Wednesday 3 October 2001 John P Ryan Financial Condition Reporting Practical Aspects GIRO / CAS...

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Wednesday 3 October 2001 John P Ryan Financial Condition Reporting Practical Aspects GIRO / CAS Convention 2001

Transcript of Wednesday 3 October 2001 John P Ryan Financial Condition Reporting Practical Aspects GIRO / CAS...

Page 1: Wednesday 3 October 2001 John P Ryan Financial Condition Reporting Practical Aspects GIRO / CAS Convention 2001.

Wednesday 3 October 2001

John P Ryan

Financial Condition Reporting Practical Aspects

GIRO / CAS Convention 2001

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Financial Condition Reporting - Practical Aspects

The FSA’s view

Assessment of individual risk

Modelling operational risk

Importance of tail dependency

Relevance of risk measures

Overlaying hard to quantify risks with a DFA model

Use of insurance to reduce capital requirements

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Institute of Actuaries paper on FCA

Provides a framework for evaluating a company’s financial position in relation to the risk it covers.

Concentrates on non-life insurance but covers the principles for all companies.

It covers both readily quantifiable risks and those not so readily quantifiable e.g. management succession risks.

The Profession’s response to the FSA proposal.

FSA will apply to all financial Institutions.

Corley Report also calls for FCR reports for Life Co’s

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Identify

Administer Control

Finance

Risk Management Circle

Effective control requires quantification

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Individual Risk Assessment.

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Methods of Modelling Risk

Financial Risk - investment models

Financial Liabilities - actuarial models

All Other - as operational risk

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Insurance Company Risks

R etrospectiveB alance sheet R isks

ProspectiveB usiness R isks

Financial

O perational External

N on Financial

R isks

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Financial Risks

Asset R isks Liability R isks

R etrospectiveB alance sheet R isks

Financial

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Asset Risks

Value, Bad debt

Modelling volatility

Market value

Reinsurance

Market

?Valuation

Concentration

ACTUARIAL ASSESSMENTRISK

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Liability Risks

Discounting

Unexpired Risks

Unearned Premiums

Outstanding claims / IBNR

ACTUARIAL ASSESSMENTRISK

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Liability Risks

Mismatch

ACTUARIAL ASSESSMENTRISK

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Financial Risks

U nderw riting R isks Exposure R isks B usiness R isks Financing R isksC apital / D ebt

PropectiveB usiness R isks

Financial

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Underwriting Risks

Impact on pricing assumptions

But varies by class

Concentration

?Acceptance

?

Growth / new classes

Pricing

ACTUARIAL ASSESSMENTRISK

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Exposure Risks

?Policyholders’ Reasonable Expectations

Claims frequency / severity

Reinsurance

PMLs

ACTUARIAL ASSESSMENTRISK

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Business Risks

Investment Strategy

?Mergers & Acquisitions

Expenses

ACTUARIAL ASSESSMENTRISK

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Financing Risks

Gearing

Debt interest / repayment

Dividend commitments

ACTUARIAL ASSESSMENTRISK

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Insurance Company Risks

R etrospectiveB alance sheet R isks

ProspectiveB usiness R isks

Financial

O perational External

N on F inancial

R isks

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Operational Risks

But might come across evidence

But might help with system requirements

Could help assess some procedures

But might come across evidence

XManagement

XTechnology

?Administrative

XFraud

ACTUARIAL ASSESSMENTRISK

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Operational Risks

DFA / Market Analysis

XReputation

?Data quality / availability

Planning

ACTUARIAL ASSESSMENTRISK

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External Risks

Possible future. Some known changes

XConfiscation / Nationalisation

XPolitical

Taxation

?Social

?

Legal / Legislative

ACTUARIAL ASSESSMENTRISK

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External Risks

XRegulatory

Group structure

?Dependency

ACTUARIAL ASSESSMENTRISK

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Operational Risk

ASSESSMENT OF OPERATIONAL RISK

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Management and Business Risk

Some can be modelled using econometric or causal modelling techniques

Some are really risks for shareholders rather than capital issues

Stress testing can be a useful quantification technique

Insurance often cannot be used for this type of risk

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Quantification of Operational Risk

Operational Risk

Delphi Techniques

Produce a Model

Quantify Risk

CorroborateResults

Collect Data

Industry Specific

Model

Quantify

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Development of loss curves

BudgetedLoss

Amount of Loss

ExpectedLevelof Loss

ProbabilityofLoss

Based on data

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Quantification of Operational Risk

It is more complex than pricing conventional insurance risk

The risks are more under control of the institution than many insured perils

Changes in practice can have a material impact

Organisations do not like to admit to Operational Risk losses

Some are not readily amenable to statistical analysis e.g. management succession risk

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Scenarios

Distributions may not be the best approach to evaluating certain types of operational risk

Test the survival of the organisation to adverse scenarios

Especially suitable for “people risks” e.g. succession planning

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Data based approach

Not many databases around

Not all losses are disclosed

Controls and mode of operation may render some data to be inappropriate

Low frequency / high severity risk requires a different approach

Some “operational risks” are budgeting items

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InternalInterviews

Example Output from a Large Loss Study

50% 60% 70% 80% 90%

Reliability of Loss Estimates

OwnClaims

Cla

ims S

ize

(US

$ b

illion

s)

1

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0.0

ExternalInterviews

ExternalResearch

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Development of loss curves

BudgetedLoss

Amount of Loss

ExpectedLevelof Loss

ProbabilityofLoss

Based on dataIncluding interviews

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Data for loss curve

Loss Limit

100

80

60

40

20

Amount ofLoss in Data

80

80

80

70

50

Amount of Losses in Data & Interviews

105

100

90

75

50

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Questions

The difficulty is the need to estimate the right tail in a skew distribution

How good is the left of the curve at predicting the right tail

Use of Bayesian statistics or credibility theory

What distributions fit the data

What techniques are best at supplementing the data for “missing large claims”

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Conclusions - Data based methods

Data based methods are the traditional actuarial technique for insurance claims, they are intuitively acceptable

There are major deficiencies in using data based methods for operational risk not present in insurance data

The major problem is non-reporting of large claims

Useful check on the reality of other methods

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What are the other methods?

Delphi techniques

Decision trees and casual modelling

? Fuzzy Logic

? Others

? Use data bases for left side and other techniques for right side

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Delphi Technique

Key Drivers of Business Unit

What are the risks to each Business Unit

What are the likely frequency

If loss occurs what is the likely cost

Fit curves following interview technique

Model uncertainty

Combine all results

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Core Operational Risk Analysis

Framework involves Business Process and Resource / Risk Classes

ResourceClasses

PhysicalAssets Technology People

Relationship(Liability)

OtherExternal

BusinessProcess

TransactionalProcess

BusinessManagement

Reputation

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Risk profiles are linked to financial measures using a financial value tree approach

Fixed AssetsDistribution

Costs

Price

Taxes

Free Cash Flow

Op. Cash Flow Investment

Gross Margin

Revenues

Volume

Working Capital

Event Risk Financial Risk Distribution Channel Business Risk

Probability Distribution of Economic Loss Due to Fire Risk

0%2%4%6%8%

10%

16.8

2

42.8

3

68.8

3

94.8

4

120.

84

146.

84

172.

85

198.

85

224.

86

250.

86

Pro

babi

lity

Probability Distribution of Price Volatility

0%1%2%3%4%5%6%7%8%9%

10%

Probability Distribution of Lead Time to Market Due to Strike

0%

2%

4%

6%

8%

10%

12%

Probability Distribution of Market Share Lost Due to New Entrant

0%2%

4%6%

8%10%

0.20

9

0.24

3

0.27

7

0.31

1

0.34

5

0.37

9

0.41

3

0.44

7

0.48

1

0.51

5

Pro

babi

lity

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Importance of the risk measure

Var implicitly assumes “elliptic risks”

Operational risk does not satisfy this condition

Market Risk needs to be frequently updated hence the importance of Var

Operational Risk does not change rapidly

Hence “equivalent Var” will not change rapidly

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Adding the efficient frontiers will overstate the costs for a given risk as no adjustment is made for diversification credits

This at a minimum changes the choices or risk loadings even if all strategies are ranked in the same way

Risk

Cost

AddingEach

Separately

Evaluating risks altogether

Consolidatedlargely independentrisks

Consolidated with manytail dependent risks

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Risk Measures

Var works well for symmetrical risks

ECOR is better for skew risks such as most insurance risks

A coherent measure needs to be used across the group as a whole

Beware of tail dependency

Other constraints are also needed such as a requirement to maintain a credit rating

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ECOR reflects both the probability and the severity of ruin

ECOR is the present value of expected deficits in excess of economic capital

ECOR is derived as the probability of a loss times the severity of the loss In today’s dollars Sum of all loss events Reflects solvency risk tolerance measure and assigned

capital

The “ECOR ratio” is the ECOR divided by the present value of expected customer payments

ECOR is a better solvency risk measure than probability of ruin because it reflects the cost of ruin, not simply the

likelihood of event

ECOR is a better solvency risk measure than probability of ruin because it reflects the cost of ruin, not simply the

likelihood of event

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Why Does This Matter?

CombinedOperational Risk

InvestmentRisk

Var

ECOR

The RBC’s are very different for different approaches

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Coherent Risk Measures

To be coherent a risk measure (p) must satisfy four

conditions:

(i) Translation Invariance p(x + .r) = p(x) -

(ii) Sub additivity p(x1+ x2) p(x1) + p(x2)

(iii) Positive homogeneity for o p(x)= p(x)

(iv) Monotoniaty If x y p(Y) p(x)

Var fails the sub additivity property

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Insurance to cover Operational Risk

This is a non-trivial subject.

Basel has many doubts.

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Coverage Gaps

If complete cover is not available then capital will need to be held against remaining risk

Insurance should mitigate operational risk cost and so should be allowable

Operational Risk models would need to be run with and without insurance

Contracts with material exclusions may not mitigate overall capital requirements much

All Risks Cover is preferable

Much operational risk violates an underwriting rule that the insured should not be able to manipulate his loss experience

Some risks may not be insurable e.g. management succession risk

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Claims Disputes

Some financial impact as a dispute creates coverage gap

Change insurance practice of conducting investigations at point of claim to investigating at point of sale

Financial Enhancement Ratings (FER)

Different in conditions (DIC) coverage