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APRIA Conference
2007
Risk Based Capital Management
PREETI CHANDRASHEKHAR & RAMA WARRIER
a “principles based approach”...
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Risk based solvency assessment
This paper considers RBC from a broader
perspective, rather than from a regulatory
stan...
| 3
Simple factor based models involve
applying factors to accounting results as of a
particular point in time. Solvency 1...
| 4
Solvency 2 – a step in this direction
European market has taken steps to adopt a
principles based approach for insurer...
| 5
addition, the company would also need to treat
the discretionary liabilities appropriately5
.
In addition, there are c...
| 6
identifying the models:
The models that can be used have been detailed in
the previous section. Any model that is chos...
| 7
Authors:
Rama Warrier and Preeti ChandraShekhar are consultants focusing on the fields of insurance and risk. They
hav...
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Risk based capital management preeti & warrier

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An article on Risk Based Capital Management for Insurer Solvency - for more papers on insurance, risk and technology visit www.conzulting.in

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Risk based capital management preeti & warrier

  1. 1. | 1 APRIA Conference 2007 Risk Based Capital Management PREETI CHANDRASHEKHAR & RAMA WARRIER a “principles based approach” to insurer solvency management Introduction Liberalization and emerging business models have led to changes in the risk profile of insurance companies. Insurers now need to manage risks in a more structured and informed manner. And the importance of risk management has assumed much larger proportions than it used to. A complementing area of focus is efficient management of capital. Efficient capital management is a function of the insurer’s ability to properly assess its assets and liabilities. Regulators have also responded to this paradigm shift and are now emphasizing on Risk Based Capital (RBC) as the basis for capital adequacy and insurer solvency. In this approach the minimum acceptable capital depends upon how risky the underwriting and investment operations of the company are. This is a major deviation from the fixed ratio approach which was in vogue world over for assessment of capital adequacy. Risk Based Capital exists in various forms and differing degrees of sophistication in various countries, ranging from the rudimentary fixed ratio approach to a more advanced level of stochastic modeling as in U.K. and Canada. This paper is aimed at discussing: - Different approaches to solvency assessment - Challenges in moving towards a principles based approach - Operational Challenges in moving towards a principles based regime Issues viewing this article? Check on www.conzulting.in More articles on insurance, risk & technology? - visit www.conzulting.in
  2. 2. | 2 Risk based solvency assessment This paper considers RBC from a broader perspective, rather than from a regulatory stand point alone. Hence, the reference to RBC throughout this document is not to be confused with the RBC in the United States of America as it exists today. RBC is an approach towards efficient and prudent management of capital for an insurance company. According to the definition of Society of Actuaries, RBC “represents an amount of capital based on an assessment of risks that a company should hold to protect customers against adverse developments”1 RBC is a method used to assess the capital adequacy of an insurance company. Since different stakeholders have different objectives, their view of “capital adequacy” would also be different - for the policyholders it is the ability to honour claims; for the shareholders it is the ability of the company to generate expected levels of profits; for the regulator it is the ability to fulfill contractual obligations. Solvency, on the other hand, reflects the company’s ability to meet its liabilities together with any margin that the supervisory authority may require the company to hold. From the regulatory perspective, both capital adequacy and solvency are used to assess the sufficiency of the insurer’s capital to meet the obligations or liabilities under all its contracts at all points in time. In that sense, they are synonymous. However, it needs to be noted that differences can be observed in some markets. For example, in life insurance in Australia, capital adequacy considers assessment on a going-concern basis (including new business) whereas solvency refers to the assessment on a run-off basis (only existing contracts)]. A traditional approach to capital adequacy and solvency assessment that involves calculating the capital requirement based on static 1 Society of Actuaries, Schaumburg, Illinois, U.S.A. www.soa.org/professional- interests/files/pdf/riskbased_capital.pdf - 2007- 02-28 (downloaded on 28 th May 2007) accounting results is limited in scope. It does not go beyond the balance sheet. This leads us to consider a solvency assessment based on risk. A “Risk based solvency assessment” involves considering the risks that the company is exposed to and factoring these risks while addressing the capital needs. The principles on capital adequacy and solvency of insurers as laid down by IAIS2 talks of 14 principles. One of the principles (#6) suggests that “Capital adequacy and solvency regimes have to be sensitive to risk”. This means that while the valuation of assets and liabilities depends on the regulations in the geography of operations, the solvency margin should also consider risks that have not been adequately reflected in this valuation i.e. “off-balance sheet items”. Models for solvency assessment A review of the various solvency assessment models that are used across various countries reveal different levels of sophistication. The models can be classified on multiple dimensions. There are different approaches for classifying solvency assessment models. CEA and Mercer Olivier Wyman3 , suggest the following classification, at a very basic level,: 2 Principles on capital adequacy and solvency (2002), www.iaisweb.org (downloaded on 28th May 2007) 3 “Solvency Assessment Models compared”, CEA and Mercer Oliver Wyman; www.cea.assur.org/cea/download/publ/article221.pdf, downloaded on 25th May 2007,
  3. 3. | 3 Simple factor based models involve applying factors to accounting results as of a particular point in time. Solvency 1 regulation, for example, adopts simple factor based models. Risk factor based models apply multiple factors to specific accounting results. The NAIC model is perhaps a good example wherein factors are applied to different risk elements like Market risk, Credit Risk, Insurance risk, Interest rate risk, Business risk (and Off-balance sheet items for life insurance). The calculation method is standardized and pre-defined. Both the models cited above are based on specific guidelines with rigid, prescriptive rules. The analyses and the formulae to be applied are clearly defined. These are categorized as “rules based” models. While the “rules-based” approach to solvency assessment is simple and easy to apply, it has certain drawbacks. For instance, company specific risk profiles are not considered. There is no allowance (or a limited allowance) for interdependency of risks and the valuation of assets and liabilities is generally not based on market-consistent approaches. The follwing two models are dynamic models as the calculations are not dependent on the position at a particular “point in time”. Rather, they are based on cashflow projections. Cashflow approach is generally considered to be better than the “rules based” approach since complex scenarios can be modeled. Under the Scenario based model, the insurance company applies the discounted cashflow method to ascertain the effect of certain predefined scenarios to its net asset value. Credit, Market, Insurance risks etc. originating in a one year time horizon are considered. The scenarios are clearly defined. The Swiss Solvency Test or SST as it is known, is an example of this approach. Lastly, under the Principles based approach, no rules are specified to arrive at the risk measure. The insurance company is expected to apply the principles laid down by the regulatory or financial authority in the geography of jurisdiction. The models to which these principles can be applied can be the company’s internal model. The UK-FSA model for capital requirement is a good example. The four models described above are the basic ones. In practice, the model that a company adopts need not fit into one of these types exclusively. It can have flavors of more than one type.. For instance, the insurance company can adopt dynamic scenario based model for some risks (asset liability mismatch) and use an overall risk-factor based approach. It should not be construed that the “rules based” approach is not based on principles. Indeed, all the detailed and prescriptive rules have sound base of financial and actuarial principles. However, in such a scenario, the regulator has a bigger role to play in ensuring that the companies adopt sound business practices while keeping the stakeholders interests in mind. Principles-based approach, on the other hand transfers the onus of sound business practices on to the insurance companies and their senior management. Companies need to align their risk management practices with regulatory solvency and capital requirements. They need to move up from being “risk evaluators to risk managers”4 . Moving from a “rules based” to “principles based” model has challenges at various levels. Both the regulator and the insurance companies have to work together to make it happen. While the uncertainty and lack of clarity may not seem unfounded from the insurance company’s perspective, there is a clear shift in the role of the regulator from a watchdog to a guide. The regulator is expected to provide clear and unambiguous guidance in understanding the principles. 4 “Principles-based regulation – looking into the future” Speech by John Tiner, Chief Executive Officer, FSA; FSA Insurance Sector Conference, 21st March 2007. downloaded on 28th May 2007 www.fas.gov.uk,
  4. 4. | 4 Solvency 2 – a step in this direction European market has taken steps to adopt a principles based approach for insurer solvency. Solvency 2, is a new, risk-sensitive system for measuring the financial stability of insurance companies in the EU. It is intended to provide greater security for policyholders and stability for financial markets by providing insurance supervisors with better information and tools to assess the financial strength and the overall solvency of insurance companies. Even before it is fully implemented, Solvency 2 is expected to usher in large scale changes in product portfolio, operations as well as the reporting requirements of insurance companies. However, the transition to a principles based approach under Solvency 2 is likely to pose several implementation challenges to the insurance industry. Challenges in moving towards a principle based approach Risk Based Capital and Solvency assessment are not just accounting or actuarial issues. They affect the entire organization and require changes at all levels covering the entire operations. The “principles based approach”, aims at establishing a system that helps the insurance company to manage risks in a more structured and informed manner, reflecting current market needs while allowing for greater transparency based on generally accepted accounting and actuarial principles. The detailed methodology is left to the discretion of the insurer as long as it is consistent with the principles set out. This brings with it implementation challenges in multiple dimensions. For one, though the approach is “principles based”, the implementation of the principles would require “rules”. The rules should be such that they allow flexibility to adapt to unforeseen circumstances. The absence of detailed rules that translate the principles into practice leaves much to the judgment of the individual company on how best to represent the principles. Another important aspect that is closely linked with the above is the choice of risk measure A good risk measure should consider the upside and downside differently. There are various risk measures like Value at Risk (VaR) and Tail VaR that would perhaps represent the individual risks (Market, Credit, Insurance etc.). But what is required is an assessment of the combined effect of these risks and its impact on the overall risk profile of the company. The positive and negative correlation between the risks and the effect of diversification must be assessed. This gets compounded due to scarce data or complete absence of accurate data . This is particularly important in the assessment of extreme events or the tail of the probability distribution that represents such risks. in the case of stochastic modeling. Each accounting practice defines the assets and liabilities differently. The same set of principles and rules applied for capital adequacy and solvency requirement may produce different results. This may lead to a “hidden” surplus or deficit that is highly undesirable. The solvency assessment model should be independent of the accounting system. This, from a practical perspective, is a challenge especially for the static models since most of them are based on accounting values. Move towards a “principles based” approach involves having a comprehensive view of the balance sheet. However, the insurance company’s balance sheet consists of liabilities other than that of policyholders (shareholders, other investors etc.). The interpretation and valuation of these liabilities would depend upon the primary aim of solvency assessment. In
  5. 5. | 5 addition, the company would also need to treat the discretionary liabilities appropriately5 . In addition, there are challenges associated with time horizon regardless of whether it is a static or dynamic approach. The cashflow approach also needs to consider the total projection frequency chosen. There needs to be a right balance between accuracy and time taken to run the model keeping in mind the costs associated with running the model.. The conflict between pragmatism and technical accuracy needs to be addressed. The inherent risks associated with an insurance company interact at different levels. This leads to complex and myriad effects. These require non-linear risk modeling at the enterprise level. The choice between deterministic and stochastic approaches is a fundamental challenge . The overall inclination of the industry is towards stochastic modeling. This however, does not mean that stochastic risk models would replace the deterministic ones. In fact, stochastic and deterministic models complement each other. Very often, a deterministic model can be extended to include the stochastic element so as to determine the variability of the estimates with a desired level of confidence. Regardless of the approach, the effectiveness of the model depends largely on the structure of the data within the model. A smart and sophisticated system is required to  Model complex risks (assets –liability mis-match, operational risks etc.)  Handle multiple scenarios  Perform Scenario modeling and sensitivity analysis  Conduct Stress Tests 5 “CEA Working Paper on the Total Balance Sheet Approach”, http://www.cea.assur.org/cea/v1.1/actu/pdf/uk/anne xe315.pdf, downloaded on 29th May 2007 The following section details some of the steps required in modeling and also highlights some data and technology challenges associated with it. Operational challenges –baby steps from theory to practice The implementation of Risk Based Capital involves, at the core, identifying and modeling the risks and appropriately aggregating them at the enterprise level. This process can be broadly split into three parts: (1) Identification of risks (2) Identification of the model (3) Running the model Identification of risks: As mentioned earlier in this paper, risks faced by the insurance company are diverse in nature and complexity. Risks that are straight forward and already form an important aspect of product design and pricing is perhaps a “no-brainer” for insurance companies – that is their core strength. It is the identification of risks and their interdependence at the enterprise level that requires expertise in risk management. Arriving at a reasonably complete list of potential risk exposures is essential for successfully implementing a risk based solvency assessment. Given below is an illustrative sample of the risks to which an insurance enterprise is exposed.
  6. 6. | 6 identifying the models: The models that can be used have been detailed in the previous section. Any model that is chosen has to suit the underlying risk. Perhaps it is equally challenging to identify the most appropriate model that truly represents the impact of underlying risk or group of risks.  The model should be valid for the purpose for which it is used  It should have the capability of handling all the relevant parameters  It should not be too complex – a model that is easy to understand and interpret is what is required Running the model: After the risks and the models have been identified, the most daunting task is to run the model, test and interpret the results. Model points have to be appropriately chosen to ensure that they adequately represent the underlying portfolio to be modeled. They should also ensure that the right business mix is considered. Information Technology plays a critical role in this phase. Insurance companies usually have different systems covering the whole spectrum of technology sophistication. And this diversity gives rise to challenges in collecting data – acceptable from an accuracy and time perspective. The following diagram gives a conceptual view of the IT model for implementing a Risk Based Capital model Implementation of an RBC based model is a major IT initiative in an insurance company. Hence, it carries all the challenges which any large initiative would. The major challenges from an IT perspective could be categorized into two – data related and application related. The following diagram indicates the IT priority areas for implementation of a risk based solvency assessment model. Conclusion Managing and optimizing the capital requirements of an insurance company requires a more dynamic and flexible approach. It needs to minimize the risk of insolvency and properly align the interests of all the stakeholders. Towards this end risk based solvency assessment founded on a “principles based approach”, is being widely recognized as the way forward in the insurance industry as demonstrated by the Solvency 2 initiative. Success of risk based solvency assessment depends upon how effectively the companies are able to address the operational challenges.
  7. 7. | 7 Authors: Rama Warrier and Preeti ChandraShekhar are consultants focusing on the fields of insurance and risk. They have varied experience across the globe with leading insurance and reinsurance companies. They have published several papers in international journals. These papers could be accessed on www.conzulting.in The authors could be reached at warrier@conzulting.in and Preeti.Chandrashekhar@towerswatson.com References: 1. Society of Actuaries, Schaumburg, Illinois, U.S.A. www.soa.org/professional- interests/files/pdf/riskbased_capital.pdf - 2007-02-28 (downloaded on 28th May 2007) 2. Principles on capital adequacy and solvency (2002), www.iaisweb.org (downloaded on 28th May 2007) 3. “Solvency Assessment Models compared”, CEA and Mercer Oliver Wyman; downloaded on 25th May 2007 www.cea.assur.org/cea/download/publ/article221.pdf 4. “Principles-based regulation – looking into the future” Speech by John Tiner, Chief Executive Officer, FSA; FSA Insurance Sector Conference, 21st March 2007, www.fas.gov.uk, downloaded on 28th May 2007 5. “CEA Working Paper on the Total Balance Sheet Approach”, http://www.cea.assur.org/cea/v1.1/actu/pdf/uk/annexe315.pdf, downloaded on 29th May 2007 6. “Solvency 2 – the IT perspective”, Rama Warrier & Nandha Kumar, The Actuary, April 2007 7. “An approach to ERM in the insurance industry” Preeti ChandraShekhar & S R Warrier, APRIA 2002 8. ST2 – PN- 06 Course notes ActEd Study material, Institute of Actuaries, UK

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