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  1. Insurers Manage Others’ Risks;Who Manages Theirs? Allan Brender Special Advisor, Capital Division Jerusalem, 16 October 2006

  2. Enterprise Risk Management • Corporate-wide approach to dealing with risk • Appears defensive but it can be a great resource in running any complex business • Increasingly seen as an indicator of sound management • Essential for all financial institutions, including insurance companies

  3. Enterprise Risk Management • Regulators encourage ERM • However, it would be a mistake and unproductive for insurers to approach ERM as a compliance exercise • With respect to ERM, there is a commonality of interests between policyholders and depositors, regulators and shareholders

  4. Standard & Poor’sWhat corporate Directors Need to Know About Credit Ratings Risk management lies at the core of a board of directors’ roles and responsibilities. Directors are accountable for the oversight of a company’s risk appetite, and it is the directors’ duty to ensure that acceptable risks are assumed and managed appropriately as part of overall corporate strategy implementation. Intrinsically a risk management tool, credit ratings are at the heart of the overall risk awareness and risk management process.

  5. Standard & Poor’sWhat corporate Directors Need to Know About Credit Ratings Credit ratings analysis seeks to incorporate many dimensions of risk that determine a company’s creditworthiness; these include commercial and operational risks, considerations of corporate and industry structure, regulatory arrangements and other public policy factors, overall strategy and management effectiveness, along with a financial analysis of historical performance, current position, and outlook.

  6. Insurers and ERM • The business of insurance is the business of managing and mitigating our customers’ risks • Insurers would appear to be “risk experts” who are at the forefront of risk management • However, the operations of an insurance company introduce their own set of risks which are often distinct from those of the company’s policyholders; these may not be given sufficient recognition

  7. Example: General American • Large U.S. life insurance company • Had a run of high claims in the mid-1990’s • Credit rating was downgraded by Moody’s • The company had accepted a large deposit of pension funds for investment administration • The contract included a 7-day call in the event GA’s credit rating declined • When GA was downgraded, it had insufficient liquid assets to meet the call • The company was put into bankruptcy and assumed by Metropolitan Life

  8. Example: General American S&P: Rating-related questions that directors can ask their CFO or Treasurer 6. How would our business model and/or strategy implementation be affected by a rating downgrade?

  9. Example: Confederation Life • In the early 1990s, the company’s investments were focused on the real estate market, including mortgages and construction financing • The company accepted a large pension deposit for investment administration • The contract included a guarantee to meet the median return of large Canadian pension funds • The company’s investors chose to invest in real estate, contrary to industry practice • When the real estate market in Canada and the U.S. suffered a severe downturn, the company was unable to meet the guarantee

  10. Example: Confederation Life S&P: Rating-related questions that directors can ask their Chief Investment Officer • How are credit ratings incorporated in our investment policy guidelines? • What is the analytical basis for our current eligible investment rating threshold; what is the resulting degree of default risk incorporated in our portfolio? • Based on the ratings distribution in our current holdings, what level of defaults should we expect in a credit cycle downturn?

  11. Example: Confederation Life • The company wanted to become a financial conglomerate • Like several other large Canadian insurers, it formed a trust company, accepting retail deposits and lending on mortgages • The incentive compensation for the managers hired to operate the trust company was based solely on the volume of mortgages they could place • As a result • A high volume of low-quality mortgages were issued • The trust company became known as a lender of last resort • The parent company was forced to assume a large volume of mortgages in default in order to save the trust company

  12. Example: Models • Models here may be • Financial models used to price assets • Corporate models used for valuation, scenario testing, valuation of liabilities, determination of capital requirements • Financial models are • based upon theoretical assumptions • often modified for special instruments • Simulation models include the company’s products, assets, experience, strategies

  13. Insurers and ERM • The operation of an insurance company exposes it to a wide variety of risks in addition to the risks assumed from policyholders • The insurance industry culture has tended to • not give these risks the attention they deserve • assume that in a long term business, most difficulties are smoothed and mitigated over time • assume that for short term business, the business plan can be altered to work out any difficulties • Successful implementation of ERM requires a change in company culture

  14. Risk Any event or action that may adversely affect an organization’s ability to achieve its objectives and execute its strategies • For quantifiable events, risk is often associated with the volatility of outcomes • Non-quantifiable events can also have significant financial costs

  15. Risk • Risk is inherent in the operation of any financial institution • Section 4 (4) of the OSFI Act“…financial institutions carry on business in a competitive environment that necessitates the management of risk …”

  16. Risk • The object of risk management is not to eliminate risk but to mitigate its effects • Risk management is a discipline for living with the possibility that future events may cause adverse effects

  17. Risk Management • RM is not totally focused on the downside • We are usually compensated for taking on risk; this compensation can be very attractive and rewarding • RM enables a company to define its risk appetite; this can help the company decide which risks it is willing to assume • In this way, RM is a valuable management tool

  18. The Many Faces of Risk • Risk-based capital requirements • Risk management • Risk-based supervision

  19. Risk-based Capital • First introduced in Canada (life insurance) • U.S. followed in the early 1990’s and extended to non-life companies shortly thereafter • International Association of Insurance Supervisors is developing a principles-based approach • IAIS asked IAA for assistance; result was A Global Framework for Insurer Solvency Assessment • In Europe, Solvency II is proceeding on a more concrete but parallel course • New developments in individual countries (U.K., Switzerland, Canada)

  20. Risk-based Capital • Insurers, faced with regulatory capital calculations, began to consider how much capital should be allocated to support various activities within their companies • A natural extension of these ideas is the development of Economic Capital

  21. Going concern with provision for eventual wind-up Protection of policyholders’ interests Standard calculation Going concern Shareholder value Company-specific, usually based upon corporate models RBC EC

  22. Economic Capital and ERM • Development of an economic capital system naturally leads to asking • How can capital allocation by risk be refined? • How can the company’s risks be better managed? • Can we analyze income based upon return on allocated risk-based capital (RAROC)? • This naturally leads to the development of ERM • An interesting description of this process as it applies to Allstate Corporation is contained in the latest issue of the Tillinghast Emphasis magazine, available at

  23. Classification of Risks • Insurance • Credit • Market • Liquidity • Operational • Legal • Reputation & Strategy

  24. Risk Types Correspond to a Possible Economic Loss Inter-risk diversification CREDIT RISK Unexpected Loss Earnings Deviation due to variations in Credit Losses Earnings Deviation due to inability to repatriate funds - immaterial for insurance TRANSFER RISK Unexpected Transfer Loss MARKET RISK Value at Risk Earnings Deviation due to changes in the Market Price or Liquidity RISK Earnings Deviation BUSINESS RISK Residual Earnings Deviation Earnings Deviation due to changes in Operating Economics (e.g. Volume, Margins or Costs) OPERATIONAL RISK Event Loss Deviation Earnings Deviation due to One-off Losses unrelated to Volume, Margins and Costs LIFE Risk Mortality Deviation Earnings Deviation due to unexpected changes in mortality rates Total Economic Risk Non-Life Risk Claims Deviation Earnings Deviation due to changes in morbidity and P&C claims

  25. Insurance Risk • Product design • Pricing • Underwriting • Selection • Transfer, retention, reduction of risk • Reserving for and adjudication of claims • Management of contractual and non-contractual contract options

  26. Risk and Diversification Traditionally, insurers have mitigated product risks through diversification • Diversification within portfolios • applies the Law of Large Numbers so that experience becomes more predictable as the size of the portfolio increases • Diversification between portfolios • Hold two portfolios for which risks, to some degree, offset • e.g. life insurance and life annuities

  27. Risk and Diversification • Increasing portfolio size does not always diversify risk • the Law of Large Numbers does not always apply • Consider the case of segregated fund guarantees (maturity guarantees (U.K.) or variable annuities (U.S.)) • The product is a mutual fund • The guarantee is that the value of the client’s account in ten years or at death if sooner will equal some function of the original investment

  28. Risk and Diversification • The primary guarantee is based upon the levels of various financial market indexes • All contracts are affected in the same direction by a change in index values • This risk is not diversifiable • The guarantee is equivalent to a put – it has a potential substantial cost • Many insurers charged no explicit price for this guarantee

  29. Do We Learn from Others? • In 1980, the U.K. Institute of Actuaries formed a working party to consider the implications of an investment product offering maturity guarantees • David Wilkie was a member of the working party and created the Wilkie Model for equity markets for its’ work • The working party concluded that a guarantee of 100% was very risky • Most U.K. companies decided not to offer this product • The Canadian life insurance industry, although connected to the U.K. industry, ignored these results in developing segregated fund guarantees

  30. Do We Learn from Others? • Consider Term to Age 100 (T100) developed in Canada in the early 1980s • This product offered no cash surrender values, or values only after age 65 • The product was priced assuming annual lapses of 5 to 6 percent; this led to very low premiums due to gains to the company resulting from surrenders • Agents realized this product could be paired with deferred annuities to produce a better alternative to whole life insurance • The product actually became one in which ultimate annual lapses are about 1.8%

  31. Do We Learn from Others? • U.S. actuaries were well informed about the Canadian experience with T100 • The common opinion was that since U.S. non-forfeiture laws require cash surrender values, this type of difficulty could not arise in the U.S. • The U.S. market has since developed Universal Life with Secondary Guarantees, a product which can be made to function like T100, with the same set of problems

  32. Credit Risk • The exact nature of this risk depends upon the nature of the instruments in which the company invests • In principle, this is similar to the same risk for banks • Insurers do not originate as many instruments • Insurers usually deal with proportionately long term investments • There is a vast literature on credit risk • David Wright of Moody’s KMV will discuss this later today

  33. Market Risk • Due to the often long-term nature of insurance liabilities, this is a very important source of risk for insurers • Policyholder behavior is often an important factor • An important risk mitigation strategy for insurers is Asset Liability Management • Canadian experience is that ALM works very well

  34. Liquidity Risk • This is not well understood • Not generally held to be quantifiable • Frequency of the event is often low but the cost (severity) of an event can be extremely high • This risk can be addressed through the company’s investment policy (e.g. concentration limits and diversification requirements)

  35. Reputation & Strategy Risk • Several insurers and reinsurers have had difficulties with respect to the use of finite reinsurance • Several U.S. and Canadian life insurers had difficulties with respect to vanishing premium policies • Total cost to the industry was many billions of dollars • CIBC • Formerly considered to be foremost among banks in ERM • Principal lender to Enron • Settled claims at a cost of $2.4 billion • The case of elusive fax number

  36. Operational Risk • The risk of loss resulting from inadequate or failed processes, people, systems or from external events • Most losses result from operational risks although they are later attributed to more technical categories • Difficult to develop sufficient data to allow proper quantification

  37. Implementing ERM • There is no unique ERM structure • Depends upon company structure, culture • Components • Direct involvement of the board of directors • Board risk committee or expanded audit committee • Quasi-independent RM structure within management • Independent of line management • Usually headed by CRO with a company-wide perspective • Involvement of internal audit but separate from it

  38. Chief Risk Officer • Interacts with • Chief Financial Officer • Chief Investment Officer • Chief Information Officer • Chief Actuary • Head of Internal Audit • Direct reporting to CEO is preferable • Often reports to CFO • In insurance companies, often an actuary

  39. Standard & Poor’sAssessing ERM Practices Of Financial Institutions The following are viewed as favorable to credit assessments Culture • RM function is independent of the business • Daily close partnership with the business through constant dialog • RM has the authority to advise the business to cut positions or halt execution of specific transactions if the need arises

  40. Standard & Poor’sAssessing ERM Practices Of Financial Institutions Culture • RM is involved at the outset in the budgeting and planning process • CRO participates at strategic planning sessions with senior management and/or the board • The institution appoints as senior risk managers individuals with significant business experience and who may also have advanced degrees

  41. Standard & Poor’sAssessing ERM Practices Of Financial Institutions Risk appetite • Risk appetite is established through dialog between RM and the businesses • Strategically consider risk-reward tradeoffs • Aggregate level risk tolerances are expressed holistically in terms of impact on earnings, volatility of revenues, capital, work force retention and reputation

  42. Standard & Poor’sAssessing ERM Practices Of Financial Institutions Risk aggregation and quantification • In association with business units, managers decide upon appropriate global risk metrics that effectively and accurately assess the firm’s risk exposures • The institution periodically provides senior management with a coherent picture of the risks to which the firm is exposed at any given point in time

  43. Standard & Poor’sAssessing ERM Practices Of Financial Institutions Risk disclosure • Articulate to senior management all risks through clear high-quality internal reporting • Hold weekly, monthly, quarterly meetings with RM, the business, and senior management to discuss risks • Ensure the board is well-engaged with ERM initiatives and is to some degree setting the tone

  44. Standard & Poor’sAssessing ERM Practices Of Financial Institutions Technical and quantifiable risks • Clear company-wide definitions and classifications • Consistent risk-measures • Clear limits for risk tolerance • Risk-specific criteria

  45. Supervisors and ERM Section 4 (2) (c) of the OSFI Act (2) The objects of the Office, in respect of financial institutions, are … (c) to promote the adoption by management and boards of directors of financial institutions of policies and procedures designed to control and manage risk

  46. Supervisors and ERM • The fundamental interest of supervisors is that financial institutions continue as going concerns and all obligations to policyholders are honored • Supervisors encourage ERM as a means of ensuring institutions will continue to operate in good financial health • Approaching supervisors’ request to engage in ERM as a compliance exercise is inappropriate

  47. Commonality of Interests Risk versus Return Risk versus Capital • Regulators • Rating Agencies • Creditors Senior Management • Shareholders • Analysts Regulators demand that risks are well managed (to avoid taxpayer bail-outs) Policyholders/creditors expect safety of their savings and investments Rating agencies will only give high ratings to institutions able to measure and manage risk • Shareholders have entrusted the board with their capital • They don’t want to lose it • They expect a decent return on it • They don’t want any surprises • They penalise volatility Capital Adequacy Capital Efficiency

  48. Risk-based Supervision • The object is to allocate the supervisor’s scarce resources efficiently • Greater resources should be devoted to institutions that pose greater risks • Supervisors assess each institution’s overall level of risk • The assessment is shared with senior management on a confidential basis

  49. Risk-based Supervision • The quality of a firm’s RM is an important component in evaluating its risk score • OSFI operates in a reliance mode • To the extent thata firm has solid risk management, the supervisor may rely on that independent oversight of the firm’s operations

  50. ERM and Risk-based Capital • The “new” RBC requirements will provide for sufficiently sophisticated companies to use advanced (company-specific) approaches, including internal models, to determine required capital • Approval for the use of such methods will generally depend upon the existence of a strong risk management program and culture in the company