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Economic Capital Modeling A Key Part of the ERM Process

Mid-Atlantic Mutual Advantage Convention August 5, 2014. Economic Capital Modeling A Key Part of the ERM Process Ronald T. Kuehn, FCAS, MAAA, CERA, CPCU, ARM, FCA Consulting Actuary, Huggins Actuarial Services, Inc. Definition of Economic Capital. Economic Capital is defined as

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Economic Capital Modeling A Key Part of the ERM Process

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  1. Mid-Atlantic Mutual Advantage Convention August 5, 2014 Economic Capital ModelingA Key Part of the ERM Process Ronald T. Kuehn, FCAS, MAAA, CERA, CPCU, ARM, FCA Consulting Actuary, Huggins Actuarial Services, Inc.

  2. Definition of Economic Capital • Economic Capital is defined as • Sufficient surplus to cover adverse outcomes or to meet a business objective • With a given level of risk tolerance • Over a specified period of time

  3. Definition of an Economic Capital Models (ECM) • One primary tool to assess risk in an insurance organization • Simulates the internal operations of the company relative to the external environment within which it is operating • Indicates future levels and volatility of profitability, and • Estimates appropriate amounts of capital to hold

  4. A Brief History of ECM

  5. A Brief History of ECM

  6. ECM Can …. • Model • Company or Product Risk Profiles • Risk Tolerance, Constraints & Strategies • Insurance Pricing & Business strategies • Performance Measurements • Capital Adequacy & Budgeting • Incentive Compensation Investment & Risk-Adjusted Rates of Return • Merger & Acquisition Pricing Details • Capital Allocation Among Business Units

  7. Key Risks Being Measured by a Comprehensive Economic Capital Model

  8. Benefits of an Economic Capital Model Compliance Related ECM • Satisfy rating agency and regulatory criteria/inquiries • Aid in discussions with rating agencies and regulators • Capital adequacy measured against a company’s risk profile

  9. Benefits of an Economic Capital Model Compliance Related • A.M. Best’s Supplemental Rating Questionnaire (no longer asks the ECM question as of year-end 2013) • Q 56: ECM – Risk Identification & Monitoring • Q 57: Frequency of Update to ECM and Measurement of Aggregate Risk • Q 58: Impact of Calendar Year Inflation on Reserves • Strong emphasis on Catastrophe Management (Updated as of January 14th, 2014) • Preparation of the ORSA summary report • Essential for Solvency II Compliance

  10. Benefits of an Economic Capital Model Value Beyond Compliance More to gain from ECM than compliance • Improves risk awareness at all levels • Enables better risk/reward decisions making • Facilities linking strategy with planning • Empowers firm to improve value for stakeholders • Provides a competitive advantage including reduced cost of capital (University of Georgia Study 2013)

  11. Insurance Companies & ECM A.M. Best 2010 ERM SRQ: • Overall 28% of respondents use ECM to quantify aggregate risk • Large (55%), • Medium (33%), and • Small (17%) • 8% use ECM for management compensation NAIC moving with European regulator EIOPA ? • Solvency II will allow companies capital relief by use of internal ECM rather than standard model

  12. Insurance Companies & ECM • Savvy Investors, media, and the financial community speak language of risk modeling (VaR, TVaR, PML, etc.) • Demand more disclosure of metrics from ECMs. • Developing ECM is costly as it requires: • Acquiring actuarial and financial expertise • Collecting of significant volume data • Analyzing data to develop risk parameters • Licensing or building ECM software platform • Validating the model and organizing the management process for audit

  13. Existing Capital Adequacy Measures • RBC (Risk-Based Capital) Ratio • Implemented by the NAIC in the 1990’s • Formulaic estimate of necessary surplus and comparison to reported surplus • Used to authorize regulatory intervention into financially-distressed • NAIC ORSA (Own Risk and Solvency Assessment) • Companies with at least $500 M WP • Group with at least $1B WP • Effective circa 2015

  14. Insurance Companies & ECM • Rating Agency Measures: BCAR and others • Both formulaic and simulation-based • Used as significant input into assignment of financial strength ratings • Lack full transparency, as not all parameters are made public

  15. Insurance Companies & ECM • Economic Capital Models (ECM’s) • Simulation based • Direct calculation of Economic Capital needed • Many other uses in addition to Economic Capital measure

  16. Basic Inputs to an Economic Capital Model Balance Sheet Inputs: • Assets • Cash • Bonds • Common Stock • Other Asset Classes • Liabilities • Loss and Loss Adjust Reserves by Line / Subline • Payment patterns for Existing Reserves • Unearned Premium Reserve • Other Liabilities

  17. Basic Inputs to an Economic Capital Model (Line of Business Inputs) • Direct Written Premium • Claim Payout Pattern for Newly Generated Loss • Underwriting Expenses • Earnings Pattern • Operational Risk – Lognormal Distribution

  18. Basic Inputs to an Economic Capital Model (Cause of Loss) • Frequency and Severity Model – Frequency of Individual Claims with No Correlation • Claim Frequency Distribution - Examples • Poisson – often selected • Negative Binomial • Binomial

  19. Basic Inputs to an Economic Capital Model (Cause of Loss) • Frequency and Severity Model – Severity of Individual Claims with No Correlation • Claim Severity Distribution - Examples • Lognormal – often selected • Exponential • Gamma • Generalized Pareto • Normal • Uniform • Weibull

  20. Basic Inputs to an Economic Capital Model (Cause of Loss) • Aggregate Loss Model – Aggregate claims model can incorporate copulas (i.e., correlation between lines of business) • Aggregate Loss Distribution Examples • Lognormal • Generalized Pareto • Normal • Uniform • Weibull

  21. Basic Inputs to an Economic Capital Model (Cause of Loss) • Selection of Copulas - adds correlation between lines of business • Normal Copula – linear correlation coefficient • Student’s T Copula – varies weight of coefficients in tail of distribution • HRT Copula – more weight in right tail of distribution • Partial Perfect Copula – mixes perfect correlation with uncorrelated

  22. Basic Inputs to an Economic Capital Model (Reinsurance Inputs) • Reinsurance Contract Terms • Per Risk • Excess • Corridors • Ceded Premium • Ceded Reinsurance Attachment Point • Ceded Reinsurance Limit • Specific Catastrophe Reinsurance Terms • Reinsurance Catastrophe Modeling Results (i.e. AIR, EQECAT, RMS)

  23. Basic Inputs to an Economic Capital Model (Economic Scenarios) • Leading edge economic models, providing full market risk and asset class coverage • Estimates inflationary changes, wage & CPI • Estimates of investment returns and default risk: • • US Treasury bonds• US, United Kingdom, and Euro stock markets• Emerging Markets stocks• Blue Chip Stocks• Corporate and Municipal bonds of varying quality • Master Limited Partnerships• Real Estate Investment Trusts (REITs)• Mortgage Backed Securities

  24. Basic Outputs from an Economic Capital Model • Outputs include but are not limited to: • Over 180 customizable reports • Cumulative Probability Density Functions • Compare results from differing assumptions • Include effect of catastrophe losses • Calculates Value at Risk (VaR) & Tail Value at Risk (TVaR) • Pro Forma Financial Statements • Balance Sheet • Income Statement • Number of projected years is flexible

  25. ECM - Key Risk Metrics Return on Equity = Net Income/Shareholder's Equity Value at Risk (VAR) – Maximum loss at no more than one minus the confidence level Tail Value at Risk (TVaR) – Expected loss in worst X percentage of distribution; also called CTE Risk Adjusted Performance – Measure risk adjusted returns on some established capital amount Return on Equity – Simple accounting performance metric

  26. Happy Valley Insurance Company • Case Study

  27. Happy Valley Insurance CompanyBase Case - Liabilities & Surplus

  28. Happy Valley Insurance CompanyBase Case - Assets by Class

  29. Happy Valley Insurance CompanyBase Case - Earned Premium 2015

  30. Happy Valley Insurance CompanyBase Case - Reinsurance Program

  31. Happy Valley Insurance CompanyBase Case ECM Results Solvency II Standard

  32. Happy Valley Insurance Company Alternative Investment Scenario • In the Base Case scenario, Happy Valley invests in: • Government bonds, • Blue chip stocks • Cash • Miscellaneous other assets • In the Alternative Investment Scenario, Happy Valley increases its investment in: • Blue chip stocks and • Adds a substantial investment in master limited partnerships (MLP’s)

  33. Happy Valley Insurance CompanyComparison of Investment Distribution

  34. Happy Valley Insurance CompanyAlternative Investments Happy Valley Insurance CompanyAlternative Investment Scenario ECM Results Solvency II Standard

  35. Happy Valley Insurance Company Case Study - Buys Small Auto Insurer • In the Base Case scenario, Happy Valley invests in: • Government bonds • Blue chip stocks • Cash • Miscellaneous other assets • In the second alternative, Happy Valley uses excess surplus, to buy small, profitable personal auto insurer • Costs $2.3 million over book value • Assumes $5.0 million in net loss & loss adjustment reserves • Assumes $3.5 million in unearned premium reserves

  36. Happy Valley Insurance CompanyBuy Auto Insurer - Liabilities & Surplus

  37. Happy Valley Insurance Company Buy Auto Insurer - Assets by Class

  38. Happy Valley Insurance CompanyBuy Auto Insurer - Earned Premium 2015

  39. Happy Valley Insurance CompanyBuy Auto Insurer - ECM Results Solvency II Standard

  40. Happy Valley Insurance Company Case Study – Alternative Reinsurance • In the third alternative scenario, Happy Valley reduces its reliance on reinsurance by: • Doubling retention on General Liability • Doubling retention on Property Per Risk • Eliminating first Catastrophe layer Graphic: RadientSkies/123RF.com

  41. Happy Valley Insurance CompanyAlternative Reinsurance – Liabilities & Surplus Graphic: RadientSkies/123RF.com

  42. Happy Valley Insurance CompanyAlternative Reinsurance - Assets by Class Graphic: RadientSkies/123RF.com

  43. Happy Valley Insurance CompanyComparison of Reinsurance Program Graphic: RadientSkies/123RF.com

  44. Happy Valley Insurance CompanyAlternative Reinsurance - ECM Results Solvency II Standard Graphic: RadientSkies/123RF.com

  45. Happy Valley Insurance Company Case Study – $1.8 M Dividend Per Year • In the Base Case scenario, Happy Valley invests in: • Government bonds • Blue chip stocks • Cash • Miscellaneous other assets • In the fourth alternative scenario, Happy Valley begins to pay its shareholders $1.8 million of dividends per year beginning in 2015 to reduce under-utilized surplus. Graphic: CSA Images / B&W Engrave Ink Collection / Getty Images

  46. Happy Valley Insurance Company $1.8 M Dividend Per Year – Liabilities & Surplus Graphic: CSA Images / B&W Engrave Ink Collection / Getty Images

  47. Happy Valley Insurance Company $1.8 M Dividend Per Year - Assets by Class Graphic: CSA Images / B&W Engrave Ink Collection / Getty Images

  48. Happy Valley Insurance Company $1.8 M Dividend Per Year - Same as Base Case Reinsurance Program Graphic: CSA Images / B&W Engrave Ink Collection / Getty Images

  49. Happy Valley Insurance Company $1.8 M Dividend Per Year - ECM Results Solvency II Standard Graphic: CSA Images / B&W Engrave Ink Collection / Getty Images

  50. Happy Valley Insurance CompanyComparison of Key Metrics for Scenarios

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