Economic Capital in APAC Insurance: A Brief Overview of Current … · Economic Capital in APAC...

ENTERPRISE RISK SOLUTIONSMAY 2014

Economic Capital in APAC Insurance: A Brief Overview of Current PracticeOverview

We have seen increased interest from insurers in Asia Pacific to adopt economic capital in the last few years. This is largely driven by expected national solvency regulatory changes, additional mandatory enterprise risk management requirements, and a general desire to adopt risk management best practices beyond just the mandatory requirements.

The most apparent reason behind this wave is a desire to stay ahead of the game and be better prepared for future regulatory changes. Others are aiming to optimize capital allocation and utilization, with a view of reducing cost of capital, increasing efficiency and ultimately creating value for shareholders.

In this paper we will explore the theoretical features and building blocks of a good economic capital model. We will also look at the practical implications and challenges for implementation and business applications.

B&H RESEARCH MAY 2014

Eric YauMoody’s Analytics

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2 MAY 2014 ECONOMIC CAPITAL IN APAC INSURANCE: A BRIEF OVERVIEW OF CURRENT PRACTICE

MOODY’S ANALYTICENTERPRISE RISK SOLUTIONS

CONTENTS

1. THE RISE OF ECONOMIC CAPITAL IN ASIA PACIFIC ........................................................................... 3

2. A BRIEF REVIEW AND INTRODUCTION ................................................................................................ 3

The economics .................................................................................................................................................3

The capital ........................................................................................................................................................4

Regional development ...................................................................................................................................5

3. BUILDING BLOCKS .................................................................................................................................... 6

Risk factor model ............................................................................................................................................6

Asset valuation methodology and model .................................................................................................7

Capital methodology .....................................................................................................................................9

4. BUSINESS APPLICATIONS ...................................................................................................................... 10

Optimize returns on economic capital ....................................................................................................10

Plan for future economic capital ............................................................................................................... 11

Risk appetite ...................................................................................................................................................12

Determine strategic asset allocation .......................................................................................................13

5. CHALLENGES .............................................................................................................................................14

Implementation effort .................................................................................................................................14

Volatility of balance sheet measures .......................................................................................................14

Timeliness of calculation .............................................................................................................................15

6. CONCLUSION ...........................................................................................................................................15



1. The rise of economic capital in Asia Pacific

With its technical details and application dates being gradually nailed down, Solvency II is increasingly seen as a benchmark for ERM for insurers in the Asia Pacific region. Many elements of the Directive, from technical provision, capital methodology to reporting and disclosure are being referred to when insurers plan for and develop their ERM measures. Having said that, the APAC region is at a different development stage. China, for instance, while being the second largest economy in the world, is still largely an emerging market. It comes as no surprise, therefore, when the China Insurance Regulatory Commission (CIRC) published their plan last year for the new solvency regulatory regime, China Risk Oriented Solvency System (C-ROSS), one emphasis is to ensure it is consistent with the development path and resources available. Practitioners are often keen to learn from the experience gained from Solvency II, but they would also need to factor in local business challenges and market environment. More advanced economies, like Australia, Japan and Singapore, have already implemented or are also on track to put in place measures to enhance enterprise risk management. The Monetary Authority of Singapore (MAS) is currently reviewing their risk-based capital framework (RBC) to align it with “evolving market practices and global regulatory developments”.

In addition to regulatory requirements, firms in the region are increasingly keen to adopt risk management best practices beyond just the mandatory requirements. This is driven by a variety of reasons. The most apparent one is a desire to stay ahead of the game and be better prepared for future regulatory changes. Others are aiming to optimize capital allocation and utilization, with a view of reducing cost of capital, increasing efficiency and ultimately creating value for shareholders.

Regardless of whether it is for internal or regulatory purposes, an efficient quantitative tool for assessment will be needed. Economic capital has emerged as a natural tool for this purpose – it is responsive to changes in market environments, it captures the economic value-add for insurance business and it helps management and the Board to make better business and capital allocation decisions.

In this paper we will explore, what economic capital aims to capture, how it is done, and challenges with practical application.

2. A brief review and introduction

THE ECONOMICS

Economic capital is not intended to be a rule-based approach. Instead, it should address the underlying economics of insurance companies and pension funds, at least conceptually. So what does it mean in practice? One can take this as a realistic representation of how these companies make economic profit. The most common sources of profit for insurers are probably:

» UNDERWRITING : the most fundamental source stems from the fact that insurers offer protection to policyholders. For a healthy business, we would expect, on a long term basis and with a sufficiently diversified portfolio, the protection portion of the premium is more than enough to cover the cost of providing such protection. Economic profit is therefore made through the spread between the fee and cost of insurance. This source of profit is probably a major element in P&C companies, as well as composites with a strong focus on protection businesses. Modeling of such a business, however, is not a straight forward exercise. We would need to consider, for example, the insurance company’s ability to reflect actuarial experience in their pricing, the potential deterioration of claims experience, future underwriting strategies and so on. The true cost of insurance would also include cost of guarantees provided to policyholders too – for instance if the crediting rate for universal life products is no lower

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Originally Q4 2009

but shifted to Q2 2010

in some cases



than a specified rate, and the true cost of such provision should also include expected payout of this shortfall. At a deeper level, one also needs to consider how policyholders might react to external environment changes (such as changes in interest rate post Quantitative Easing (QE) era), which impacts the persistency as well as profitability of the portfolio.

» INVESTMENT SPREAD: it is not uncommon in Asia (or perhaps globally) that insurance products also serve as savings vehicles. To attract customers and remain competitive, guarantees (in the form of minimum rate of returns) are typically offered, and would likely be comparable to other forms of savings such as bank deposits, certificate of deposits, treasury or investment grade bonds. To make an economic profit, an insurer would need to beat this guarantee level in their investment portfolio, bearing in mind that they will need to absorb the downside when their portfolio turns sour. This hinges on the assumption that the insurer can indeed invest smartly and consistently earn above average (risk-adjusted) returns. Is this a valid assumption? Perhaps so, but it relies heavily on investment managers ability to outperform consistently (over the product life cycle and through economic boom-and-bust cycle), which is probably not a strength for most insurers. Another common feature of insurers’ asset-liability profile is the portfolio liquidity. It has also been argued that insurance is a long term business, and that liability demonstrates a high degree of illiquidity (i.e. insurance cash flows are fairly predictable). With this at hand, insurers can then invest their portfolio in illiquid assets or transfer liquidity to other financial institutions, with a view of generating additional returns. Investment spread is also dependent on insurance benefits payments, which are sometimes discretionary in some markets (e.g. cash dividends for participating products in jurisdiction without a ring-fenced participating fund requirement). The strategies for determination of these discretionary elements would naturally impact the expected investment spread too.

» MANAGEMENT FEE: the above two sources generate profits through taking positions and bearing corresponding risks. Conceptually this creates opportunity for high accounting profits, but it is also subject to volatility due to changing market conditions and operating environment. A third and probably more stable source is the agency or management fee through service provision. A typical example would be the administration of unit-linked businesses, where insurers take no or little market position on the underlying funds, and charge policyholders for expenses or fund management fees. This stream of profit would certainly be dependent on policyholder persistency and operating environments; however the fact that there is limited volatility in the fee level to be charged means that the primary risk is business volume and economy of scale; market volatility has only secondary impact.

THE CAPITAL

Practitioners have different views on the definition of capital; economic capital definition is no different in that respect. Over the last decade, however, we have witnessed a convergence in capital measurement approach throughout Asia Pacific. More focus is now placed on risk-based measures, based on the belief that risk adjustment would better reflect an individual insurer’s exposure and hence lead to a more accurate capital requirement. Several regulators in the region also require either voluntary or mandatory reporting for economic capital.

What is driving this trend in capital management and practitioners’ preference?

Firstly, insurers are no longer treating capital management as a compliance exercise. Capital measures, in the past, have often been used as a tool to demonstrate solvency to regulators and analysts. While it was certainly considered in business planning and other strategic initiatives, capital was not widely used as a hurdle for decision making. Return on capital, for instance, was not a typical benchmark practitioners used. After the global financial crisis and with increased focus on capital sufficiency (partly driven by the global influence of Solvency II), management are more conscious of capital impact from business decisions. If insurers want to create value for their shareholders, the capital measure (and rate of return on capital) used need to align with the business processes and reflect an insurer’s own risk-return exposure. The

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static (i.e. non-risk-based) capital measure is therefore less relevant; instead a risk based measure such as economic capital is increasingly used to aid such business decision.

Secondly, the trend is also fueled by requirements on enterprise risk management. While statutory national capital requirement is still a reliable indicator of a firms’ solvency position serving as a comparison benchmark, regulators have also recognized the importance of a capital measure relevant and calibrated to individual businesses. The Australian Prudential Regulation Authority (APRA) has allowed insurers to use internal models for their solvency capital calculation and reporting. Insurers are often required to form their own view of their risk and solvency position, using extra measures (or internal models) in addition to the prescribed statutory standard formula. Such internal models are expected to better reflect the underlying risk nature of specific insurers, and are often welcome in the context of Own Risk and Solvency Assessment (ORSA). As a result, full internal or partial internal models are now getting greater traction, and stochastic models have now become the norm in the region.

REGIONAL DEVELOPMENT

Even risk based capital measures can still be defined in a number of different ways. In Solvency II, for example, it refers to the market-consistent 1-year value-at-risk (more to be discussed in later sections). Over the past few years, this capital definition is increasingly prevalent in insurer’s economic capital implementation globally, including Asia Pacific.

But, is this definition a globally universal one? Not necessarily.

Traditionally, North American insurers calculate capital on a real world run-off basis, which means the focus, is on how insurers meet emerging insurance liabilities as they fall due, over the life of the policies. Such an approach is not unique to just North America. In Asia, several countries have used similar approach, for some specific product types, like variable annuity (VA). In both South Korea and China, guarantee reserve for VA is based on the conditional expected future net losses over the life of the policies across a number of stochastic scenarios.

Figure 1 below summarizes regulatory requirements of some major economies in Asia Pacific. There is an apparent trend for countries that are using solvency margin, to now move to risk based capital, and for those using risk based capital to further enhance their approach in light of industry practices. Given the own view nature of economic capital and the diverse requirements in the region, economic capital is often referred to as a possible tool for risk assessment, if not a mandatory one.

The trend is clear – economic capital has emerged as a preferred way for risk assessment and management.

Figure 1. Regulatory requirement on solvency and capital for selected economies in APAC

COUNTRY /

TERRITORY

SOLVENCY REQUIREMENT ECONOMIC CAPITAL

AUSTRALIA RISK BASED CAPITAL VOLUNTARY, AS PART OF ICAAP, FROM 2013

CHINA SOLVENCY MARGIN; RISK BASED C-ROSS EXPECTED IN 2015 AT THE EARLIEST

MANDATORY FROM 2015; PILOT TESTING IN 2014

HONG KONG SOLVENCY MARGIN; STUDY FOR AN RISK BASED REGIME UNDERWAY

NO SPECIFIC REQUIREMENT

JAPAN RISK BASED CAPITAL ECONOMIC VALUE-BASED REGIME BEING CONSIDERED BY JAPAN FSA

SINGAPORE RISK BASED CAPITAL; “RBC2” REVIEW UNDERWAY MANDATORY, AS PART OF ORSA, FROM 2014

2 A full-scope investment firm satisfies the following conditions:

» it is a firm; and

» its head office is in the United Kingdom and it is not otherwise excluded from the definition of a BIPRU firm under BIPRU 1.1.17 R (Exclusion of certain types of firm from the definition of a BIPRU firm):

» an incoming EEA firm;

» an incoming Treaty firm;

» any other overseas firm;

» an ELMI;

» an insurer; and

» an ICVC (Investment Company with Variable Capital)

3 See BIPRU 12.6

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3. Building blocks

RISK FACTOR MODEL

Papers on economic capital often include a definition of economic capital itself. Economic capital can actually be defined in different ways, for example, we can define it as:

» The capital (or amount of surplus) required to withstand stresses within defined probability for a given period of time, with specified economic measure of the balance sheet.

In fact, the probability distribution over a given horizon is the common and also core concept in economic capital. Instead of striving to achieve solvency for all possible shocks, our aim here is to stay above water for most of the time, and accept the fact that insolvency is inevitable for some extreme scenarios. The fundamental question to ask is: how do we define such distribution of risk factors and calibrate them to suit our asset liability portfolio?

Few can predict the future state of the world consistently and accurately. Instead quantitative models can then help us understand how the market could behave and could evolve over time. There are a few elements to a comprehensive risk factor model:

» STYLIZED FACTS – It is common to have some beliefs about how the financial markets behave. After all, price discovery and trading in financial markets are international activities, and certain assumptions are expected to apply across most, if not all, economies. For instance, it is a common belief that yield curve exhibits mean reversion – that is to say when interest rates are much lower than long term average, it is expected to gradually increase over time, on average across the scenarios. Before one starts building models and calibrating them, it is wise to list out stylized facts that one would expect, and ensure they are captured in the structure or dynamics of the models.

» MODELS AND CORRELATION STRUCTURE – Models are a representation of reality but not reality. Model features are often tied to stylized facts and are a simplified view of the real world. Limitations exist, which is why it is essential for users of models (including actuaries and risk managers) to have, at least, some basic understanding of how the models work and why it is designed in such a manner. How could this be done in practice, given the complexity of modeling techniques involved? Based on our experience, user training workshops, as well as formal model and calibration documentation, are key elements to help users appreciate modeling implications on their ultimate economic capital numbers. It can be, at times, a steep learning curve and requires dedicated efforts.

» TARGET SETTING AND CALIBRATION APPROACH – A big part of a modeler’s work is to calibrate the model so that it is suitable for applications at hand. In the context of economic capital, barring market consistent liability valuation (which is being discussed in a later section), the key is how risk exposure over the next say the 12-months is being reflected. Through-the-cycle and point-in-time are two major calibration methodologies for economic capital. The former assumes that, for the purpose of economic capital, the next year is going to be an “average” year in that the market volatilities are based on long term targets. Under this, economic capital requirements tend to be less volatile (we would not expect the “average” to change dramatically from quarter to quarter), but are less responsive to market changes. At the height of the global financial crisis in 2008, for instance, we felt nervousness of the markets through elevated levels of option implied volatilities. Should we treat these as signs of expected market volatilities in the coming months and years, and hence adjust our economic capital to reflect such? A point-in-time calibration is precisely designed to capture this conditionality, and is often adopted by firms which hold the belief that their economic capital should be responsive and adaptive to the latest market conditions.

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Figure 2. Illustration of 1-year equity excess returns distribution

What are the specific challenges for Asia Pacific-orientated risk factor model calibration? Clearly, market conditions can be fast-changing for emerging economies in the region (such as China), and this, to a lesser extent, applies to economies which are significant trade partners of the former. Distant past historical data might not be appropriate when we project the future behaviors of the markets. Purely in terms of economic development, China in 1992 and China in 2014 can be viewed as two completely different countries. One way to mitigate this is to use a different weighting scheme (such as an exponential one) which gives more weight to more recent data so that older data will have less impact on future projection estimates.

Macro-economic risks (such as currency crises, capital flights) or political events are also additional risks that some emerging markets face. Mathematical modeling of some of these risks is very difficult, if at all possible. Qualitative treatments, such as capital add-on and macro-economic stress testing are common and practical approaches to cater for these risk exposures.

ASSET VALUATION METHODOLOGY AND MODEL

Asset valuation tends to be an area that is overlooked – perhaps because of the seemingly simple nature of assets that a typical insurer would hold, or because many actuaries are highly trained and skilled in liability valuation and relatively less so on the asset side. Across the region, valuation approaches for assets vary, depending on the asset type and jurisdiction. Common approaches include amortized book value, mark-to-market, or hybrid approach like available-for-sale. Mark-to-market valuation is often treated as the preferred option for asset valuation, primarily because it reflects the latest market sentiments and automatically captures the consensus market views. Value of a firm’s investment holdings is therefore rather objectively defined as the price that one party is willing and able to buy, and another is willing and able to sell. It overcomes the subjective elements such as the “locked-in” rates which can differ across different holders of the same security, simply because the security was bought at different times.

Is mark-to-market easy to implement in practice? Yes for most cases, but sometimes the financial markets are far from perfect. One major challenge for mark-to-market valuation is when a liquid and deep enough market does not exist. Illiquid investments are now getting more attention, partly because of the

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competitive pressure to achieve higher yield, especially during the low yielding environment. Examples of such include private equity projects, long term deposits with banks and infrastructure investments. By holding these investments over a long term, investors expect (or hope) that additional yields will be earned, as a compensation for taking such liquidity risk. As there is no active market for trading these investments, quantification of either the market price, or equivalently the risk premium, can be a very challenging task.

LIABILITY VALUATION METHODOLOGY AND MODEL

Liability valuation is an important and challenging area, especially for life insurers. For the majority of regimes in APAC, fair valuation of liabilities using a stochastic approach has not been mandatory. In most cases, for accounting (i.e. national GAAP or IFRS 4 Phase 1) or statutory reporting purposes, firms are still relying on deterministic reserving approach. Fair valuation is increasingly recognized as a better approach, and is commonly used in economic capital calculation. The most obvious reason is that, while best estimate single scenario is easy to understand and communicate, it lacks an explicit consideration of guarantees and embedded options. Those are typically catered for implicitly through margins in assumptions, which are often hard to quantify and may not be sensitive to changes in the market conditions.

When firms start to move to fair liability valuation, it is important to ask the question: how is this going to impact our financials? Two (sometimes offsetting) effects come into play. Firstly, fair valuation is based on best estimate risk free rates, and hence the margin embedded in assumptions is typically released through a change in valuation. The direction or magnitude of the impact would of course depend on the difference between the two discount curves, and the level of current risk free curve. The second effect is an explicit estimate of the cost of guarantee. This can again vary greatly from firms to firms, but are often a sizeable portion of the best estimate liability for many guarantee businesses in Asia.

Another challenge brought by stochastic liability valuation is the increased run time. Stochastic valuation requires runs of thousands of plausible scenarios. A brute force run (i.e. running the deterministic setup thousands of time) will likely lead to unreasonable run time. Specialized software packages are designed to reduce run time and model points need to be compressed. These have proven to be useful tools and techniques. What else can we do to streamline the run time?

If we think of liability valuation as a set of discounted cash flows, we end up having to analyze two components – namely the sensitivities of cash flow to underlying risk drivers, and the volatilities of the risk drivers themselves. The former is concerned about how risk factors impact cash flow. For example, policyholder dividends or bonuses in participating business depend greatly on the fund’s performance, which is heavily influenced by changes in market conditions. Protection business or non-participating business tends to be less sensitive. The latter is concerned about the discounting process itself. Even if we assume cash flows are independent of the underlying risk factors, a change in discount curve would affect valuation. With these two aspects in mind, it is not difficult to imagine that liability valuation can be reasonably accurately captured through a simple mathematical function linking valuation to underlying risk factors. Such functions will take underlying risk factors as input, and produce liability valuation as output.



Figure 3. Liability valuation sensitivities to interest rate

These functions (also known as proxy functions) often also need to satisfy a few criteria:

» Capture the sensitivities of cash flows to risk drivers

» Capture impact of risk factor changes on discount curves

» Can be updated and calibrated without excessive additional efforts

Commonly used approaches for estimating proxy functions include curve fitting and least square Monte Carlo (LSMC). It might take a while to identify and calibrate such proxy functions; however with these functions at hand, the valuation process can be further streamlined for intra-period reporting, stress testing, and more commonly economic capital.

CAPITAL METHODOLOGY

Capital calculation methodology defines how we derive the say 99.5th percentile value-at-risk. Simultaneously modeling all risk factors that an insurer is exposed to (e.g. interest rate risk, credit spread risk, morbidity risk, lapse risk, etc.) is a very challenging task in itself. To assess the impact of these risks we will need to further quantify the impact on the balance sheet – for each node of fair asset and liability valuation (i.e. for each stress point), thousands of stochastic scenarios are typically required. This means that millions of scenarios are required to quantify the full distribution of an insurer’s balance sheet, which is impractical based on most insurers’ software and hardware configurations.

Typical approximation approaches adopted in the industry so far are based on two broad categories:

» STANDARD FORMULA (or stress-and-correlate) approach – the idea is that, instead of defining economic capital as the percentile of net asset value movement, economic capital is defined as the shortfall in net asset, based on a series of stresses in the underlying risk drivers. We will first define percentile stress for each risk category, and then quantify the impact on net asset value for each of these stresses. Economic capital is then calculated based on a correlation matrix which intends to measure diversification.



» MONTE CARLO (LSMC, curve fitting, replicating portfolio) approach – the standard formula approach makes simplifying assumptions about risk factor distribution (e.g. risk factors are correlated using correlation matrix); the Monte Carlo approach, on the other hand, makes simplifying assumptions on the net asset valuation itself. This is usually the more preferred approach in terms of accuracy and validation. Why? Firstly, as we can relatively easily perform valuation of liability based on a set of conditions, a given shock to the yield curve or a given mortality improvement), the liability proxy function can be validated. The same also applies to asset valuation. Secondly, insurers now have more control over the desired risk factor distribution, in terms of calibration, structural relationship as well as forward looking view. This will help not only to incorporate a firm’s own views, but also to better reflect its unique asset and liability exposure.

Figure 4. Economic capital building blocks visualization

Risk Factor Model

Asset Valuation

Capital Methodology

Liability Valuation

4. Business applications

The implementation phase of an economic capital project tends to be technically demanding and requires collaboration among various parties including actuarial, investments, finance, IT and risk management. For the economic capital thus calculated to be fully functional, however, it must be in the culture of the business – it should be seen as one major quantitative criterion to drive business decisions, to weigh against different strategies, rather than merely a compliance exercise.

Before discussing the business applications, it is worthwhile highlighting that, while reporting is only a means to an end, it is also an essential element that is often not given the right level of attention it deserves. The competitiveness of the market often demands firms to make not only sound but also timely judgment. Seamless reporting structure, which enables reliable calculation routines and quick updates, is in fact a pre-requisite for economic capital business application.

OPTIMIZE RETURNS ON ECONOMIC CAPITAL

From the perspectives of strategic corporate development and risk management, it is essential to ensure business initiatives or product pricing are on track to create value for shareholders and are expected to give reasonable return on economic capital. These measures will also help firms to prioritize the use of capital on high yielding and profitable project, with a view of optimizing capital use. To assess the return on economic capital, firms will need to project the same, over the life of the products. This tells us how much economic capital injection is needed, and when capital will be released. An overall return on economic capital can then be assessed together with the expected economic profit over the horizon.

Projection of statutory factor-based capital is relatively easy and is now an integrated part of most business plans that insurers do. Due to the technical demands, calculation of economic capital at reporting date (i.e. time 0) is already consuming significant run time; practitioners often need to work with this number and make some simplifying assumptions for the forward projection of economic capital. We have published a number of white papers (e.g. multi-year projection of liability and capital) in this area, highlighting the use of proxy models or simplified forward looking view to facilitate economic capital projection. Indeed, proxy models help reduce run time required and hence allow reasonably accurate calculation and projection of capital.



PLAN FOR FUTURE ECONOMIC CAPITAL

Both demand and supply of economic capital are subject to uncertainty. To illustrate this, consider the case of a surge in interest rate. How will such an event impact the economic capital position?

If we further assume that such market movement has no impact on other risk factors (such as equity risk, mortality risk), we are now dealing with a higher level of interest rate, and hence a wider potential range of interest rate reduction in the following 12 months, ceteris paribus. While we should not preclude the possibility of negative interest rate, what we have observed over the last few years in the US and Euro zone market is an effective interest rate floor around the zero percent level. Empirically it is also noted that a higher interest rate level is often associated with an increased (absolute) volatility. This implies that at higher rates level, we would expect higher total volatility, and hence a stress of higher magnitude at an extreme tail percentile such as 99.5th. With common stabilizing mechanisms in many forms of life insurance (such as participating products), there is no rule of thumb in determining the required capital implication, however it is intuitive to think that a higher stress level (at a higher base interest rate level) will likely demand a greater amount of required capital.

How about the supply of capital, i.e. the financial resources available? It is a common feature in the APAC fixed income markets that high quality bonds of long duration are not liquidly traded, or simply do not exist. A duration gap often exists, with liability duration being moderately longer than asset duration. However, from a total balance sheet perspective, as asset investments typically exceed liability values (with the excess being surplus), the dollar duration (i.e. the impact in monetary terms rather than relative percentage terms) gap can be narrower. Movement in interest rates could have minimal impact on the net asset position. From an asset-liability management (ALM) perspective this might be desirable, and helps to maintain balance sheet stability. From a capital management perspective, however, it would mean that increase in available surplus might not be able to catch up with the increment in required capital, leading to a deterioration of capital position as rates rise.

A seemingly simple question can lead to a range of different answers, and different implications on economic capital. As firms strive to balance business growth, financial position stability and other financial metrics, it is important to ask relevant “what-if” questions, and plan for obvious or implicit adverse market conditions, including contingency plans for sources of new capital. Risk managers will also need to ensure that these capital implications are appropriately reflected in risk appetite which in turn is one of the factors that business units should consider when planning and executing business activities.

Figure 5. The total balance sheet

Asset

Liability

Req. Cap.

Free Cap.



Investigation and discussion of possible actions

External environment further deteriorates while re-pricing of products still to be reflected

New pricing is effective

Market conditions returning to normal

RISK APPETITE

Risk appetite is a fundamental part of both risk and capital management. It governs the type and amount of risk that a firm is willing and able to take. The concept of risk appetite, however, is quite abstract. It would not be operational and effective, without the help of implementable and practical limit structures, which risk managers can review, define and act upon in response to changes in the internal and external environments. So, the question is, how should we establish the link between appetite and limits?

Assume a firm’s risk appetite is defined as below:

» Over the next 1 year horizon, with at least 99.75% chance, there are enough financial resources to remain solvent, measured based on the economic balance sheet.

This is essentially saying that the firm should have net assets greater than (or equal to) its 99.75th percentile 1-year VaR, which is the economic capital requirement.

The capacity of the firm to take risk, however, is bound by the actual financial resources available. The free surplus, over and above the economic capital requirement, acts as buffer for market volatility. The ratio between available financial resources (or net assets) over economic capital requirement the Economic Capital (EC) ratio can therefore measure how much of a buffer is available, or alternatively how much capacity have been used up.

How can we take this economic capital ratio and define risk limits?

One obvious choice is to set soft and hard limits around the ratio. For example, we can set a soft limit at 120%. When EC ratio breaches this soft limit, a set of management actions (such as new business re-pricing, strategic asset re-positioning, etc.) will be discussed in the management committee to mitigate risk exposure and to avoid further deterioration of the ratio, based on the current market environments. Soft limits are needed as it takes time for management actions to be effective (e.g. re-pricing or disinvestment in certain assets), while the market conditions can continue to deteriorate.

Figure 6. Illustrative example of how EC ratio performs over time



The EC ratio is a good overall indicator of the firm’s level risk capacity usage. In practice, however, economic capital is often allocated to local business units, or even at the asset class level of each local business unit. Insurers need to monitor and track the performance of local EC ratios, across all business units, on a regular and timely basis. A methodology for quick update of economic capital calculation, granular reporting mechanism, and governance around the reporting/calculation process are all key to monitoring and enforcing limits.

Regional offices often play an important role here. Besides being the “go-to” expert in the region, they are often tasked with facilitating the governance and approval process. For instance, some capital buffer might need to be retained at regional office level to address ad hoc breaches and provide additional support. Depending on the fungibility of local business unit’s capital, limits can also be to some extent shared among business units for practical management.

DETERMINE STRATEGIC ASSET ALLOCATION

Strategic asset allocation serves not only as a way to determine optimal asset allocation, but also provides insights into investment risk profile, and economic capital consumption. Investment managers can be given economic capital to “spend”, giving them additional leeway in positioning the portfolio based on investment opportunities. From a risk management perspective, on the other hand, allocated economic capital gives the firm a sense of how much investment risks are contributing to the firm’s total capital requirement, and whether they are within the desired ranges. The major challenge in this area is how asset-liability profile can be captured so that capital and liability driven investment strategies can be implemented on a timely manner.



5. Challenges

Embedding an economic capital business processes is certainly not an easy task. Our experience shows that there are at least three major areas that firms need to tackle for a successful economic capital implementation.

IMPLEMENTATION EFFORT

The efforts required for the implementation phase should not be underestimated. As outlined above, numerous building blocks are required for a successful implementation, and each will require rather unique expertise and dedicated efforts. Our experience shows that, besides having a good project team to iron out the technical issues in implementation, it is essential to plan ahead and to align resources with the right qualification in the project.

» PLANNING. Given the extent of work required sufficient planning is needed. This is not only limited to timeline, resources and the budget, but also the technical roadmap. If a firm evaluates solutions and makes decision solely based on current needs, it might miss areas for potential further enhancement. It would be unfortunate if a firm spends significant money implementing a solution that is going to be made obsolete with a change in methodology in economic capital quantification. A few years ago the requirement for automation of Economic Scenario Generator (ESG) (re)calibration did not draw much attention, but now this requirement is almost a pre-requisite for insurers who want to implement internal models utilizing curve fitting or LSMC. Those who have not planned ahead might find themselves in the difficult position of deciding whether to switch ESG provider, or to build some solutions around an ESG that has not been designed with automation in mind.

» RESOURCES. Obviously implementation projects require significant human resources. What is more subtle is how knowledge embedded in the process can be effectively transferred to the risk management or actuarial team that is going to run economic capital as a business-as-usual activity. Consultants can often bring a wealth of knowledge to a project implementation phase, sharing best practices and educating staff members of their clients. What is also important is the continuation of such knowledge flow. Given the turnover of staff members and continuous development of new techniques, documentation and pro-active knowledge transfer becomes the key. Documentation, either internally written or accessed through third parties, should also be updated on a regular basis to reflect changes in the business requirements and emergence of new techniques.

VOLATILITY OF BALANCE SHEET MEASURES

How would a 50bps increase in the yield curve impact our balance sheets? Relative to statutory capital measures in many Asian regimes, economic capital is often more sensitive to market condition changes. Depending on the valuation approaches and calibration methodology, the answer to the question can differ quite dramatically. If we assume that asset dollar duration is less than that of liability, we would expect an overall increase in net asset value given an increase in interest rates. Under a fair valuation approach, we may expect to see further strengthening of the balance sheet through a reduction in cost of options and guarantees (or time value of options and guarantees), as the current interest rate is now even higher than the guarantee rate. As for the capital requirement, as explained above, an increased interest rate level would mean that there will actually be more room for central banks to cut interest rate and for the overall yield curve to drop, leading to a higher capital charge. On a total balance sheet basis, therefore, it is not easy to tell how our financial positions are impacted by market movements.

Risk managers and actuaries will need to invest time and resources to understand the implication of market movements on their firms’ financial positions, and then educate the business, senior executives and the Board to ensure they understand the underlying drivers of the volatility. Few people like to see surprises, and demonstrating the value of these volatile capital-risk measures can be, at times, a challenging task.



TIMELINESS OF CALCULATION

Given the volatility of economic capital measures, it is natural to recalculate and report the latest financial positions on a frequent basis, say every month. Unfortunately, due to the complex calculation and validation process, it is not uncommon for insurers to take 4-6 weeks for the whole economic capital production process to complete. This challenge gets more apparent when we try to incorporate economic capital in the business. It would be tough to ask business decision makers to wait for weeks for an updated financial analysis. It would be almost impossible for economic capital to gain visibility and creditability as a business-decision tool given these contexts.

It is therefore important to have a timely calculation engine, either in the form of accurate recalculation or proxy estimation, to support business initiatives. We have seen numerous insurers using proxy approaches such as LSMC to speed up the reporting and calculation lag time. Workflow process such as automation would help reduce run time and human error, and increase reliability of the process. Robust and reliable data management and reporting tools are also key elements – they make sure that time is not wasted on data consolidation and preparing report formats. All these elements help to ensure that economic capital production is reliable and industrialized.

6. Conclusion

Economic capital is considered as the core and most important quantitative element in many insurers’ ERM programs. It is also the corner-stone for many risk-capital business applications, such as risk appetite, business planning and asset allocation. Given the many facets of implementation and various approaches to modeling, risk management practitioners and actuaries are in the best positions to steer these projects and advance risk management practices in-house. This multi-year journey from conceptualization to implementation to business applications can be a challenging one full of obstacles, but, from professional and industry-wide development perspectives, it can be a rather rewarding one.



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