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Valuation Actuary Symposium Austin, TX www.ey.com/us/actuarial
INSURANCE & ACTUARIAL ADVISORY SERVICES
Session 35
Advanced Economic Reserves and Capital
Matthew Clark FSA, CFA
Agenda
Methodology
Modeling Challenges
Scenario Generation
Aggregation
Diversification
2
Methodology
Methodology Selection
Most organizations are implementing a
single economic capital methodology
– Statutory Balance Sheet
– Fair Value Balance Sheet
– Other
Multiple economic capital audiences
– Internal
– External
4
Methodology Challenges
Statutory Balance Sheet Approach
– Distribution of total assets required (TAR) is
not informative
– Stranded capital
– Consider including a cash balance approach
to gain insight into the redundancy of
reserves
– Limited number of scenarios requiring
additional capital
Methodology Challenges – Cont.
Fair Value Balance Sheet Approach
– Applying fair value mechanics can be a
challenge
– Difficult to reconcile results to existing metrics
– Defining risk margins
• Cost of Capital
• Percentile
6
Modeling Challenges
Modeling Challenges
Runtime Considerations
Policyholder Behavior
Management Actions
8
Runtime Considerations
How many scenarios is enough?
– Tail metrics
– Aggregation challenges
Cell Compression
– Accuracy of results
– Balance precision with practicality
Need to balance “shelf life” of the results
and the production time
Runtime Considerations – Cont.
Solutions:
– Perform sensitivity analysis on cell compression
– Note that the tail metric will impact the number of
cells and/or scenarios needed
– Consider impact across the distribution
– Balance the robustness of the population with the
entire process
– Focus on both the assets and liabilities
– Understand the value introduced by additional cells
versus the runtime
10
Policyholder Behavior
Predicting policyholder behavior is difficult
in the tail events
Need to balance historic events with the
universe of possible events
Does a single dynamic assumption meet
your needs?
Accept the fact that policyholder behavior
is a difficult to predict
Policyholder Behavior – Cont.
Lapse Assumptions
– Dynamic equations lose functionality in the tail
– Realize that the focus may be on the extreme tail
events
– How does lapse activity impact mortality or
morbidity?
Premium Assumptions
– Premiums are not traditionally considered a dynamic
assumption
– Tail events where the product guarantees are rich
need to be considered
– Consider the impact of premium payments at both
ends of the distribution
12
Policyholder Behavior – Cont.
Solutions
– Perform sensitivity tests to understand the
policyholder behavior across the distribution
– Awareness of the limitations in your
policyholder behavior is important
– Consider optimal policyholder behavior
– Consider the perfect storm conditions
– Do not ingore the impact lapses might have
on other assumptions
Management Actions
Modeling management actions tends to
challenging
Need to balance historic actions with
emerging risk management platform
Note there is a difference between what
management can do versus what
management will do
Consider management actions across the
organization
14
Scenario Generation
Scenario Generation – Market Risks
Economic scenario considerations
– Are the market parameters generated in a
single generator?
– Are interest, equity and credit generated on a
consistent basis?
– Are credit charges consistent with credit
spreads?
– Does your generator regime switching?
– Understand the limitations of your generator
16
Scenario Generation – Non-Market Risks
Mortality and Morbidity Considerations
– Do you have a mortality generator?
– What parameters are being used?
• Trend
• Volatility
• Underwriting
• Catastrophe
– Consider calibration to tail events
– How sensitive are your results to the
non-market risks?
18
Aggregation Techniques
Correlation Matrix
– Mix of business
– Tail considerations
• What point in the tail?
• What metric is being used?
– Black box
• What events contribute to the tail metrics
• Note the distribution is more important than a
single tail metric
Aggregation Techniques – Cont.
Integrated Scenarios
– Requires correlation assumptions
– Allows the user to understand the impact of
correlation assumptions
– Requires more scenarios than other
techniques
20
Diversification
Diversification
Organizations are determined to allocate capital
back to business units/profit centers
How do you treat the diversification impact?
– Allocate all or part to the business unit?
– Allocate all to corporate?
How will diversification impact business
decisions?
– Pricing
– Sales
Economic Capital
Implementation Issues
Howard L. Rosen
Chief Insurance Risk Officer & Chief Actuary – Retail Life ING USFS
2007 V
aluationA
ctuaryS
ymposium•
Definition of Economic Capital
•
Implementation Issues
•
ING Responses
2
Definition of Economic Capital (“EC”)
• Capital requirements are set to meet S&P requirements for a AA rated Insurer on a required total asset basis and have been defined as:
The amount of capital required to protect the market value of the liabilities with a 99.95% one-sided confidence over a 1-year time horizon
• Market Value of Liabilities (“MVL”) is the value at which the liabilities could be transferred to a willing, rational, diversified counterparty in an arms’ length transaction under normal business conditions • The risk that is captured in the capital also relates to uncertainties
beyond the 1-year period through the MVL
Risk Types Correspond To Sources Of Economic Loss
LIFE RISK
Mortality Deviation
OPERATIONAL RISK
Event Loss Deviation
BUSINESS RISK
Residual Earnings Deviation
MARKET RISK
Value at Risk
TRANSFER RISK
Unexpected Transfer Loss
CREDIT RISK
Unexpected Loss
Earnings Deviation due to variations in Credit Losses Earnings Deviation due to
inability to repatriate funds - immaterial for insurance
Earnings Deviation due to
changes in the Market Price or Liquidity Earnings Deviation due to changes in
Operating Economics (e.g. Volume, Margins or Costs) Earnings Deviation due to One-off Losses unrelated to Volume, Margins and Costs Earnings Deviation due to
unexpected changes in mortality rates
In ter-r isk di v e rs ification RISK Earnings Deviation Total Economic Risk
4
Implementation Issues
• Cost • Processing Time • Volatility of Results • Definition of 1 – in – 2000 Event • Treatment of Taxes• Treatment of “Lazy Capital” Charges • Credited Rates
• Diversification
• Level Playing Field ???
Implementation Issues
Cost • Issue(s) • New System • Hardware • Operating Environment • People • Conversion • Ongoing • ING Response • Prophet • Upgraded Machines • Grid Environment • Additional FTEs6
Implementation Issues
Processing Time
• Issue(s)
• 45 day Reporting Lag
• Need For Up-to-date Asset Files
• Delayed Input From Other Functional Areas • Need To Aggregate Results
• ING Response
• Replicating Portfolios For Assets & Liabilities • Interim Quarter Gross-ups
• ECAPs
Implementation Issues
Volatility Of Results
• Issue(s)
• Use of Risk Free Rates Creates Market Risk Volatility • Inconsistency With Retail Life Business Model • Methodology Improvements
• ING Response • LIVE WITH IT !
8
Implementation Issues
One In 2000 Event
• Issue
• How Do You Define For Risk Capitals Not Subject To Stochastic Projection ? • ING Response • Arbitrary Sensitivities • Expense • Lapse
Implementation Issues
Treatment Of Taxes • Issue• Not Currently Considered • Not Clear How To Reflect
• ING Response • Still Under Review
10
Implementation Issues
Treatment Of Lazy Capital
• Issue
• Redundant Reserves Don’t Exist In MC Environment • LOC Or Other Charges Are Real
• ING Response
• Assume Borne By “Corporate” • Limited Or Unlimited ?
Implementation Issues
Credited Rates
• Issue(s)
• Real World Or Spread Off Of Risk Free? • Real World Inconsistent With Risk Free Rates
• Spread Off Of Risk Free Rates Inconsistent With Real Costs, CV, etc.
• ING Response
• Currently Use Real World
12
Implementation Issues
Diversification
• Issue(s)
• How To Properly Reflect Benefits of Multiple • Risks Within Same Product
• Risks Within Same Business Unit • Risks Across (Global) Business Units
• ING Response
• Enormous Multidimensional Matrix Within ECAPS • Black Box Process
• Significant Reduction in EC • Hard To Conceptually Understand
• Potentially Inconsistent With Rating Agency Perspective
Implementation Issues
Level Playing Field ???
• Issue(s)
• Are We Consistent With Our Competitors? • Methodology
• Definitions
14
