Our Changing Future - ICAPeter McDadeNeil MeldrumDavid Stevenson

All views are those of the authors and do not necessarily represent the views of their employers

Agenda

Background to ICA Main challenges ICG Process

Operational Risk

Using the ICA Possible future developments What does it all mean for actuaries?

David Stevenson

Peter McDade

Neil Meldrum

ICA and ICG

The Individual Capital Assessment (ICA) is a firm’s own assessment of its capital requirements, given its risk exposures

Self-assessment introduced with effect from 31.12.2004 (GENPRU 2.1.6)

Individual Capital Guidance (ICG) is any guidance provided by the FSA on the amount or nature of capital resources to be held by the firm under SUP 9.3 (eg. as a result of review of the ICA)

ICG is not published (private between firm and FSA)

ICAS - Motivation

To provide firms with an incentive to improve risk management Past weaknesses eg. provision for guarantees Limited engagement with operational risk

Reinforce responsibililty of senior management to manage capital resources of the firm in line with its risk No longer acceptable to rely on compliance with regulatory minimum

requirements Firms should consider their own risk exposures and form their own views on the

amount and quality of capital they should hold

To help inform FSA’s own view of overall capital adequacy of firm Together with wider supervisory view, helps in providing Individual Capital

Guidance

Sarah Wilson speech to ABI ICAS conference 06.03.2007 (paraphrased)

ICA

Internal risk based capital assessment Considers all major risks explicitly

Market Credit Insurance (mortality/longevity, morbidity, persistency, expense) Liquidity Group Operational

Can allow for exercise of Management Actions Responsibility of Board (advised by Actuarial Function Holder) Responsibility to notify FSA if ICA has fallen, or is expected to fall,

below ICG (SUP App 2.7)

FSA Regulations

No detailed rules Three main ICAS principles + high level

guidance on their implementation (INSPRU 7.1) Supplemented by Guidance on ICAS produced

by ABI & other trade bodies BAS Guidance (GN46/GN47) Indication of FSA’s approach to “Principles

Based Regulation” ?

ICA – Key challenges

Absence of detailed rules Deciding what approach to follow Model calibration Data limitations Risk aggregation/correlations/non-linearity Subjectiveness/application of judgement Engaging senior management ICG Process

What approach to follow?

Instantaneous stress, simulations of t=1 balance sheet or run off?

Measurement – Value at Risk or Tail VaR ? Confidence level/time horizon Aggregation of risk (correlation matrix,

copulas…) ICG set using Value at Risk approach at 99.5%

confidence level over 1 year time horizon

What approach to follow? Most companies built on existing RBS or Economic

Capital models Capital requirements for individual risks determined by

applying instantaneous shocks to „economic balance sheets“ (VaR approach)

Analogous to RCM stress for RBS Shocks calibrated to be equivalent to a 0.5th percentile

event over a one year time horizon Allowance made for management actions taken to

mitigate impact Overall capital requirement calculated by applying

correlation matrix to individual capital reqs Capital = [ i,j KiKj ]1/2

(i,j are correlations between risk factors, Ki capital reqs)

Build-up of ICA - illustration

Marketrisk

Creditrisk

Insurancerisk

Operationalrisk

Diversi-fication

Mgtactions

ICA

Liquidity risk & Group Risk typically zero or v.small

Longevity/Mortality

Morbidity

Persistency

Expense

Choice of model

Investment risks – normal, lognormal, percentile from from ESG output, Jarrow-Lando-Turnbull for credit spreads,etc ... Is model tractable? How well does model fit historic data?

Insurance risk Analysis of A/E may help in setting mis-estimation stress Trend risk more difficult (eg. future mortality improvements % of

Long cohort with floor, internal cause of death models)

Operational risk – new territory for many insurers

Data limitations Lack of data – trying to calibrate a “1 in 200 year event”!! Relevance of data Most acute for non-investment risks Example - pandemic event (Avian flu H5N1) How relevant are past pandemics?

1918/19 Spanish Flu (40m deaths) 1957/58 Asian Flu (2m deaths) 1968/1969 Hong Kong Flu (1m deaths)

What could 1 in 200 year event look like? Re-assortment of H5N1 genes could result in extremely virulent strain

capable of transmission between humans Greater infection rates due to urbanisation, increase in travel Availability of antiviral drugs, medical advances Improved monitoring, transmission containment measures Different impact on different age groups?

Need to apply judgement

Model calibration

Even where data exists, how relevant is it? Example – choice of time period for investment data Should periods like World Wars be excluded? Should we include periods of high UK inflation? Shorter period => more volatile stresses & more volatile

ICA result, but more relevant to current market conditions

Longer period => more stable stresses & ICA result, but possibly less relevance to current market conditions

Question of philosophy/judgement

Inconsistency of data

Example – Correlation between Equity Returns and Fixed Interest Returns

Positive for most of 20th Century Including during 1929 Wall Street Crash, 1973/74

Middle East Oil Crisis, 1987 “Black Monday”, 1997/1998 Russian debt/LTCM crisis, 1990s recession in Japan

Negative in period following bursting of dotcom bubble in 2001/2002

What is an appropriate “stressed correlation” assumption?

Risk aggregation/correlations

Diversification benefit often very large item on ICA balance sheet

Most companies use correlation matrix approach Judgement in setting „stressed“ correlations Correlation matrix approach doesn‘t pick up non-linear

interactions between risks Non-linearity could lead to understatement (or

overstatement) of ICA Need to investigate & make adjustments if appropriate

Non-linearity

Scenario testing approach Combined market scenarios calibrated to 99.5%/one

year confidence level using results of individual market stresses

„Medium bang“ approach Calculates adjustment factor by comparing result of Running individual stresses at lower confidence level (eg.

93%), and Combined scenario where all happen simultaneously

„Killer scenario“ Similar to „medium bang“ but prob of stresses weighted

towards most significant risk exposures

Engaging senior management

Time constraints Initial „education“ overhead Ongoing commitment to review & exercise

judgement Provides a common language for management

of risk across business

ICG Process

InternalPlanning

SubmissionRequest

InitialReview

FSA InitialView

MeetingWith FSA

WrittenQuestions

IndicationTo Firm FSA Panel ICG issued

ICG Process – How was it for you?

More resource intensive than expected Open discussions Drip-feed of follow-up questions FSA views evolved during process Outcome no surprise

ICG

First round now almost complete & second round begun

ICG provided to 53 life companies (95% of market by liabilities) 102 general insurers (97% of market by net premium income)

Average ICG (ICG issued in 2006 + Jan 2007) General insurers – 110% of ICA Life insurers – 114% of ICA (range: 100% to 170% + “a few

outliers”)

Sarah Wilson speech to ABI ICAS conference 06.03.2007

ICG

Main reasons for ICG “add-ons”

Life Aggregation (diversification, stressed correlations & non-

linearity) Operational risk

General Operational risk Lack of evidence to support choice of assumptions

Sarah Wilson speech to ABI ICAS conference 06.03.2007

Asking the impossible?

Pro

bab

ility %

Residual Severity £

£2m £20m£10m

“most likely”

“Severe 1”“Extreme”

“Severe 2 and 3”

Quantifying Operational Risk

Op Risk = risk of loss from inadequate or failed internal processes, people and systems, or from external eventsWho cares?Could adopt simple factor-based approach (eg x% of assets)Motivation for more advanced approach:

Internal Better understanding of risk Effectiveness of controls Incentivise risk management as controls lead to lower capital

External FSA Emerging best practice Ratings agencies?

Can’t get there from here?

How to get from this

...to this?

Capital requirement = x% * Assets

Capital requirement

99.5%

0.5%

Main stages of the journey

Design a new process Identify the key risks Collect data (actual loss data & ‘expert

testimony’) Create loss distributions Build & use a Monte Carlo model Identify required capital at 99.5th percentile

Data – the key issue

Data is scanty even for market risks Much less available for OR

Internal loss data – inadequate by definition External loss data – useful, but not enough Expert judgement – subjective but vital to plug gaps

Use everything available, but biggest challenge is to harness the expert knowledge in the company.

Key risk identification Filtering process trying to identify the most significant risks Focus on loss events not strategic risks

For risk management purposes the whole chain of causality is important. For the modelling we focused on the “immediate prior cause” (eg poor complaints handling)

This is where the financial loss actually occurs More concrete and therefore easier for people to come up with numbers

Identified collection of front line risks eg Business interruption Poor complaints handling Legal risk Fraud Pandemic Flu

Failure to set strategic direction

Low moraleHigh staff turnover

Staff shortage

Poor complaints handling

Scenario workshops Series of workshops set up involving risk owners /

experts in each field Tasked with creating loss distributions for each of the

front line risks Facilitation challenge – strike balance between

Motivation (this affects actual capital & perhaps S&P rating) Terror (this affects actual capital/rating!!)

Asking the impossible? at least 3 points on a loss distribution for each risk: most likely,

severe, extreme events need both impact and probability for each point use experience of actual losses & existing controls brainstorming, no wrong answers, ‘what if’ analysis knowledge, enthusiasm, creativity

Example of a loss distribution

Prob

ab

ility %

Residual Severity £

£2m £20m£10m

“most likely”

“Severe 1”“Extreme”

“Severe 2 and 3”

Monte Carlo modelling - best way to combine the loss distributions

Note – can allow for correlations between risks

1. Inputs to model:

• Loss distributions

• Correlation assumptions

2. Each simulation produces an aggregate loss across all risks

3. Run 10,000 simulations

4. Now have aggregate loss distribution

5. Capital requirement = 99.5th percentile loss

Aggregate loss distribution

0.5%

Risk 1 Risk 2 Risk 3

Capital requirement

99.5%

Useful to have drill down facility – can examine component loss events for any simulation

Management challenge - is this scenario plausible?

Losses incurred in 99.5th percentile scenario

EVENT 1 EVENT 2 EVENT 3 EVENT 4 EVENT 5 EVENT 6

Embedding Such a process should become a core part of risk management Rapid development in recent months – will want to go round loop again

this year to ensure robust Management review of data & modelling results:

Challenge / feedback / refinements Not an exact science – a means to an end Improving understanding of the key risk drivers Help to formulate & articulate risk appetite Connecting up operational and financial areas of the business

Eg value of good insurance policies => no changes should be made without considering capital implications.

Improved collaboration across functions. Helping you to understand:

for some risks holding capital is unavoidable for others better solution is strengthen controls tradeoffs between the cost of improving controls and the savings in capital [cf

cost/benefit of hedging market risk]

Are we there yet?

Journey will continue Can always improve on

the modelling, but the data is a bigger challenge

Not impossible! Scope for creativity

Final Destination Reached?

Using the ICA (“Embedding”) ICA is more than just a number, it’s about good risk

management.

ICA is “superior” to the old Pillar 1 calculations as it measures the capital required based on the risks inherent in a company’s business.

But the measurement of risk is only one part of a

strong risk management structure.

The first wave of reviews largely focused on the measurement of risk……

Using the ICA (“Embedding”) …. However, the second wave of reviews will be

different.

“……we are looking at how best to add real value to the next round of reviews of ICAs……...scope for added value from taking a more qualitative approach – challenging firms on how they are using their ICA in practice to make better business decisions and improve risk and general governance”.

Sarah Wilson, Director Retail Firms Division FSA (6th March 2007)

So the bar is being raised by the FSA.

What have companies done so far? Strategic Decisions

Review of risk appetite Information gleaned from ICA used to develop hedging

strategies. Revised reinsurance arrangements. De-risking asset mix.

Operational decisions Using in capital projection plans. Some companies have sought to embed economic capital into

pricing. Used in the determination of investment policy

Regulations and Guidance FSA launched its new ICA Principles during 2006.

Objective was to give greater clarity over FSA’s expectations and help deliver consistent capital guidance across the industry.

3 sub-principles (rules), which can be summarised as: Assessment must reflect the firm’s actual risk profile. Comparability to a 99.5% / 1 year probability that the value of the firm’s assets will

exceed the value of their liabilities. Model methodology: documenting the firm’s reasoning and judgement underlying the

ICA assessment.

The ABI also launched its “A Guide to the ICA Process for Insurers”, which aimed to provide advice to companies on how to interpret guidance.

Possible Future Developments ICA is still in its relative infancy and emerging best practice will

continue to develop.

Methodology and assumption changes are becoming less of a priority

Short term challenges include (Refining) Projections of the ICA Developing robust analysis of change Enhancing operational risk methodology Developing scenarios

More attention is planned to be given by the industry to improving integration and use of the ICA in the business

Possible Future Developments Future developments are likely to be influenced by Solvency II, as

UK Insurers are likely to want to go down the “internal model” route. To have internal model approved for solvency II, there are three

tests to be passed. They are: Statistical Quality Test Calibration Test Use Test

FSA to suggested to date that the hurdle to be passed for these is

much higher than the UK industry has had to achieve so far under the ICAS regime.

Final Destination Reached?

•Still work to be done in embedding ICA by the industry

•Work required by industry to get internal model approval for Solvency II

•So the journey not yet complete.

What does this mean for actuaries? ICA is principles based not rules based.

Requires a lot more judgement which have to be justified to Board (ultimate ownership).

Quantifying the risk requires detailed modelling, but also understanding of the weaknesses of the model.

Need knowledge of all the business Cannot be a “one department” number. Need to listen to the business to ensure

that the risks are considered. Need to explain what the number means in business terms – how does this

number relate to risk in the business.

Therefore, actuaries are very well placed for ICA/Solvency II with skills and knowledge we can bring to the table.

This provides interest work and enhances marketability. Opportunities in Europe as they address Solvency II ? However, no room for complacency – other skilled professionals in the risk

assessment field.

Question Time.