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Economic Capital

Economic Capital. Appointed Actuary Seminar September 2004 Doug Brooks. Topics. Sun Life’s Risk Framework Economic Capital in Life Companies Issues around Economic Capital Aggregation Regulatory vs. Economic Capital Issues – Model Risk. RISK. COMMUNICATIONS. RISK. RISK. TOOLS.

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Economic Capital

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  1. Economic Capital Appointed Actuary Seminar September 2004 Doug Brooks

  2. Topics • Sun Life’s Risk Framework • Economic Capital in Life Companies • Issues around Economic Capital • Aggregation • Regulatory vs. Economic Capital • Issues – Model Risk

  3. RISK COMMUNICATIONS RISK RISK TOOLS PHILOSOPHY CULTURE RESOURCES OBJECTIVES RISK RISK TOLERANCES POLICIES ACCOUNTABILITIES RISK PROCESSES Risk Management Framework

  4. Objectives of Risk Management • Avoid risks that could materially affect the value of the company • Contribute to sustainable earnings • Take risks that the company can manage in order to increase returns • Provide transparency of the company’s risks through internal and external reporting

  5. Risk Philosophy • Our business is accepting risks for appropriate returns • Risk Filter: • Understand the risk • Capability to manage the risk • Monitoring/reporting capabilities • Actionable mitigation strategies • Appropriate return for the risk taken on • Acceptable impact on total company risk profile • Embedded into the business management practices of every Business Group leader

  6. Organizational Attributes Everyone is a Risk Manager • Acting with Integrity • Understanding Impact on Customers • Embedded Risk Management – Discipline • Full and Transparent Communication • Collaboration • Alignment

  7. Risk Categorization • Categories • Sub-categories • Source • Exposure Triggers • Direct Consequences

  8. MARKET CREDIT RISK RISK OPERATIONAL RISK INSURANCE RISK Risk Categorization

  9. Rationale for Common Measurement • Help Ensure Solvency and Viability • Consistent Understanding of Risk & Return • Understand the Impact of Diversification • Understand Contributions of Businesses to Value • Appropriate Arbitrage of Regulatory Capital • Influence Regulators & Anticipate Regulatory Direction • Consistent Disclosure

  10. Economic Capital – A Common Risk Measure • Comprehensive coverage of risk types (financial, insurance, credit, operational) • All risks measured on a consistent basis. • Time horizon harmonized across analysis. • Confidence interval linked to strength. • Forward-looking, not historical volatility. • Additive across the businesses

  11. Illustration of Economic Capital

  12. Economic Capital - Steps • Identify and Model Risk Distributions • Determine Economic Capital by Risk • Aggregate Individual Risks Using Correlations • Allocate Economic Capital to Businesses • Benefits of Diversification? • Determine Risk-Adjusted Return

  13. Economic Capital - Issues • Modelling Different Risks - Methodology • Time Horizon and Level of Capital • CTE vs. Percentile • Reflecting “pass through” • Quantifying Operational Risk • Aggregation - Diversification

  14. Economic Capital Issues - Methodology • Purpose is to determine a model of the distribution of the risk based on company data • Different models may be appropriate for different risks, or based on materiality or data availability • Stochastic modelling is necessary where there is significant tail risk • Modelling using other distributions may be appropriate for risks with less tail risk, more symmetry, diversifiable risks • Reliance on regulatory factors • Benchmarking where information not available • Approximate means are appropriate where risk is not material

  15. Economic Capital Issues – Time Horizon and Level • Time horizon must be able to be modelled • Time horizon must be consistent across risks • Whatever horizon is used must still reflect lifetime liabilities • Level chosen will reflect the time horizon (a greater level will be chosen for a lesser horizon and vice versa – e.g. 99.95% for 1 year, 99.5% for 10 years) • Level is chosen to provide a level of security, and based on desired ratings and commitments to stakeholders

  16. Economic Capital Issues – Measure: Percentile vs. CTE • The measure used must reflect risk appropriately • The measure used must be consistent for all risks • CTE is appropriate for measuring tail risks • If there are substantial portion of the company’s risks that have significant tail risk, then CTE may be more appropriate • Level may reflect use of CTE or percentile (e.g. a higher level is appropriate if percentile is chosen, both numerically and to reflect potential for uncaptured risk)

  17. Economic Capital Issues – Reflecting Pass-Through • Many insurance products have some degree of pass-through to policyholders • Degree of pass-through varies • Ability to apply pass-through in practice must be assessed to determine appropriate offset to capital • Contractual constraints (e.g. minimum guarantees) • Actual practice of adjusting - expectations • Competitive constraints

  18. Economic Capital Issues – Areas with Little Experience • New products: • Policyholder behaviour and policyholder options • Health benefits • Current products in new economic conditions • New markets • Late-duration experience • Concentration risks Conservatism in tail assumptions

  19. Economic Capital Issues – Quantifying Operational Risk • Operational risk is an extremely important risk • Most failures have operational roots • What experience is appropriate to use for modelling operational risk? • Must reflect long-term nature of liabilities • Systems and processes and management will change over the lifetime of the liability • Is it worth a lot of investment to model? • Benchmarking approach • Incentive to management • Modifiers based on assessments

  20. Economic Capital Issues – Aggregation - Diversification • Risks must be aggregated – requires modelling • Copulas suggested by the IAA Working Group • Should reflect correlation BUT • Must be very careful with assumptions about persistence of observed correlations in the tails

  21. Economic Capital Issues – Aggregation • Correlation matrix approach has weaknesses, particularly if non-normally distributed risks • Copulas are a technique to aggregate via a multivariate uniform distribution • T-Copula approach captures both marginal distribution of risks and joint probability of extreme values (tail dependencies of a T-copula are controlled by parameter) • Data issues/calibration - a major factor

  22. Example of Aggregation

  23. 50 45 40 35 30 25 20 15 10 5 0 99.3 99.4 99.5 99.6 99.7 99.8 99.9 Aggregation - Parameters Gaussian_Copula Correlation T_Copula(V=1) T_Copula(V=4) T_Copula(V=10) T_Copula(V=20) T_Copula(V=100) 50 45 40 35 Correlation Benefit (%) 30 25 20 15 10 5 0 90.0 91.0 92.0 93.0 94.0 95.0 96.0 97.0 98.0 99.0 99.1 99.2 CTE

  24. Regulatory vs. Economic View • Creates basis for arbitrage • Appropriate reporting basis • Changes in regulatory capital requirements • Ability to influence regulatory developments

  25. Regulatory vs. Economic:Risk Distribution Economic Regulatory

  26. Definition of Model Risk: Model risk is a general term referring to the possibility of loss or error resulting from the use of models. This risk has a number of components: • Model misspecification • Assumption misspecification • Inappropriate use or application • Inadequate testing, validation, and documentation • Lack of knowledge or understanding, user and/or management • Inadequate systems structure and change management controls • Error and negligence

  27. CAS Stochastic Reserve GMIB Example

  28. “Full Run” Relative Error Plot

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