The document discusses topics related to enterprise risk capital frameworks including modeling issues like correlation assumptions and stress testing. It addresses principles of capital framework development and management implications such as using the framework for strategic decisions and product development. Emerging issues like assessing systemic risk are also covered.

1. Michel Rochette, MBA, FSA, PhD Student
2010 Valuation Actuary Symposium
Chicago
September 21th 2010

2. Topics
 Purpose and principles of any capital framework
 Modelling issues:
 Diversification: correlation assumptions
 Stress testing
 Management implications:
 Use test and ORSA
 Capital types and liquidity
 Emerging issues
09/21/2010 Enterprise Risk Advisory LLC

3. Purpose of an EC framework
 ¨ Risk management system of an insurer for the
analysis of the overall risk situation of the insurance
undertaking, to quantify risks and determine the
capital requirement on the basis of the company
specific risk profile¨ CEA Groupe Consultatif
 Required capital is assessed in light of:
 available capital & other financial resources
 enterprise risk management processes
 strategic goals & risk appetite
 regulatory requirements
09/21/2010 Enterprise Risk Advisory LLC

4. Principles: EC Development
 All material risks should be covered: links to ERM and emerging risks
 Models must be appropriate for the scale and complexity of the firm
 Models must be dynamic and flexible
 Models must be embedded in the financial, strategic and operational
processes: Use Test in Solvency II
 Governance of models development:
 Board/top management oversight and involvement
 documentation of models, limitations & changes
 internal controls over development: auditable
 independent review: More than peer review
 Others:
 consistency between valuation and EC models: valuation framework
 input data verifiable and controllable
 validation and calibration
09/21/2010 Enterprise Risk Advisory LLC

5. Correlation: Proposals
 Correlations exist at different levels:
 (CRO Forum, Dec. 2009, QIS5)
Some risk factors Corr. Coefficients
Equity/IRR 50%(D)/0%(U)
FX/IRR 25%
Default/Equity 25% CROF,QIS4
75% QIS5
Default/IRR 50%(D)/0%(U)
 Between legal entities for Solvency II: zero because of
the non-fungibility of capital and the non recognition of
group capital support
09/21/2010 Enterprise Risk Advisory LLC

6. Correlation: Crisis Dependent
 According to a 2009 Pimco study:
Correlation to S & P 500 Corr elation Correlation
Early 90s Early 2008
S & P 500 1 1
High-Yield Bonds 20% -30% 80%
International stocks 30% -40% 70%
Real Estate 30% 60% -70%
Commodities 0% -20% -30%
09/21/2010 Enterprise Risk Advisory LLC

7. Correlation: Implications
 In times of crisis, negative correlation benefit between
asset classes disappears.
 “When people start buying an asset, the act of them
diversifying ultimately makes the asset less of a diversifier .”
Pimco’s Head of analytics
 Rule: total diversification benefit should not be above 30%
 Solvency II QIS4: 31%
 CROF: 21%
 Swiss Solvency Test: 24%
 Ultimately, correlation assumptions should determined
by linking back to your own company’s ERM processes.
09/21/2010 Enterprise Risk Advisory LLC

8. Stress Testing: Complimentary
Approach
 Regulatory Approach:
 QIS5 risk shocks by type of risk:
 Some examples:
 Global Equity: 39% & volatility Up: 10% additive
 Property: 25%, low compared to recent US experience!
 Spread Widening, AA-rated, 4yr: 10.4%
 Management Approach:
 Prospective scenario modelling with a top down approach
 Historical perspective:
 Ex. 2008 credit crunch
 Similar risk events at other firms, in other industries
09/21/2010 Enterprise Risk Advisory LLC

9. Management Implications of EC:
Use it!
 Investment decisions: existing and new
 Product development
 Strategic decisions: probably the most important of all
 Corporate finance decisions: financial leverage
 Hedging strategies: use it within the treasury
department
 Solvency II regulatory proposal:
 “…widely used and plays an important role in the course
of conducting an insurer's regular business, particularly
in risk management. "
09/21/2010 Enterprise Risk Advisory LLC

10. Solvency II ORSA & EC
 Pillar II requirement: Own Risk & Solvency Assessment
 Goal is to demonstrate “sound and prudent management of the
business and assess overall solvency needs.”
 In other words, is risk management – including EC – aligned
with your strategies and internal risk and control processes?
Demonstrate that!
 Useful references:
 Bermuda Monetary Authority: “Opportunity to align management
and regulatory reporting & encourage sound risk management
practices within the jurisdiction.”
 CEIOPS: Preliminary views on the definition and importance of the
ORSA as a management tool, requirements and guidance:
 Alignment of risk profile, risk tolerance, risk strategy
09/21/2010 Enterprise Risk Advisory LLC

11. Capital and Liquidity of EC
 Types of required capital: expressed in Tiers in Solvency II
 Tier 1: most secure and liquid, permanent
 shareholder’s equity and inforce cash flows
 Tier 2: revaluation reserves, general provisions, hybrid like
instruments and subordinated term debt, callable equity,
group support, letters of credit, unpaid shares, Max. 50%
 Tier 3: Hybrid capital, subordinated loans, Max. 15%
 Liquidity
 New explicit requirement since the 2008 crisis
 The insurance industry should be concerned about assessing
explicitly liquidity risk and liquid capital instead of trying to
do it indirectly through the debate over liquidity premium in
valuation reserves. Not in line with best EC/ERM practices.
09/21/2010 Enterprise Risk Advisory LLC

12. EC Emerging Risk: Systemic risk
 “The risk of disruption to the flow of financial services that is (i)
caused by an impairment of all or parts of the financial system; and (ii)
has the potential to have serious negative consequences for the real
economy.“ (IMF)
 “Treat systemic risk as an emerging risk” Dave Ingram, SVP Willis Re
 Some insurers are already considered “ systematically relevant
institutions”: Aegon, Allianz, Aviva, Axa, Swiss Re and Zurich, not any
US insurer? (Financial Stability Board)
 "Most insurers will be impacted by systemic risks, but only a few
insurers can contribute to creating systemic risk" - Dr Shaun Wang
 Does insurance create systemic risk?
 Emerging consensus is NO
 But insurance business will be impacted by systemic risk events.
(Bennett, AAA)
09/21/2010 Enterprise Risk Advisory LLC