Linking Risk & Return under Solvency 2Christopher ChappellAssociation of Financial MutualsLondon, February 2013

AgendaTopic Issue

ORSA & ERM Context

Linking business strategy and risk strategy

How practically can I use them interactively?

Performance measurement Lots of performance metrics, so how do I make decisions?

Risk appetite How do I generate risk appetite statements?

Operationalising risk appetite How do I set risk limits / budgets?

Strategic risk managementWhich risks do we want to take and why?

How much risk do we want to take?

Business strategyWhat are our competitive advantages? Are we generating value for our

members?

Emerging risk mgtWhat are the threats &

opportunities to our business? Are events

likely to invalidate our model? What is the plan to manage threats? What

are the triggers?

Solvency & capital management

How much capital do we need to hold in each

entity? How do we manage risk-taking?

Risk & capital modelsWhat risks do we face?

What is the range of potential impacts?How do our risks

interact?

Strategicplanning

Products & pricing

Governance & controls

Performance mgt

Capital mgt Reporting

Strategic Approach

Enterprise risk and capital

management framework

Embedded through business

processes

Culture How do we behave in managing our business?

Linking Risk & Return

Linking the risk strategy and the business strategy

Articulate the business model

The business model Outlines what the business does, and How it makes money doing it

Helps stakeholders to Understand where the return is expected to come from, and The sort of risks the business is expected to take.

LONG TERM PROFITABILITY

OF FIRM

/-COMPETI TI VE ADVANTAGE

OF FI RM I N THATSECTOR

PROFI T POTENTI ALOF I NDUSTRY

orMARKET

SEGMENT

+=

Qualitative risk strategy/risk appetite statements

Overarching principles:• We do not wish to take unrewarded risks• We do not want to take risks that are not consistent with the delivery of our

strategy as an insurer.• We will take on risks dependent on the expected return exceeding the cost of

capital • We will charge a price for accepting risk that seeks to optimise our risk/reward

profile and that fully reflects the cost of taking that risk

By risk category - market risk: The Group has no appetite for market risk exposures except where exposures

arise as a consequence of core strategic activity (principally as a consequence of exposure of revenue streams to market risks). Business units are expected to limit market risk exposures by matching the

features of liabilities to features of assets. Exposures may be incurred where there is an overriding business need and

specific appetites will be established as necessary.

Example evidencing challengeBusiness strategy Implications for Risk

and ReturnValidating strategic alignment

……We have appetite for taking [xxxx] risk as we believe that we can achieve [return] on this risk

We do not want to take [xxxxx] risk as we believe the upside to be limited.

Questions as to how strategies align or may appear mis-aligned

Linking Risk & Return

Establishing performance measures and risk appetite statements

Context of risk and returnRe

turn

RiskTarget risk appetite

Target return

Impact of balancing multiple appetite statements. Zone bounded by target tolerances controlled by limits

Risk-adjusted ‘primary’ performance measures

Risk-Adjusted Return on Lifetime Economic Capital (RARLEC)• RARLEC is a measure of

how much value is generated for members relative to the risks being taken on

• Simple way of ranking products when making capital allocation decisions

• EVNB/PV(ECap)

• Economic value of new business (EVNB) is the EVC at point of sale of a policy

Economic Value Creation (EVC)

• EVC is a measure of value created less the explicit cost of holding the required economic capital

• Cost of capital used is not the same for all products / projects

• Capital allocated reflects diversification benefits

• If EVC is greater than zero, value has been generated for members

Franchise value

= Net assets

+ Present value of potential transfers to members from in-force business

+ Goodwill for new business member value-add capability

Other metrics(constraints)

Payback period Distributable cash

New business strain IFRS profit

Solvency II profit …….

Common risk appetite dimensions

Dimensions

Capital

Earnings

Liquidity

Franchise value

Brand & reputation

Definitions

Buffer above regulatory diversified Solvency Capital Requirement (SCR) in a 1-in-10 event

Pre-defined 1-in-10 event results in, at worst, zero Group operating profit

Coverage of liquid assets over net cash flows in a 1-in-10 shock event

Reflection of how our brand is perceived by our major stakeholders, e.g. customers, employees & regulator

1

2

3

4

Operational & capability

Tracking events that could occur and result in operationally being unable to deliver the strategic plan

BAU cash flows

In a stressed scenario

Ability to meet BAU cash outflows on a day-to-day basis

Linking Risk & Return

Operationalising risk appetite

Risk category Regulatory capital requirement

Economic Capital target (140% coverage)

Amber trigger level(170% coverage)

Total 1000 1400 (=1000 * 1.4) 824 (=1400 / 1.7)Financial 500 700 412- Equity 100 140 83- Interest rate 400 560 329Business 300 420 246Operational 200 280 165

• The target capital level has been established at 140% of the SCR• Amber trigger level established at the capital position of being able to cover 170% SCR.

RAG for each risk proportionately allocated from central target

SCR multiples are implied solvency levels and therefore risk capital limits are inverted

Then refine to assess how RAG statuses should change to reflect earnings risk appetite and risk strategy output

Limits move over year in line with plan numbers

Setting risk limits using risk appetite

Risk category Regulatory capital requirement

Economic Capital target (140% coverage)

Amber trigger level(170% coverage)

Total 1000 1400 (=1000 * 1.4) 824 (=1400 / 1.7)Financial 500 700 412- Equity 100 140 83- Interest rate 400 560 329Business 300 420 246Operational 200 280 165

• The target capital level has been established at 140% of the SCR• Amber trigger level established at the capital position of being able to cover 170% SCR.

Setting risk limits using risk appetite

Risk category Marginal contribution (base)

Marginal contribution (scenario)

Total 45% 48%

Financial 75% 80%- Equity 60% 62%- Interest rate 45% 50%

Business 25% 24%

Operational 60% 63%

Scenario: business operating at the upper red limit for particular risk type

Scenario tests whether limits reasonably protect diversification benefit

Linking Risk & Return

Summary

Summary : linking risk and reward under Solvency 2

Performance metrics have explicit allowance for risk that is appropriately costed This means creating value greater than zero is creating value for shareholders Define primary metrics and identify other metrics that act as constraints

Risk appetite is multi-dimensional It focuses on what the Board is concerned about in running the business

Derived from stakeholder expectations Capital risk appetite and risk limits link together

Limits set to preserve benefit of diversification Economic (risk) capital is allocated appropriately to those products that

create the risk exposure Ensures products are charged appropriately for capital usage Projections of the risk profile are appropriate as business mix and volume

change Ensures the assessment of return from taking risk is appropriately allocated to

products to ensure we grow the right parts of the business

Questions and comments?

Christopher Chappell

E-mail: cichappell@live.com