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RISK MANAGEMENT OF A FINANCIAL CONGLOMERATE A challenge for the actuaries?

RISK MANAGEMENT OF A FINANCIAL CONGLOMERATE A challenge for the actuaries?. Luc Henrard – Chief Risk Officer, Fortis Enterprise Risk Management symposium – Chicago, April 26-27, 2004. Overview. Introduction Measurement of risks Differences Insurance and Banking

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RISK MANAGEMENT OF A FINANCIAL CONGLOMERATE A challenge for the actuaries?

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  1. RISK MANAGEMENT OF A FINANCIAL CONGLOMERATE A challenge for the actuaries? Luc Henrard – Chief Risk Officer, Fortis Enterprise Risk Management symposium – Chicago, April 26-27, 2004

  2. Overview • Introduction • Measurement of risks • Differences Insurance and Banking • Food for thought: Role of the actuary • Conclusion

  3. 1. INTRODUCTION

  4. 1.1. External and internal constituencies want a clear understanding of risks Risk versus Capital Risk versus Return • Creditors • Regulators • Rating Agencies • Shareholders • Analysts Executive Committee Shareholders have entrusted the board with their capital They don’t want to lose it They expect a decent return or optimal use of their capital They don’t want any surprises They penalise volatility Regulators demand that risks are well managed (to avoid tax-payer bail-outs) Depositors/policyholders expect safety of their savings and investments Rating agencies will only give high ratings to institutions able to measure and manage risk

  5. Example in Life Insurance • Question in the traditional model : • Given set of liabilities what is the optimal strategic asset allocation strategy. • Question in the “risk” model : • Given my constraints in capital, what is the best use of this capital • More risky asset mix and if yes, equities, credit or should the company strive for more conservative investment policy and try to invest the capital for (more) growth? If yes, what type of business? • New development in product design; Insurance savings products merely ‘packaging of capital market commodities’ such that residual market risk and related capital for insurance companies is low

  6. Risk vs. Return Risk vs. Capital Debt holders Rating Agencies Regulators Shareholders Stock Analysts RISK = Volatility Operational Risk Investment Risk Insurance Risk Business Risk Event Risk Credit Risk Market Risk Life Risks Property & Casualty Risks • Changes in business volumes • Changes in margins and costs • Fraud • Unintentional errors • Legal risk • Man-made shocks • Loans • Derivative counter parties • Reinsurance counter parties • Settlement • Equities • Bonds • Foreign Exchange • Real Estate • ALM risk • Liquidity risk • Claims for ‘normal’ events • Losses due to catastrophes/ natural disasters (eg earthquakes, hurricanes, floods, etc) • Life policies • Annuities • Health 1.2. A Bancassurance group faces a wide range of risks NB : In this fairly arbitrary classification, insurance risk is the residual risk you have on the liability side when you have stripped out all of the investment risk.

  7. Ordering of risks Consumption Economic Capital at Fortis RELATIVE CAPITAL CONSUMPTION (illustrative) Credit Risk capital is expected to be large for a wholesale bank ALM is invariably the largest consumer of capital in insurance companies (especially in Life) given that Insurance Risks diversify away in large portfolios The potential duration mismatch in banking is proportional to the book and sensitive to the options of lending products, e.g. prepayment options for residential mortgages Insurance risks (Mortality and Underwriting) will diversify away substantially in large portfolios because they are not correlated with the other (financial) risks and because a lot of the volatility is already reserved for in the provisions Operating risks are typically proportional to the fixed cost base First order Second order Third order Capital 100% 0% Trading ALM - Bank Credit - Bank Underwriting ALM - Insurance Operating - Bank Credit - Insurance Mortality/morbidity Operating - Insurance

  8. 2. Measurement of risks

  9. A Bancassurance group faces a wide range of risks Illustrative RISK Operational Risk Investment Risk Insurance Risk Business Risk Event Risk Credit Risk Market Risk Property & Casualty Risks Life Risks

  10. Step 1 : Model each risk in terms of (earnings or value) volatility and target debt rating EARNINGS OR VALUE VOLATILITY MEASUREMENT REQUIREMENTS TAILPROBABILITIES Probability of Outcome • Shareholders to define the risk profile i.e. the confidence interval. BBB AAA AA A 0,01% 0,03% 0,07% 0,30% Default probability • All risk need to be adjusted forthe same capitalization horizon (Basel 2 Recommendation: one-year horizon) Earnings or Value Mean 0 KBBB KA KAA Capital required to achieve rating = Economic capital KAAA

  11. Available Financial Resources (Fair value) Required Capital (Economic Capital) Regulatory Capital (Statutory Reserves andBasel requirements) Actual capital Step 2 : Look at the capital consumption and define a corridor for solvency capital € MM Actual <- capital FairValue Amount of equity capitalheld to protect againsteconomic and statutoryinsolvency Economic Capital • Amount of capital required to protect the company against statutory insolvency. • Acts as a floor, which triggers takeover by the regulators. • Based on rules of thumb that do not reflect real economic risk of the business. Regulatory capital --> -

  12. Step 3 : Look at the risk/return “Framework” Accounting view – RoA / RoE Regulatory view – RoRE RARORACEconomic view (Basel 3? – Solvency 3 ?) – RAROC RORAC

  13. Example Risk return frameworkAlternative investment strategies for Group life product Profit sharing based on book yield underlying bonds Change in Fair Value(1 yr period) Increasing bond duration ALM EC / Technical Provision

  14. Consequence : we need to develop an alternative Economic Measure for Solvency capital. • Needed: discussion between experts (actuaries and non-actuaries) on pragmatic economic solvency measure • Developments of risk based measures (NAIC RBC/Solvency II) • Consistency in taxonomy and terminology between Bank and Insurance regulators • Regulators and rating agencies to familiarize with the way banks/insurance companies measure economic solvency based on ‘real measurement’ of risk; no ‘fixed rules of thumb’. Only then financial institutions can start managing risks and capital

  15. 3. Differences Insurance and Banking

  16. 3.1. Actuaries and bankers have evolved different approaches and terminology

  17. 3.2. The purpose of an economic capital/solvency project is to arrive at the capital requirements of the Group based on the risks taken. REGULATORY CAPITAL AGENCY DRIVEN CAPITAL ECONOMIC CAPITAL ACTUAL CAPITAL • Amount of capital required • Amount of capital the • Amount of capital required • Amount of equity capital or to protect the Group rating agencies expect in to protect the Group Embedded Value actually statutory economic against order to feel comfortable against held to protect the Group insolvency over a one-year giving Fortis a ‘AA’ rating insolvency (over a one-year against economic and time-frame time-frame) statutory insolvency over a one-year time-frame • Based on undifferentiated • Based on relatively • Reflects real risks taken in • Accounting result; rules of thumb that do not undifferentiated rules of the sense of unexpected expanded definition reflect the real economic thumb (bank), and/or movements in the value of includes hidden reserves risks of the business and simple models (insurance) assets and liabilities and usually based on on the confidence interval • Not formulaic – other (relatively) public management wishes to factors such as quality of information tolerate management and • Designed to protect policy likelihood of Government • Designed to be a tool for holders and creditors bail-out are also management considered • Acts as a floor, which triggers takeover by the regulators BARE MINIMUM CAPITAL CAPITAL YOU ARE CAPITAL YOU OUGHT TO CAPITAL YOU ACTUALLY YOU MUST HAVE EXPECTED TO HAVE HAVE HAVE

  18. Example different forms of capital life insurance company Surplus Regulatory Capital Additional Prudency Required Regulatory Solvency Capital Expected Liabilities Balance Sheet Reserves/Provisions Solvency Capital Required Economic Solvency Capital Expected Liabilities

  19. 3.3. How to bridge the GAP ? * Market risks are highly correlated with credit risk. It is not the case however for operational risk. ** The existing European insurance capital requirements assume some “average” level of correlation within one licensed entity. In case several such entities form part of an insurance group, any additional diversification (e.g. geographic diversification) are ignored.

  20. Leeway for regulatory arbitrage Example : CAPITAL REQUIREMENTS FOR “A” RATED CREDIT RISK • EU Life Insurance • Treat as an investment (no explicit focus on credit risk) • Implicit asset risk charge = 3% outstanding • US Insurance P&C (NAIC RBC) • 0.3-1.0% for investment grade credit TODAY • Banking Regulation (BIS I) • 8% (minimum 4% must be Tier 1) • Banking Regulation (FDIC) • US Banks also subject to “prompt corrective action” (PCA) requirements • END INVESTORS • No capital requirements • BIS II will bring regulatory requirements much closer to Economic Capital, decreasing banks’ incentives for regulatory arbitrage, although some will remain among lower quality credit (BB-BBB) • More risk sensitive requirements is also observed in the insurance industry (Solvency II) • Definition of Regulatory capital still differs between banking and insurance. TOMORROW CONCLUSION

  21. 4. Food for thought: Role of the Actuary

  22. Actuaries in a risk management process… • Traditionally Actuaries focused on technical insurance risks (mortality, disability, P&C claims risks, etc). • Today the actuaries’ perspective includes the whole risk taxonomy • Integration of ALM and Actuarial departments • Shift from traditional solvency to Risk based solvency measures This has consequences for the academic actuarial curriculum: transition to curriculum all-round financial risk manager integration actuarial science, (mathematical) finance, econometrics financial markets, etc

  23. ..and the use of current models in a risk framework… • In order to do risk modeling current models (e.g. Embedded Value models) have to be ‘dynamized’ • From policy-to-policy to model points • Full integration with asset side of the balance sheet • Stochastic simulations • Risk adjusted cash flows • Calculations with the ‘dynamized’ model: • Economic Capital/Solvency calculations • Fair Value type computations • Development of robust Economic Solvency Framework in the light of Solvency II and link to pricing

  24. …possible consequences for the actuarial profession • Actuarial and other financial experts have to educate the external constituencies re the economic risk picture • For bank-insurance groups: how can diversification-netting benefits be explained to rating agencies? • This has consequences for the academic actuarial curriculum: transition to curriculum all-round financial risk manager integration actuarial science, (mathematical) finance, econometrics financial markets, etc

  25. 5. CONCLUSION

  26. Conclusions • We need a more rational and appropriate framework for responding in an appropriate manner to the issues and opportunities raised by the convergence of the Banking and Insurance models.- Role of the actuary crucial- Current models (e.g. Embedded Value) have to be turned into risk models. • It is only in this spirit of co-operation and mutual willingness to learn from each other that we will reap the full benefits of convergence. • Basel 2/Solvency 2 is a necessary condition to reach that objective: uniform economic solvency framework  Still quite a lot of issues to be discussed. • Internal reporting  external reporting. • Integration of the major regulators (Bank – Insurance – Stock exchange).

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