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Economic Capital at Manulife Sara Wattling, Manager, Integrated Risk Measurement Date: November 20, 2009
Economic Capital at Manulife
Sara Wattling, Manager, Integrated Risk Measurement
Date: November 20, 2009
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Economic Capital
Economic Capital Project Overview
Manulife’s General Framework
Framework by Risk
Aggregation & Diversification Benefits
Conclusions
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Economic Capital Project Overview
Goals of internal Economic Capital (EC) model: Provide an improved measure of risk-based required
capital Allow management to better attribute capital to sources
of risk and manage overall risk profile Be an important tool to help management make better
decisions about optimizing risk-adjusted returns
Internal EC is not intended to: Replace sound business judgment in decision making Replace regulatory capital
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Economic Capital Project Overview
Expected uses of Economic Capital include: In-force Risk Measurement Defining Risk Appetite and setting Risk Targets Allocating capital to business units
Risk/Return Business Decisions: Investment and ALM decisions In-force Management Product Pricing
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Economic Capital
Economic Capital Project Overview
Manulife’s General Framework
Framework by Risk
Aggregation & Diversification Benefits
Conclusions
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Manulife’s General Framework
Total Asset Requirement (TAR) Approach EC = TAR less Reserves TAR is purely “economic”
One Year Time Horizon But coupled with Terminal Provision that reflects lifetime
risk horizon
Measure EC at two First Year Probability Levels: BBB level: CTE99 AA level: higher internal target CL
TAR = CTEx [PV(Year 1 Cashflow + Terminal Provision)]
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TAR reflects extremely adverse
experience over risk horizon, and …
… have sufficient assets at end of horizon to hedge or retain risk as appropriate
Time 0 Time 1 Lifetime
Risk Horizon
Manulife’s General Framework
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Terminal Provision
Two Practices Assume risk is hedged or closed at the end of year 1 Assume risk is retained
Calculation Market Value for risks assumed to be hedged at end of
year CTEx for risks assumed to be retained for lifetime Either way, reflects first year stress scenario
By Risk All insurance risks assumed retained Treatment of market and credit risks varies by
circumstance
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Economic Capital
Economic Capital Project Overview
Manulife’s General Framework
Framework by Risk
Aggregation & Diversification Benefits
Conclusions
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Framework by Risk
AggregateEC
MarketRisk
Credit Risk
InsuranceRisk
Operational &Strategic Risk
Interest Rate Risk
Other NFI RiskPublic Equity
Risk
Interest Rates
Interest Spread
Direct Investments
Off-Balance Sheet
DirectInvestments
Mortality &Longevity Risk
Morbidity Risk
Lapse Risk
DirectInvestments
Counterparty
Other P/h Behaviour Risk
Expense Risk
Currency
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Framework by Risk
Pass-Through Products All risks measured on a combined basis to ensure
constraints on pass-through features are captured
Other Products Each risk measured separately
Following sections describe risk framework for non Pass-Through products
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Market Risk
AggregateEC
MarketRisk
Credit Risk
InsuranceRisk
Operational &Strategic Risk
Interest Rate Risk
Other NFI RiskPublic Equity
Risk
Interest Rates
Interest Spread
Direct Investments
Off-Balance Sheet
DirectInvestments
Currency
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Market Risk
Experience simulated by stochastic return generators Interest rates, public equity indices, bond funds, private
equities, real estate, timber, agriculture, oil & gas, and currency
Across all geographical markets on a correlated basis
Incorporate dynamic policyholder behavior functions where appropriate
Asset-sensitive liabilities are valued using integrated asset/liability models Use scenario reduction techniques to avoid full
stochastic on stochastic calculations
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Interest Rate Risk
AggregateEC
MarketRisk
Credit Risk
InsuranceRisk
Operational &Strategic Risk
Interest Rate Risk
Other NFI RiskPublic Equity
Risk
Interest Rates
Interest Spread
Currency
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Interest Rate Risk: General Interest RatesAssume positions hedged or closed at end of year
Where hedged Assume yield curve is extended past 30 years Discount lifetime net asset and liability cash flows at
point-in-time projected forward rates resulting from each shocked one year experience scenario
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Interest Rate Risk: Interest Spreads
Calculation is similar to that for Interest Rates
Assume assets are rebalanced to target quality mix at end of stressed first year
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Public Equity & Other NFI Risk
AggregateEC
MarketRisk
Credit Risk
InsuranceRisk
Operational &Strategic Risk
Interest Rate Risk
Other NFIRisk
PublicEquity Risk
Direct Investments
Off-Balance Sheet
DirectInvestments
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NFI includes: Private Equity, Real Estate, Timber, Agriculture, Oil & Gas
Assume assets are retained for longer than one year At the end of year one, determine the market value of
non fixed income assets required to meet the liabilities on CTEx go-forward lifetime experience scenario returns
Assume future NFI return distribution starting at the end of year one is independent of prior performance over first year
Public Equity & Other NFI Risk
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Public Equity Risk on Off-Balance Sheet Products
AggregateEC
MarketRisk
Credit Risk
InsuranceRisk
Operational &Strategic Risk
Interest Rate Risk
Other NFIRisk
PublicEquity Risk
Direct Investments
Off-Balance Sheet
Currency
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Off-Balance Sheet Products Include VAs / Segregated Funds Mutual Funds Group Pensions VUL products
Measures Fund Performance Risk Labeled as equity risk as this is the dominant risk Not split by interest, equity, other-NFI, credit yet
Public Equity Risk on Off-Balance Sheet Products
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Fee Income Risk EC = DAC Balance – CTEx [PV(Year 1 Net Fees +
Terminal Provision)]
Guaranteed Benefit Risk EC = CTEx [PV(Year 1 Guarantee cash flow + Terminal
Provision)] – Booked Reserves
Avoid full stochastic on stochastic by modeling terminal provision as a function of risk drivers
Public Equity Risk on Off-Balance Sheet Products
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Credit Risk
AggregateEC
MarketRisk
Credit Risk
InsuranceRisk
Operational &Strategic Risk
DirectInvestments
Counterparty
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Closed form analytic calculation
TAR is present value of Stressed Defaults in year 1 Cost of Defaults over remaining lifetime based on the
stressed credit migration in year 1
Security by security calculation
Credit Risk
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Single factor model Each security is correlated to a single general global
economic factor One common correlation factor is used for each
individual ratings class Key underlying assumption is that the portfolio is well
diversified: no reflection of name concentrations
Counterparty Risk Same methodology as for direct holdings except
exposures at default are unknown and must be modeled
Credit Risk
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Insurance Risk
AggregateEC
MarketRisk
Credit Risk Insurance Risk
Operational &Strategic Risk
Mortality &Longevity Risk
Morbidity Risk
Lapse Risk
Other P/h Behaviour Risk
Expense Risk
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Mortality/Longevity Stress scenarios Four risks: level, volatility, trend, catastrophe
Morbidity Stress scenario Based on external practices and internal expert
judgment
Lapses Retained MCCSR stress scenario
Insurance Risk
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Par & Pass-Through Products
AggregateEC
MarketRisk
Credit Risk
InsuranceRisk
Operational &Strategic Risk
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Calculate Market, Credit and Insurance EC for Pass-Through products separately Reflect actual pass-through feature instead of using
factor
Calculations are the same as for non pass-through products Except assume all risks are retained at the end of year 1 Credited rates are adjusted based on scenario
Care must be taken to ensure that same pass-through room is not used for multiple risks
Par & Pass-Through Products
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Operational & Strategic Risk
AggregateEC
MarketRisk
Credit Risk
InsuranceRisk
Operational &Strategic Risk
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Factor-based Currently use Basel II Basic Indicator approach
Low priority to develop stochastic model
Operational & Strategic Risk
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Economic Capital
Economic Capital Project Overview
Manulife’s General Framework
Framework by Risk
Aggregation & Diversification Benefits
Conclusions
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Recap of Major Risks
AggregateEC
MarketRisk
Credit Risk
InsuranceRisk
Operational Risk
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Within Market Different market risks aggregated directly based on
integrated correlated economic scenarios
Within Credit One-factor model reflects diversification benefits of a well
diversified portfolio
Within Insurance Stress tests reflect global diversification benefits for a
given risk Use correlation matrix to aggregate different insurance
risks
Aggregation
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Within Operational Factor based approach assumed net of diversification
benefits
Between Major Risks Currently, aggregation between EC results of major risk
categories performed using correlation matrices
Aggregation
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Within Credit, Insurance and Operational Risks Post-diversification by nature
Within Market Risk Risks aggregated by summing EC requirements across
each scenario and taking the CTEx of the total market results across all scenarios
As underlying economic scenarios are correlated, diversification is explicitly reflected
Diversification Benefits
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Within Market Risk, continued Simple example where EC is the worst scenario out of 5:
In this example, the diversification benefit between Equity, Other NFI and Interest is 20
Between Major Risks Second layer of diversification using correlation matrix
Diversification Benefits
EC 110 170 175 435Scenario Equity Other NFI Interest Total
1 100 150 175 4252 90 125 170 3853 80 120 160 3604 110 170 155 4355 105 160 150 415
EC for sum of standalone risks = 455
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Economic Capital
Economic Capital Project Overview
Manulife’s Framework
Market Risk
Credit, Insurance & Operations Risk
Aggregation & Diversification Benefits
Conclusions
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Conclusions
EC better reflects relative contribution by risk element than MCCSR Reflects specific risk profile & diversification of company Same CL for each risk
EC provides quantitative framework to support existing initiatives However results extremely sensitive to key assumptions EC is an additional decision making tool, but does not
replace sound business judgment nor regulatory capital
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Questions?
