individual capital assessment david king 8 th september 2004 # !@
TRANSCRIPT
Individual Capital Assessment
David King
8th September 2004
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Contents
• Regulatory Requirements: Pillar 1 vs Pillar 2
• ICA: Implementation Progress
• ICA: Assumptions
• ICA: Implications
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Regulatory Requirements:
Pillar 1 vs Pillar 2
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Pillar 1 vs Pillar 2 Capital Requirements
Admissible assets
Mathematical reserves
Regulatory Peak
Resilience Capital
Requirement
Long-term Insurance
Capital Requirement
WPICC
Regulatory Surplus
Realistic Value
Liabilities
Realistic Surplus
Market Value Assets
Market (Fair) Value
Liabilities
ICA
Realistic Peak
Pillar 1 Pillar 2
Realistic Value Assets
Risk Capital Margin
• WPICC is set so that regulatory surplus equals realistic surplus if the former is higher; zero otherwise• If realistic assets equal admissible assets, WPICC is the amount of capital to bring the regulatory peak up to the realistic level
Pillar 2 Surplus
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Risks Covered: Peak 1 vs Peak 2 vs ICA
Peak 1
(LTICR + RCR + WPICC)ICA Peak 2 (RCM)
Market Risk
Credit Risk
Insurance Risk
Mortality
Persistency
Expenses
Operational Risk
Liquidity Risk
Group Risk Group Risk
Liquidity Risk
Operational Risk
Insurance Risk
Credit Risk
Market Risk
Group Risk
Liquidity Risk
Operational Risk
Insurance Risk
Mortality
Persistency
Expenses
Credit Risk
Market Risk
Mortality
Persistency
Expenses
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Capital Requirement Rules: Peak 1R
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Risk Category Assets Liabilities
Market Risk
Equity
Property
Fixed Interest
10-25% fall depending on:
- Current to 90-day average FTSE All Share level
- Earnings yield of FTSE All Share after fall equal to 4/3rds long-term gilt yield
10-20% fall depending on:
- Current to 3 -year average real estate index level
20% rise or fall in long-term gilt yield
Divided yield assumed unchanged
Earnings yield assumed to fall by 10%
Running yield assumed to fall by 10%
20% rise or fall in long-term gilt yield
Market Risk - 3% mathematical reserves where firm bears some investment risk, reduced by up to 15% for reinsurance
Insurance Risk
Expense - 1% mathematical reserves where firm bears some investment risk, reduced by up to 15% for reinsurance
25% previous year’s net administration expenses where firm bears no investment risk
Mortality - 0.3% aggregate capital at risk reduced by up to 50% for reinsurance
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Capital Requirement Rules: Peak 2
Risk Category Assets and asset share*
* Taking into account management and p/h actions
Value of contractual guarantees
Market Risk
Equity 10-20% rise or fall depending on:
- Current to 90-day average FTSE All share level
Dividend yield assumed unchanged
Earnings yield assumed unchanged
Property 12.5% rise or fall Running yield assumed unchanged
Fixed Interest 17.5% rise or fall in long-term gilt yield 17.5% rise or fall in long-term gilt yield
Value of In-Force for non-profit contracts
Outside with-profit fund: unchanged
Inside with-profit fund: stress tested
Unchanged
Credit Risk Credit spreads increased by:
(Spread Factor) x sq rt (Current Spread in Basis Points)
where: Rating Spread Factor AAA 3.0 AA 5.25 A 6.75 BBB 9.25
Risk free yields assumed unchanged
Insurance Risk
Persistency Risk
For with-profit contracts, 35% increase or decrease in realistic lapse, surrender and PUP assumptions, excluding at policy guarantee dates
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Calculation of Capital Resource Requirements (CRR)
• PRU 2.1.35 defines a firm’s CRR to be:
Resilience Capital Requirement
+ Long-Term Insurance Capital Requirement
+ With-Profit Insurance Capital Component
• FSA will issue Individual Capital Guidance (FSA’s view of appropriate capital resources for a firm), based on the firm’s ICA
• To compare ICA with CRR, adjustment is needed for any differences in valuing assets and liabilities under Pillar 2. Possible approach:
Adjusted ICA = ICA – Max (0, Realistic Value Reserves – Market Value Liabilities)
– (Market Value Assets – Realistic Value Assets)
• Additional capital required as a result of ICA is
Max (0, Adjusted ICA – CRR)
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ICA: Implementation Progress
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Typical ICA Methodologies: end 2004
Overall approach • Time zero stress tests or projection to run off
Market Risk • Proprietary Economic Scenario Generator (ESG) used to inform stress tests
Credit Risk • Modelled by ESG
• Assets assumed held to maturity to capture liquidity risk premium
Insurance Risk • Stress tests for mortality, longevity, persistency and expenses
• A few companies are investigating stochastic mortality for annuities
Operational Risk • Characterised by lack of data
• Reluctant to build models without data
• Broad metrics used (eg x% assets)
Liquidity Risk • Mitigated by contingency funding arrangements (if necessary) rather than capital
Group Risk • Contagion risk from other group companies depends on group structure
• Closure to new business from contagion likely to reduce capital
Aggregation Approach • Market and credit risk use correlations implied by ESG
• Correlation matrix assumed for the other risks (assumes Normal distribution)
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Methodology enhancements for 2005?
Overall approach • Projected Realistic Balance Sheets modelled
• Run off projections with intermediate solvency testing
Market Risk • Development of in-house ESG expertise; own calibration
Credit Risk • More sophisticated approach to credit risk modelling
Insurance Risk • Stochastic mortality models developed for annuities
• Dynamic linking of persistency and market risk
Operational Risk • Since this is a material component of ICAs, companies develop stochastic models of risks and controls
Liquidity Risk • None
Group Risk • Deeper consideration of contagion risk
Aggregation Approach • Since this has a material impact on capital requirements, development of more sophisticated approaches
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Current Implementation Issues
Overall approach • Projected one-year RBS vs run-off projections
• Determination of additional Pillar 1 capital requirement from ICA
• Assumptions for recalculating ICA after a market fall
Market Risk • Calibration of ESG to produce “real world” scenarios that reflect historic data
Credit Risk • Identifying the liquidity risk premium component of corporate bond credit spreads
• Allowing for credit risk in inter-group reinsurance arrangements
• Managing credit risk concentration risk with reinsurance arrangements
Insurance Risk • Allowance for longevity improvements
Operational Risk • Treatment of final salary pension schemes
• Data to support risk capital calculations
Liquidity Risk
Group Risk • Allowance for capital support from other group companies
• Treatment of ICA for overseas subsidiaries
Aggregation Approach
• Understanding sensitivity of correlation assumptions
• Justification of partial correlations, especially in extreme scenarios
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ICA: Assumptions
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Typical ICA Stress Tests vs RCM
RCM Typical ICA Stress Tests
Market Risk
Equity
Property
Fixed Interest
Yields
-
-
+/- 0.9%
Value
+/- 10%
+/- 12.5%
+/- 6.5% *
Yields
-
-
-1.0%
Value
-40%
-25%
-7.5%
Credit Risk Change in credit spread
Change in market value*
Companies are mainly considering changes in market value for the portfolio; typically this is a fall of around 10%
AAA 21 -10.6%
AA 44 -3.3%
A 68 -5.1%
BBB 113 -8.3%
Insurance Risk
Mortality +20%
Persistency +/-35% +/-50%
Expenses +10% and increase in expense inflation
* Based on 10-year gilts
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Typical Correlation Assumptions
Correlations
Market Credit Insurance Operational Liquidity Group
EquityFixed
interest Property Mortality Persistency Expenses
Equity 1.00 0.00 0.30 0.65 0.00 0.50 0.65 0.50 0.25 0.25
Fixed interest 1.00 0.30 0.65 0.00 0.50 0.50 0.50 0.25 0.25
Property 1.00 0.65 0.00 0.50 0.65 0.50 0.25 0.25
Credit 1.00 0.00 0.40 0.65 0.20 0.10 0.25
Mortality 1.00 0.00 0.00 0.30 0.10 0.10
Persistency 1.00 0.40 0.40 0.25 0.40
Expenses 1.00 0.50 0.25 0.10
Operational 1.0 0.10 0.25
Liquidity 1.00 0.10
Group 1.00
Typically, companies are reporting diversification benefits of around 25-30%
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ICA: Implications
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Shareholder Value Implications of ICA
Product Development
• Price new business using ICA (large impact on annuities and products with guarantees)
• Redefine commission structures
Reduce Risk-Based Capital
• Better matching to reduce market risk
• De-risking with-profit funds (lower EBR, charging for guarantee costs, hedging)
Reinsurance Arrangements
• Manage credit risk exposure
• Review efficiency of existing reinsurance arrangements
Group Structure • Revise group structure to optimise capital position
• Consider combining operating companies
Portfolio Mix • Buy and sell portfolios of business to maximise diversification benefits
Performance Management
• Align performance measures to Risk-Based Capital
• Reward management according to these measures
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Top Ten Management Actions From ICA
1. Ensure the firm’s ICA calculation is consistent with its risk policies
2. Collect and analyse company/market data to justify volatilities and correlations
3. Build management information systems to understand risk exposures
4. Understand key drivers of ICA and develop mitigations to reduce capital requirements
5. Develop analysis of change in ICA over the period
6. Take ownership of calibration of the ESG
7. External review of ICA to negotiate Pillar 1 waivers
8. Develop management information to ensure ICA known at all times
9. Price new business to reflect ICA capital costs
10. Manage business on the basis of risk based capital