CIA%20Annual%20Meeting

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CIA Annual Meeting

• LOOKING BACKfocused on the future

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• Session 3402 -Informal Presentation
• Moderator
• John Brierley
• Speakers
• John Brierley
• Lynne Patterson

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• Bank Economic Capital Concept
• A measure of the amount of capital required to
  underpin the business, based on the risks
  inherent in that business
• Measure risk specifically associated to the
  business, not a general industry perspective
• Banking is viewed on a short-term basis and the
  capital is measured over a one-year time horizon
• How far in the tail of the distribution depends
  on the bank target credit rating (AA 99.95th
  percentile)

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• Bank Economic Capital Uses
• Allocate economic capital by product and use for
  product pricing
• Fair and consistent way of allocating capital by
  platform and by product
• Return on economic capital the primary ROC
  measure used by analysts
• Effective way for management to compare
  profitability of different products and services
  within the financial institution

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• Bank Economic Capital Components
• Credit Risk
• Operational Risk
• Business Risk
• Neutral Position Risk
• Interest Rate Risk
• Fixed Asset Risk
• Goodwill
• Other

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• Bank Economic Capital Components Credit Risk
• Primary emphasis and largest component
• Stochastic model measuring credit migration
• Change in market value over the period
• Credit migration probabilities
• Default probabilities
• Loss in the event of default (LIED)

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• Bank Economic Capital Components Operational
  Risk
• Difficult to measure
• Build a database of loss events
• Experience expressed as an amount per transaction
• Evolving component of risk management

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• Bank Economic Capital Components Business Risk
• Very difficult to measure
• Small number of events
• Difficult to model
• Express as a percentage of revenue

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• Bank Economic Capital Components Neutral
  Position Risk
• Asset Liability mismatch
• Simplistic approach would look at 200 basis point
  parallel shifts ( -) in the yield curve
• Refined approach would use stochastically modeled
  interest rate scenarios
• Centrally calculated and allocated to each
  platform

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• Bank Economic Capital Components Interest Rate
  Risk
• Measures potential change in market value for
  capital assets
• Simplistic approach would look at 200 basis point
  parallel shifts ( -) in the yield curve
• Refined approach would use stochastically modeled
  interest rate scenarios
• Centrally calculated and allocated, except for
  insurance

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• Bank Economic Capital Components Fixed Asset
  Risk
• Non-invested assets
• Covers decrease in income from depreciation
• ROC requirement for pricing
• Goodwill
• Non-invested asset
• ROC requirement for pricing
• Other
• Insurance components

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• Bank Economic Capital Components Diversification
• Recognition given to risk diversification
• Between risks within a component
• Between components
• A correlation matrix is used
• Can only be accomplished if calculations are
  centralized

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• Integrating with Bank Economic Capital
• Credit Risk Component
• All insurance assets combined with other platform
  assets within the financial institution
• Combination of all assets is required in order to
  properly reflect diversification within the total
  asset portfolio
• Longer duration assets attract more capital
  (measure based on market value movement due to
  credit migration)
• Reinsurance ceded liability treated like any
  other asset - extremely long duration but low
  LIED
• Offset calculated amount with the Provision for
  Adverse Deviation embedded in the liabilities

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• Integrating with Bank Economic Capital
• Operational Risk Component
• A work in progress
• Risk areas identified
• Operational error database
• Reporting issues
• Expressed as a percentage of gross revenue, less
  claim payments (including change in policy
  liabilities)

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• Integrating with Bank Economic Capital
• Neutral Position Risk Component
• This is where asset liability mismatch risk (as
  measured by CALM) should go
• Since insurance capital managed separately from
  other platform capital management, the Insurance
  ALM provision is not added here
• Insurance is allocated a portion of the overall
  component some double counting

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• Integrating with Bank Economic Capital
• Interest Rate Risk Component
• This is where asset liability mismatch risk is
  added (as measured by CALM using stochastically
  generated economic scenarios)
• Total Balance Sheet approach used
• Economic capital 99.93rd percentile liability
• Life Insurance measures the long-term interest
  rate risk, which is primarily a reinvestment risk
• Properly identifies capital for embedded options,
  such as Universal Life minimum interest rates
• Some offset from market movement of capital
  assets, since this risk is negatively correlated
  when liabilities increase with lower interest
  rates

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• Integrating with Bank Economic Capital
• Business, Fixed Asset and Goodwill Risk
  Components
• Centrally calculated factors (multiplied by Gross
  Revenue) applied consistently across all
  platforms
• Determined most appropriate definition for
  Insurances Gross Revenue to be consistent with
  bank definitions
• Centrally calculated diversification factors

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• Integrating with Bank Economic Capital
• Other Risks (Insurance Risks)
• Mortality
• Morbidity (incidence and termination)
• Lapse
• Home
• Auto
• Travel
• Property Catastrophe Reinsurance
• Auto loan buyback
• No explicit recognition of diversification within
  insurance risks

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• Integrating with Bank Economic Capital
• Other Risks (Insurance Risks)
• Monte Carlo simulations using actual inforce
  seriatim data where available (individual
  insurance, some group, some reinsurance)
• Binomial Distribution approximations used where
  actual inforce seriatim data is not available
  (some group insurance, home, auto, travel, some
  reinsurance)
• Annual modeling, generating factors to be applied
  for quarterly reporting

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• Integrating with Bank Economic Capital
• Other Risks (Insurance Risks)
• Modified Balance Sheet Approach used
• Economic capital 99.93rd percentile of the
  distribution mean of the distribution
• Do not offset economic capital by the Provision
  for Adverse Deviation
• PfAD measures misestimation and deterioration of
  the mean
• Economic capital measures volatility

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• Integrating with Bank Economic Capital
• Other Risks (Insurance Risks)
• Multi-year models used for multi-year guarantees
  (most individual insurance)
• Single year models used for short-term products
  (most PC and group insurance)
• Multi-year model based on binomial distributions
• Mean and standard deviation obtained from
  projected inforce data (readily available from
  AXIS output)
• Randomly select a result from each future year
  binomial distribution and present value the
  result
• Repeat 100,000 times to obtain a multiple to
  apply to the single year model 99.93rd percentile
  amount

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• Insurance Uses for Economic Capital
• Consistent profit measurement with other
  platforms
• ROC reporting in published financial statements
• Pricing some products
• Property catastrophe reinsurance
• Embedded options within products, such as
  Universal Life account minimum interest rate
  guarantees
• Will expand use, especially for products where
  economic capital exceeds regulatory capital

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• Economic Capital vs. MCCSR
• Both risk based, but EC more accurately reflects
  the risk specific to the company
• MCCSR grossed up for excluded components
• EC takes risk diversification into account, where
  MCCSR does not
• MCCSR significantly under-provides for interest
  rate risk, especially where embedded options (UL
  account guarantees) are present
• Before diversification EC gt MCCSR
• After diversification EC lt MCCSR
• Pricing with EC would result in charging more for
  interest rate risk and less for other insurance
  risks