ENTERPRISE RISK MANAGEMENT (ERM) ENTERPRISE RISK ... Maistry - Creating... · Enterprise Risk...
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ENTERPRISE RISK MANAGEMENT (ERM) ENTERPRISE RISK MANAGEMENT (ERM) – CREATING A RISK-INTELLIGENT INSURER Gavin R. Maistry, FSA, FSAS, CERA, CFA Chief Actuary , Life Asia Chief Actuary , Life Asia 1 ST ST IAI SEMINAR ON ENTERPRISE RISK MANAGEMENT IAI SEMINAR ON ENTERPRISE RISK MANAGEMENT GURGAON, GURGAON, 26 AUGUST 2011 26 AUGUST 2011
Transcript of ENTERPRISE RISK MANAGEMENT (ERM) ENTERPRISE RISK ... Maistry - Creating... · Enterprise Risk...
ENTERPRISE RISK MANAGEMENT (ERM) ENTERPRISE RISK MANAGEMENT (ERM) ––CREATING A RISK-INTELLIGENT INSURER
Gavin R. Maistry, FSA, FSAS, CERA, CFAChief Actuary, Life AsiaChief Actuary, Life Asia
11STST IAI SEMINAR ON ENTERPRISE RISK MANAGEMENT IAI SEMINAR ON ENTERPRISE RISK MANAGEMENT GURGAON, GURGAON, 26 AUGUST 201126 AUGUST 2011
The World is Fill of Risk and DangersThe World is Fill of Risk and Dangersstarting on a lite note…
THE ACTUARY
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Actuaries are Natural Risk ManagersActuaries are Natural Risk Managersbut it does not always end well…
THE ACTUARY
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The 1The 1st st (Future) Enterprise Risk Manager(Future) Enterprise Risk Manager
USS Enterprise
superpowers help…
USS Enterprise
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Actuaries & Risk ManagementActuaries & Risk Managementwe have to make long term, predictions…need to understand RISK…
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Actuaries shaping the future of risk management…Actuaries shaping the future of risk management…
Evolution of the Actuarial Profession...Evolution of the Actuarial Profession...Th E l ti f th A t E D i ti Ti t E
major drive by most actuarial bodies…
The Evolution of the Actuary Emergence Description Time to EmergeActuary of the 1st kind 17th century life insurance actuaries using deterministic methodsActuary of the 2nd kind 20th century casualty actuaries using probabilistic methods 250Actuary of the 3rd kind 1980's investment actauries applying financial economics (Bühlmann) 70Actuary of the 3rd kind 1980's investment actauries applying financial economics (Bühlmann) 70Actuary of the 4th kind current actuaries working in ERM (Embrechts) 25
Source: Stephen P. D‘Archy, CAS Presidential Address, 2005
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Actuaries shaping risk managementActuaries shaping risk managementi l f i h f f f i k
Causes of the GFC & Lessons for
actuarial profession at the forefront of risk manangement…
actuaries
ERM & the CERA designation
Latest CI Experience Studies from the UK & ANZ
Latest Research into Mortality Improvements
Product Development Challenges in Japan
The Changing Face of the Life Insurance Market in South Africa
etc.
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The CERA Actuarial DesignationThe CERA Actuarial Designation
THE ACTUARY
the new gold standard in risk management credentials?
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The CERA Actuarial DesignationThe CERA Actuarial Designationstarted by the SoA…www.ceranalyst.org
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The CERA Actuarial DesignationThe CERA Actuarial Designationthe new global designation website…www.ceraglobal.org
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CERA’s Making theirCERA’s Making their Mark in the ERM SpaceMark in the ERM Space
THE ACTUARY
the new ERM textbook…
Si S l FSA CERASim Segal, FSA, CERA
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The SoA’s CERA CurriculumThe SoA’s CERA Curriculumprovides some good reference material…
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What Enterprise Risk Management is about …What Enterprise Risk Management is about …
Enterprise Risk Management (ERM) is an enterprise wide discipline by which risks from allEnterprise Risk Management (ERM) is an enterprise wide discipline by which risks from all
basic definitions
Enterprise Risk Management (ERM) is an enterprise-wide discipline by which risks from all potential sources are identified, measured, exploited, controlled, and monitored for the purpose of achieving the risk management objectives.
Enterprise Risk Management (ERM) is an enterprise-wide discipline by which risks from all potential sources are identified, measured, exploited, controlled, and monitored for the purpose of achieving the risk management objectives.
Risk management is concerned with possible future deviations Risk management is concerned with possible future deviations
Possible risk management objectives arePossible risk management objectives are
Qualitative, e.g.: Global presence in (re-) Qualitative, e.g.: Global presence in (re-)
Risk DefinitionRisk Definition Risk Management ObjectivesRisk Management ObjectivesCompany ObjectivesCompany Objectives
from a predefined goal, i.e. both with positive deviations (opportunities) and negative deviations (risks)
from a predefined goal, i.e. both with positive deviations (opportunities) and negative deviations (risks)
Ensure a target degree of confidence in meeting policyholders’ claims
Protect and generate
Ensure a target degree of confidence in meeting policyholders’ claims
Protect and generate
insurance marketsFinancial targets, e.g.: Earnings RoRaC
insurance marketsFinancial targets, e.g.: Earnings RoRaC deviations (risks).deviations (risks). Protect and generate
sustainable shareholder value Achieve and protect a target
rating
Protect and generate sustainable shareholder value
Achieve and protect a target rating
RoRaC Combined RatioOther goals, e.g.: Code of Conduct
RoRaC Combined RatioOther goals, e.g.: Code of Conduct
Protect the reputation Protect the reputation PIRI1 Employer Value Proposition PIRI1 Employer Value Proposition
1 Principles for Responsible Investments
Risk Management objectives must be aligned with company objectives.
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Risk DefinitionRisk Definitiondiff b i k & i i idifference between risk & uncertainty – in an economic sense…
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Why Enterprise Risk Management?Why Enterprise Risk Management?
Implementing ERM leads to... Corporate value enhanced by...
benefits of ERM…
Elimination of tail outcomes (reduced probability of financial distress)
Reduction of cost of capital (financial distress costs) and thus costs of products; creation of clients’ confidence in sustainably meeting all obligations
Level taxable earnings stream Increase of expected profits by reduction of expected taxes in the g p p y ppresence of a convex tax schedule; increase of predictability reduces cost of capital and increases reputation supporting new business
Increase of transparency for stakeholders, e.g. clients, shareholders, rating agencies or analysts,
Reduction of cost of capital (asymmetric information costs, financial distress costs) and thus cost of products; creation of clients’ g g y
and signal management ability) p
confidence in sustainably meeting all obligations
Optimization of capital structure by measurement and reduction of required capital
Reduction of cost of capital and thus costs of products
Enforcement of a minimum level of diversification Reduction of cost of capital (financial distress costs) and thus costsEnforcement of a minimum level of diversification by budgeting of available capital resources
Reduction of cost of capital (financial distress costs) and thus costs of products
Enhancement of the company’s risk-return profileby identifying products with attractive risk-return profile
Reduction of cost of capital and thus costs of products; safeguardingsustainable fulfilments of obligations
profile
Potential resp. prerequisite for a better rating Reduction of cost of capital and thus costs of products; potential for business opportunities where ratings matter
ERM sustainably increases shareholder value and safeguards clients’ interests.
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How to Implement ERM?How to Implement ERM?
Cultural Cultural
some key success factors…
Top management support for ERM, buy-in at business unit level
Balanced risk governance
Finding a balance between risk mitigation and business enabling
Top management support for ERM, buy-in at business unit level
Balanced risk governance
Finding a balance between risk mitigation and business enablingg g g
Business Sound and profitable business model makes ERM easier
g g g
Business Sound and profitable business model makes ERM easier
Methodology and systems Define an appropriate risk measure (right degree of sophistication)
Establish effective systems to support risk management processes
Methodology and systems Define an appropriate risk measure (right degree of sophistication)
Establish effective systems to support risk management processesEstablish effective systems to support risk management processes
Staff Broad perspective of ERM staff required – a lot of training needed!
Establish effective systems to support risk management processes
Staff Broad perspective of ERM staff required – a lot of training needed!
St t b B d f M t i i di bl i it f
Exchange of staff between risk functions and business Exchange of staff between risk functions and business
Strong support by Board of Management is an indispensable prerequisite for successfully introduce and maintain ERM.
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Elements of Munich Re’s ERMElements of Munich Re’s ERME t i Ri k M t t M i h REnterprise Risk Management at Munich Re
Clear limits indicateRisk strategy
Clear limits indicateprecise signals for the internal and external world and define the framework for operational actions
Risk identification andearly warning
Necessity for comprehensive overview,
Risk steeringSystem consisting
but with special focus on main issues
Risk modelling
System consistingof triggers, limits and measures …in conjunction
ERMCycle
Central competition factorin the right balance
between flexibility and stability
…with responsible management actions
Risk-based incentive systems
and sustainable responsibility
Sound risk governanceand effective risk management functions
Risk management culture as solid base17
The ERM CycleThe ERM Cycle
1. Context & Governance
used to structure the talk…
Governance
2 Ri k2. Risk Identification
6. Review &Improvement
ERM Cycle
3. Risk Quantification
5. Risk Monitoring, Reporting & Rewarding
4. Risk Response
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ERM Step #1: ERM Step #1: Context & Governance…Context & Governance…
The Scream of the Banker…The Scream of the Banker…
who/what will impact risk management – e.g. the Global Financial Crisis…
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Dramatic Change in Market Value of InsurersDramatic Change in Market Value of Insurers
Pre-crisis (31 March 2008) Post-crisis (31 March 2009)
ggpre and post crisis…
Rank Company Market value ($bn) Company Market
value ($bn)
1 China Life 109.50 China Life 94.732 AIG 109.09 Ping An 42.663 Allianz 89 50 Allianz 38 053 Allianz 89.50 Allianz 38.054 ING 84.35 Munich Re 25.155 AXA 75.06 AXA 25.106 Generali 63 63 Generali 24 156 Generali 63.63 Generali 24.157 Manulife 57.38 Travelers Cos 23.768 Ping An 54.24 Zurich 22.519 Zurich 46 02 Tokio Marine 19 509 Zurich 46.02 Tokio Marine 19.50
10 Munich Re 43.48 Metlife 18.62
Source: FT Global 500 per market cap (excl. Berkshire Hathaway)
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Risks Management: Lessons from the CrisisRisks Management: Lessons from the Crisisi ll f A t i f ICA 2010
Lesson #1:Lesson #1: MonitorMonitor the the Market EnvironmentMarket Environment
especially for Actuaries – from ICA 2010
Lesson #2:Lesson #2: TrackTrack the the TrendsTrends
Lesson #3:Lesson #3: Crumbling Crumbling of of Capital Capital During a CrisisDuring a Crisis
Lesson #4: Lesson #4: CConsider onsider Credit RiskCredit Risk
Lesson #5Lesson #5 LackLack ofof LiquidityLiquidity During a CrisisDuring a Crisis Lesson #5 Lesson #5 Lack Lack of of LiquidityLiquidity During a CrisisDuring a Crisis
Lesson #6: Lesson #6: Sensitized Sensitized to to Systemic RiskSystemic Risk
Lesson #7: Lesson #7: BewareBeware of the of the Black SwansBlack Swans
Lesson #8: Lesson #8: CarefulCareful of of ContagionContagion & Tail & Tail CorrelationCorrelationgg
Lesson #9: Lesson #9: MindfulMindful of Financial of Financial ModelsModels
L #10L #10 R l tiR l ti R iR i Lesson #10: Lesson #10: Regulation Regulation Review Review
Lesson #10+: Lesson #10+: BackBack to the to the Basics…Basics… 21
WhoWho is shaping the future of risk managementis shaping the future of risk management
Academics, etc.Academics, etc.
which bodies are influencing the development of ERM…
Actuarial bodiesActuarial bodies
Acco nting bodiesAcco nting bodiesAccounting bodiesAccounting bodies COSO
Industry bodiesIndustry bodies
Rating AgenciesRating Agencies
RegulatorsRegulators 22
A d iA d i h i th f t f i k th i th f t f i k t
Risks Management: Lessons from the CrisisRisks Management: Lessons from the Crisis
AcademicsAcademics shaping the future of risk management…shaping the future of risk management…
Lesson #1:Lesson #1: Capital Capital AllocationAllocation ModelModel
Talk by Myron Scholes – NUS Policy Forum, July 2010 Singapore
Lesson #2:Lesson #2: Capital Capital structure structure IssuesIssues
Lesson #3:Lesson #3: OptimizationOptimization ToolsTools Lesson #3:Lesson #3: Optimization Optimization ToolsTools
Lesson #4: Lesson #4: Plan for crisis, Plan for crisis, scenarioscenario analysisanalysis
Lesson #5 Lesson #5 Feedback Feedback MechanismMechanism
Lesson #6Lesson #6: : Reporting Reporting system for riskssystem for risksp gp g yy
Lesson #7: Lesson #7: Firm Firm structure/compensationstructure/compensation
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Industry Bodies shaping risk managementIndustry Bodies shaping risk managementd i f h CFO F
• Sound and comprehensive internal risk governance• Risk management needs to be preemptive, independent and empoweredIntegrated
risk
advice from the CFO Forum…
• Clearly articulating and monitoring the company’s risk tolerance• Compensation should be based on risk-adjusted performance
risk governance
• Indispensable tools for variety of reasons, increasingly used for regulatory purposes• But they can never be a substitute for common sense• Require regular improvement in the light of experience and need the complement of
sound management judgment to be effective
Risk models
Li idit • Liquidity risk distinct from risk to capital adequacy• Liquidity risk management to rely on scenario testing• Liquidity risk of insurers is fundamentally different from that of banks
Liquidity risk
manage-ment
• Renewed market confidence requires accurate valuation and the prompt disclosure• Market-consistent valuation of both assets and liabilities should become the principle
that underpins financial information and prudential oversight in insurance• Rating agencies should be brought under supervision
Valuation and risk
disclosure• Use of ratings in financial regulation should be curtailed
• Crisis emphasizes the need for international cooperation among regulators• Principle and economic risk-based approach for the supervision of groups neededGroup
i i • Efforts of the IAIS should be strengthened by introducing binding standards that would accelerate regulatory convergence
supervision
Source: CRO Forum, April 2009 24
Rating Agencies shaping risk managementRating Agencies shaping risk managementi i b f bli i f i i ERMincreasing number of publications from rating agencies on ERM…
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Regulations shaping risk managementRegulations shaping risk managementf B l III & S l II i li ifocus on Basle III & Solvency II implications…
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Regulations shaping risk managementRegulations shaping risk managementi li i f S l II f h i i d
Solvency II acts as a catalyst…Solvency II acts as a catalyst… …to resolve some old industry issues…to resolve some old industry issues
implications of Solvency II for the insurance industry…
y yy y yy
Example: Primary life insurance Issue: Long-term guarantees and options often not
properly priced and hedgedS l II R i it l f i t h d t t
Example: Primary life insurance Issue: Long-term guarantees and options often not
properly priced and hedgedS l II R i it l f i t h d t tLong- Solvency II: Requires capital for mismatch; demonstrates where return is insufficient for risk taken
Solution: Improving ALM, product design
Solvency II: Requires capital for mismatch; demonstrates where return is insufficient for risk taken
Solution: Improving ALM, product design
Example: ReinsuranceExample: Reinsurance
Longterm
industry issues
Example: Reinsurance Issue: Reinsurance programmes not always optimal in
terms of risk transfer Solvency II: Reinsurance matters for capital requirements Solution: Impact of reinsurance structures can be
Example: Reinsurance Issue: Reinsurance programmes not always optimal in
terms of risk transfer Solvency II: Reinsurance matters for capital requirements Solution: Impact of reinsurance structures can beSolutions to
Solvency II
Solution: Impact of reinsurance structures can be measured and optimised
Solution: Impact of reinsurance structures can be measured and optimised
Solutions to these issues
Example: Investments Issue: Insufficient profitability of underwriting Example: Investments Issue: Insufficient profitability of underwriting
compensated by taking high investment risks Solvency II: Risk capacity places limit on this strategy Solution: Focusing on profitable underwriting
compensated by taking high investment risks Solvency II: Risk capacity places limit on this strategy Solution: Focusing on profitable underwriting
Solvency II brings more discipline to the industry
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ERM References…ERM References…ERM References…ERM References…
Doherty: Integrated Risk Management1 Risk Context & ERM Risk Strategy Doherty: Integrated Risk Management Ch. 1, The Convergence of Insurance Risk Management & Financial Risk Management Ch. 7, Why Is Risk Costly to a Firm? Ch. 8, Risk Management Strategy: Duality and Globality
1. Risk Context & Governance
ERM Risk Strategy
(AFE References)
Segal: Corporate Value of ERM Ch.1, ERM Basics and Infrastructure Ch.2, Defining ERM
Ch 3 ERM Framework
Enterprise Risk Management Framework
Ch.3, ERM Framework Ch.6, Risk Decision-Making Ch.7, Risk Messaging Ch.8, Risk Governance and Other Topics, p Willis Managing the Invisible: Measuring Risk, Managing Capital, Maximizing Value SoA Risk Management, June 2009: Risk Appetite Statements: What’s on your Menu, Risk Management Wharton: Risk Measurement, Risk Management and Capital Adequacy in Financial Conglomerates CFO Forum: Methodology: Assessing Management's Commitment To And Execution of ERM Processes COSO: ERM Integrated Framework SoA: “Actuarial Aspects of SOX 404”, The Financial Reporter, Dec. 2004 SoA: “Responsibilities of the Actuary for Communicating Sarbanes Oxley Controls” The Financial Reporter
ERM Regulatory/Industry Perspective
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SoA: Responsibilities of the Actuary for Communicating Sarbanes-Oxley Controls” The Financial Reporter
ERM Step #2: ERM Step #2: Risk Identification…Risk Identification…i k fil f th G
2. Risk Identification
Types of RisksTypes of Risks
risk profile of the Group…
Underwriting The risk of a change in value due to a deviation of the actual claims payments from the expected amount of claims payments (including expenses).
Types of RisksTypes of Risks
Market
Credit
The risk of economic losses resulting from price changes on the capital markets.
The risk of a counterparty to a transaction defaulting before the final settlement of the transaction’s cash flows.
Operational The risk of a change in value caused by the fact that actual losses, incurred for inadequate or failed internal processes, people and systems, or from external events, differ from the expected losses.
Liquidity
Strategy
The risk that we are unable to fund assets or meet obligations at a reasonable time.
The risk of making wrong business decisions, implementing decisions poorly, or being able to adapt to changes in our operating environment.
Reputation The risk that adverse publicity regarding an insurer’s business practices and associations, whether accurate or not, will cause a loss of confidence in the integrity of the institution.
must measure and manage all relevant types of risks.
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ERM Step #2:ERM Step #2: Risk IdentificationRisk Identification2. Risk Identification
SCR: Solvency Capital RequirementAdj: Adjustments for loss absorbing effects
SCRSCR
ERM Step #2: ERM Step #2: Risk Identification…Risk Identification…
BSCR: Basic Solvency Capital RequirementSCRop: Operational riskMarket (SCRmarket) Currency (Mktfx) Property (Mktprop)
BSCRBSCRAdjAdj SCRopSCRop
SCR lifSCR lifSCR k tSCR k t SCRh lthSCRh lth SCRd fSCRd f SCRlifSCRlif SCRi tSCRi t Property (Mktprop) Fixed interest (Mktint) Equity (Mkteq) Concentrations (Mktconc) Spread risk (Mktsp) Health (SCRhealth)
SCRnon‐lifeSCRnon‐lifeSCRmarketSCRmarket SCRhealthSCRhealth SCRdefSCRdef SCRlifeSCRlife
NlPrem&ResNlPrem&Res NLc
NLc
MktfxMktfx LifemortLifemortHealth
SLTHealth
SLTHealthNonSLTHealthNonSLT
HealthCAT
HealthCAT
SCRintangSCRintang
health Similar to life techniques (HealthSLT) Non‐Similar to life techniques
(HealthNonSLT) Catastrophe (HealthCat)Counterparty/Default (SCRdef)
catcat
MktpropMktprop
MktintMktint
LifelongLifelong
LifeLife
LifeDis/MorbLifeDis/Morb
HealthMort
HealthMort
HealthLong
HealthLong
H lthH lth
HealthPrem&ResHealthPrem&Res
HealthNSLTLapseHealthNSLTLapse
NLLapseNLLapse
Life (SCRlife) Mortality (SCRmort) Longevity (SCRlong) Disability / Morbidity (SCRDis/Morb) Lapse (SCRLapse) E (SCR )
MkteqMkteq
MktspMktsp
catcat
LifeLapseLifeLapse
LifeExpLifeExp
HealthDis/MorbHealthDis/Morb
HealthSLTLapseHealthSLTLapse
HealthExp
HealthExp
Adjustment for the risk mitigating effect of future profit sharing
Expense (SCRmort) Catastrophe (SCRExp) Revision (SCRRev) Catastrophe(SCRCat)Non‐Life (SCRnon‐life) Premium and Reserve (NL )
LifeRevLifeRevMktconcMktconc HealthRev
HealthRev
Source:
Premium and Reserve (NLpr) Lapse(NLLapse) Catastrophe (NLcat) Intangible assets risks (SCRintang)
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2. ERM Risk Identification(AFE Reference)
AAA: Mapping of Life Insurance Risks, Report to NAIC Tilman: ALM of Financial Institutions - Ch. 16, Understanding options embedded in insurers' balance sheets
Global Risks Landscape 2011…Global Risks Landscape 2011… 2. Risk Identification
demographic challenges; terrorism; liquidity crunch; etc.…
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APPENDIX: Insurance Risk ReferencesAPPENDIX: Insurance Risk References2. Risk Identification
APPENDIX: Insurance Risk ReferencesAPPENDIX: Insurance Risk References
Insurance Risk Identification
Insurance Risk Quantification Insurance Risk ManagementIdentificationmortality risk Economic Capital marginsmorbidity risk capitallapse risk reinsurance securitizationlapse risk reinsurance, securitizationproduct risk, and embedded options C
laim
s
O b s e rv e d H is to ry F u tu re
S h o c k
look at components ‐ level, volatility, trend, shock
T re n d
O T im e
P a ram e te r
B e s t E s t im a teS ta is t ic a l V o la t ility
ReferencesRMS L i f h 2009 H1N1 I fl P d iAtkinson & Dallas, Life Insurance Products and Finance ‐ Ch. 13 Annuity and
O T im e
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RMS: Learning from the 2009 H1N1 Influenza PandemicWharton: Insuring against Catastrophies
Demographic ChallengesDemographic Challenges 2. Risk Identification
Japan Population Projections rapid change in 100 years…
128m
95m
83m
128m
Source: Special Report: Japan
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Demographic ChallengesDemographic Challengesd i f t lit i t
2. Risk Identification
drivers of mortality improvements…
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Source: RMS
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APPENDIX: Interest Rate Risk ReferencesAPPENDIX: Interest Rate Risk References2. Risk Identification
APPENDIX: Interest Rate Risk ReferencesAPPENDIX: Interest Rate Risk References
Interest Rate Risk Identification
Interest Rate Risk Quantification Interest Rate Risk Management
Interest rate level Duration; convexity; VaR; CTE; etc. Treasuries; Hedge - interest rate derivatives; Treasury & Eurodollar options
Yield curve shape Key rate durations; scenarios; VaR; etc. Above + structured notes
Volatility Volatility durations; VaR Swap options; caps; floors; etcVolatility Volatility durations; VaR Swap-options; caps; floors; etc.Credit spread Spread duration; VaR; holding limits Interest rate swaps; credit default swaps; etc.AFE References Ho: Key Rate Durations: Measures of Interest Rate Risks
Rubin: Hedging with Derivatives in Traditional Insurance Products Goldman Sachs: Revisiting The Role of Insurance Company ALM within a Risk Management Framework Tilman: ALM of Financial Institutions - Ch. 25, Implications of Regulatory and Accounting Reqts for ALM
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APPENDIX: Other Market Risk ReferencesAPPENDIX: Other Market Risk References2. Risk Identification
APPENDIX: Other Market Risk ReferencesAPPENDIX: Other Market Risk ReferencesMarket Risk Identification Market Risk Quantification Market Risk ManagementEquity - guarantees Betas; VaR; CTE; stress testing hedge, ALM - Equity derivativesEquity guarantees retained by the company
Betas; VaR; CTE; stress testing hedge, ALM Equity derivatives
dynamic hedgingCommodity Notional exposures; VaR; stress testing Commodity futures & options
Foreign exchange Notional exposures; VaR; stress testing Forward rate agreements; foreign excahenge options; currency swaps; etc.
Reinvestment Cash flowprojections; scenario analysis Forward contracts
AFE References Introduction Ch. 1, History and Development of the Variable-Annuity Market (background only) Ch. 2, North American Variable Annuities (background only)
Ravindran: Variable Annuity – A Global Perspective
Ch. 5, Risks Underlying Variable Annuities Ch. 10, Overview of Commonly Used Risk Management Strategies Ch. 11, Using Product Development to Manage Risks Ch. 12, Using Reinsurance to Manage Risks
Ch 13 U i C it l M k t t M Ri k Ch. 13, Using Capital Markets to Manage Risks Ch. 14, Putting It All Together: From Dynamic to Static
Ch 10 “Emerging Cost Analysis”
Hardy: Investment Guarantees, 2003 (equity risk) Ch.9, “Risk Measures”
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CFA Institute : Black Monday and Black Swans
Ch.10, Emerging Cost Analysis Ch.11, “Forecast Uncertainty”
APPENDIX: Credit Risk ReferencesAPPENDIX: Credit Risk References2. Risk Identification
APPENDIX: Credit Risk ReferencesAPPENDIX: Credit Risk References
Credit Risk Identification Credit Risk Quantification Credit Risk ManagementC dit d S d d ti V R C ditM t i i t t t dit d f lt t t l tCredit spreads Spread duration; VaR; CreditMetrics interest rate swaps; credit default swaps; total return swapsDefault risk Credit ratings; KMV credit default swaps; structured products; Ratings; capitalCounter-party risk Credit limits credit derivatives, diversification, Recei ables defa lt probabilities concentration limits and credit s pport agreementsReceivables default probabilities concentration limits, and credit support agreements.
due diligence and aggregate counter-party exposure limits. References
Ch 4 Loans as Options: The Moody’s KMV Model Saunders: Credit Risk Management In & Out of the Financial Crisis, 2010 Ch. 4, Loans as Options: The Moody s KMV Model Ch. 5, Reduced Form Models: Kamakura’s Risk Manager Ch. 6, Other Credit Risk Models
Ch 7 A Critical Parameter: Loss Given Default Ch. 7, A Critical Parameter: Loss Given Default Ch. 8, The Credit Risk of Portfolios and Correlations Ch. 9, The VAR Approach: CreditMetrics and Other Models
Ch 10 Stress Testing Credit Models: Algorithmics Mark-to-Future Ch. 10, Stress Testing Credit Models: Algorithmics Mark-to-Future Ch. 12, Credit Derivatives Tilman: ALM of Financial Institutions - Ch. 9, Measuring and Marking Counterparty Risk CSFB Credit Portfolio Modeling Handbook – Ch 9-Risk measures: how long is a risky piece of string?
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CSFB Credit Portfolio Modeling Handbook Ch. 9 Risk measures: how long is a risky piece of string? Fridson: Financial Statement Anaysis - Ch.13, Credit Analysis
APPENDIX: Liquidity Risk ReferencesAPPENDIX: Liquidity Risk References2. Risk Identification
APPENDIX: Liquidity Risk ReferencesAPPENDIX: Liquidity Risk References
Liquidity Risk Identification Liquidity Risk Quantification Liquidity Risk Managementy y y gForced selling & Stress testing sizing of liquid versus liiliquid positionsmargin callsInability to satisfy Scenario analysis cash flow managementliabilitiesliabilitiescashflow strain liquidity ratios; scenarios; etc. diversification run on the bank surrender chargeshidden callable options contract designAFE R f G G l A i Lif C ’t P I t L k t S itAFE References Green: General American Life Can’t Pay Investors, Looks at Suitors
CIA: “Liquidity Risk Measurement,” CIA Educational Note Brunnermeier: Deciphering the Liquidity and Credit Crunch
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APPENDIX: Operational Risk ReferencesAPPENDIX: Operational Risk References2. Risk Identification
APPENDIX: Operational Risk ReferencesAPPENDIX: Operational Risk References
Operational Risk IdentificationTh i k f di t i di t l
Market Conduct (e.g., sales practices) HR i k d ti it t l t t l d tThe risk of direct or indirect loss
resulting from inadequate or failed internal processes, people, systems or from external events…
Process risk, e.g., supply chain, R&D Technology risk, e.g., reliability, external attack, internal attack Judicial risk, e.g., litigation
HR risk, e.g., productivity, talent management, employee conduct
Governance risk
Compliance risk, e.g., financial reporting Internal and External fraud Execution risk Supplier/partner risk Disaster risk, e.g., natural disaster, man-made disaster MODEL Risk
Operational Risk Quantification Economic Capital (diificult)
Operational Risk Management COSO GuidelinesS XSoX…
AFE References SoA Risk Management, Dec 2006: Operational and Reputational Risks: Essential Components of ERM
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Khan: “Why COSO Is Flawed,” Jan 2005. G30: Derivatives: Practice and Principles
Root Causes of Market Capitalization Decline Root Causes of Market Capitalization Decline decline drivers; top 20% of Fortune 1’000 (1998-2009)
THE ACTUARY2 Risk Identification2. Risk Identification
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APPENDIX: Strategic Risk ReferencesAPPENDIX: Strategic Risk References2. Risk Identification
APPENDIX: Strategic Risk ReferencesAPPENDIX: Strategic Risk ReferencesStrategic Risk IdentificationThe risk of direct or indirect adverse impact
Product sustainability riskDistribution sustainability riskp
on the operating results or value of the business unit as a result of the strategies not being optimally chosen, implemented or adapted to changing conditions
Distribution sustainability risk Consumer preferences and demographics Geopolitical risk Competitor riskE t l l ti i kor adapted to changing conditions… Legislative/Regulatory risk Reputation Risk Sovereign risk
External relations risk
Strategic Risk Quantification ERC, MCEV, RAROC, IRR, etc.
Strategic Risk Management Risk Analysis & Quantification Tables
AFE References Ch.1, The Strategic Nature of Corporate Risk Management Ch.7, Stategic Risk Analysis
Anderson - Strategic Risks Management Practice
, g y Ch.8, Strategic Risk Management – ammendents to the ERM framework Ch.9, Stategic Risk Management SoA Risk Management, Mar 2007: Strategic Planning Models
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SoA Risk Management, Mar 2008: Measuring and Managing Reputational Risk HBR: "Countering the Biggest Risk of All" by Slywotzky and Drzik, April 2005
APPENDIX: Strategic Risk ReferencesAPPENDIX: Strategic Risk References2. Risk Identification
APPENDIX: Strategic Risk ReferencesAPPENDIX: Strategic Risk References
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ERM Step #3:ERM Step #3: Risk QuantificationRisk Quantification3. Risk Quantification
key modern technique is Economic Risk Capital (ERC)
ERM Step #3: ERM Step #3: Risk Quantification…Risk Quantification…Credit riskL&H
Capital (ERC)
using VaR; CTE; etc, techniques
increasingly stochastic modeling but also c eas g y stoc ast c ode g bu a soscenarios & factors
VaR is well established for financial risks (J i t )(Jorian, etc.)
one year view sometimes difficult to apply for business with long term insurance grisks
Also use “Greeks” to quantify risk inherent in hedging platformsin hedging platforms
3. ERM Risk Quantification
SoA Risk Management, Sept 2009: Modeling Tail Behavior with Extreme Value Theory
Segal: Corporate Value of ERM - Ch.5, Risk Quantification Milliman: Economic Capital Modeling – Practical Considerations
(AFE References)
GARP: Value-at-Risk: Evolution, Deficiencies and Alternatives Shaw: Measurement and Modeling of Dependencies in Economic Capital Chapters 1-8 only
43
g , p g y(AFE References)
Hardy: A Comparative Analysis of U.S., Canadian and Solvency II Capital Adequacy Requirements in Life Insurance SoA Risk Management, Aug 2008: Summary of “Variance of the CTE Estimator”
CAS: Dynamic Financial Models of Property-Casualty Insurers
Hardy: Regulatory Capital Standards for Property and Casualty Insurers Under the U.S., Canadian and Proposed Solvency II (Standard) Formulas
Risk Quantification under Solvency IIRisk Quantification under Solvency IIPill 1Pillar 1…
Source: CEIOPS ReportsSource: CEIOPS Reports
44
Risk Quantification Risk Quantification -- Solvency II, Pillar 1Solvency II, Pillar 1l isolvency requirements…
Solvency I (EU) Solvency II
uity
Free CapitalRisk. Charge(0,3% SaR)
One Risk Factor
S l I nds SCR
Free Capital Several Risk Factors
Equ
Plain Charge(4% of Liab.)
Solvency IRequired Capital O
wn
Fun (Solvency
Capital Requir.) MCR
(Minimum
abili
ty
V l F t rov
CapitalRequir.)
FRS
Lia Volume Factor
echn
Pr
Solvency Conditions:• Equity > Required Capital
Solvency Conditions:• Own Funds > SCR => o.k.
IF Teq y q p
• Few allowance to increase equity • Own Funds < MCR => Supervisory control• Quality of Own Funds relevant (Tier 1-3)
45
Risk Quantification Risk Quantification -- Solvency II, Pillar 1Solvency II, Pillar 1h f N A V l d i h SCR
The Solvency II Economic Balance Sheet
Distribution of NAV=> Solvency Capital Requirement
change of Net Asset Value determines the SCR…
Economic Balance Sheet
n ds Net Assets Value =
Prob
=> Solvency Capital Requirement
Ow
nFu
nd Net Assets Value =Assets
minus Best Estimates Cum Prob
99 5%Risk Marg
sset
s Liabilities
NAV
= 99,5%
Est
im.L
.As NAV
NAV(1) @ 99 5%
Δ NAV
Bes
t E NAV(1) @ 99,5% NAV(0)ΔNAV =
NAV (@ balance sheet date) minus
SCR = ΔNAV @ minus
NAV (@ worst 1 year scenario)NAV @
99,5% VaR 46
Risk Quantification Risk Quantification -- Solvency II, Pillar 1Solvency II, Pillar 1
Case 1 - Pure Liability Stress
Case 2 - Pure Asset Stress
change of Net Asset Value - cases 1 & 2….
Stress
Ow
n Fu
nds
Ow
n Fu
nds
Net Assets Value O
wn
Fund
s Δ NAV
Risk Marg
ets
F
Risk Marg
Value
Δ NAV Risk Marg
ets
F
Net Assets Value
s
stim
.L.
Ass
e
Est
im.L
.
stim
.L.
Ass
e
Ass
ets
Bes
t Es
Bes
t E
Bes
t Es
t=0 t=1(Stress)
Example: Mortality Risk
t=0 t=1(Stress)
Example: Equity Market RiskExample: Mortality Risk Example: Equity Market Risk
47
Risk Quantification Risk Quantification -- GGroup ERCroup ERC
Risk category1 Group RI PI MH Div. Explanation
with diversification benefits….
Year end 2009 2010 2010 2010 2010 2010€bn
Property-casualty2 7.6 8.9 8.8 0.6 0.0 –0.5 Slightly higher exposure in natural catastrophes scenarios, weaker euro, change of external protection
Life and health 3.7 5.1 3.9 1.3 0.7 –0.8 Weaker euro (mainly affecting reinsurance portfolio) and lower interest-rates
Market 6.8 9.9 5.5 7.9 0.0 –3.5 Strong increase due to higher equity positions and increased interest-rate risk
Credit3 3.1 4.5 3.4 1.2 0.0 –0.1 Spreads still above average, lower yield curves, downgrades of counterparties
Operational risk 1.5 1.6 1.3 0.5 0.1 –0.3 Low increase due to higher exposure
Simple sum 22.7 30.0 22.9 11.5 0.8 –5.2
Diversification effect4 −5.3 –9.3 –8.1 –2.0 0.0 – Higher diversification due to increases in risk exposures
and lower tail dependencies
Total ERC 17.4 20.7 14.8 9.5 0.8 –4.4
1 Risk categories broadly based on refined "Fischer II" risk categories recommended for standardised industry disclosures.2 Credit (re)insurance included. 3 Default and migration risk.4 The measured diversification effect depends on the risk categories considered and the explicit modelling of fungibility constraints.
Market environment main driver of ERC increase
48
Risk Quantification Risk Quantification -- Market RiskMarket Risk ERCERC
Risk category Group RI PI Div. Explanation
with diversification benefits….
Year end 2009 2010 2010 2010 2010€bn
Equity 3.8 5.5 3.8 1.8 –0.1 Increase due to higher equity-backing ratio
G l i t t t 4 0 5 6 4 0 6 3 4 7 L i t t t l di t i d d ti i t hGeneral interest-rate 4.0 5.6 4.0 6.3 –4.7 Lower interest-rates leading to increased duration-mismatch
Credit spread 2.2 3.6 1.8 2.6 –0.8 Refined spread risk modelling in the MCEV
Real estate 1.8 2.0 1.1 1.0 –0.1 No material change
Currency 2 3 0 6 0 6 0 2 0 2 Refined modelling of currency risk regarding free surplusCurrency 2.3 0.6 0.6 0.2 –0.2 Refined modelling of currency risk regarding free surplus
Simple sum 14.1 17.3 11.3 11.9 –5.9Diversification –7.3 –7.4 –5.8 –4.0 –Sum ERC 6 8 9 9 5 5 7 9 –3 5
2009
Interest-rateInterest-rateEquityEquity Credit spreadCredit spreadRating classification1 %
Sum ERC 6.8 9.9 5.5 7.9 –3.5
Equity-backing ratio Net DV01 in €m Duration
–12.9
6.1
–17.6
18.8
RI
PI
20092010 Assets 2010 Liabilities2
20%
40%
60%
80%
100%<BBB & NRBBBAAA
2.84.4
incl. derivatives %
6 3
6.6
5.9
7 3
8.3
5.1
Group
PI
RI
–6.81.2Group 0%
20%
2009 2010
AAA
2009 20101 Fixed-Income portfolio.2 Based on replicating portfolio of liabilities.
Note: Asset and liability durations apply to different underlying volumes
6.3 7.3Group
49
ERM Step #4: ERM Step #4: Risk ResponseRisk ResponsePillar 2 - qualitative requirements under Solvency II…
1. Context & Governance
6 R i &
Risk monitoring
Risk reporting
2. Risk Identification
6. Review &Improvement
reso rces needed to compl ithRisk
ERM Cycle
resources needed to comply with the qualitative requirements are often underestimated!
Risk identifi-cation
Risk control
3. Risk Quantification
5. Risk some European Regulators expect that approx. 75% of the effort of a certification process will be spent on Pillar 2
Risk analysis
Quantification
4 Ri k
Monitoring, Reporting &Rewarding
Pillar 2 ...4. Risk Response
50
Risk Response Risk Response -- Solvency II, Pillar 2Solvency II, Pillar 2
Avoid not accept the risk - e.g. exit the business Reinsurance ILSCredit risk Will depend on rating of the
iCat bonds avoid credit risk to the i
the basics…
Accept accept the level of risk and take no further action to minimize it further
Transfer transfer the risk e g to a reinsurer or the capital
reinsurer issuerBasis risk None – as reinsurance is based on
company’s actual portfolioSignificant – as insurer pays own losses but receives payoff on index
Moral Hazard Primary firm may be lax in uw – reinsurer needs to align interests
Defining ILS on index controls moral hazardTransfer transfer the risk - e.g. to a reinsurer or the capital
markets (securitization)
Mitigate take action to manage risk through natural hedges or other controls
reinsurer needs to align interests hazardSize & Costs Could be done for smaller deals &
on a less costly basis.Need to be of a certain size to be economically viable. Costly.
Capacity Limited capacity Independent capacityPrice Dependency Prices may depend on market cycle Limited dependency on insurance other controls market cycle
4. Risk Response Securitization Doherty: Integrated Risk Management, Chapter 16 - Securitization ofCatastrophe Risk Tiller: Life, Health and Annuity Reinsurance, 3rd Edition., 2005, Ch. 5, “Advanced Methods of Reinsurance” Ch. 16, “Assumption” Ch. 17, “Special Purpose Reinsurance Companies”
Reinsurance(AFE References)
C , Spec a u pose e su a ce Co pa es
51
Risk Response Risk Response
Ri k M tRi k M t ALM / SAAALM / SAA TAATAA
liability driven investment process…
Risk ManagementRisk Management ALM / SAAALM / SAA TAATAA
I
Benc
Econom Investme
chmark P
mic N
eutra
Replicati
Insuranc nts
Portfolio
al Positio
ing Portfo
ce Liabili
Risk preferences
and restrictions
Risk-minimal surplus
Risk-minimal replication of
liabilities
Market timingonolios
ties
restrictions
Liability-driven investment process a priori limits market risk.
52
Risk Response Risk Response -- Solvency II, Pillar 2Solvency II, Pillar 2the system of governance
Principle oriented Solvency II framework
the system of governance
Principle oriented Solvency II framework
Management body is fit and properResponsibility of Management: business and risk strategy
Governance Requirements Transparent organizational
Risk Management System
Quantitative requirementsality
Transparent organizational structure
Clear segregation of responsibilities
written policies
Quantitative requirements Risk Management Function Contingency plans Internal modelpr
opor
tion Interna
written policies Regular review
Internal Control System
ORSA
Actuarial Functionncip
le o
f pl A
udit
te a Co t o Systeand Compliance Function
Information, documentation, reports
OutsourcingPri
p
53
Risk Response Risk Response -- Solvency II, Pillar 2Solvency II, Pillar 2
Supervisory practices (Pillar 2)
risk management & actuarial function…
Governance processes of the insurance company
comprising strategies, processes and reporting procedures
Risk Management (Art. 44) – must have an effective risk management system…
E l i
Actuarial function (Art. 48) – must have an effective actuarial function…
understanding of the stochastic nature of the business (risk, finance, ALM) and
Business organization
and reporting procedures monitor, manage and report the risks on a continuous basis.
well integrated in the organizational structure
outsourcing
Fit and
Early warning system
Risk management
of the business (risk, finance, ALM) and the use of actuarial methods (probabilities of insurance risks, statistical methods, risk mitigation, discounted cash flows etc.)
contain contingency plans
cover all material risks and inform about risk mitigating techniques
proper ofmanagement and key personalities
"Own Risk & Solvency Assessment"(ORSA)
assessment of: underwriting and investment policy; risk mitigation techniques; claims management procedures; appropriateness of methods models assumptions andq
implement an independent risk management function
for partial or internal model: a risk modelling function needed -
Actuarial function Internal controlsmethods, models, assumptions and sufficiency and quality of the data used in the calculation of technical provisions
comparison of the best estimate against experiencerisk modelling function needed
design, implementation, testing, validation, documentation and for the integration of the internal model in the risk management system (use test)!
p
actuarial function shall deliver a written report to the management with its findings and recommendations
system (use test)!
54
Risk Response Risk Response -- Solvency II, Pillar 2Solvency II, Pillar 2A 45 O Ri k & S l A (ORSA)
Continuous compliance
Art. 45 – Own Risk & Solvency Assessment (ORSA) …
p
Overall Solvency
SCR
Time horizon
Confidence level
Investors Products M&A
Business Strategy
needsRisk Profile
TP Own funds
MCRObjective 1e.g.
Reputation
Objective 2e.g. Growth
Analysts Market
Material RisksORSA
Management Actions
External factors
Insurance Market
Economic ConditionsORSA
y
MCEV Regulator RisksORSAfactors
Legal environment
Derivates/ Hedging Diversification
FDB Tax
Objective 4e.g. strong
finance
Objective 3e.g. create
value
MCEV
VBM Rating
Regulator
Risk Mitigationg g
ReinsuranceSecurization
VBM Rating
ORSA is the entirety of the processes and procedures employed to identify, assess, monitor, manage and report short and long term risks which a company faces or may face and
determine the own funds necessary to cover the overall solvency needs at all time.55
Risk Response Risk Response -- Solvency II, Pillar 2Solvency II, Pillar 2A 46 I l C l S
Companies should have in place an effective internal control system
Art. 46 – Internal Control System…
Procedures to prevent/ combat illegal activities e.g. money laundering terror Appropriate standing
Companies should have in place an effective internal control system.
laundering, terror financing, bribe
Implementation of accounting policies
Administrative and accounting procedures
Appropriate standing within the company
Compliance planCompliance function
Quality check of internal programs
Reporting of mayor compliance problems to the management
Internal Control S t
Appropriate reporting
Control environment
Control activities
System
Appropriate reporting arrangementsIC Framework
Monitoring
Information and communicationcommunication
56
ERM Step #5:ERM Step #5: Risk Reporting & RewardingRisk Reporting & Rewarding
5. Risk Monitoring, Reporting & Rewarding
Market Consistent pricing i k t @
ERM Step #5: ERM Step #5: Risk Reporting & Rewarding…Risk Reporting & Rewarding…
– risk management @ point of sale
Explicit risk capital (CoNHR) – based on ERC & frictional charges based& frictional charges based on Reg. Capital
Also values options &
Replicating Portfolio
Also values options & guarantees – optionality.
Value added can be usedValue added can be used for value based management
Various issues including:
risk-free discount rates; liquidity premiumg
57
stability of results; etc.
ERM Step #5:ERM Step #5: Risk Reporting & RewardingRisk Reporting & Rewarding
5. Risk Monitoring, Reporting & Rewarding
ERM Step #5: ERM Step #5: Risk Reporting & Rewarding…Risk Reporting & Rewarding… Stern Stewart: "EVA and Strategy” - Babbel: "Fair Value – Financial Economics Perspective”, NAAJ
5. Risk Reporting & Rewarding
Economic Measures
AAA: "Fair Valuation of Insurance Liabilities: Principles and Methods,” Monograph Towers: A Principles-Based Reserves and Capital Standard CFO Forum: Market Consistent Embedded Value Principles CRO Forum: A Market Cost of Capital Approach to Market Value Margins
g(AFE References)
CRO Forum: A Market Cost of Capital Approach to Market Value Margins Herget: Insurance Industry Mergers & Acquisitions Ch.4, Valuation Techniques Fridson: Financial Statement Anaysis Ch.1, The Adversarial Nature of Financial Reporting
Ch 2 The Balance Sheet
Accounting Measures
Ch.2, The Balance Sheet Ch.3, The Income Statement Ch.4, The Statement of Cash Flows Tilman: ALM of Financial Institutions - Ch. 24, Accounting Standards & Requirements
58
Risk ReportingRisk Reporting5. Risk Monitoring, Reporting & Rewarding
economic solvency ratios….
59
Regulations shaping risk managementRegulations shaping risk managementIFRS MCEV & S l II i b i ?
5. Risk Monitoring, Reporting & Rewarding
Current IFRS MCEV Solvency II
IFRS, MCEV & Solvency II – convergence to economic basis?
b. V
alue
AN
W
Ow
n Fu
nds
CoCets
Emb
CoCPV
FP
Risk Marget
s
O F
CoC
m. L
.
Ass
e C Marg
m. L
.
Ass
e
est E
stim
est E
stim
• Liability incl. implicitmargin (PAD)
• CoC = Explicit risk margin • Risk Margin ≈ CoC (same method ≠ parameter)
Be
Be
margin (PAD)• No gain at inception• Lock in
• Gain at inception (VANB)• Current estimates
(same method ≠ parameter)• Gain at inception • Current estimates
60
ERM Step #5: ERM Step #5: Risk Reporting & Rewarding…Risk Reporting & Rewarding…Solvency II impacts in selected Asian countries
5. Risk Monitoring, Reporting & Rewarding
Solvency II impacts in selected Asian countries…
other Asia specific issues:
subsidiaries of European companies will also have to comply with Solvency II – Group issues
many regulators in Asia are following Solvency II closely (see below)
reserving & capital requirements under Solvency II will increase for Par blocks & decrease for non-par blocks.
ERM in Asia will evolve over time – need platform of sound pricing & valuation processes.
Country Regulator Rules/Principles Reserves Mortality Required CapitalIndia IRDA Principles GP valuation BE + PAD Solv I (2 factor)
Singapore MAS Principles GP valuation BE +PAD RBC (5 factor)
Malaysia Bank Negara Principles GP valuation BE +PAD RBC (5 factor)
China CIRC Rules 1 yr FPT or Zillmer presecribed Solv I (2 factor)
HK OCI Rules NP valuation BE + PAD Solv I (2 factor)
Taiwan Insurance Bureau Rules FPT presecribed Solv I (2 factor)
Korea FSS Rules NP valuation presecribed Solv I (2 factor)
61
Korea FSS Rules NP valuation presecribed Solv I (2 factor)
Japan FSA Rules NP valuation presecribed RBC (5 factor)
The Evolution of ERMThe Evolution of ERM –– Complexity Science? Complexity Science? ERM U li h l i f i kERM: Unraveling the complexity of risk
62
nce
Com
pany
© 2
009
Mun
ich
Rei
nsur
ansi
cher
ungs
-Ges
ells
chaf
t ©20
09 M
ünch
ener
Rüc
kver
s©
2
THANK YOU VERY MUCH FOR YOUR ATTENTION
Gavin R. Maistry, FSA, FSAS, CERA, CFAChief Actuary, Life [email protected]
63
g y@
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