching

Duration is sensitivity of value to a change in interest rate

Also equal to PV of time weighted cashflows

Sum of PV(t x Cft)

Focus on DA v. D

L

Set Limit for abs(DA

– DL)

– Usually ½ to 1 year

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Duration Matching

• Most Insurers adjust assets to match duration of liabilities

• First step is to assess expected DL for a new

product

– Set DA target for new cashflow

• Second step is to set schedule for assessment of portfolio D

A & D

L

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Duration Matching

• If assessment reveals excessive abs(DA

– DL)

gap then will plan to:

– Adjust DA target for future cashflows

– Sell some assets and purchase others to change D

A

– Purchase derivatives • Macro or Micro Hedge

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ALM – Advanced

• Duration matching only works well if interest rate moves are

– Small

– Similar for all durations

• Advanced methods take care of:

– Larger movements (Convexity)

– Non-parallel shifts (Key Rate Durations)

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Convexity

• Change in Duration with change in interest rates

– Second derivative of value with respect to a change in interest

• Duration measures slope of the value plot

– If Value Plot is a curve, then slope is only accurate measure for very small moves

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Key Rate Durations

• Change in value with change in rate at a specific duration

– For example, 5 year rate only

• Matching Key Rate Durations allows protection against yield curve twists

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3.4 Risk Treatment Options – Hedging

Financial Market Risk Treatment• Derivative Instruments used for Hedging

– Futures

– Put & Call Options

– Swaps

• Derivatives are often low cash outlay

– Usually means that derivatives involve significant leverage

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Example of Financial Market Risk

Product – Index Annuity

– Feature – Product promises the greater of • 80% of stock market growth

• Floor interest Rate on 90% of funds

On a specified maturity date

To match without derivatives would require insurer to invest twice

– 80% In Stock Fund

– 90% in Bonds

– For a total of 170% of deposit

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Hedging Methods

• Cashflow Hedging

– Works like Cashflow matching in ALM

– Purchase derivatives that have strike dates where there are potential cash mismatches

• Most firms use this method to manage Index Annuities

– Invest 90% of deposit in fixed income

– Use other 10% to buy Option contracts tied to Equity market

• Adjust participation percentage (80%) based upon cost of Options

• Strike Date3 for Options is maturity date

• Of Index Annuity Contract

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Hedging Methods

• Delta Hedging

– Is fundamentally the same idea as Duration Matching

– Delta is change in price (value) per change in an underlying (usually a market index)

– Delta hedging often uses derivatives with extremely different term to hedge obligations

• Delta hedges are only good for a very short time period (usually a day)

• Delta Hedges must be rebalanced every day

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Delta Hedging Index Annuity

• Buy bonds to cover interest guarnatees

– Delta hedging ignores interest rate risk

• Then determine Delta of liabilities

– Plus Delta of existing hedges

• Purchase new derivatives that will bring Delta of assets + hedges to be within tolerance for difference from liabilities

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Hedging Methods

• Greeks

– Greeks are partial derivatives of Prices with change in various factors

• Gamma

• Vega

• TauGet Definitions

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Hedging Index Annuity with Greeks

• Investments can be any mixture of bonds and stocks

• Greeks will determine adjustments needed with derivatives to match all of the risk characteristics

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Custom Hedging

• Can purchase custom hedge contracts from a bank that have terms tailored to your specific need

• If using custom hedges, would expect very low amount of rebalancing needed

• Hedges are tied to market indices – not to actual liabilities

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Hedging Programs Favorable Unfavorable

Cashflow Hedging Easy to understand & ControlLock in protection

Inflexible Difficult to adjustCan be costly

Delta Hedging Can produce low cost hedging programSingle Metric – easy to controlWorks well in normal market conditions

Requires sophisticated models & derivative trading abilitiesRequires that derivatives are always available and always reasonably pricedIgnores risk of jump and other risks

Greeks Can provide protection that is effective in normal & abnormal markets

Requires highly sophisticated models and derivative trading capabilitiesCan result in high amount of trading to balance many Greeks

Custom One step hedging process

May not work as expectedCustom hedge is illiquid – usually must sell back to same bankMay be costly

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3.5 Risk Treatment Options – Reinsurance

Insurance & Financial Market Risk Treatment

Reinsurance is broadly similar to Custom hedges just described

Usually much more customized than Custom hedges

Reinsurers will usually promise to offset some portion of an insurers exact claims experience

Types of Reinsurance

• Facultative v. Treaty

• Proportional v. Non-Proportional

• Per Risk v. Per Occurrence v. Aggregate

Facultative v. Treaty

• “Facultative” reinsurance applies to a single insurance contract

• “Treaty” reinsurance applies to all contracts in a defined block

Proportional v. Non-Proportional

Proportional reinsurance: the reinsurer takes a defined percentage of all losses

Non-proportional reinsurance: the reinsurer only takes losses that exceed some threshold

Almost always subject to a maximum limit Threshold may be on per risk, per occurrence, or

aggregate basis

Per Risk v. Per Occurrence v. Aggregate

Types of loss threshold for non-proportional reinsurance

Per Risk: threshold applies to losses from each insurance policy

Per Occurrence: threshold applies to total loss from each specific event (for example, each hurricane or earthquake)

Aggregate: threshold applies to total loss from a specific time period

Reinsurance

• Advantages:

– Customized to take exact aspect of risk that insurer wants to lay off

– Available through a market of 50-100 firms globally

• Disadvantages

– Cost and availability of specific covers varies widely

– Need to be concerned about credit quality of reinsurer• Sometimes for many, many years

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Actuarial Analysis of Reinsurance Decision

Quantify frequency & severity of insurance losses

Apply terms of various reinsurance options

Compare cost / benefit and Risk/Reward tradeoffs

Evaluate options in light of company goals in order to determine best strategy

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Strategies for Managing Underwriting Risk

• Remove– Cancel policy or exit LOB

• Pro: eliminates future risk• Con: also eliminates

opportunity for profit

• Reduce– Stringent UW & claims

management• Pro: leverage company

expertise• Con: competitive forces are

outside company control

• Reinsure– Purchase reinsurance

• Pro: customized hedge• Con: cost of risk transfer

• Retain– Live with the risk

• Pro: retain profit opportunity• Con: risky; requires supporting

capital

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Determining Reinsurance Needs

Increase

Risk

Capacity

Provide

Stability

Provide

Surplus

Relief

Provide U/W

Expertise

Facilitate

Withdrawal from

Business

Business Strategy

Growth X X X

LOB

FocusX X X X

Financial Position

Limited Asset

LiquidityX X

Limited Surplus

X X X

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Functions Served by Different Types of Reinsurance

Increase

Risk

Capacity

Provide

Stability

Provide

Surplus

Relief

Provide U/W

Expertise

Facilitate

Withdrawal from

Business

Facultative X X

Proportional Treaty

X X X

Non-Proportional

TreatyX X X

Reinsurance

• Advantages:

– Customized to take exact aspect of risk that insurer wants to lay off

– Available through a market of 50 to 100 firms globally

• Disadvantages

– Cost and availability of specific covers varies widely

– Need to be concerned about credit quality of reinsurer

• Sometimes for many, many years

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3.6 Risk Treatment Options – Capital Markets

Securutization of Firm Risks

Use of General Capital Markets products (ILW)

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Capital Markets Options for Insurance Risks

• Two broad Capital Markets Solutions to Risk

– Securitize & Sell your own risk on the Capital Markets

– Buy Capital Markets Instruments that offset a risk that you have

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Securitize your Risk

Advantages:

• Covers your exact risk

• Pricing may be better than reinsurance

• Capacity can be higher than reinsurers

Disadvantages

• Market might balk at any non-standard aspects of your risk

• Large fixed cost of securitization

• Market appetite varies widely for insurance

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Buy Capital Markets instruments to offset your risk

• There are some instruments – usually related to insurance cats that have been created by banks or (re)insurers

– Mortality Cat Bonds

– Industry Loss Warrents

• Usually, these are bonds where principle is not repaid if trigger event occurs

• Trigger event is usually very large catastrophe

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3.7 Risk Treatment Options – Risk Design

Life Insurance

Annuities

Health Insurance

Property Insurance

Casualty Insurance

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Risk Design – Life Insurance

• Increasing Insurance Amount

– To limit underwriting anti-selection

• High Premium Levels

– For Guaranteed Options

– Assumed high degree of anti-selection

• Offsetting Insurance & Investment Risks

– If investments perform poorly, must buy more insurance

– Explicit in UL product

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Risk Design - Annuities

• Deferred Annuities

– Surrender Charges

– Market Value Adjustments (fixed)

– Investment restrictions (variable)

• Immediate Annuities

– Limited or no Withdrawal options

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Health Specific ERM Concerns

Underwriting controls-- centralized authorizations required for larger cases

Avoiding Anti-Selection--being one of several health options offered by employer could invite anti-selection

Experience monitoring--ability to slice and dice claim experience and trend, monthly, down to segment/geography/product

Diversification—(Large Accounts, small accounts, by location, public/private).

Provider contract renewal (for example – staggering renewals).

Assessing counterparty credit risk of providers, especially those accepting capitated risk.

Stress scenario modeling: Bioterrorism, Pandemic

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ELEMENTS OF AN INSURANCE POLICY – Declarations Page(s)Coverage Part(s)DefinitionsGeneral Provisions Exclusions – General Additional Coverages Conditions Duties After an Accident or LossExcluded Property Excluded Perils

POLICY CONTRACTS As Risk Treatment Tool

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POLICY CONTRACTS …OCCURRENCE & CLAIMS-MADE

Policies written to cover losses two ways:

Occurrence Basis – Pays for losses that occur during the policy period.

Claims Made – Pays for losses reported during the policy period

Due to nature of Claims Made policies, they are written with either:Extended Reporting Provision, or

Retroactive Date Provision

Both extend the “period” during which losses may be reported and covered

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BASIC Reinsurance CONTRACT TYPES

Facultative or Treaty

Individual Risk

Entire Book of Business

Excess or Pro Rata

Limit and Retention

Proportional Sharing of Loss

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“BUSINESS” PROVISIONS

Business CoveredLine(s) of businessIn force, new and renewal

ExclusionsWhat isn’t covered

TerritoryWhere can the risks be located or policies written

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COVERAGE PROVISION“Coverage” Article establishes the Reinsurer’s

liability to the Company for the subject business:

Excess – Retention and LimitQuota Share or other Pro Rata – Percentage of

Cession

The Basis of Coverage is defined. For example, on an XOL contract the Basis of Coverage is “each loss occurrence” or “each risk,” etc.

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Commencement and Termination

Definitions – Excess vs. Pro Rata

ECO/XPLLAE/DJUNL – excess onlyLoss Occurrence – Property vs Casualty

COVERAGE PROVISIONS

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Other Reinsurance – Inuring vs Underlying

Reinstatement

Warranties

Notice Of Loss and Loss Settlements

COVERAGE PROVISIONS

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“MONEY” PROVISIONSThree Types of Accounting Basis1. Accident Year2. Calendar Year3. Underwriting Year

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3.8 Risk Treatment Options – Diversification

Diversification among risks

Diversification between risks

Correlations v. Dependencies

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Diversification of Like Independent risks

• If rate of claim is q, amount of claim is C, number of insured is N

• Expected claims = NqC

• Standard Deviation of Claims amount is

– Square Root {Nq(1-q)}C

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Independent Like Risks

• q=.01 C=1000

N Expected Std Dev COV

1 10 99 995%

5 50 222 445%

10 100 315 315%

50 500 704 141%

100 1,000 995 99%

500 5,000 2,225 44%

1,000 10,000 3,146 31%

5,000 50,000 7,036 14%

10,000 100,000 9,950 10%

50,000 500,000 22,249 4%

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Combining Unlike Risks

• Dependent = Add Ranked Values

• Fully independent = Square Root(A2 + B2) if both are Normally distributed

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Unlike Risks

Risk 1 Risk 2 Dependent Independent

5% -6 -18 -24 -19

15% -0 -6 -6 -6

25% 3 2 5 4

35% 6 7 13 10

45% 9 12 21 15

55% 11 18 29 21

65% 14 23 37 27

75% 17 28 45 33

85% 20 36 56 41

95% 26 48 74 55

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Correlation v. Dependencies

• Correlation is a mathematical term

– Can calculate correlation between finger length and car ownership

• Dependency is a statement about the fundamental relationship between things

– Net Wealth and Car ownership

• Correlations can be found for things with no conceivable dependency

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Copulas

General Mathematical technique for combining two random variables that are partially dependent

• Gaussian Copula

• Non-Gaussian Copula

– Some non-Gaussian Copulas will allow higher dependence in the tails of the distribution

– Which is popular to more closely fit with reality

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3.9 Risk Treatment Options – Avoid/Retain

Operational Risks

Holding Capital for Retained Risks

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Operational Risks

• Usually a firm is not paid to take Operational Risks

• So most firms will choose to avoid Operational Risks

– If unavoidable, to minimize them

– Using cost benefit to choose how to lminimize

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Operational Risk

Definition

Identifying Risks

Assessing Risks

Risk Control

Risk Transfer & Reduction

Case Studies

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Operational Risk

“the risk of loss, resulting from inadequate or failed internal processes, people and systems, or from external events”. Basel

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Operational Risks(a partial listing)

• Regulatory Changes• Tax Changes• Governance Problems• Industry reputation• Company reputation• Information systems risks• Legal risks• Financial Reporting Risk• Outsourcing

• Inadequate Controls

• Process inefficiencies

• Business strategy risks

• Political risk

• Terrorism

• Natural Catastrophe

• Misselling

• Fraud

• Insourcing

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Operational Risk Measurement

Measurement is not the most important aspect of operational risk management

Operational Risk Management Process:

Identify Risks

Classify risks by frequency and severity

Develop plans and strategies for controlling high frequency and high severity risks

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Risk Management Continuum(Harvard University)

Proactive ManagementAnticipate Risks

ReactiveCrisis Management

Active Management

Timely Response

• Improved Services

• Protection of Reputation

• Improved Work Place

• Understanding and Evaluation of Risks

• Decreased Crisis Response

• Governance / Compliance Standards

• Central Oversight / Assurance

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Compliance Paradigm Shift(Harvard University)

• Informal Policies

• Limited Oversight

• Reactive

• Fragmented

• Limited Involvement

• People Orientation

• Ad Hoc

• Formal Policies

• Senior Level Oversight

• Anticipate, Prevent, Monitor

• Focused, Coordinated

• Everyone is Involved

• Process Orientation

• Continuous Activity

From To

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Banks should implement a sound process to identify in a consistent manner over time the events used to set up a loss database and to be able to identify which historical loss experiences are appropriate for the institution and represent the current and future business activities.

Banks should develop rigorous conditions under which internal data would be supplemented with external data, as well as the process of ensuring relevance of this data for their business environment.

Basel Prescribed Methodology

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Operational Risk Tracking

Need Standard List of Risks

Need to Track

Losses

Exposures

Process should be similar to mortality studies for Life Insurers

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Operational Risk Management

Control Systems

Internal audit

Back-up and Redundancy

Insurance

Compliance monitoring

Process improvement

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Categories of Operational Risk

1. Clients, Products & Business Practices

2. Fraud, Theft, Unauthorized Activity

3. Execution & Processing Errors

4. Employment & Safety

5. Physical Asset

Suitability, breach of fiduciary duties, sales practices

Unauthorized transactions, money laundering, fraud

Execution errors & systems failures

Wrongful dismissal, harassment, workers comp & related legal liability

Natural Disasters and human-instigated acts of damage

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Case Study Misselling Risk

Risk Description

Occurs during Sales Process

Improper Illustrations

Misrepresentation of Policy Provisions

Misrepresentation of Company intentions regarding non-guaranteed elements

Loss occurs when

Incorrect expectations are not met by company

policyholder obtains redress via regulator or courts

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Misselling Risk

Risk Assessment

Isolated casesFrequency – Low to Medium

Severity – Low to Very Low

Systematic MissellingFrequency – based on economic & competitive

conditions

Severity – Very High

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Misselling Risk

Risk Management Options

Transfer – Insurance Coverage?

Offset – Not Applicable

Manage - Controls

Avoid – Improve Procedures

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Misselling Controls & Improved Procedures

Culture

Training

Clear Marketing Materials, Illustrations & Contracts

Supervision

Monitoring

In Depth Review

Random

Triggered

Complaints

Turnover

Spot Checking

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Case Study Equity Linked Product Execution

Risk Description

Occurs with client directed transactions

processing lags corrected with backdating of transactions

company has gain or loss with each backdated transaction

Original thinking – gains & losses would cancel

Actual findings – direction of client fund movement tends to create more losses than gains

with extreme market movements volumes increase, delays increase and losses increase

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Equity Linked Product Execution

Risk Assessment

Frequency – Very High

Severity – Low

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Equity Linked Product Execution

Risk Management Options

Transfer – Insurance, Hedging

Offset – Possibly

Manage – Controls

Avoid – Improve Procedures

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Equity Linked Product Execution

Insurance Option

Insurer will require improvement in procedures & controls

Hedging Option

buy hedge contracts to offset losses from late processing

may want to use if cost of improved processing & controls is very high

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Equity Linked Product Execution

Controls & Improved Procedures

Monitoring processing lag

Set targets for max daily lag

Review cases with longest lags

Monitoring losses

Review losses with supervisors

Review Processes

look for avoidable delays in processing

enhance technology & training

Special attention to larger transactions

Develop standards for overtime vs. delays

empower management to make decisions

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Risks to Avoid

• Most firms will have certain risks that they will always AVOID

• Important to explicitly document these

– Either in Standards or Limits

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Retained RIsks

• Insurers and Banks are usually in the business of retaining some risks as their primary business

• Important for each to appropriately provision for the risks that are retained

• Reserves + Capital

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Total Asset Requirement (TAR) approach to provisioning

• Risk area calculated the Total amount of assets needed to pay off risks with desired confidence interval (for example 99.5% under Solvency 2) – This is TAR

• Reserves are held for expected losses plus prudent margin (as required)

• Capital requirement is then TAR - Reserves

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3.10 Choosing a Primary Risk Metric

Ruin v. Volatility

Short Term v. Long Term

Other Risk Aspects

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Ruin v. Volatility

• Ruin = Large and usually unlikely loss potential

– 99.5%tile loss – Solvency 2

• Volatility = Fluctuations in earnings

– Standard Deviation of distribution of probable earnings or

– 90%tile loss

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Ruin v. Volatility

Reasons to Choose Ruin Reasons to Choose Volatility

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Short Term v. Long Term

• Short Term

– 1 year – Solvency 2

• Long Term

– Multi Year

– Until finall run-off of liabilities - US

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Short Termv. Long Term

Reasons to Choose ST Reasons to Choose LT

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Other Aspects of Risk

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3.11 Uses of multiple Risk Models

Risk & Light

Full Risk Profile

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Law of Risk & Light

There is a danger that whatever risks you ignore will accumulate in your firm.

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Full Risk Profile

Risk Profile is your distribution of Risks

A) By Risk Type

B) By Business Area

C) By Region

D) With Other important risk aspects

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Other Risk Aspects

• Can determine Risk Profile by Measurement

• Or by Queary

– Ask Underwriter to note whether each case has• High, Medium, Low data integrity risk

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3.12 Using Economic Capital for ERM

Loss Controlling

• EC Provides common metric for exposures & Limits

Risk Trading

• EC Provides common standard for risk margins

Risk Steering

• EC provides common metric for macro risk reward

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3.13 Capital Management & Allocation

Risk Steering

• Overall Capital Target

• Capital Allocation (retrospective)

• Capital Budgeting Process (prospective)

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Capital Target

Base Target plus

Security

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Base Target DIRECT REFERENCE TO RATING AGENCY

Target the level of capital that supports the desired rating according to the exact rating agency capital model.

Advantages • Rating agency model widely used / thoroughly vetted • Offers greater certainty on capital portion of the rating Disadvantages • Uses broad industry average risk factors• Inaccurate unless firm replicates industry average risk per

exposure • Actual capital held by similar firms with target rating may

vary from Rating Agency guidelines; adjustments reduce this to a modified peer comparison method

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Base Target INDIRECT REFERENCE TO RATING AGENCY

Using an internal company risk model, target Economic Capital level at an exceedence probability consistent with default rate for desired rating.

Advantages • Reflects management knowledge of the risks of the firm • At least one rating agency (S&P) has stated that it will eventually

incorporate internal capital models into ratings decisions

Disadvantages • Effort of developing a full internal risk model • Work required to validate the model to the satisfaction of both

internal and external users • Probabilities related to A and AA rating levels are extremely low

(0.02% and 0.008% per one Moody's study); in almost no case is there enough data to reliably calibrate a model to those probability levels

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BUFFER CAPITAL

There are often dire circumstances associated with failure to maintain minimum rating agency capital; therefore, most firms establish a safety buffer.

At one extreme is a firm that plans to maintain its rating through a 1-in-500-year catastrophe loss scenario (99.8th percentile).

In contrast, another firm believes it will be possible to access the capital markets about once every five years to replenish capital after moderate losses, and therefore sets a buffer at the 80th percentile loss.

Most firms, whether they directly calculate a buffer or not, fall somewhere in the 1-in-10 to 1-in-20 range (90th to 95th percentile).

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Capital

Economic Risk Capital

Amount needed to support particular probability of loss event over a time period

i.e. 95% probability of maintaining solvency over 5 years

Face Capital

Additional amount needed to satisfy regulators, rating agencies, board and stock analysts

Free Capital

Actual capital in excess of above

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Reasons for Allocating Capital

Pricing

Reflecting cost of capital in premiums, expense charges and interest rates

Financial Reporting

Determining ROE (RAROC)

Capital Budgeting

Determining who gets the scarce resource

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Allocating Risk Capital

Total Firm Risk Capital is usually less than total risk capital for each unit

Diversification Benefit

Correlation Benefit

How can the overlap be allocated?

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Allocating Risk Capital

First, calculate Risk Capital for each unit separately

Three general methods for allocating overlap:

Proportionate

Marginal

Corporate

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Proportionate Allocation

Multiply each unit’s separate Risk Capital Calculation by

ratio of overlap to sum of separate risk capital calculations

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Marginal Allocation

Order of calculation is key

“Base” Unit gets overlap

“Other” Units get overlap

Marginal Factors by risk category

128

Corporate

Each unit holds full separate Risk Capital

Corporate unit “holds” the overlap(Could be coordinated with Face Capital and Free Capital)

129

Proportionate Allocation

Pros

• Easy to explain & understand

• Easy to calculate

• Can be seen as fair / impartial

Cons

• No recognition of source of correlations

130

Marginal Allocation“Base” Unit gets overlap

Pros

• Helps to “feed the franchise”

• Recognizes that “Base” unit creates the opportunity for overlaps

Cons

• Makes it difficult for new Unit to get started

• Ignores fact that “Other” units are necessary for overlap to exist

131

Marginal Allocation“Other” Units get overlap

Pros

• May give newer units a pricing advantage

• Recognizes that “Other” units create the new situations that lead to overlaps

Cons

• Is another way that the “Other” units are subsidized by “Base” unit

• Encourages shift of business to the new unit

132

Marginal AllocationMarginal Factors by Risk

Pros

• Allocates some of overlap to each business unit that contributes

Cons

• Difficult to explain

• Factors difficult to develop

133

Face Capital Allocation

Methods of Allocations

Offset against “Overlap” and use overlap allocation techniques

Corporate keeps Face Capital

134

Free Capital

Retained Earnings approach

Units keep what they earn

regardless of short term needsusually a long term expectation of need

Sometimes followed by international firms where moving capital is difficult

Profits Released approach

all free capital flows to corporate for re-allocation

135

Investing Capital

Many firms let unit management determine investment strategy for assets backing capital

Firm can use investment strategy as a major Risk Management tool

Can be especially effective if all capital is used

may want to use a “transfer pricing” approach to allocate investment results back to units

136