Role of Enterprise Risk Management in Risk Based Capital
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The document discusses the role of enterprise risk management (ERM) in managing risk-based capital (RBC) within the life insurance sector, highlighting key concepts such as risk capital, risk diversification, and risk management strategies. It outlines the importance of accurately measuring solvency capital based on associated risks and emphasizes the necessity for a collaborative regulatory approach to enhance resilience in insurance firms. Additionally, the document illustrates the challenges faced in implementing ERM while advocating for its benefits in optimizing capital and boosting company profits.
![Risk Capital Calculation
8
• Based on Statistical distribution
• Value at Risk (VaR) is the maximum loss that a financial institution can
suffer in a given time frame and within a certain confidence level.
• J P Morgan developed a simplified report that used to arrive every day at
4.15 pm on the maximum loss that the Company can suffer in one day at
95% confidence
• Internal models
Value at risk (VaR) = 99.5th percentile value of loss due to each risk
• Stress testing
RC(r)= [Assets - Liabilities ] @ Base assumption
@ Stressed assumption
Stressed assumption is equivalent to 99.5% confidence level for each risk “r”
or at any other desired level of confidence.](https://image.slidesharecdn.com/roleoferminrbcparallelsession-3sonjaikumar-170716030118/85/Role-of-Enterprise-Risk-Management-in-Risk-Based-Capital-8-320.jpg)
Role of Enterprise Risk Management in Risk Based Capital
- 1. Role of Enterprise Risk Management in Risk Based Capital By Sonjai Kumar, Aviva India Life Insurance 13th July 2017 1st SOUTH ASIAN ACTUARIAL CONFERENCE 12 – 13 JULY 2017 COLOMBO, SRI LANKA 1
- 2. Contact Details Name: Sonjai Kumar Vice President- Business Risk Aviva India Life Insurance Mobile: +91-9810389622 Email: [email protected] https://www.linkedin.com/in/sonjaikumar/ Website: www.risk-management.in 2
- 3. Agenda 1. Risk Capital 2. Risk Diversification 3. Risk Management 4. Challenges in implmenting RBC and ERM 5. Lessons learnt from other markets 3
- 4. Solvency Capital 1. What is Solvency Capital ? 2. Risk Capital is extra assets kept aside to meet the contingency in case reserve is insufficient to meet the contracted liabilities. 3. How Solvency Capital is calculated? 4. Traditional approach and 5. Risk based approach 4 Free Assets Book Value of Assets Solvency Capital Policyhol ders Liability (Reserve) To write New Business and meet expenses
- 5. Traditional Approach 1. Solvency Capital = (X% of Reserve + y% of Sum at Risk) 2. Sum at Risk = (Sum assured – Reserve) 3. “X” and “Y” varies for different products 4. Solvency Capital is not a direct function of risks 5. No Direct benefits of risk management 6. Two identical Companies will keep similar capital irrespective of how risks are managed in both Companies 7. Any prudence in reserving takes a hit on Solvency Capital as well impacting shareholders 5
- 6. What is Risk Based Capital? 6 • Solvency Capital as a function of “Risks”, higher risk would require higher capital requirement and vice versa. • However, there is a diversification benefits as risks are correlated leading to overall lowering of total capital requirement. • Also, the total risk capital can be reduced by managing the risks better, therefore, • Capital as a function of risk RC (r) = Risks – Risk Diversification – Risk Management • Consider each of the three elements one by one • Let’s first consider “Risks”
- 7. Risks 7 Risks in Life Insurance Interest Rate Insurance Risk Credit Risk Liquidity Risk Mortality Expense Lapses Equity Operational Risk Regulatory Financial Risk •If an insurance company is selling products that gives guarantees to the Customer on Maturity, this will increase the interest rate risk capital. •Similarly, better management of mortality risk in the term product will reduce overall mortality risk capital.
- 8. Risk Capital Calculation 8 • Based on Statistical distribution • Value at Risk (VaR) is the maximum loss that a financial institution can suffer in a given time frame and within a certain confidence level. • J P Morgan developed a simplified report that used to arrive every day at 4.15 pm on the maximum loss that the Company can suffer in one day at 95% confidence • Internal models Value at risk (VaR) = 99.5th percentile value of loss due to each risk • Stress testing RC(r)= [Assets - Liabilities ] @ Base assumption @ Stressed assumption Stressed assumption is equivalent to 99.5% confidence level for each risk “r” or at any other desired level of confidence.
- 9. Stresses 9 Risks Shocks in Sri Lankan Insurance Market Insurance Risk Mortality 10% - Guaranteed Premium 7.5% Non-Guaranteed Premium Longevity -15% Lapse "+ &" -"20% Expense 10% Financial Risk Interest rate Range 25% to 70% Up and Down Shock based on Yield curve Equity 35% & 45% listed and unlisted Risk Aggregation Diversification: The total RC is not sum of RCs of each risks because the risks are correlated, so diversification between the risks are allowed for
- 10. Risk Diversification 10 • Value at Risk (VaR) is the maximum loss that a financial institution can suffer in a given time frame and within a certain confidence level. P is the marked-to-market value of the portfolio. zα is the left-tail α percentile of Normal distribution • The volatility of a portfolio composed of two risks is given by: • w1 is the weighting of the first risk • w2 is the weighting of the second risk • σ1 is the standard deviation or volatility of the first risk • σ2 is the standard deviation or volatility of the second risk • ρ1,2is the correlation coefficient between the two risks
- 11. Risk Diversification 11 • Portfolio VaR is • The value of ρ1,2 ,varies between -1 to 1, so the Company can choose the risks so that the correlation between the risks are either negative such as mortality and longevity or close zero to allow for maximum diversification compared to correlation +1 • The correlation between mortality and longevity risk as per QIS-5 is -0.25 • The choice of risk is important, for example, if we control lapse risk, the mortality risk experience will improve; there is a relationship between the interest rate risk and lapse risk.
- 12. What is Risk Management? 12 • Risk- Uncertainty that can derail meeting the objectives of the Company • Risk Management- Enable meet Company’s objective in the presence of risk and optimize the capital position • What is process of risk management (IMMMR) • Risk Identification (I)- Key stage for identification • Risk Measurement (M)- Quantification • Risk Management (M)- Risk Treatment • Risk Monitoring (M)- Improvement in identification and risk treatment • Risk Reporting (R)- Reporting to the Board to assess the risk position • The risk management process has practical implementation issues.
- 13. What is Enterprise wide Risk Management? 13 • Where risk management is not a job of few individuals within a Company, but the ownership lies with all the business objective holders • All the business growth related objectives from the business plan is mapped to all the functions- except Risk, Audit and Compliance • As each function have expertise in their areas, they must identify the risks that can fail to meet their objectives and prepare action plan to manage the risk, if those risk occur in reality. So all the functions are frontline risk managers • The oversight is provided by the risk function on the risk management process- three line of defence model with Audit function completing the 3rd line.
- 14. Three Line of Defence Model 14
- 15. What is Enterprise wide Risk Management? (2) 15 • Here Board has ownership of all the risks and its management passed it over to CEO which in turn make accountable to all function heads. • CRO provide the oversight on the risk management process • This helps in integrating the risk management process across the organization. • As risk is synonymous to capital, risk management helps in managing the risk and overall reduction in the capital requirement. • To enhance the risk culture of the organizations, the variable reward of the Senior management may be linked to effective use of risk management tools. • Also, to increase the use of risk management tools across organization, there could be incentive for finding risks and control gaps within the each function.
- 16. Risk Treatment 16 • Four risk treatments are available to address any risk • Accept the risk • Avoid the risk • Transfer the risk • Manage the risk • There is an opportunity for a life insurance Company to adjust price of a product and risk to attract customer • A term insurance product may be priced very competitively by managing the risks through underwriting, reinsurance, claim management, sales control • Similar, application can be done in participating products by managing the insurance and financial risks to pass the dividend to customers. • Some of the risk management available for insurance and financial risks are
- 17. Example of Risk Management 17 Accept Manage/ Mitigate Transfer Avoid
- 18. Risks Management 18 Risks in Life Insurance Interest Rate Insurance Risk Credit Risk Liquidity Risk Mortality Expense Lapses Equity Operational Risk Regulatory Financial Risk ALM CFs DMT Ratings Investment Limits U/W, Claim Mgt Reinsurance Monitoring Control miss-selling RCSA Blue Chip Companies Need based selling Expense Control Likelihood and Impact study Monitoring Product Design
- 19. Risk Based Decision 19 • What is a good risk to take • Whether the risk is a strategic fit and add value to the Company • For any new initiative, if the risk-adjusted return on Capital (RAROC) exceeds the cost of equity capital, the initiative will add value to the business. • Whether the risk is within the risk appetite of the Company • Any risk accepted outside the risk appetite should have proper justification Risk Based Decision Risk Impact on Risk Appetite Strategic Fit People & Infrastructure Alternate opportunity Stress and Scenario Testing Example Group Product
- 20. Re-visit Risk Capital Equation 20 RC (r) = Risks – Risk Diversification – Risk Management
- 21. Sources of Profit 21 Profit Maximize Profit Sources of Surplus LapsesExpenses Investment Mortality Actual experience against Expected Risk management helps in improving actual experience
- 22. Capital and Profit Management 22 Interconnection of risk in different areas
- 23. Challenges 23
- 25. Conclusion 25 • There is an advantages of risk capital based on risk as opposed to traditional approach • Risk Diversification plays an important role in the selection of products so that risks can be diversified • ERM is a very important tool in not only optimizing the capital position but also boosting the profit of the Company • There are challenges in its application, however, a proper implementation would increase the resilience of the Company against the risks • There is a need to have global collaboration in the regulatory regime to learn from each other.