individual capital assessment (ica) in an international company: issues and challenges

© Aviva plcSlide 1

Individual Capital Assessment (ICA) in

an international company: Issues and

Challenges17th October 2006

Coomaren P. Vencatasawmy

Risk & Economic Capital Development

[email protected]

© Aviva plcSlide 2

Agenda

• A short history of Aviva

• Insurance regulation in the UK

• Economic Capital Modelling

1. Aviva’s approach

2. Operational challenges

3. Technical Challenges

4. Business uses of Economic Capital

5. Future developments & Solvency II

© Aviva plcSlide 3

Aviva Plc

UK

France

Netherlands

Ireland

Italy

Poland

Spain

Other

International

World’s 6th largest insurance group

Largest Insurance services in the UKProfit of £2.5 billion

Main activities:Long-term savings (PVNBP £24.6 billion)

Fund management (AUM £317 billion)

General insurance(NWP £10.3 billion) Present in over 25 countries across

Europe, North America, Asia & Australia

© Aviva plcSlide 4

Insurance regulation in the UK• January 1998 - Responsibility for prudential supervision of insurance

companies transferred from the Department for Trade and Industry (DTI) to

HM Treasury

• January 1999 - HM Treasury’s role as prudential insurance regulator

delegated to FSA from this date.

• January 1999 – Equitable life launched court proceedings in order to gain

approval for bonus cuts

• December 2000 – Equitable closed for new business. The Treasury

announces a probe of the FSA failure to protect policy holders.

• August 2001 – Lord Penrose heads the enquiry on the downfall of the

insurer.

• December 2001 - Financial Services & Markets Act 2000 came into force,

making the FSA the single regulator for financial services in the UK.

© Aviva plcSlide 5

Insurance regulation in the UK

• July 2003 - Enhanced capital requirements and individual capital

assessments for non-life insurers (CP 190)

• August 2003 - Enhanced capital requirements and individual capital

assessment for life insurers (CP 195)

• March 2004 - The Penrose report on the equitable is published

• June 2004 - Integrated Prudential sourcebook for insurers (PS 04/16).

Introduced the economic realism into the revised prudential regime for with-

profits life insurers and the ICAS regime for all insurers [ in force 31st

December 2004]

• September 2006 - Prudential Changes for Insurers (CP06/16). Extension of

the realistic balance sheet regime to non-profit life insurers [In force 31st

December 2006?]

• Solvency II 2007?

© Aviva plcSlide 6

Economic Capital Modelling

• Model 1: Individual Capital Assessment (ICA)

- Supports FSA economic capital submissions

- Largely stress and scenario based

- Fourth iteration this year

- Twice submitted to the FSA

- Part of the ICG process of the FSA

• Model 2: Risk Based Capital (RBC)

- Largely based on stochastic Monte Carlo simulation

- Just completed its first group aggregation

- Parts have been used to calibrate ICA for 2 years

The alternative models are complementary and both are subject to continual enhancement

Both are based on an economic balance sheet view of our business

Presentation Title Slide 7 04/20/23 © Aviva plc© Aviva plcSlide 7

•All key Business Units are within scope of modelling•All major risk types are considered including financial, insurance and operational risk

Aviva Level 3

Aviva Risk ModelAviva Risk Model

© Aviva plcSlide 8

Agg

rega

te

ICA = 1 number for each business unit, given all of the risks considered

BU ICA’s converted into Group ICA using similar approach

Feedback loop:

• Identify most important risks

• Match against appetite, given rewards available for bearing risk

• Input to decisions on acceptance, management and mitigation of risks

Filter risks for which capital is an

appropriate response

Probability

Significant

Critical

Catastrophic

Impa

ct

Extremely remote

Remote Possible Likely to happen

45.

43.

39.

14.

40.

13.

12.

18.

7.

24.

9.

27.

3.

2.

15. 23.

54.

10.

19.

6.

16.

Acceptable risk

28.

37.

31.

29

53.

50.

33.

35.

26.

48

46.

47.

56. 52.

22.

38.

44.

36.

42.

41.

21.

49. 34.

Unacceptable risk

Adequate mitigating actions

“Red” Risks are unacceptable risks due to:• insufficient mitigating action plans; and/or• action plans do not reduce the risk quicklyenough.

KEY:

“Volatile” Risks are Green or Amber risks where:• the risk is volatile so could increase rapidly (including due to external constraints); however• existing mitigating actions are appropriate but will need to be reassessed frequently

25.

20.

Volatile Risks

55.

“Amber” Risks are unacceptable but have future mitigating action plans that:• reduce the risk sufficiently; and• reduce the risk quickly enough

“Green” Risks:• sufficient controls are in place; and • the risk is within acceptable tolerance levels.

8.

11.

51.

17.

Example Risk Map

Stress test each risk calibrated to 1:200 using stochastic models where available e.g. ESG & RBC

Risk-by-risk assessment of:

• 3 point likelihood of event happening – optimistic, best estimate and worst case

• Estimate cost if it does happen at each of these 3 levels

• Model results to estimate 1:200 year Operational Risk loss

Specific ICA Stress & Scenario Tests

Market

Liquidity

Credit

Insurance

Group

Operational

Allows for diversification, so that ICA is less than the sum of the individual tests

ICA - modelling approach

© Aviva plcSlide 9

ICA – Main stress tests

UK Businesses European Businesses

Tests Up Down Up Down

Equity 68% 40% 68% 40%

Property 51% 33% 31% 24%

Actual 5 year Interest Rate is: 6.5% 3.0% 4.8% 2.3%

Credit test (AAA Spread

Increase)1

0.75% - 0.75% -

Insurance tests Calibrated by the business units with guidance

1 Examples from a calibration matrix10

Market risks calibrations are based on an Economic Scenario Generator

© Aviva plcSlide 10

ICA – Methodology (I)

Stresses are applied to realistic balance sheets

Our ICA methodology applies stresses to realistic balance sheets constructed on a market consistent basis. This ensures appropriate allowance is made for financial options and guarantees.

Stresses are applied as immediate balance sheet stresses

Although calibrated to changes over one year, tests are applied as immediate balance sheet stresses. This means that the stress emerging over one year is carried through to the closing balance sheet – the stress is a change in long-term expectations as well as one-year experience.

Non-linearity is addressed by combination tests

As well as individual risk stress tests, we also apply combination tests where all risk factors change simultaneously by reduced amounts to calibrate to an overall 1-in-200 scenario. This allows us to test for non-linearity and situations where risk factors interact with each other

Staff pension funds are included

Stress tests are also applied to the assets and liabilities in staff pension schemes to assess the impact on capital requirements.


ICA – Methodology IIExternal models are used for market risk and catastrophe scenarios

Market risk stresses and correlations are based on Economic Scenario Generator from Barrie & Hibbert. Outputs from the models are benchmarked against historic data and strengthened where we feel appropriate.

Catastrophe modelling is based on simulations provided by Guy Carpenter using RMS, subject to internal review by Aviva.

Risk aggregation is performed in a robust manner

Individual stress test results at Business Unit level are combined using a sum-of-squares methodology in a single step. Correlations for each pair of risks are set out in a correlation matrix that is subject to extensive management review.

Correlations are based on suitable market/company data where available, but subject to management judgment of future trends and with recognition of the need for prudence.

Some allowance is made for management and policyholder actions

Business Unit models take limited credit for management actions – in general credit is limited to situations where there is a clearly documented management policy supported by past actions. Some Business units make allowance for changes in future policyholder behaviour e.g. dynamic lapses related to changing market conditions.


RBC – Approach

Like ICA, RBC is based on stressing realistic balance sheets constructed on a

market consistent basis but:

• RBC is based on stochastic models (Monte Carlo simulation)

• RBC projects over longer time horizons than 1 year – up to 25 years for life

business.

• Most material risks are modelled stochastically including market risk, credit

risk, longevity risk and general insurance risk (including catastrophes).

• External models are used for globally consistent market simulations (Barrie &

Hibbert) and catastrophe simulations (Guy Carpenter/RMS).

• Risks that are not stochastic are dynamic (e.g. policyholder lapses) or

deterministic.

• Includes three years’ of planned new business.

• Aggregation is performed by combining Business Unit simulations to create

stochastic results for the whole group.


GI BU 1GI BU 1GI BU 1GI BU 1BU Igloo models running scenarios

GI BU 1GI BU 1GI BU 1GI BU 1Cut down BU

Prophet Models running scenarios

Group Level

EconomicScenarioGenerator

GI BU 1

Business UnitsCO

GI BU 1GI BU 1GI BU 1GI BUs

GI BU 1GI BU 1GI BU 1GI BU 1Life BUs

5,000 Scenarios generated with:• Investment Returns• Inflation Rates• Interest Rates• Credit Costs• FX Rates10,000 Cat losses simulated

Asset Liability Models take inputs and project realistic balance sheets, dividends and capital injections. Life BUs cover insurance risks using deterministic downside estimates

Results Aggregated for

Group

CO

Group review of results• Aggregation of results• Allowance for Operational risk and unmodelled business• Allowance for CO cashflows• Group diversification benefits identified• Group Capital requirements determined

Group LevelCat

Simulations

RBC - Approach


RBC – Complementary to ICA

RBC and ICA have complementary strengths:

RBC

• Considers risk over multiple time

horizons at varying risk tolerances

• Allows more accurate modelling of

cashflows and risk

• Allows directly for non-linearity and

interaction of risks

• Allows more sophisticated dynamic

policyholder and management actions

to be modelled.

ICA

• Excellent risk driver analysis

• More transparent for

management to understand

• Simpler to implement

(particularly for smaller Business

Units)

• Faster to run.


ICA – Operational Challenges

Robust internal review process

16

The 2006 ICA Internal Approval Process

Group tests set at CO and issued to BUs

BUs consider appropriateness of group tests (e.g. insurance tests) within their submissions and tailor to fit business circumstances

Review of central methodology in

light of BUs’ submissions and further refinement

ICA review teams and ICA panel

• Review led by RACI with the support of AI, AGI ops, FRM, treasury, GFC and Group Tax

• Independent review of BU submissions

• Results of review discussed with BUs and adjustments agreed

• Iterate BU sign-off to ensure Group view reflected in BU ICA

ICA represented on Group Technical Committeeto ensure consistency of technical approaches to ICA, RBC and accounting bases

Business Unit Technical/Steering Committees

UK GI

Treasury Committee signs off ICA result

Weekly forum with membership from ICA, Capital Management, Financial Modelling, Planning and Risk

Input from AGI Ops (U/w RI and Actuarial)

BU ICA results signed off by BU FD or local executive. Audit committees. Review and approval taken through line responsibilities.

Where UK BU s are required to submit their own ICA’s, the results also will be approved by the local exec and relevant

Legal entity Board.

RBC/ICA Technical Committee

• Supervised initial ICA Guidance

• Reviewed changes to methodology for 2006

–External review

–Internal developments and feedback

• Agrees all technical changes to Group tests and approach

Liaison and representation

Board responsibility for ICA discharged through ALCO and Audit Committee.

BUs’ tests reviewed by CO in aggregation and review process


ICA – Operational Challenges

• ICA process and methodology reviewed by

• Internal Auditors

• External auditors

• FSA

• Rating agencies

• FSA ICG process is rigorous and demanding

• Models reviewed by consultants

• Further changes will be required as both FSA and industry standards evolve.

• The ARROW review have involved a significant number of meetings (c70) to form a view of the strength of our risk management processes and economic modelling capabilities.

• Benchmarking to other businesses or among same businesses.


ICA – Technical Challenges

• Both ICA and RBC face major technical challenges

- Stress tests

• How to calibrate?

• How to test for sensitivity?

• How to validate ESG models?

- Correlation between risk

• Lack of data to inform correlation assumptions

• How to account for tail correlations?

• Requirement of positive definite matrix

• Aggregation matrix becomes large

- Diversification

• Depends on correlation assumptions

• Is there a GI/Life diversification?

• Is it a mathematical construct?


ICA – Technical Challenges

Combination tests

• How to determine the correct confidence level?

• How to model the interaction between risks?

• How to account for non-linearity?

• How many combination tests?

Fungibility

Restrictions on movements of capital

Securitisation

Loans

Dividends

Modelling liabilities

• Closed form?

• Iterative approach? Stochastic within Stochastic

• Management actions

• Non-linearity


Business uses of Economic Capital

PSI – Strictly Private & Confidential © Aviva plcSlide 20

Business uses of Economic Capital

• Understanding the Group risk profile

• Aligning risk appetite and strategy

• Assessing the Group capital position

• Providing transparency to analysts and key stakeholders

• Prioritising of growth opportunities across the Group

• Optimising of the use of capital


Business Uses of Economic Capital

Risk Committees: Financial and Operational Risk

Asset Liability Committee

Life Insurance

General Insurancet

Credit

Capital Management

Investment Reserving

Executive Committee

Board

Risk & Regulatory Committee

Audit CommitteeCSR

Committee

Operational Risk Committee

IT

Business Protection Compliance

Business Standards

HR Management


Other business uses of Economic Capital

• Regular ‘what if’ questions from Finance Exec members

• M&A and Corporate Partners deals

• Reinsurance design and purchase Advised on capital impact and attractiveness of the main CAT program Used in the derivation of the CAT option product

• Asset allocation

• Informing the Business Plan

• Volatility of earnings


Gross / Net CATs - Reordered

0

250

500

750

1,000

1,250

1,500

1,750

2,000

2,250

2,500

CATs ordered in decreasing size

To

tal C

os

t o

f C

AT

s (

£m

)

Gross Net

Single CAT breaches excess

Two CATs both sitting in CAT cover

Combined effect of multiple CATs

One CAT over limit or multiple smaller CATs

CAT RI Treaty


New Developments and Solvency II

• More emphasis on methodology and assumptions

• Factor based approach of Solvency II

• ABI guidance

• Actuarial guidance

• Disclosure of economic capital and ICG

• ERM, internal models and Credit Agencies

• More regulation?

individual capital assessment (ica) in an international company: issues and challenges

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