Strategie di gestione di Economic Capital e Risk-Adjusted ... · Risk-Adjusted Performance per...

Strategie di gestione di Economic Capital e

Risk-Adjusted Performance per imprese di assicurazione

Mauro Piccinini, FIA, Ph.D.

ISTITUTO ITALIANO DEGLI ATTUARI

ATTIVITA’ SEMINARIALI E WORKSHOP DELL’ISTITUTO ITALIANO DEGLI ATTUARI

ANNO 2017

Roma, 15 giugno 2017

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Piccinini - Strategie di gestione di EC e RAP - 15Giu2017.pptx 1

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Topics and questions to be addressed today

Topic Question to be addressed today Key references

1What is Economic Capital (EC)? How different is it from SCR?

Why return should be adjusted for risk?

What relationship between EC and Risk-Adjusted Performance?

Introduction to

Economic Capital

and Risk-Adjusted

Performance

• Modigliani-1997

• McNeil-2005

• Wilson-2015

• Piccinini-2016

2Are dividends more volatile in a mkt consistent,risk-based regime?

What are the drivers of Total Shareholder Return?

Challenges in S/Hs

returns – Model and

empirical evidence

• Dacorogna-2013

• Piccinini-2014

• Wilson-2015

• Coppola-2017

3• BCG-2015

• Wilson-2015

• Piccinini-2016

• Coppola-2017

How can Total Shareholder Return be linked back to mgmt. levers?

How can an EC-based model be leveraged to choose the capital,

ALM and pricing strategy of the company?

Risk-based

strategic steering

4 How does insurers' operating model look like in risk-adjusted

corporate finance framework?

What is the role of actuaries of the "fifth" kind?

Actuaries of the

5th kind

• Borch-1974

• Buhlman-1987

• DeFe-2011

• BCG-2015


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Topics of today's discussion

Economic Capital (EC) and Risk-Adjusted Performance (RAP) – Overview

Current challenges affecting dividends & Total Shareholder Return (TSR)

EC and RAP management strategies

ACTION REQUIRED – for actuaries of the 5th kind

References


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Economic Capital is the last part of the new CERA syllabus

Sections of the CERA syllabus

Enterprise risk management concept and

framework

ERM process – Structure of the ERM

function and best practices

Risk categories and identification

Risk modelling and aggregation of risks

Risk measures

Risk management tools and techniques

Economic capital

Course programme

Definition of Economic Capital

Economic Capital in the banking industry

Measuring Economic Capital for insurers

Risk-Adjusted Performance Measures

How to use Economic Capital to generate

value in an ERM framework

1

2

3

4

5

6

7

Work in Progress

a

b

c

d

e

Source: Chartered Enterprise Risk Actuary (CERA) Global Association


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© Oliver Wyman

Assets

covering

technical

provisions

and SCR

Assets Liabilities

99.9th percentile

(e.g. Risk Appetite)

99.5th percentile

50th percentile

Excess EC

Technical

Provisions

SII Pillar 1

Excess

Capital

SCR

i

iiProbability of

ruin

Acceptable band

Lower Amber trigger

Lower Red threshold

Upper Amber trigger

Upper Red threshold

Acceptable range of capital

that does not require

management actions

Actions to improve

capital position

Actions to release capital

RAC (or Economic capital) is defined based on firm's RAF1

While S-II SCR is a capital requirement calculated as the

99.5% percentile of the loss distribution of eligible own funds

over a 1-year time horizon, Required Economic Capital is an

internal measure which depends on a number of factors, e.g.:

• Firm’s Risk appetite;

• Desired buffer over the required capital;

• Hurdle rate set by shareholders;

• Target credit ratings (AAA, AA, etc.).

The level of excess capital depends of the risk and capital

management strategy of the firm

iii

1. Risk Appetite Framework

EC can be allocated to single BUs and used in order to measure their

Risk-Adjusted Performance (e.g. EVA, NPV, RoRAC, RARoC, etc.)


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Accurate EC calculations would require nested stochastics...

How should EC be calculated? Illustrative: Nested stochastics

For insurers with a complex organizational structure and liabilities

with embedded options, computational challenges become an issue


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...but Monte-Carlo with proxies approach is more widely used

Continuous Marginal Contribution approach can be easily used in order to

allocate economic capital and identify the "critical scenarios"


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Designing the target metric is key to make risk-based

strategic decisions

3 lens used to define the strategy ... ... and to design metrics to be optimized

• Capital Mgmt plan • Risk Appetite

Framework

Profitability

• Business plan

Capital Risk

RARoC

RoRAC

Return

CapitalRisk-

adjustment

Return

Capital

Risk-

adjustment

Economic Value

Added

Risk-Adjusted Capital

(coherent with RAF)

Source: BCG analysis


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Example: Modigliani's RAP

Measures like “total return” assess the performance of

investments ignoring the fact that investors can

increase expected returns simply by accepting

higher level of risk. However:

• Investors are often risk averse, i.e. require a “risk

premium” for any uncertain outcomes

• These “risk premia” can be observed, measured

and indeed acquired in an open market

• Hence, risk premia do not reflect particular skills of

the investor, but simply their higher risk appetite

The underlying idea in making a performance

measure “risk-adjusted” is that it should not be

sensitive to increased return results achieved by

simply increasing exposure to risk

Modigliani's Risk Adjusted Performance

measures the performance of any managed ptf

against a notional unmanageable “market” ptf

Why should performance be adjusted for risk?

The idea of "risk-adjusting" a measure

P

MfPfP rrrM

2

Source: Modigliani (1997)


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On the relationship between EIRR, RoRAC and RARoC

Economic Capital can be used to risk-adjust a well-known measure such as the Internal Rate of Return (IRR) of

a cash-flow, i.e. the discount rate i* which makes the Net Present Value of future cashflows equal to zero:

0;,0,0 *

0

itvXXNPVT

t

t

Approaches to calculate the Economic Internal Rate of Return (EIRR)

Approach

1

Adjust the cash-flow to consider an initial

Economic Capital needed to cover

uncertainty over future cash flows, as a sort of

"capital strain" to be set aside at time 0

Approach

2

Adjust the cash-flow to consider the notional

cost of capital in the single future cash-flows

Coincides

with RoRAC

in a 1 y case

Coincides

with RARoC

in a 1 y case

0

~X

X

X

Source: Piccinini (2016)


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There is an intrinsic relation between profit ambitions and risk

profile – the desired trade-off is called Risk Appetite

Profitability is considered as the other

side of the coin of risk

-6

-5

-4

-3

-2

-1

0

1

2

Change in Economic Value (€ Bn)

Return Period in Years (logscale)

1000101 100

SCR1

The blue curve corresponds to a higher risk

appetite than the green one

Expected profit

Source: Dacorogna (RiskMinds Insurance (2016)

SCR2

A higher risk appetite implies that:

• Higher expected profit is achievable

• Exposure to potential losses is higher

• A higher amount of capital is required

A higher risk appetite leads to a

higher profitability gap between

favorable and adverse scenarios


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In fact, dividends policies are usually defined

in terms of target capital & risk

180%

Boundary Comment

220%

100%

186%

160%

145%

Allianz

• 50% dividend pay-out

• 20% of s/h NI1 to M&A budget

Capital actions

Q3 '16 level

De-risking

Dividends review

Aviva

• 50% of post tax operating

earnings per share

180%

100%

174%

150%

n.a.

Boundary Comment

Q3 '16 level

Capital redeployment

Risk reduction

Axa

• 45-55% of adjusted earnings

net of undated debt charges

230%

100%

191%

170%

n.a.

Boundary Comment

Q3 '16 level

Capital redeployment

Risk reduction

Capital

range

and risk

appetite

Payout

ratio

1. Net IncomeSource: Allianz, Axa and Aviva investors presentations, Q4 2016


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References


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Market

consistent

balance-sheets

3 factors threatening the attractiveness of insurance industry

Fact Consequence Call for action

Low interest

rates

Challenging

competitive

landscape

Design metrics and initiatives

aiming at reducing risk and

stabilizing balance-sheets

Manage in-force books to

maximize value extraction

and push NB on capital light

LoBs

Leverage on diversification

and automation to reduce

technical rates and expenses

• B/Ss move in line with market

dynamics, so are more volatile

• Higher capital requirements,

reflecting firm's risk-profile

• Traditional business model

challenged by direct, P2Ps, ...

• Higher compliance costsSolvency II, Insurance Core

Principles and ICSs

• Low fixed income rates

negatively affecting inv returns

• Profitability of in-force ptf hit by

high guarantees given in the past

A new "risk-adjusted corporate finance" is needed to redefine firms' strategies

using the concepts of Economic Capital and Risk-Adjusted Performance


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14

Premium model

Lognormal losses1

2Technical result

3

Profit After Tax5

Dividends Wealth of shareholders Shareholders’ annual earnings

Operating result4

6

In a 'traditional' model, premiums and claims drive profitability

Source: Dacorogna (2013)


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Lognormal losses

Premium model

1

2Technical result

3

Profit After Tax5

Dividends Wealth of shareholders Shareholders’ annual earnings

Operating result4

6

15

C

B A

tt RACRAC 1

A risk-based model is enhanced for, realistic returns1,

risk dependency2 and Required Economic Capital3A

B C

1. We added a market model to capture the dynamic of the asset portfolio 2. We used a copula approach in order to correlate market and CAT dynamics (assuming 25% rank correlation) 3. We considered the dynamic of the projected SCR in the calculation of payable dividendsSource: Piccinini (2014)


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16

0

0.2

0.4

0.6

0.8

1

1.2

1 2 3 4 5

Dividends (D)

0.5%

10.0%

50.0%

90.0%

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1 2 3 4 5

Dividends (B)

0.5%

10.0%

50.0%

90.0%

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1 2 3 4 5

Dividends (B)

0.5%

10.0%

50.0%

90.0%

0

0.2

0.4

0.6

0.8

1

1.2

1 2 3 4 5

Dividends (D)

0.5%

10.0%

50.0%

90.0%

Dividends get more volatile in an EC-frameworkEffect mainly due to market consistent balance sheet and cyclical effect risk-based capital

Approach

Traditional

simulation

approach

Company A Company B

New

EC-based

model

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1 2 3 4 5

Dividends (B)

0.5%

10.0%

50.0%

90.0%

0

0.2

0.4

0.6

0.8

1

1.2

1 2 3 4 5

Dividends (D)

0.5%

10.0%

50.0%

90.0%

€M

€M

€M

€M

Projected year Projected year

Projected yearProjected year

Dividends

Percentile

Dividends

Percentile



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© Oliver Wyman

Empirical analysis shows very differentiated TSR

performance of European insurers after 2008

Note: TSRs are Dec through Dec, except current era through 31-Jan-2017. Source: S&P Capital IQ; BCG ValueScience® Center

Pre-Financial Crisis Era Post-Crisis Era

Total Shareholder Return (TSR)

Capital gains + cash flow distribution

Index 100 = Dec 2008

Dec 2008 = 100

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Group A

Group B

Group C

Group D

Group E

Group F


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Main components of the TSR movements

Source: Capital IQ, BCG Value Science Center, BCG analysis

Key components of TSR Group A Group B Group F

22%

1%

16%

6%

-1%

5%

0%

17%

13%

-1%

21%

-21%

1%

-1%

2%

TSR +

Capital gains

Cash flow distribution

x

Change in TB

Change in P/TB

multiple

Dividends

Change in shares

+

Total TSR

(2008-2015)

(Contribution to TSR by driver, 2008-2015)

Why some Groups outperformed others?


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References


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Adj R2 = .85

1. Dividends paid in the year 2. Next twelve month average market consensus 3. Sum of Net Earned premiums, Investment income and Asset Management/ other commissions and feesSource: S&P Capital IQ, SNL; BCG ValueScience® Center Smart Multiple® equation ; BCG ValueScience® Center

Dividends

Revenue / TBV

Consensus Net

Income/ Revenue

Business mix

(Life %)

Solvency ratio

-1.0

-1

Market analysis and multiple regression help explaining the

drivers of P/ TB multiple valuation

85% of P/TB variance explained by 5 fundamental drivers

BCG proprietary tool –

Regression on P/ TB

Actual P/ TB multiple

Predicted P/ TB multiple

9 years observation for the

20 largest European insurers

by market cap

B/S

drivers

% of the P/ TB variance explained

To drive valuation high, need to manage both

profitability and B/S strength

P&L

drivers

• Company growth especially in capital-light

products and business areas

• Expected improvements in operational

efficiency and technical excellence

• Sound capital allocation between P&C vs. Life

• Sound capital position vs. underyling risks

• Ability to generate and pay cash to S/H1

3

2


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Quantitative

assessment

Strategic

targets and risk

contraints

Detailed design

of options

Stress testing

and decision

making

Define Risk Appetite Framework & cascade into operational limits

Set profitability targets and define dividends policy

Allocate capital across entities / BUs or define run-off options

Design options for new products, reinsurance, asset allocation, etc.

Calculate profitability for each option (accounting & economic view)

Assess Pillar 1 and Pillar 2 risks for each option

Project solvency position to get the NPV1 for each option

Strategic

options

design

Strategic

options

valuation

Decision making step What is required

Test solvency and profitability based on stressed assumptions

Detail contingency plans – what to do in case things go wrong

Approve decision and start execution/ monitoring or reiterate

We developed an EC-model to replicate

a risk-based strategic decision making process in 4-steps

1. Net Present ValueSource: Piccinini (2016)

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22

Reiteration 1: Effect of diversification benefit

Diversification benefit is not captured by ROE

Scenario A

Scenario B

Base scenario

Identical balance sheets and identical risk factors' distributions

All risk factors are uncorrelated

Identical balance sheets and identical risk factors' distributions

BU1 and BU2 are positively correlated, while BU3 is negatively correlated with BU1 and BU2

BU1 provides lower return and risk, while BU3 offers the highest return and risk




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Reiteration 2: Capital allocated to optimize RoRAC

Create transparency on risk-adjusted

performance by BU / geography ...

10

0

-10

-20

30

40

20

BU 1 BU 8BU 2 BU 6BU 3 BU 4 BU 5 BU 10BU 9

... to design specific actions for each BU/

geography, considering existing constraints

• Non core BUs: Release capital,

reallocate NB capital, consider run-off

• Turnaround: Define turnaround

actions to improve profitability

• Intra-group capital actions include

Capital injections, infra-group debt,...

• Regulation (e.g. ring-fencing)

• Capital structure

• Volatility of business

Diversified SCR (€)

PerformingNon

coreTurnaround

Operating profit on SCR (%)

Potential

actions

by BU

Capital

fungibility

constraints

Source: BCG analysis


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24

Reiteration 2: Investing more in one of the BUs

Having a “balanced” Group helps to maximise ROEC

Base scenario

Scenario C

Scenario D

BU1 provides lower return and risk, while BU3 offers the highest return and risk


Exposure to BU3 is increased by 25% and to BU1 is reduced by 25%

Exposure to BU3 is reduced by 25% and to BU1 is increased by 25%



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Reiteration 3: Changing the ALM strategy and SAA to

optimize risk – return trade-off (1/2)

Risk/return valuation by class Review of SAA & liability profile

• Identified the most efficient asset

classes considering risk/ return

• Redefined asset allocation

• Implemented risk-mitigating

actions

0

2

4

6

0 10 20 30 40 50 60

Alternatives

Real Estate

Equity

Corporate Debt

Government Bonds

Exposure SCR (% market value)

Return (% market value)High yields, limited

capital absorption

High capital

absorption, limited

returns

9%

13%

74%

Previous SAA1

20%

80%

2%2%

AlternativesEquity

Real EstateCorporate

Sovereign

Allocazione raccolta netta (%)Risk profile/ return by asset class

New SAA1

19F18F17F16A

Plan SAA

Baseline

Financial

margin

Market

risk SCR

Unrealized

gains/

losses

xx

xx

xx

xxProjection

Limit

Projected profitability and risk limits

xx

xx

xx

xxProjection

Limit

xx

xx

xx

xx

Other risk indicators in line with RAF

SAA = Strategic Asset AllocationSource: BCG analysis


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26

A strictly-controlled mismatching might be beneficial for Group ROEC

Scenario E

Scenario F

Scenario G

A portion of assets of BU2 previously invested in equity is reinvested in more ZCBs

ALM position is improved, but expected return on assets decreases

As E, but BU1 reduces duration of ZCBs to 5 years by investing into shorter term ZCBs

Higher expected reutrn, but mismatch with liabilities also increases (15 years)

As E, but BU1 reduces duration of ZCBs to 10 years

Expected return is lower than in F, but mismatch with liabilities is less significant

Reiteration 3: Changing the ALM strategy and SAA to

optimize risk – return trade-off (2/2)



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Reiteration 4: Risk-based pricing makes the firm's UW

strategy more competitive

Pricing is adjusted to consider

diversification benefits ...

... making firms more competitive on

products which better fit in their ptf

Diversified RAC

pr. B, firm RED

pr. A, firm RED

pr. B, firm BLU

pr. A, firm BLU

Allocate return on risk capital (RoRAC) targets

Define product concept and specify features

Calculate risk absorption (after div. benefit)

Obtain risk-based premium from target

RoRAC (and adjust it vs. elasticity of demand)

1

2

3

4

Profitability1 (%)

Firm BLU more competitive than

GREEN on product B

B has hedging features for firm BLU?

Product

A

Product

B

1. Net Profit MarginSource: BCG analysis

Risk-based pricing allows firms to price products more

accurately and be more competitive

GREEN is more competitive

than BLU on product A

Is BLU overexposed?


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28

Reducing risk might decrease diversification benefit, with negative effect for the Group

Scenario H Reduce riskiness of equity portfolio in BU3

Scenario I Reduce riskiness of underwriting policy in BU3

Scenario J Improve ALM position of BU3

Reiteration 4: Testing other risk mitigation techniques



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29

Decisions taken under a ROEC framework differ significantly

from optimal decision using a traditional ROE framework

ROEC-based optimal strategy following the four iteration of the model

Using the right RAPM is a key success factor for any

strategic decision making process



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References


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• Plan profitability targets

• Risk Appetite Framework

• Product plan

Capital management Business planning & risk mgmt

Business

strategy

Quantitative

analysis

• Profitability assessment

• Assessment of Pillar 1 and Pillar

2 risks

• Required capital projections

• Solvency ratio and

profitability projections

• Capital allocation and plan

• Stress testing on solvency &

profitability

• Regular monitoring of risks and

profitability

• Capital allocation and

dividends payout

• Contingency planning

Business

plan and

risk

strategy

Risk

assessment

Capital

projection &

stress testing

Monitoring,

capital mgmt &

contingency

planning

A new operating model to define a risk-based strategy

A

B

C

A

B

C

A

B

C

A

ORSA1

B

C

1

23

4

ORSA1 is a way to assess the sustainability of the business

plan and identify actions to stabilize dividends 1. Own Risk and Solvency AssessmentSource: BCG (2015)


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Many studies in the theory of risk have lacked a clear purpose [...]

Actuaries have estimated ruin probabilities and approximated claims distributions, without being very articulate

as to how their results could be used in the decisions-making process of an insurance company [...]

The responsibility for this does not fall entirely on actuaries: Top Management of insurance companies has not

always been very articulate when it comes to spelling out the objectives of the company

– Karl Borch

(Management & Objectives in Insurance Companies, GIIA, 1974)

A new risk-based corporate finance is needed?


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4th kind

A call for action, for actuaries of the fifth kind

1st kind

• Emerged in the XVII

century

• Focus on life

insurance

• Use deterministic

methods

2nd kind

• Developed in the

start of XX century

• Mainly casualty

actuaries

• Use probabilistic

approaches

3rd kind

• Developed in late-

1980s

• Investments and

ALM focus

• Use stochastic

processes

• First mentioned in

2005

• Focus on ERM and

non financial risks

• Quantitative risk

management

5th kind'strategic actuaries'

• Post Solvency II era

• Strategic steering

through risk-based

corporate finance

• Proxy projections &

communication

Source: Buhlmann (1987), Embrechts (2005)

Kind of actuaries


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References


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Androschuck T., Piccinini M. (2013), Measuring risk-adjusted performance for insurance: Methodological

insights and applications, Working paper, XXXVIII NATIONAL AMASES CONFERENCE

Bailleul B., Boulanger F., Tran Van Lieu L., Solvabilité et rentabilité: vers un modèle d’équilibre?, Bulletin

Français d’Actuariat, Vol. 4, n. 8, 2000

BCG (2015). Evoluzione di ORSA & Stress Testing alla luce di esperienza bancaria e esercizio ORSA 2015,

Atti del convegno su"Le sfide del mercato assicurativo", Moody's Analytics

Borch K. (1974). Management and Objectives in Insurance Companies. Giornale Italiano degli Attuari

Buhlmann, H., ASTIN Bulletin editorial (1987) entitled, “Actuaries of the Third Kind?”

Coppola M., Piccinini M. (2017), When Risk meets Strategy. How the CRO creates value for shareholders,

Working paper, RiskMinds Insurance, Amsterdam, 13-15 March 2017

Dacorogna M., Albrecher H., Moller M., Sahiti S. (2013). Equalization reserves for natural catastrophes and

shareholder value: a simulation study, European Actuarial Journal

De Felice M., Moriconi F. (2011). Una nuova finanza d'impresa. Le imprese di assicurazione, Solvency II, le

Autorità di vigilanza. Il Mulino

European Central Bank (2014). Guide to Banking Supervision, European Central Bank, 2014

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McNeil A. J., Frey R., Embrechts P. (2005). Quantitative Risk Management. Concepts, Techniques and Tools,

Princeton Series in Finance

Morgan Stanley, Oliver Wyman, European Insurance - Generating cash in a volatile Solvency II world, Morgan

Stanley Research, London, 2015

Modigliani F., Modigliani L., Risk-Adjusted Performance, The Journal of Portfolio Management, 1997

Piccinini M. (2014), Set-up the dividends strategy using Economic Capital – An application to Non-life

insurance, Working paper, XXXIX NATIONAL AMASES CONFERENCE

Piccinini M. (2016), Setting the strategy of insurance firms using Economic Capital. Concepts and tools to

manage Risk-Adjusted Performance, PhD Thesis, Sapienza Università di Roma, 2016

Rebonato R., Jackel P., The most general methodology to create a valid correlation matrix for risk

management and option pricing purposes, Quantitative Research Centre of the NatWest Group, 1999

Shang K., Chen Z. (2012). Risk Appetite: Linkage with Strategic Planning. Society of Actuaries

Tasche D., Allocating portfolio economic capital to sub-portfolios, 2004

Wilson T. (2015). Value and capital management, Wiley

36

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l

m

n

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p

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r


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© Oliver Wyman

Mauro Piccinini, FIA, Ph.D.

Mauro works in the Rome office of The Boston Consulting Group. He is a Fellow of the UK and of the Italian

Institute of Actuaries and Adjunct Professor of Actuarial Mathematics at LUISS Business School.

Recent project experience

• Design of the new Risk-Based framework for insurance supervision for a G-20 emerging Country, incl.

defining KRIs, controls, scoring systems and supervisory/inspection processes

• Risk-based planning (ORSA) for a Large Italian insurer, incl. preparation of regulatory report

• Design and evaluation of Run-off vs. Business Turnaround strategy for a Large German Life insurer (incl.

preparation of the regulatory discussions)

• Design of the new Risk Operating Model for a Large Global composite Group, to streamline processes

around risk capital calculations, incl. performing workshop sessions in Italy, France, Germany and CEE

• Regulatory application for a European insurer to use Undertaking Specific Parameters (USP) to calculate

regulatory capital, incl. preparation for an on-site supervisory inspection

• Set up of the new ALM function and lead the Strategic Asset Allocation for a Large Italian composite

Insurer, supporting the client's newly formed ALM team to set up the new SAA

• Solvency II Internal Model methodology and implementation for a Leading European composite Group, incl.

documentation and preparation of regulatory on-site supervision

• Capital methodology review for a large UK insurer, to ensure compliance with regulations

• Strategic business planning review for a Large UK Life Insurer, projecting Group's B/S & P&L

Work experience prior to BCG

• Junior manager at Oliver Wyman (Milan, European insurance practice)

• Senior Actuarial Advisor at KPMG (Actuarial and Risk consulting team, London)

• Senior Analyst at Aviva Group (ALM and Solvency II team, London)

Education

• PhD in Actuarial Science at Sapienza University of Rome (2016)

• MSc (cum laude) in Financial and actuarial sciences at Sapienza University of Rome (2010)

[email protected]

mailto:[email protected]

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