Risk versus Return under Solvency II

Report
Agenda
Topic
Issue
ORSA & ERM
Context
Linking business strategy and
risk strategy
How practically can I use them
interactively?
Performance measurement
Lots of performance metrics, so how do I
make decisions?
Risk appetite
How do I generate risk appetite
statements?
Operationalising risk appetite
How do I set risk limits / budgets?
Strategic
Approach
Business strategy
What are our competitive advantages? Are we generating value for our
members?
Strategic risk management
Which risks do we want to take and why?
How much risk do we want to take?
Enterprise
risk and
capital
management
framework
Risk & capital models
What risks do we face?
What is the range of
potential impacts?
How do our risks
interact?
Emerging risk mgt
What are the threats &
opportunities to our
business? Are events
likely to invalidate our
model? What is the plan
to manage threats?
What are the triggers?
Solvency & capital
management
How much capital do
we need to hold in each
entity? How do we
manage risk-taking?
Culture
How do we behave in managing our business?
Embedded
through
business
processes
Strategic
planning
Products
& pricing
Governance
& controls
Performance
mgt
Capital
mgt
Reporting
Articulate the business model
 The business model
 Outlines what the business does, and
 How it makes money doing it
 Helps stakeholders to
 Understand where the return is expected to come from, and
 The sort of risks the business is expected to take.
LONG TERM
PROFITABILITY
OF
FIRM
=
PROFIT POTENTIAL
OF INDUSTRY
or
MARKET
SEGMENT
+/-
COMPETITIVE
ADVANTAGE
OF FIRM
IN THAT
SECTOR
Qualitative risk strategy/risk appetite statements
Overarching principles:
• We do not wish to take unrewarded risks
• We do not want to take risks that are not consistent with the delivery of our
strategy as an insurer.
• We will take on risks dependent on the expected return exceeding the cost of
capital
• We will charge a price for accepting risk that seeks to optimise our risk/reward
profile and that fully reflects the cost of taking that risk
By risk category - market risk:
 The Group has no appetite for market risk exposures except where exposures
arise as a consequence of core strategic activity (principally as a consequence of
exposure of revenue streams to market risks).
 Business units are expected to limit market risk exposures by matching the
features of liabilities to features of assets.
 Exposures may be incurred where there is an overriding business need and
specific appetites will be established as necessary.
Example evidencing challenge
Business strategy
……
Implications for Risk and Validating strategic alignment
Return
We have appetite for taking Questions as to how strategies
[xxxx] risk as we believe
align or may appear mis-aligned
that we can achieve [return]
on this risk
We do not want to take
[xxxxx] risk as we believe
the upside to be limited.
Return
Context of risk and return
Target
return
Impact of balancing multiple
appetite statements. Zone
bounded by target tolerances
controlled by limits
Target risk
appetite
Risk
Risk-adjusted ‘primary’ performance measures
Franchise value
Economic Value Creation
(EVC)
= Net assets
• EVC is a measure of
+ Present value of
potential transfers to
members from in-force
business
+ Goodwill for new
business member valueadd capability
value created less the
explicit cost of holding
the required economic
capital
• Cost of capital used is
not the same for all
products / projects
• Capital allocated reflects
diversification benefits
• If EVC is greater than
zero, value has been
generated for members
Other metrics
(constraints)
 New business strain
 IFRS profit
Risk-Adjusted Return on
Lifetime Economic Capital
(RARLEC)
• RARLEC is a measure of
how much value is
generated for members
relative to the risks
being taken on
• Simple way of ranking
products when making
capital allocation
decisions
• EVNB/PV(ECap)
• Economic value of new
business (EVNB) is the
EVC at point of sale of a
policy
 Solvency II profit
 Payback period
 Distributable cash  …….
Common risk appetite dimensions
Dimensions
1 Capital
Definitions
 Buffer above regulatory diversified Solvency Capital Requirement (SCR) in
a 1-in-10 event
2 Earnings
3 Liquidity
4
Franchise
value
 Pre-defined 1-in-10 event results in, at worst, zero Group operating profit
BAU cash
flows
 Ability to meet BAU cash outflows on a day-to-day basis
In a stressed
scenario
 Coverage of liquid assets over net cash flows in a 1-in-10
Brand &
reputation
 Reflection of how our brand is perceived by our major
Operational
& capability
 Tracking events that could occur and result in
shock event
stakeholders, e.g. customers, employees & regulator
operationally being unable to deliver the strategic plan
Setting risk limits using risk appetite
•
•
The target capital level has been established at 140% of the SCR
Amber trigger level established at the capital position of being able to cover 170% SCR.
Risk category
Regulatory capital
requirement
Total
Financial
- Equity
- Interest rate
Business
Operational
1000
500
100
400
300
200
Economic Capital
target (140%
coverage)
1400 (=1000 * 1.4)
700
140
560
420
280
Amber trigger
level
(170% coverage)
824 (=1400 / 1.7)
412
83
329
246
165
Limits move over year in line
with plan numbers
SCR multiples are implied
solvency levels and therefore
risk capital limits are inverted
Then refine to assess how RAG
statuses should change to
reflect earnings risk appetite
and risk strategy output
RAG for each risk
proportionately allocated from
central target
Setting risk limits using risk appetite
•
•
The target capital level has been established at 140% of the SCR
Amber trigger level established at the capital position of being able to cover 170% SCR.
Risk category
Regulatory capital
requirement
Total
Financial
- Equity
- Interest rate
Business
Operational
1000
500
Risk category
Marginal
contribution
(base)
45%
75%
60%
45%
25%
60%
Total
Financial
- Equity
- Interest rate
Business
Operational
100
400
300
200
Economic Capital
target (140%
coverage)
1400 (=1000 * 1.4)
700
140
560
420
280
Marginal
contribution
(scenario)
48%
80%
62%
50%
24%
63%
Amber trigger
level
(170% coverage)
824 (=1400 / 1.7)
412
83
329
246
165
Scenario: business
operating at the upper
red limit for particular
risk type
Scenario tests whether
limits reasonably
protect diversification
benefit
Summary : linking risk and reward under Solvency 2



Performance metrics have explicit allowance for risk that is appropriately
costed
 This means creating value greater than zero is creating value for shareholders
 Define primary metrics and identify other metrics that act as constraints
Risk appetite is multi-dimensional
 It focuses on what the Board is concerned about in running the business
 Derived from stakeholder expectations
 Capital risk appetite and risk limits link together
 Limits set to preserve benefit of diversification
Economic (risk) capital is allocated appropriately to those products that
create the risk exposure
 Ensures products are charged appropriately for capital usage
 Projections of the risk profile are appropriate as business mix and volume
change
 Ensures the assessment of return from taking risk is appropriately allocated to
products to ensure we grow the right parts of the business
Questions and comments?
Christopher Chappell
E-mail: [email protected]

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