Introduction to economic capital
Upcoming SlideShare
Loading in...5

Introduction to economic capital






Total Views
Views on SlideShare
Embed Views



2 Embeds 33 32 1


Upload Details

Uploaded via as Adobe PDF

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
Post Comment
Edit your comment

Introduction to economic capital Introduction to economic capital Presentation Transcript

  • Michel Rochette, MBA, FSA, PhD Student 2010 Valuation Actuary Symposium Chicago September 21th 2010
  • Topics  Purpose and principles of any capital framework  Modelling issues:  Diversification: correlation assumptions  Stress testing  Management implications:  Use test and ORSA  Capital types and liquidity  Emerging issues09/21/2010 Enterprise Risk Advisory LLC
  • Purpose of an EC framework  ¨ Risk management system of an insurer for the analysis of the overall risk situation of the insurance undertaking, to quantify risks and determine the capital requirement on the basis of the company specific risk profile¨ CEA Groupe Consultatif  Required capital is assessed in light of:  available capital & other financial resources  enterprise risk management processes  strategic goals & risk appetite  regulatory requirements09/21/2010 Enterprise Risk Advisory LLC View slide
  • Principles: EC Development  All material risks should be covered: links to ERM and emerging risks  Models must be appropriate for the scale and complexity of the firm  Models must be dynamic and flexible  Models must be embedded in the financial, strategic and operational processes: Use Test in Solvency II  Governance of models development:  Board/top management oversight and involvement  documentation of models, limitations & changes  internal controls over development: auditable  independent review: More than peer review  Others:  consistency between valuation and EC models: valuation framework  input data verifiable and controllable  validation and calibration09/21/2010 Enterprise Risk Advisory LLC View slide
  • Correlation: Proposals  Correlations exist at different levels:  (CRO Forum, Dec. 2009, QIS5) Some risk factors Corr. Coefficients Equity/IRR 50%(D)/0%(U) FX/IRR 25% Default/Equity 25% CROF,QIS4 75% QIS5 Default/IRR 50%(D)/0%(U)  Between legal entities for Solvency II: zero because of the non-fungibility of capital and the non recognition of group capital support09/21/2010 Enterprise Risk Advisory LLC
  • Correlation: Crisis Dependent  According to a 2009 Pimco study: Correlation to S & P 500 Corr elation Correlation Early 90s Early 2008 S & P 500 1 1 High-Yield Bonds 20% -30% 80% International stocks 30% -40% 70% Real Estate 30% 60% -70% Commodities 0% -20% -30%09/21/2010 Enterprise Risk Advisory LLC
  • Correlation: Implications  In times of crisis, negative correlation benefit between asset classes disappears.  “When people start buying an asset, the act of them diversifying ultimately makes the asset less of a diversifier .” Pimco’s Head of analytics  Rule: total diversification benefit should not be above 30%  Solvency II QIS4: 31%  CROF: 21%  Swiss Solvency Test: 24%  Ultimately, correlation assumptions should determined by linking back to your own company’s ERM processes.09/21/2010 Enterprise Risk Advisory LLC
  • Stress Testing: ComplimentaryApproach  Regulatory Approach:  QIS5 risk shocks by type of risk:  Some examples:  Global Equity: 39% & volatility Up: 10% additive  Property: 25%, low compared to recent US experience!  Spread Widening, AA-rated, 4yr: 10.4%  Management Approach:  Prospective scenario modelling with a top down approach  Historical perspective:  Ex. 2008 credit crunch  Similar risk events at other firms, in other industries09/21/2010 Enterprise Risk Advisory LLC
  • Management Implications of EC:Use it!  Investment decisions: existing and new  Product development  Strategic decisions: probably the most important of all  Corporate finance decisions: financial leverage  Hedging strategies: use it within the treasury department  Solvency II regulatory proposal:  “…widely used and plays an important role in the course of conducting an insurers regular business, particularly in risk management. "09/21/2010 Enterprise Risk Advisory LLC
  • Solvency II ORSA & EC  Pillar II requirement: Own Risk & Solvency Assessment  Goal is to demonstrate “sound and prudent management of the business and assess overall solvency needs.”  In other words, is risk management – including EC – aligned with your strategies and internal risk and control processes? Demonstrate that!  Useful references:  Bermuda Monetary Authority: “Opportunity to align management and regulatory reporting & encourage sound risk management practices within the jurisdiction.”  CEIOPS: Preliminary views on the definition and importance of the ORSA as a management tool, requirements and guidance:  Alignment of risk profile, risk tolerance, risk strategy09/21/2010 Enterprise Risk Advisory LLC
  • Capital and Liquidity of EC  Types of required capital: expressed in Tiers in Solvency II  Tier 1: most secure and liquid, permanent  shareholder’s equity and inforce cash flows  Tier 2: revaluation reserves, general provisions, hybrid like instruments and subordinated term debt, callable equity, group support, letters of credit, unpaid shares, Max. 50%  Tier 3: Hybrid capital, subordinated loans, Max. 15%  Liquidity  New explicit requirement since the 2008 crisis  The insurance industry should be concerned about assessing explicitly liquidity risk and liquid capital instead of trying to do it indirectly through the debate over liquidity premium in valuation reserves. Not in line with best EC/ERM practices.09/21/2010 Enterprise Risk Advisory LLC
  • EC Emerging Risk: Systemic risk  “The risk of disruption to the flow of financial services that is (i) caused by an impairment of all or parts of the financial system; and (ii) has the potential to have serious negative consequences for the real economy.“ (IMF)  “Treat systemic risk as an emerging risk” Dave Ingram, SVP Willis Re  Some insurers are already considered “ systematically relevant institutions”: Aegon, Allianz, Aviva, Axa, Swiss Re and Zurich, not any US insurer? (Financial Stability Board)  "Most insurers will be impacted by systemic risks, but only a few insurers can contribute to creating systemic risk" - Dr Shaun Wang  Does insurance create systemic risk?  Emerging consensus is NO  But insurance business will be impacted by systemic risk events. (Bennett, AAA)09/21/2010 Enterprise Risk Advisory LLC