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Case study presentations [pdf]


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Case study presentations [pdf]

  1. 1. How the Integration of Insurance and Banking Techniques and Thinking Can Add Real Commercial Value. Bruce Porteous Head of UK Risk Capital Development Standard Life UK Financial Services AGB Networking Evening
  2. 2. Agenda. <ul><li>Action Group for Banking ( Bruce Porteous ). </li></ul><ul><li>Life Modelling Techniques in Banking ( Harvey Chamberlain ). </li></ul><ul><li>Lifetime Mortgage Products ( John Young ). </li></ul><ul><li>A Day in the Life of a Pension Fund Buy Out Actuary ( David Collinson ). </li></ul><ul><li>Funded Reinsurance Financing – the Warehouse Innovation ( Greg Solomon ). </li></ul><ul><li>A Lawyer’s Comparison of Banking and (Re)insurance Contracts ( Ian Fagelson ). </li></ul><ul><li>Actuaries in Alternative Investments including Hedge Funds ( Keith Guthrie ). </li></ul><ul><li>Economic Capital – A Unifying Approach ( Pradip Tapadar ). </li></ul><ul><li>A Tale of Two Institutions ( Chris Hancorn, Patrick Kelliher ). </li></ul><ul><li>Banker Response ( Iain Allan ). </li></ul>
  3. 3. AGB Goals. <ul><li>The AGB “operates” in areas where the actuarial and banking worlds overlap. </li></ul><ul><li>Push: To demonstrate where actuarial thinking and skills have been applied in a banking or financial context to add real commercial value. </li></ul><ul><ul><ul><li>=> create new career opportunities for the profession. </li></ul></ul></ul><ul><li>Pull: To narrow the knowledge gap on tools and skills available in banking and finance that not all actuaries might be aware of. </li></ul><ul><ul><ul><li>=> draw new ideas and thinking into the profession. </li></ul></ul></ul>
  4. 4. AGB Membership and Activities. <ul><li>Push: Actuaries working in; </li></ul><ul><ul><ul><li>Retail banking. </li></ul></ul></ul><ul><ul><ul><li>Bancassurance. </li></ul></ul></ul><ul><ul><ul><li>Academia. </li></ul></ul></ul><ul><ul><ul><li>Investment banking. </li></ul></ul></ul><ul><li>Pull: Actuaries working with non actuaries in; </li></ul><ul><ul><ul><li>Reinsurance. </li></ul></ul></ul><ul><ul><ul><li>Pensions buy out companies. </li></ul></ul></ul><ul><ul><ul><li>Consulting. </li></ul></ul></ul><ul><ul><ul><li>Hedge funds. </li></ul></ul></ul><ul><ul><ul><li>Investment banking. </li></ul></ul></ul><ul><li>Activities: </li></ul><ul><ul><ul><li>Articles and events showcasing push/pull themes. </li></ul></ul></ul>
  5. 5. Life Modelling Techniques in Banking Harvey Chamberlain Head of product profitability and pricing National Australia Bank Complete article at: AGB Networking Evening
  6. 6. Financial Forecast Granularity for Performance Measurement <ul><li>Financial Forecast </li></ul><ul><ul><li>Volume </li></ul></ul><ul><ul><li>Income </li></ul></ul><ul><ul><li>Losses </li></ul></ul><ul><ul><li>Capital </li></ul></ul><ul><ul><li>Expenses </li></ul></ul><ul><li>Granularity </li></ul><ul><ul><li>Channel </li></ul></ul><ul><ul><li>Sub-product </li></ul></ul><ul><ul><li>Back & Front Book </li></ul></ul><ul><ul><li>Monthly steps </li></ul></ul><ul><ul><li>Extended time horizon </li></ul></ul>
  7. 7. Process <ul><li>Specify Output </li></ul><ul><li>Source bases & assumptions </li></ul><ul><ul><li>Product </li></ul></ul><ul><ul><li>Financial & Economic </li></ul></ul><ul><ul><li>Customer </li></ul></ul><ul><ul><li>Capital & Accounting </li></ul></ul><ul><li>Build & Test Excel prototypes </li></ul><ul><li>Build & Test PROPHET prototype </li></ul>
  8. 8. Financial Forecast Output
  9. 9. Related Uses <ul><li>Pricing </li></ul><ul><li>Capital / Asset / Liability management </li></ul><ul><li>Scenario & sensitivity </li></ul><ul><li>Customer profitability </li></ul><ul><li>Capacity planning </li></ul>
  10. 10. Forecast Control Cycle Model Forecast Performance Experience Monitored Interpretation Initial (Data, Basis, Assumptions) Revisions (Data, Basis, Assumptions)
  11. 11. Lessons <ul><li>Engagement </li></ul><ul><ul><li>Product </li></ul></ul><ul><ul><li>Customer/Technology </li></ul></ul><ul><ul><li>Treasury </li></ul></ul><ul><ul><li>Risk </li></ul></ul><ul><ul><li>Finance </li></ul></ul><ul><li>Data availability & limitations </li></ul>
  12. 12. Development of a House Price Inflation model to investigate pricing and risk for lifetime mortgage products John Young Head of product profitability RBS Retail Markets Finance AGB Networking Evening Complete article at
  13. 13. What is a lifetime mortgage? <ul><li>Customer borrows against equity in their home – while still living in the home </li></ul><ul><li>Two options available: </li></ul><ul><ul><li>Lump Sum </li></ul></ul><ul><ul><li>Income </li></ul></ul><ul><li>Loan accumulates until owner dies or enters care. </li></ul><ul><li>No Negative Equity Guarantee (NNEG). </li></ul>
  14. 14. What is different for a Lifetime mortgage? <ul><li>Various risks taken on board. </li></ul><ul><ul><li>Mortality risk </li></ul></ul><ul><ul><li>Interest rate risk </li></ul></ul><ul><ul><li>House Price Inflation (HPI) risk </li></ul></ul><ul><li>Mismatch between income and costs </li></ul>
  15. 15. How does NNEG cost arise?
  16. 16. Why Stochastic Model? <ul><li>Important when world is not linear </li></ul><ul><li>E.G. no cost if return exceeds a threshold </li></ul><ul><li>Simple case could be say 0%, 2% and 4% </li></ul><ul><li>If we used an average of say 2% then no cost </li></ul><ul><li>In real world the 0% outcome has a cost </li></ul><ul><li>Model with a stochastic model that gives probabilities to all outcomes – good and bad </li></ul>
  17. 17. How to model HPI? <ul><li>Look at past data (limited data available) </li></ul><ul><li>To remove the distortion effect of volatile price inflation we looked at Real HPI </li></ul><ul><li>Two main features : </li></ul>“ Twin peaks” for real returns Clumping of +ve and –ve returns HPI has clear runs of positive and negative returns. This shows boom & bust in UK HPI HPI has clear peaks of positive and negative returns in distribution.
  18. 18. <ul><li>Log normal is simple approach but does not capture key features of “twin peaks” and clumping. </li></ul><ul><li>Use approach borrowed from Barrie and Hibbert to give fat tails for stock market modelling. </li></ul><ul><li>Sample from a two state Markov model to represent “Boom” and “Bust”. Draw from underlying boom and bust log normal distributions. </li></ul>Two state model for HPI “ Bust” Lognormal: Example; Mean = -2% Std Dev = 7% “ Boom” Lognormal: Example; Mean = 7% Std Dev = 9% “ Bust” “ Boom” 75% 25% 85% 15%
  19. 19. Results 1. <ul><li>Two State stochastic approach gives a c40% higher expected cost of NNEG (versus single Lognormal model) and </li></ul><ul><li>Insight into additional behavioural risks: </li></ul><ul><ul><li>Customers continue to drawdown maximum possible following “boom” in house prices. Reduces buffer to the lender in bad times. Could result in a c60% increase in expected cost </li></ul></ul><ul><ul><li>Early pre-payment rates would fall when NNEG close to biting. More people continue to hold property when NNEG bites. Could result in a c5% increase in expected cost </li></ul></ul>
  20. 20. Results 2. <ul><li>This approach shows increased risk of expensive outcomes from the “income product” </li></ul><ul><li>Products may be designed to have same expected costs </li></ul><ul><li>Lump sum product has thinner tail of very high excess costs </li></ul><ul><li>Mix of business sold could be very important if HPI falls </li></ul>
  21. 21. Pension fund Buy out actuary David Collinson Head of liability acquisition Pension Insurance Corporation (PIC) AGB Networking Evening Complete article at
  22. 22. Pension Corporation <ul><li>Pension Corporation </li></ul>P I C H Pension Security Insurance Corporation Guernsey approved Reinsurer Pension Corporation Investments Corporate pension owner Pension Insurance Corporation Fully FSA approved insurance company
  23. 23. Pension Corp -- Team Background <ul><li>Private Equity </li></ul><ul><li>Insurance </li></ul><ul><li>Reinsurance </li></ul><ul><li>Capital Markets </li></ul><ul><li>Fund Management </li></ul><ul><li>Risk Management </li></ul><ul><li>M&A </li></ul><ul><li>Pensions </li></ul>
  24. 24. Role <ul><li>Insurance pricing </li></ul><ul><li>Longevity pricing </li></ul><ul><li>Longevity risk transfer </li></ul><ul><li>Combined corporate/pension fund pricing </li></ul><ul><li>Capital efficiency </li></ul><ul><li>Financial versus operating company covenant calculations </li></ul>
  25. 25. Funded Reinsurance Financing The Warehouse Innovation Greg Solomon Director of Structured Life Reinsurance for Asia Swiss Re Complete article at AGB Networking Evening
  26. 26. Action Group for Banking <ul><li>Push actuaries out to ‘alternative’ fields, like banking </li></ul><ul><li>Pull skills & tools from the banking world into the life industry </li></ul><ul><li>The “Warehouse” is a banking/treasury tool now being directly applied in the area of reinsurance financing for life companies </li></ul>
  27. 27. The Challenge for Life Companies <ul><li>Life companies have a large economic asset on their balance sheet, their embedded value </li></ul><ul><li>For regulatory reporting, the insurer may often not take credit for this asset, as future profits “might not emerge” </li></ul><ul><li>At inception of a new policy there are significant outflows, covering commission, admin & other expenses, reserves, solvency capital, etc. </li></ul><ul><li>With no credit for future profits, this puts a strain on the company’s balance sheet – “new business strain” </li></ul>
  28. 28. Realistic Portfolio Projections
  29. 29. Conservatism Creates Capital Strain
  30. 30. Accelerating the Balance Sheet <ul><li>Although the Regulator may not give the company credit for future profits, a reinsurer (or investors) might </li></ul><ul><li>The company then effectively gets a capital boost in their regulatory accounts, and repays this capital out of future surpluses, as they emerge </li></ul><ul><li>Effectively, a portion of the embedded value is provided up front, and is thus guaranteed to emerge </li></ul>
  31. 31. Acceleration eases Initial Strain
  32. 32. Variety of Solutions <ul><li>Cashless Reinsurance Financing </li></ul><ul><ul><li>many structures exist </li></ul></ul><ul><ul><li>e.g. rather than paying the money, the money is owed </li></ul></ul><ul><ul><li>but sometimes liquidity is required/desired </li></ul></ul><ul><li>Securitisation of Embedded Value </li></ul><ul><ul><li>investors pay money to buy a share of those future profits </li></ul></ul><ul><ul><li>transactions need to be very large (hundreds of millions) </li></ul></ul><ul><li>Warehouse Financing </li></ul><ul><ul><li>a cash facility which works for smaller deals too </li></ul></ul>
  33. 33. The Warehouse Life Co. P&C Co. Life Co. Corporate warehouse Swiss Re Capital Markets securitisation Bigger Life Company securitisation
  34. 34. Advantages of the Warehouse <ul><li>Cash is available for deals which would be too small for a full securitisation </li></ul><ul><li>The resulting pooled asset can be (but need not be) “repackaged” and securitised, depending on our need for additional capacity, market conditions, etc. </li></ul><ul><li>Liquidity can be sourced in any form of debt, allowing for flexibility in amount & duration </li></ul><ul><li>Diversification across transactions makes for a more “stable” and thus saleable repackaged asset </li></ul>
  35. 35. Global Market “Meltdown” <ul><li>We have the choice of not securitising at the moment, leaving the Warehouse on our balance sheet until conditions settle down </li></ul><ul><li>We are not limited to conduit financing as a source of liquidity – so can continue to finance transactions </li></ul>
  36. 36. Insurance / Banking Contracts a lawyer’s perspective Ian Fagelson Partner at Reed Smith Richards Butler LLP AGB Networking Evening Complete article at
  37. 37. Insurance and Banking Contracts <ul><li>Previously clear product distinctions now blurred </li></ul><ul><li>Unified regulatory structure </li></ul><ul><li>Legal and cultural differences continue to influence contract forms </li></ul>
  38. 38. Insurance and Banking Contracts <ul><li>In England, justice must not only be done </li></ul><ul><li>It must be seen to be believed </li></ul>
  39. 39. Insurance and Banking Contracts <ul><li>Insurable interest </li></ul><ul><li>Utmost good faith </li></ul><ul><li>Many a slip </li></ul>
  40. 40. English Insurance Contract Law <ul><li>Is different from ordinary contract law </li></ul><ul><li>The differences: </li></ul><ul><ul><li>stem primarily from the utmost good faith doctrine </li></ul></ul><ul><ul><li>are surprising to the uninitiated </li></ul></ul><ul><ul><li>are thought to be unfair to policyholders </li></ul></ul><ul><ul><li>are modified by regulators in consumer cases </li></ul></ul>
  41. 41. Insurance Contract Law <ul><li>Reform is proposed from time to time </li></ul><ul><li>The Law Commission proposed reform in 1980 – but nothing happened (at least not in this country) </li></ul><ul><li>The Law Commission is looking at the question again </li></ul><ul><li>Reform may be a real possibility this time </li></ul><ul><li>Reform likely to affect business and consumer insurance; life and non-life; direct insurance and reinsurance </li></ul>
  42. 42. Misrepresentation and Non-Disclosure <ul><li>Description of the Current Law </li></ul>
  43. 43. Misrepresentation <ul><li>Misrepresentation is: </li></ul><ul><ul><li>an untrue statement; </li></ul></ul><ul><ul><li>of a material fact; </li></ul></ul><ul><ul><li>that induces the insurer to enter into the contract; </li></ul></ul><ul><ul><ul><li>either at all </li></ul></ul></ul><ul><ul><ul><li>or on the particular terms </li></ul></ul></ul>
  44. 44. Non-Disclosure – the Duty of Utmost Good Faith <ul><li>An applicant for (re)insurance is obliged to disclose facts:- </li></ul><ul><li>Which are material to the risk; </li></ul><ul><li>Which are within the knowledge of the applicant; </li></ul><ul><li>Which are not within the knowledge of the (re)insurer; and </li></ul><ul><li>Which induced the (re)insurer to enter into the contract at all or on its particular terms. </li></ul>
  45. 45. Consequences of Misrepresentation and Non-Disclosure <ul><li>The insurer may avoid the policy </li></ul><ul><li>This involves declining future claims and demanding refund of paid claims </li></ul><ul><li>Except in the case of fraud, the premium must be refunded </li></ul>
  46. 46. Warranties and Conditions <ul><li>'When I use a word,' Humpty Dumpty said, in a rather scornful tone,' it means just what I choose it to mean, neither more nor less.‘ </li></ul><ul><li>'The question is,' said Alice, 'whether you can make words mean so many different things.' </li></ul><ul><li>'The question is,' said Humpty Dumpty, 'which is to be master - that's all.' </li></ul>
  47. 47. Warranties <ul><li>In ordinary contract law, a warranty is a contractual provision of relatively minor importance. Breach of a warranty entitles the innocent party to damages but does not entitle him to treat himself as discharged from the obligation to perform the contract. </li></ul><ul><li>In insurance law, a warranty is a provision of such fundamental importance that its breach automatically discharges the innocent party from any further obligations under the policy. </li></ul>
  48. 48. Conditions <ul><li>In insurance law, a condition (unless it’s a condition precedent or subsequent) is a contractual provision of relatively minor importance. Breach of a condition normally entitles the innocent party to damages but does not entitle him to treat himself as discharged from the obligation to perform the contract. </li></ul><ul><li>In ordinary contract law, a condition (unless it’s a condition precedent or subsequent) is a provision of such fundamental importance that its breach entitles the innocent party to bring the contract to an end. </li></ul>
  49. 49. Inominate Term <ul><li>A term which is neither a condition nor a warranty </li></ul><ul><li>Remedy for breach depends on the consequences of breach </li></ul><ul><li>Breach of a time limit for claims notification will rarely justify denial of claim </li></ul>
  50. 50. Law Commission Proposals for Reform Consultation Paper – 17 July 2007 <ul><li>Proposals include </li></ul><ul><li>Abolition of the duty of disclosure in consumer cases </li></ul><ul><li>Modifying the duty in business cases by changing the test of materiality </li></ul><ul><li>Restricting insurers’ ability to convert representations into warranties </li></ul><ul><li>Consumer life insurers likely to lose the right to avoid for non-fraudulent misrepresentation after five years? </li></ul><ul><li>Abolition of insurer’s remedy for innocent misrepresentation/non-disclosure </li></ul><ul><li>Proportionate remedy for negligent misrepresentation </li></ul><ul><li>New rules concerning notification of warranties </li></ul><ul><li>Softening insurers’ remedies for breach of warranty </li></ul>
  51. 51. Actuaries in Alternative Investments Keith Guthrie Investment Manager, Arbitrage Strategies GAM Multi-manager Fund of Hedge Funds AGB Networking Evening
  52. 52. Roles in Alternative Investments <ul><li>Manager Selection: </li></ul><ul><ul><ul><li>Fund of funds/ fund of hedge funds analyst/portfolio manager </li></ul></ul></ul><ul><ul><ul><li>Research and analysis of hedge fund managers and strategies </li></ul></ul></ul><ul><ul><ul><li>Portfolio construction </li></ul></ul></ul><ul><ul><ul><li>A useful skill set for understanding : an intuitive and deep understanding of discounted cash flows, probabilities, options pricing and financial economics </li></ul></ul></ul><ul><li>Risk Management: </li></ul><ul><ul><ul><li>Value at Risk analysis </li></ul></ul></ul><ul><ul><ul><li>Statistical techniques eg. cluster analysis for identifying risk clusters, principle component analysis </li></ul></ul></ul><ul><ul><ul><li>Interpretation of statistical measures eg. factor exposures such as credit spread sensitivity, interest rate sensitivity, vega etc. </li></ul></ul></ul><ul><li>Investment Analysis: </li></ul><ul><ul><ul><li>Analysis of complex cash flow projections eg. Structured Credit </li></ul></ul></ul><ul><ul><ul><li>Yield curve modeling </li></ul></ul></ul><ul><ul><ul><li>Understanding impacts of regulatory frameworks </li></ul></ul></ul>
  53. 53. Example 1: Sub-prime mortgage ABS analysis <ul><li>Analysis of Asset Backed Securities </li></ul><ul><ul><ul><li>Pool of mortgages underwritten, with various characteristics eg. loan to value, credit scores, geography etc. </li></ul></ul></ul><ul><ul><ul><li>Prepayment risk (analogous to lapse rates) </li></ul></ul></ul><ul><ul><ul><li>Default risk (analogous to mortality rates but with a recovery value!) </li></ul></ul></ul><ul><ul><ul><li>Complex “cashflow waterfall” structure, Rating Agency input, scenario analysis </li></ul></ul></ul><ul><ul><ul><li>Investment opportunity : A very large supply from distressed sellers! </li></ul></ul></ul><ul><li>Complications: </li></ul><ul><ul><ul><li>Data management: Trustees reports, collateral updates </li></ul></ul></ul><ul><ul><ul><li>Real world complexity: Servicing agents, political intervention. </li></ul></ul></ul>Assets Pool of 1000 subprime mortgages Liabilities Senior AAA Mezz BBB Equity (First Loss)
  54. 54. Example 2a: Corporate Credit Correlation Trading <ul><li>Understanding the reasons behind apparent “arbitrage” opportunities. </li></ul><ul><ul><ul><li>Pension & insurance regulatory regimes distort efficient capital allocation. </li></ul></ul></ul><ul><ul><ul><li>Creates excess demand for BBB Investment Grade paper over high yield paper => high reward for risk levels of equity paper. </li></ul></ul></ul>Assets spread received Pool of 100 IG credits Liabilities spread paid Senior AAA Mezz BBB Equity $100m in credit exposure Average spread 30 bpts p.a. Wtd Avg spread 30 bpts p.a. $3m firsts loss exposure $7m “second loss” exposure $90m last loss exposure Synthetic CDO structure T=0
  55. 55. Example 2b: Corporate Credit Correlation Trading <ul><li>Understanding the reasons behind apparent “arbitrage” opportunities. </li></ul><ul><ul><ul><li>Pension & insurance regulatory regimes distort efficient capital allocation. </li></ul></ul></ul><ul><ul><ul><li>Creates excess demand for BBB Investment Grade paper over high yield paper => high reward for risk levels of equity paper. </li></ul></ul></ul>Assets spread received Pool of 100 IG credits Liabilities spread paid Senior AAA Mezz BBB Equity $100m in credit exposure Average spread 30 bpts p.a. Wtd Avg spread 30 bpts p.a. $3m firsts loss exposure $7m “second loss” exposure $90m last loss exposure Synthetic CDO structure T=1
  56. 56. Example 2c: Corporate Credit Correlation Trading <ul><li>Complications: </li></ul><ul><ul><ul><li>Idiosyncratic risk management of high risk equity positions </li></ul></ul></ul><ul><ul><ul><li>Investors “believing” mathematical models eg, May 05. </li></ul></ul></ul>Assets spread received Pool of 100 IG credits Liabilities spread paid Senior AAA Mezz BBB Equity $100m in credit exposure Average spread 40 bpts p.a. Wtd Avg spread 40 bpts p.a. $3m firsts loss exposure $7m “second loss” exposure $90m last loss exposure Synthetic CDO structure T=2
  57. 57. Challenges and Rewards <ul><li>Challenges for actuaries working in Alternative Investments: </li></ul><ul><ul><ul><li>“ What on earth is FIA/FFA?” </li></ul></ul></ul><ul><ul><ul><li>Trader’s jargon </li></ul></ul></ul><ul><ul><ul><li>The real world vs. the theoretical world </li></ul></ul></ul><ul><ul><ul><li>Have you any trading experience ? </li></ul></ul></ul><ul><li>The rewards </li></ul><ul><ul><ul><li>Tremendous variety, a constant learning curve </li></ul></ul></ul><ul><ul><ul><li>An opportunity to meet interesting people </li></ul></ul></ul><ul><ul><ul><li>Very objective, daily performance assessment </li></ul></ul></ul>
  58. 58. Economic Capital – A Unifying Approach. Pradip Tapadar & Vaishnavi Srinivasan Lecturers in Actuarial Science University of Kent AGB Networking Evening
  59. 59. Definition of Economic Capital <ul><li>Economic capital for the business of a firm </li></ul><ul><li>. . . is the amount of capital that this business requires </li></ul><ul><li>. . . to ensure that its realistic , or market value, </li></ul><ul><li>. . . balance sheet remains solvent, </li></ul><ul><li>. . . over a specified time horizon </li></ul><ul><li>. . . with a prescribed probability , </li></ul><ul><li>. . . following events that are unexpected, yet not so unlikely </li></ul><ul><li>. . . that they might never occur in practice. </li></ul>
  60. 60. Capital Repayment Mortgage Example
  61. 61. Lifetime Mortgage Example
  62. 62. Life Insurance Annuity Example
  63. 63. Conclusions <ul><li>Regulatory change is a driver for improvements all round. </li></ul><ul><li>Economic Capital: </li></ul><ul><ul><li>Common risk currency across the whole financial services sector. </li></ul></ul><ul><ul><li>Enables risk consistent performance to be assessed. </li></ul></ul><ul><ul><li>Highlights regulatory capital anomalies. </li></ul></ul><ul><ul><li>Satisfies the needs of all interested parties. </li></ul></ul><ul><ul><li>Has the potential to unify the whole financial services industry . . . </li></ul></ul><ul><ul><li>. . . and bring the entire sector under an overarching umbrella. </li></ul></ul><ul><li>Economic Capital is key. </li></ul>
  64. 64. UK Banks and Life Insurers . A comparison of risks faced by each AGB Networking Evening Patrick Kelliher Senior Risk Manager (Actuarial) Scottish Widows
  65. 65. Overview <ul><li>If banking and life insurance professionals are to learn from each other, it is important to understand the similarities and differences in the risks faced by each. </li></ul><ul><li>In some ways, UK life insurers and banks have very similar business models – both take money in from investors (policyholders / depositors); they invest (/ lend) these funds and earn a margin (management charge / interest spread) over what is credited back to investors. </li></ul><ul><li>However their purpose is different – banks have a key role in providing liquidity to the economy through lending; while life insurers role is more about long term savings and protection. </li></ul><ul><li>Banks also differ in having a strong high street presence while life insurers tend to rely on IFAs for distribution. </li></ul><ul><li>Life insurers also differ in presenting results on an embedded value basis in their accounts, crystallising future margins on business written. </li></ul>
  66. 66. Market Risk – Banks <ul><li>A key market risk for banks is lending at fixed rates where there is the option to redeem at par. </li></ul><ul><li>However for UK banks, this risk is mitigated by the short term of fixed rate offerings, redemption penalties and interest rate hedges. </li></ul><ul><li>UK banks will typically have trading desks which arrange hedges as well as dealing on their own account. The latter risks are well controlled, with systems capable of daily monitoring of VaR against limits while positions can usually be closed out within a fortnight. </li></ul>
  67. 67. Market Risk – Life Insurers <ul><li>UK life insurers by contrast have considerable unhedged market risk exposure in respect of With-Profit Funds where there is a mismatch between the nominal guarantees typically offered with such policies and policyholder expectations that policies will be invested in real assets like equities and property. </li></ul><ul><li>There is also the expectation of regular bonus additions to guarantees. </li></ul><ul><li>Valuation is complicated as the investment mix and bonus additions are set at an aggregate level, meaning policies can’t be valued on a stand-alone basis – the whole office must be projected simultaneously. </li></ul><ul><li>Banks and life insurers do have a common market risk exposure in respect of final salary pension schemes. </li></ul>
  68. 68. Credit Risk <ul><li>Credit risk is a key risk for banks, and managing this is a core competence, particularly as the credit risk attaching to loans and mortgages is not readily transferable. </li></ul><ul><li>As such, banks have detailed lending policies and exposure limits to manage credit risk. </li></ul><ul><li>For life insurers, a key risk relates to corporate bonds but these are generally investment grade and can be readily traded. The focus is on managing credit events such as takeovers and downgrades rather than defaults. Policies and limit structures tend not to be as detailed as banks. </li></ul><ul><li>Would however note that recent market turbulence lead to rises in bond spreads as well as the problems some banks had in securitising loans. </li></ul>
  69. 69. Credit Risk
  70. 70. Insurance Risk <ul><li>Life insurers are exposed to mortality (death) and morbidity (sickness) risk on protection products, as well as longevity risk (of people living longer) on annuities. </li></ul><ul><li>While banks may not appear to be exposed to these risks, sickness and death can affect loan repayment, though this is mitigated if the borrowers takes out PPI. </li></ul><ul><li>Banks may also be indirectly exposed to general insurance risk through profit share arrangements. </li></ul><ul><li>Banks are exposed to longevity risk on lifetime mortgage lending as the “no negative equity” guarantee will increase in value the longer people live. </li></ul><ul><li>Finally both banks and life insurers have considerable longevity exposure through their final salary schemes. </li></ul>
  71. 71. Persistency Risk <ul><li>UK life insurers incur high commission and other up-front costs. Product regulation and market pressures mean that current products may take a number of years before these costs are recouped. </li></ul><ul><li>Higher than expected lapses also lead to a write-down of embedded values, leading to adverse analyst comment. </li></ul><ul><li>Banks do not experience such write-downs of expected future margins, but persistency is arguably as important as credit risk in terms of economic value, as early loan redemptions lead to a loss of future interest margins on that loan. </li></ul><ul><li>Higher than expected retail deposit withdrawals may also have a cost if these have to be replaced by more expensive wholesale funds. </li></ul>
  72. 72. Expense Risk <ul><li>UK life insurers face considerable risk in relation to the expenses incurred over the term of policies, as stricter regulation of With-Profits and Unfair Contract Terms regulations (UTCCR) have limited the scope to increase charges to address cost overruns. </li></ul><ul><li>They at least do not have to deal with the heavy ongoing fixed cost of a retail branch network. </li></ul><ul><li>However for banks, there is usually scope to address cost overruns by increasing interest margins and varying charges, though the former is constrained by competition (and is not an option on tracker mortgages) while the latter may be constrained by current UTCCR challenges. </li></ul>
  73. 73. Liquidity Risk <ul><li>This is a key risk for banks who borrow short (e.g. instant withdrawal deposit a/c) and lend long (e.g.25-year mortgage). In particular, there is a risk of a run of deposit withdrawals leading an otherwise solvent bank to ruin. </li></ul><ul><li>Banks devote considerable resources to liquidity scenario testing and are adept at securitising otherwise illiquid assets such as mortgages. </li></ul><ul><li>UK life insurers by contrast have little liquidity risk as they take in long term savings and invest in marketable assets. Moreover, until recently most insurers had surplus premium income over claims. </li></ul><ul><li>However Equitable Life showed the possibility of mass surrenders akin to a run, albeit more protracted. </li></ul>
  74. 74. Operational Risk <ul><li>UK life insurers have incurred considerable losses from the misselling of pension and mortgage endowments, often by banks acting as their Appointed Representative. Life insurers have tightened up systems and controls as a result, and will generally no longer bear the risk of banks misselling their products. </li></ul><ul><li>Banks face ongoing losses from external fraud, but with tightening controls (e.g. chip & PIN) there are now indications that fraudsters are turning to life companies. </li></ul><ul><li>Both banks and life insurers face regulatory challenges to charges, but for life insurers, the immediate impact would be more pronounced as this will lead to a write down of embedded values. </li></ul>
  75. 75. Aggregation – Banks <ul><li>For UK banks, credit risk is the most significant risk, though arguably persistency risk is as significant in terms of economic value destroyed. </li></ul><ul><li>Market risk is substantially hedged while expense risk is not presently a problem due to bank’s flexibility in recouping costs. </li></ul><ul><li>Operational risk, while it may be significant on a stand-alone basis, may only make a modest contribution to post-diversification economic capital if low correlation is assumed. </li></ul><ul><li>Liquidity risk, while very important, is more properly addressed by ensuring access to lines of credit rather than holding capital. </li></ul>
  76. 76. Aggregation – Life Insurers <ul><li>For UK life insurers, market risk is usually the largest risk, followed by persistency risk. </li></ul><ul><li>Insurance risk will be large but generally taken as uncorrelated with these, so its contribution to diversified economic capital may be modest. However for some insurers with large annuity and / or term assurance books, it may be key. </li></ul><ul><li>Credit and expense risk may be significant, particularly if they are assumed to be correlated with market risk. </li></ul><ul><li>Operational risk may also be assumed to be correlated with market risk due to the impact of market falls on misselling claims. For some linked life offices with significant legacy misselling exposure, operational risk may even be the most significant risk faced. </li></ul><ul><li>Liquidity risk economic capital requirements will be minimal. </li></ul>
  77. 77. Conclusion <ul><li>While there are some significant differences, UK banks and life insurers can usefully share experiences as well as tools and techniques for managing risk. </li></ul><ul><li>For example, banks could learn from life insurers approach to quantifying persistency losses, as well as the impact of longevity on their pension schemes. </li></ul><ul><li>Banks have a lot to teach life insurers in terms of management of credit risk, as well as securitisation techniques to pass on risks to the wider market. </li></ul><ul><li>UK life insurers, in terms of their misselling experiences, the limitations they face under UTCCR, and product regulation, may offer an uncomfortable example to banks of adverse regulatory intervention. </li></ul>