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Economic Capital and Risk Modeling. February 22, 2008 • Iowa Actuaries Club Session #2. Jeff Fitch, Senior Actuary - Corporate . Outline. Principal’s Risk Metric and Economic Capital Framework Lesson’s Learned from Principal’s Implementation Applications of Economic Capital models

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economic capital and risk modeling
Economic Capital and Risk Modeling

February 22, 2008 • Iowa Actuaries Club Session #2

Jeff Fitch, Senior Actuary - Corporate

outline
Outline
  • Principal’s Risk Metric and Economic Capital Framework
  • Lesson’s Learned from Principal’s Implementation
  • Applications of Economic Capital models
  • Emerging Industry Economic Capital Trends

2

principal s risk metrics and economic capital framework
Principal’s Risk Metrics and Economic Capital Framework
  • Background
    • Where we were
    • Where we are at now
    • Looking forward
  • My role in the process

3

driving forces objectives
Driving Forces & Objectives
  • Better understanding of risk exposures and incorporate into decision making process
  • Improve our ability to measure and manage risk and return
  • Appropriate capital level and capital allocation
  • Competitive Pressures
  • Economic Uncertainty
  • Rating Agencies
  • Board

4

principal s economic risk metrics
Principal’s Economic Risk Metrics

3 Primary Risk Metrics

  • Earnings at Risk (EaR)
  • Embedded Value at Risk (EVaR)
  • Economic Total Asset Requirement

5

earnings at risk ear
Earnings at Risk (EaR)
  • Measures short-term volatility of GAAP Operating Earnings
  • Difference between:
    • Best Estimate (baseline) GAAP Operating Earnings; and
    • 90th percentile confidence level GAAP Operating Earnings
  • Difference expressed as percent of Best Estimate (baseline) GAAP Operating Earnings
  • Time horizon of one year GAAP Operating Earnings
  • New business included in projection
  • Also look at GAAP Net Income

6

earnings at risk ear example 1 year ear at 90 th percentile
Earnings at Risk (EaR) Example1 year EaR at 90th Percentile
  • Run 1,000 scenarios of 1 year operating earnings
  • Rank them from best to worst
  • EaR is difference between Best Estimate and 900th scenario

7

embedded value ev and embedded value at risk evar
Embedded Value (EV) and Embedded Value at Risk (EVaR)
  • Measures value of inforce business – doesn’t reflect new business or intangibles (brand, reputation)
  • Present Value of Distributable Earnings
  • Embedded Value at Risk measures potential volatility in value
    • Difference between:
      • Best Estimate (baseline) Embedded Value; and
      • 90th percentile confidence level Embedded Value

8

economic total asset requirement
Economic Total Asset Requirement
  • Economic Total Asset Requirement is the amount of assets needed to cover our obligations at a given risk tolerance level over a specified time horizon.
    • 99.5% risk tolerance level for a AA rated company
    • 30 year time horizon
  • Economic Total Asset Requirement =

Economic Reserves (cover obligations based on our

best estimate of claims plus a margin)

+

Economic Capital (cushion on top of Economic Reserves

to cover potential obligations from unanticipated adverse experience)

  • Our external Total Asset Requirement is equal to statutory regulatory reserves plus rating agency required capital.
  • Trapped Capital is the difference between external Total Asset Requirement and our Economic Total Asset Requirement.

9

steps in quantifying economic capital
Steps in quantifying Economic Capital
  • Identify and categorize risks
    • Credit
    • Market
    • Product / Pricing
    • Operational / Business
  • Quantify each risk individually
    • Deterministic Stress Test and / or stochastic modeling
  • Aggregate risks and capture any diversification impact

12

risk hierarchy deeper dive
Risk Hierarchy – Deeper Dive

Mortality Risk, for example, can be broken down into 4 components

  • Volatility – statistical mortality fluctuation
  • Level – misestimation of mortality mean
  • Trend – misestimation of mortality improvement
  • Calamity – 1 time spike mortality (flu pandemic)

13

top 10 lessons learned from principal s implementation
Top 10 Lessons Learned from Principal’s Implementation
  • Importance of Quick Wins
  • Simplify
  • It isn’t all about modeling
  • Involve all parties in the process
  • Set up guiding principles up front

15

top 10 lessons learned from principal s implementation cont
Top 10 Lessons Learned from Principal’s Implementation (cont.)
  • Set up risk appetite and tolerances up front.
  • Not a project. Never really done.
  • Look at entire distribution of results (don’t focus only on the downside)
  • Use lots of pictures
  • Communication, communication, communication.

16

applications of economic capital models if you build it they will come
Applications of Economic Capital Models (if you build it they will come)

Initial Uses:

  • Product / Business Unit decision making
  • Hedging / Reinsurance
  • Internal Risk Reporting

Medium Term Uses:

  • Strategic Decision Making
  • Capital Allocation
  • Performance Measurement
  • External Reporting

Long Term Uses:

  • Pricing
  • Incentive Compensation

17

emerging industry trends economic capital
Emerging Industry Trends – Economic Capital

Two methods have emerged as the most common:

  • Liability Run Off Approach
    • Level of starting assets needed to pay all future policyholder obligations at a chosen confidence level
    • Approach used for RBC C3 Phase 2
  • One Year Mark to Market Approach
    • Level of assets needed to cover a fall in the market value of net assets over a one-year time horizon at a chosen confidence level
    • Approach used for Solvency 2

18

lots of different variations in approaches
Lots of different variations in approaches
  • Many decisions to make:
    • Time Horizon
    • Confidence Level
    • What risks to include and how to measure
    • Stochastic vs. Stress Testing

Many possible combinations!

19

one year mark to market approach
One Year Mark to Market Approach
  • Emerging as most common method to calculate Economic Capital
  • Driven by emerging solvency standards, particularly in Europe (Basel II, Swiss Solvency Test, Solvency II)
  • Consistent with emerging international accounting and solvency standards
  • US principles based approach for reserves and capital is more of a liability runoff approach
    • Although use of one year market-to-market for EC is increasing in the US

20

is one year enough
Is One Year Enough?
  • Since our products have a long duration, how can you capture the risk using a 1 year approach?
    • You are still projecting your cash flows out to maturity and factoring in the residual impact of that 1 year event.
    • Confidence interval on a 1 year approach is likely higher than a multi-year approach
      • Ex: 99.95% instead of 99.5% for a AA Rated Company
  • After one year company can likely recapitalize and take other management action

22

market consistent valuation
Market Consistent Valuation
  • Market price to transfer a liability between willing participants
  • Applies capital market principles to liabilities
    • No arbitrage (identical cash flows must have the same value)
  • Uses risk neutral scenarios, discount at risk free rates
    • Calibrated to current market conditions & prices
    • Captures embedded options & guarantees
  • Add an additional margin for non-hedgeable risks (Market Value Margin)
    • Percentile Method
    • Cost of Capital Method

23

in a market consistent embedded value framework selecting assets does not create value
In a Market Consistent Embedded Value Framework, selecting assets does not create value

Example:

Company has Capital of 25, Borrows 75 at 4%, and invests 100 in equities expected to earn 8%

  • Using traditional EV techniques, the 30 might be discounted at say 9%, giving a value of 27.5 on day 1.
  • Under MCEV the asset CFs are discounted at 8% and the liability CFs at 4%, giving a value of 25 on day 1.
  • The effective discount rate on capital is 20%.
  • The risk discount rate is an output of the MCEV valuation, and not an input.
  • Under a Market Consistent Framework you can’t take credit up front for taking market risk.

24