Download - Linking Risk & R eturn under Solvency 2
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