Individual Capital Assessment (ICA) in an international company: Issues and Challenges

1. Individual Capital Assessment (ICA) in an international company: Issues and Challenges 17th October 2006 Coomaren P. Vencatasawmy Risk & Economic Capital Development Coomaren.vencatasawmy@aviva.com

2. Agenda • A short history of Aviva • Insurance regulation in the UK • Economic Capital Modelling • Aviva’s approach • Operational challenges • Technical Challenges • Business uses of Economic Capital • Future developments & Solvency II

3. Aviva Plc World’s 6th largest insurance group Largest Insurance services in the UK Profit of £2.5 billion Main activities: Long-term savings (PVNBP £24.6 billion) Fund management (AUM £317 billion) General insurance (NWP £10.3 billion) Present in over 25 countries across Europe, North America, Asia & Australia

4. Insurance regulation in the UK • January 1998 - Responsibility for prudential supervision of insurance companies transferred from the Department for Trade and Industry (DTI) to HM Treasury • January 1999 - HM Treasury’s role as prudential insurance regulator delegated to FSA from this date. • January 1999 – Equitable life launched court proceedings in order to gain approval for bonus cuts • December 2000 – Equitable closed for new business. The Treasury announces a probe of the FSA failure to protect policy holders. • August 2001 – Lord Penrose heads the enquiry on the downfall of the insurer. • December 2001 - Financial Services & Markets Act 2000 came into force, making the FSA the single regulator for financial services in the UK.

5. Insurance regulation in the UK • July 2003 - Enhanced capital requirements and individual capital assessments for non-life insurers (CP 190) • August 2003 - Enhanced capital requirements and individual capital assessment for life insurers (CP 195) • March 2004 - The Penrose report on the equitable is published • June 2004 - Integrated Prudential sourcebook for insurers (PS 04/16). Introduced the economic realism into the revised prudential regime for with-profits life insurers and the ICAS regime for all insurers [ in force 31st December 2004] • September 2006 - Prudential Changes for Insurers (CP06/16). Extension of the realistic balance sheet regime to non-profit life insurers [In force 31st December 2006?] • Solvency II 2007?

6. Economic Capital Modelling • Model 1: Individual Capital Assessment (ICA) • Supports FSA economic capital submissions • Largely stress and scenario based • Fourth iteration this year • Twice submitted to the FSA • Part of the ICG process of the FSA • Model 2: Risk Based Capital (RBC) • Largely based on stochastic Monte Carlo simulation • Just completed its first group aggregation • Parts have been used to calibrate ICA for 2 years Both are based on an economic balance sheet view of our business The alternative models are complementary and both are subject to continual enhancement

7. Aviva Risk Model Aviva Level 3 • All key Business Units are within scope of modelling • All major risk types are considered including financial, insurance and operational risk

8. Example Risk Map Aggregate ICA - modelling approach Specific ICA Stress & Scenario Tests Market Liquidity Credit Insurance Group Operational Filter risks for which capital is an appropriate response Stress test each risk calibrated to 1:200 using stochastic models where available e.g. ESG & RBC • Feedback loop: • Identify most important risks • Match against appetite, given rewards available for bearing risk • Input to decisions on acceptance, management and mitigation of risks • Risk-by-risk assessment of: • 3 point likelihood of event happening – optimistic, best estimate and worst case • Estimate cost if it does happen at each of these 3 levels • Model results to estimate 1:200 year Operational Risk loss ICA = 1 number for each business unit, given all of the risks considered Allows for diversification, so that ICA is less than the sum of the individual tests BU ICA’s converted into Group ICA using similar approach

9. ICA – Main stress tests 1 Examples from a calibration matrix10 Market risks calibrations are based on an Economic Scenario Generator

10. ICA – Methodology (I) Stresses are applied to realistic balance sheets Our ICA methodology applies stresses to realistic balance sheets constructed on a market consistent basis. This ensures appropriate allowance is made for financial options and guarantees. Stresses are applied as immediate balance sheet stresses Although calibrated to changes over one year, tests are applied as immediate balance sheet stresses. This means that the stress emerging over one year is carried through to the closing balance sheet – the stress is a change in long-term expectations as well as one-year experience. Non-linearity is addressed by combination tests As well as individual risk stress tests, we also apply combination tests where all risk factors change simultaneously by reduced amounts to calibrate to an overall 1-in-200 scenario. This allows us to test for non-linearity and situations where risk factors interact with each other Staff pension funds are included Stress tests are also applied to the assets and liabilities in staff pension schemes to assess the impact on capital requirements.

11. ICA – Methodology II External models are used for market risk and catastrophe scenarios Market risk stresses and correlations are based on Economic Scenario Generator from Barrie & Hibbert. Outputs from the models are benchmarked against historic data and strengthened where we feel appropriate. Catastrophe modelling is based on simulations provided by Guy Carpenter using RMS, subject to internal review by Aviva. Risk aggregation is performed in a robust manner Individual stress test results at Business Unit level are combined using a sum-of-squares methodology in a single step. Correlations for each pair of risks are set out in a correlation matrix that is subject to extensive management review. Correlations are based on suitable market/company data where available, but subject to management judgment of future trends and with recognition of the need for prudence. Some allowance is made for management and policyholder actions Business Unit models take limited credit for management actions – in general credit is limited to situations where there is a clearly documented management policy supported by past actions. Some Business units make allowance for changes in future policyholder behaviour e.g. dynamic lapses related to changing market conditions.

12. RBC – Approach Like ICA, RBC is based on stressing realistic balance sheets constructed on a market consistent basis but: • RBC is based on stochastic models (Monte Carlo simulation) • RBC projects over longer time horizons than 1 year – up to 25 years for life business. • Most material risks are modelled stochastically including market risk, credit risk, longevity risk and general insurance risk (including catastrophes). • External models are used for globally consistent market simulations (Barrie & Hibbert) and catastrophe simulations (Guy Carpenter/RMS). • Risks that are not stochastic are dynamic (e.g. policyholder lapses) or deterministic. • Includes three years’ of planned new business. • Aggregation is performed by combining Business Unit simulations to create stochastic results for the whole group.

13. RBC - Approach CO Business Units CO GI BU 1 GI BU 1 GI BU 1 GI BU 1 GI BUs GI BU 1 GI BU 1 Group Level Cat Simulations GI BU 1 GI BU 1 BU Igloo models running scenarios Results Aggregated for Group Group Level Economic Scenario Generator GI BU 1 GI BU 1 GI BU 1 GI BU 1 Life BUs GI BU 1 GI BU 1 GI BU 1 GI BU 1 Cut down BU Prophet Models running scenarios • 5,000 Scenarios generated with: • Investment Returns • Inflation Rates • Interest Rates • Credit Costs • FX Rates • 10,000 Cat losses simulated Asset Liability Models take inputs and project realistic balance sheets, dividends and capital injections. Life BUs cover insurance risks using deterministic downside estimates • Group review of results • Aggregation of results • Allowance for Operational risk and unmodelled business • Allowance for CO cashflows • Group diversification benefits identified • Group Capital requirements determined

14. RBC – Complementary to ICA RBC and ICA have complementary strengths: ICA • Excellent risk driver analysis • More transparent for management to understand • Simpler to implement (particularly for smaller Business Units) • Faster to run. RBC • Considers risk over multiple time horizons at varying risk tolerances • Allows more accurate modelling of cashflows and risk • Allows directly for non-linearity and interaction of risks • Allows more sophisticated dynamic policyholder and management actions to be modelled.

15. ICA – Operational Challenges Robust internal review process

16. ICA – Operational Challenges • ICA process and methodology reviewed by • Internal Auditors • External auditors • FSA • Rating agencies • FSA ICG process is rigorous and demanding • Models reviewed by consultants • Further changes will be required as both FSA and industry standards evolve. • The ARROW review have involved a significant number of meetings (c70) to form a view of the strength of our risk management processes and economic modelling capabilities. • Benchmarking to other businesses or among same businesses.

17. ICA – Technical Challenges • Both ICA and RBC face major technical challenges • Stress tests • How to calibrate? • How to test for sensitivity? • How to validate ESG models? • Correlation between risk • Lack of data to inform correlation assumptions • How to account for tail correlations? • Requirement of positive definite matrix • Aggregation matrix becomes large • Diversification • Depends on correlation assumptions • Is there a GI/Life diversification? • Is it a mathematical construct?

18. ICA – Technical Challenges Combination tests • How to determine the correct confidence level? • How to model the interaction between risks? • How to account for non-linearity? • How many combination tests? Fungibility Restrictions on movements of capital Securitisation Loans Dividends Modelling liabilities • Closed form? • Iterative approach? Stochastic within Stochastic • Management actions • Non-linearity

19. Business uses of Economic Capital Industry leading function Robust governance and risk management processes Embedded Risk Culture Buy-in of management Diversification

20. Business uses of Economic Capital • Understanding the Group risk profile • Aligning risk appetite and strategy • Assessing the Group capital position • Providing transparency to analysts and key stakeholders • Prioritising of growth opportunities across the Group • Optimising of the use of capital

21. Business Uses of Economic Capital Risk Committees: Financial and Operational Risk Board Risk & Regulatory Committee Audit Committee CSR Committee Executive Committee Asset Liability Committee Operational Risk Committee Life Insurance Capital Management Business Standards IT Compliance General Insurancet Credit Business Protection Investment HR Management Reserving

22. Other business uses of Economic Capital • Regular ‘what if’ questions from Finance Exec members • M&A and Corporate Partners deals • Reinsurance design and purchase • Advised on capital impact and attractiveness of the main CAT program • Used in the derivation of the CAT option product • Asset allocation • Informing the Business Plan • Volatility of earnings

23. CAT RI Treaty

24. New Developments and Solvency II • More emphasis on methodology and assumptions • Factor based approach of Solvency II • ABI guidance • Actuarial guidance • Disclosure of economic capital and ICG • ERM, internal models and Credit Agencies • More regulation?