Download - Managing Capital Volatility
2nd Senior Actuary Investment & Risk Symposium
Managing Capital Volatility
Gaston Nossiter FIAA, MBA, CFA
Senior Vice President
Business Development
Global Financial Solutions
27 March 2012
Capital
What Capital?
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Capital Dimension
Regimes Comment
Statutory •Solvency I / II, U.S. stat., local solvency, etc.
•Slow convergence led by S.II
•Liquidity premium & discount rates
Economic •Company specific RBC model
•Used for decision making
•Most detailed RBC model
•May be used in statutory capital as internal model
Rating Agencies •S&P, Moody’s, AM Best, Fitch •The other RBC model…
Accounting •IFRS phase 1 / phase 2, US GAAP, local GAAP
•It’s broken – where to go from here? EV, EEV, MCEV, …
•P&L is important though
Market •Relative to local / global peers •Position in the cycle
•M&A currency
Volatility – VIX
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What Volatility?
Chicago Board of Trade S&P500 Volatility Index
Interest Rates – USD 10 Year Treasury
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Historical Low
Increasing HKD Capital Pressure
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USD HKD Interest Rate Differential
VIF as a Source of Capital
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Available Economic Capital => VIF
Source: Allianz Market Consistent Embedded Value Report 2008 & Allianz Market Consistent Embedded Value Report 2010
� Options to Manage VIF
� Full Monetisation
� Partial Monetisation
� Contingent Monetisation
Managing VIF Volatility
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Market Value of Assets
Best Best Best Best Estimate Estimate Estimate Estimate LiabilityLiabilityLiabilityLiability
Risk MarginRisk MarginRisk MarginRisk Margin
Solvency Solvency Solvency Solvency Capital Capital Capital Capital
RequirementRequirementRequirementRequirement(SCR)(SCR)(SCR)(SCR)
SurplusSurplusSurplusSurplus
� Monetization of expected future profits on the in-force portfolio with a release of some regulatory required capital
� Effectively selling the block of business for a fixed price
� Conceptually equity tranche
� Volatility of the VIF completely removed
� Maximize certainty, full future value realized today
Full Monetization
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Full Risk ReinsurancePolicyholder
Premium
Reinsurer
Upfront
payment
Premiums
Claims +
commissions
Insurer
Claims
payment
� Monetization of expected future profits on the in-force portfolio
� “Value in Force”
� Can be cashless or cash funded
� Allows release of some regulatory required capital
� Acts like debt, as excess profits get returned to the insurer.
� Creating a low risk (i.e. high probability of repayment) tranche allows access to debt-like cost funds
� Only available for a subset of the VIF
� Upside volatile but have locked in valuable floor
� Which can be recognized as regulatory capital
Partial Monetization
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Surplus Relief / VIF Financing
Policyholder
Premium
Reinsurer
Upfront
payment
Premiums
Claims +
commissions
Insurer
Claims
payment
Profit
share
� Provide Line of Credit / Capital Facility to meet future capital needs
� Flexible and efficient source of “just in time” capital
� Can be done well in advance of potential need
� Reinsurer analyses, prices and reinsures a small quota share of a larger block
� Reinsurer regularly reports current pricing terms and remaining capital / embedded value available in the block
� Terms and documentation already negotiated and in place
� Quota share can then be increased in future to raise additional levels of capital
� Can be done quickly and quietly, with minimal effort
� Provides certainty of financing size and cost in advance of need
� Monetises an otherwise intangible asset – the embedded value
Contingent Capital
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“Just in Time” Capital
� Solvency Margin management
� M&A financing
� Finance New Product Launch / Market Entry
� Finance other business initiatives
“Just in time” Capital
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Provides Line of Credit / Capital Facility that can be used for:
� HK reserving basis can create volatility even for a perfectly ALM matched portfolio
� Volatility is amplified when the portfolio is mismatched
� Statutory volatility impacts:� Amount of capital to be held
� Ability to pay dividends
� Ability to write new business
Economic vs Statutory Capital
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Hong Kong Statutory Basis
� “We are in a situation now in our society where the temptations to
provide “bad” financial reporting are probably greater than they used
to be. The need to get the stock price up, or to keep it up, is intense.”
Floyd Norris, Reporter
2001 Annual Report of the Financial Accounting Foundation
� “Reported earnings follow the rules and principles of accounting. The
results do not always create measures consistent with underlying
economics. However, corporate management’s performance is
generally measured by accounting income, not underlying
economics. Therefore, risk management strategies are directed at
accounting rather than economic performance”
Enron in-house risk management handbook
Economic vs. Statutory Capital
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Temptation to Manage to Non-Economic Measures
� Lobby regulator for change
� Raise additional capital
� Reinsure the liabilities
Managing Statutory Capital
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Options
Raise Additional Capital: A Comparison
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Benefit Reinsurance Debt Hybrid Debt Equity Securitization
R isk Transfer:
Cove rs losses above capital prov ided Yes No No No No
Comfortable with insurance risks Very No No Som ew hat Som ew hat
T arge te d at specific risks C an be No No No C an be
Acce ss to e xpe rtise Yes No No No Maybe
Financials:
Re duces require d RB C Yes No No No No
Re duces require d rating age ncy capital Yes (for full-risk) No Maybe No Maybe
T reated as T ie r 1 C apital Yes No Maybe Yes Maybe
Dilutiv e No No No Yes No
Financial lev e rage impact D ecrease Increase Increase Decrease D epends
Incre ase s total capital Yes Yes Yes Yes Yes
M ay cause a nee d to realize losses Yes No No No No
Incre ase s solv ency ratio Yes No Som ew hat Som ew hat D epends
S tructure:
Spe cial-purpose e ntity nee ded No No No No Yes
Cre dit enhance me nt / recourse nee ded Maybe No No No Maybe
Liquidity D epends Yes Yes Yes D epends
T ax e fficiency Partial to full Partial to full Partial to full None Full
Introduces counte rparty risk Yes No No No No
Cash or “cashle ss” Yes No No No Yes
V alue and C osts:
Fle xibility Yes Som e Som e No No
M aximum tenor Long Short-Medium Short-Medium Long Medium
M aximum size Medium to large Very large Very large Very large Very large
M inimum size Sm all to m edium Large Large Large Medium to large
M arke t status O pen O pen O pen O pen O pening
Rapid imple mentation O ften No No No No
Confide ntiality Yes (except Sch S) O nly if private No No No
Re strictions on manageme nt actions Maybe Maybe Maybe No Maybe
Administration and syste ms change s Maybe No No No Maybe
Low transaction costs Yes No No No No
O ve rall cost Low -Medium Low Medium High Low -Medium
Amount of legal documentation Low Medium Medium Medium High
� Raising additional capital provides a buffer but:
� Doesn’t address underlying cause of the volatility;
� Ties up capital that could be deployed elsewhere; and
� Depresses return on capital
� Coinsurance Funds Withheld� Allows insurer to:
� Convert the liability into an alternative basis;
� Retain control over the assets; and
� Redeploy excess capital
Reinsure the Liabilities
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One Idea: Coinsurance with Funds Withheld
Coinsurance Funds Withheld
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How does it work?
� Hong Kong Statutory reserve for the covered products would be coinsured to Reinsurer. That is, Insurer would pay the HK statutory reserves to Reinsurer on day one.
� Reinsurer would pay to Insurer two amounts:
� Funds Withheld (FWH) reserve equal to insurers GAAP reserves (which is
calculated on any basis); plus
� An initial ceding commission equal to the difference between the HK statutory
reserves and the FWH reserves is paid to Insurer
INSURER Reinsurer
HK Statutory Reserves
FWH = GAAP reserves
Initial Ceding Commission
Coinsurance Funds Withheld
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How does it work?
� On an on-going basis the following cashflows occur:
� Insurer would pay to Reinsurer:
� Gross premiums
� Investment Income on the FWH
� Any decrease in the FWH reserve
� Reinsurer would pay to Insurer:
� All benefits,
� An allowance to cover maintenance expenses,
� Any increase in the FWH reserve,
� Any experience refund
Coinsurance Funds Withheld
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Illustration
Year 2010 2011 2012 2013 2014
Before ReinsuranceINCOME STATEMENT
Total Net Premium Income 3,879,476 3,671,030 3,475,853 3,295,762
Investment Income 1,515,837 1,635,709 1,746,295 1,847,514
Total Income 5,395,313 5,306,740 5,222,147 5,143,276
Total Benefits 1,256,804 1,354,585 1,452,097 1,546,923
Total Increase in Reserves 2,474,410 2,297,851 2,104,892 1,923,256
Total Commission and Expenses 426,872 362,063 322,539 293,082
Reinsurance Cost 37,028 34,996 33,144 31,435
Cash Dividend 187,618 197,685 207,349 214,923
Total Benefits and Expenses 4,382,732 4,247,180 4,120,022 4,009,618
Income/(Loss) before Tax and Capital G/(L) 1,012,581 1,059,560 1,102,126 1,133,658
BALANCE SHEET
Investment Assets at End of Year 29,259,360 32,746,351 36,103,762 39,310,780 42,367,694
Reserves at End of Year 29,259,360 31,733,770 34,031,621 36,136,513 38,059,769
Surplus at End of Year - 1,012,581 2,072,141 3,174,266 4,307,925
Coinsurance Funds Withheld
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After ReinsuranceINCOME STATEMENT
Total Net Premium Income 3,879,476 3,671,030 3,475,853 3,295,762
Ceded Reinsurance Premium to RGA 29,259,360 3,879,476 3,671,030 3,475,853 3,295,762
Total Net Premium Income (29,259,360) 0 0 0 0
Investment Income 1,515,837 1,635,709 1,746,295 1,847,514
Interest Paid on Account Payable (FWH) 1,101,343 1,213,517 1,319,129 1,418,548
Total Benefits / Reinsurance Cost / Dividends 1,481,450 1,587,265 1,692,590 1,793,280
Reinsurance Recoveries 1,481,450 1,587,265 1,692,590 1,793,280
Total Net Benefits 0 0 0 0
Total Commission and Expenses 426,872 362,063 322,539 293,082
Reinsurance Allowance Received 8,222,285 426,872 362,063 322,539 293,082
Total Net Commission and Expenses (8,222,285) 0 0 0 0
Increase of Direct Reserve 2,474,410 2,297,851 2,104,892 1,923,256
Increase of Ceded Reserve 29,259,360 2,474,410 2,297,851 2,104,892 1,923,256
Total Increase of Reserve (29,259,360) 0 0 0 0
Experience Refund Received 0 3,072,497 2,935,219 2,779,852 2,627,948
Income/(Loss) before Tax and Capital G/(L) 8,222,285 3,486,991 3,357,411 3,207,018 3,056,914
BALANCE SHEET
Investment Assets at End of Year 29,259,360 32,746,351 36,103,762 39,310,780 42,367,694
Reserve at End of Year - - - - -
Gross Reserve at End of Year 29,259,360 31,733,770 34,031,621 36,136,513 38,059,769
Ceded Reserve at End of Year 29,259,360 31,733,770 34,031,621 36,136,513 38,059,769
Account Payable (FWH) at End of Year 21,037,075 21,037,075 21,037,075 21,037,075 21,037,075
Surplus 8,222,285 11,709,276 15,066,687 18,273,705 21,330,619
� Reduced Capital Volatility
� Insurer is holding the FWH (GAAP) reserve which tends to be more stable –
reducing volatility of Insurer’s Solvency Margin
� Counterparty Protection
� FWH structure means that the assets remain with Insurer. This provides Insurer
protection against Reinsurer’s default. It also allows Insurer to continue pursuing
preferred investment strategy, as assets do not need to be transferred and
Insurer can maintain its investment approach.
� Risk Transfer� RGA’s risk is that the FWH (GAAP) reserves held on behalf of RGA are
insufficient to meet future benefit payments
Coinsurance Funds Withheld
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Rationale
Conclusions
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Volatility Remains
Thank you for your attention.
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