Property Casualty Aspects Of ERM - Sommerfeld

Property / Casualty Aspects of ERM

Frank SommerfeldEMB

Köln (Cologne), Germany

Insert Title Copy Here

2

Agenda

• Cash-Flows in P&C insurance

• Liquidity risk

• Risk Matching

• Example Risk-Matching

• Summary


3

1 2 3 4 5 62003 74,0% 15,0% 5,0% 3,0% 2,0% 1,0%

2004 74,0% 15,0% 5,0% 3,0% 2,0% 1,0%

2005 74,0% 15,0% 5,0% 3,0% 2,0%

2006 74,0% 15,0% 5,0% 3,0%

2007 74,0% 15,0% 5,0%

2008 74,0% 15,0%

development years

acci

den

t ye

ars

Cashflows in P&C insurance

• The expected CF in a calendar year is the sum of the diagonal. Assuming a constant ultimate per origin year it is 26%.

• No new accident year would implicate– no new business– no renewals– no unearned premium

• A new accident year does pay out 74% and does reserve the other 26% the expected reserves remain unchanged. the expected cash-flow balance is 0

• Additionally the cash-flow is highly volatile• Matching strategies (Duration, cash-flow,..) don’t make sense

2009 74,0%

unrealistic


4

Example - Volatility of cash flows at „going concern“

Expectation close to zero and very volatile


5

Duration of cash flows at „going concern”

You will not match this duration!


6

Cash flow P&C

• Cash flows of P&C insurance are totally different to the cash flow of life insurance:

– Considerably more volatility• Large claims• Catastrophe claims• Adverse run-off

– The expected cash flow is usually small

• A liquidity risk is not arising form a mismatch in duration but rather due to the volatility

• How can liquidity risk be assessed?

• How can the liquidity risk be managed?


7

Agenda


• Liquidity risk

• Risk Matching


• Summary


8

Example of the liquidity risk on the basis of three paths

Liquidity gap arises from one extreme negative u/w cash flow or from two

medium negative cash flows.

uw. CF 2009 2010 2011 2012 2013Path #1 29 m€- 37 m€- 133 m€ 3 m€- 50 m€ Path #2 126 m€ 24 m€ 116 m€- 99 m€- 123 m€ Path #3 80 m€ 186 m€- 55 m€ 59 m€ 87 m€

Asset CF 2009 2010 2011 2012 2013Path #1 29 m€ 28 m€ 28 m€ 30 m€ 28 m€ Path #2 27 m€ 36 m€ 35 m€ 40 m€ 24 m€ Path #3 38 m€ 26 m€ 30 m€ 28 m€ 32 m€

CF total 2009 2010 2011 2012 2013Path #1 0 m€ 10 m€- 161 m€ 27 m€ 78 m€ Path #2 153 m€ 61 m€ 81 m€- 59 m€- 147 m€ Path #3 118 m€ 160 m€- 85 m€ 88 m€ 119 m€

fungible Assets 2009 2010 2011 2012 2013Path #1 117 m€ 90 m€ 109 m€ 74 m€ 90 m€ Path #2 99 m€ 66 m€ 94 m€ 48 m€ 111 m€ Path #3 121 m€ 115 m€ 134 m€ 110 m€ 168 m€

Liquidity gap 2009 2010 2011 2012 2013Path #1 - € - € - € - € - € Path #2 - € - € - € 11 m€- - € Path #3 - € 45 m€- - € - € - €


9

Example - Volatility of cash flows at „going concern“

The ERM models we will not run with 3, but e.g. 100,000 simulations.

The results will be measured in probabilities


10

Example liquidity risk

Liquidity risk

0,85% 0,96% 1,20%0,10% 0,35%

0%

5%

10%

15%

20%

25%

30%

35%

40%

2009 2010 2011 2012 2013

calendar year

% S

ce

na

rio

s

0%

20%

40%

60%

80%

100%

120%

140%

co

ve

rag

e

% Liquidity gap % neg. CF % neg. u/w CF Ø Asset not fungibel / Liquidity gap


11

Strategies on managing liquiditiy risks

• The liquidity risk is an asset/liability matching risk – market value of fungible assets < payment obligations

– The liquidity risk can arise out of• Decreasing market values• Insufficient fungibility• Increasing payment obligations

– The liquidity risk is a timing problem and due to this fact it can not be capitalized

• Strategies to decrease the risk can be set at the asset and the liabilites side– Asset side

• Matching of the asset cash flow can not lead to the target• Market values: Investments in less volatile assets• Fungibility: Investments in more liquid markets

– Liabilities side• Arrangements of the reinsurance contracts • Implementation of „Cash-Calls“

• The handling of liquidity risks defines a constraint but does not determine a whole strategy


12

Agenda


• Liquidity risk

• Risk Matching


• Summary


13

Risk Matching

• The insurer is exposed to underwriting and market risks

• The ERM models calculates both profit profiles

• The risk capital can be calculated from the profit profiles

– VAR– TVAR– …

Profit Profile

-800

-700

-600

-500

-400

-300

-200

-100

0

100

200

300

400

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Perzentil

m€

Profit Passiv

Profit Aktiv


14

Risk Matching

• The asset and liability risks have a only a small dependency

• There is a strong diversification effect between both sides

– Bad results on the one side are often balanced by good ones on the other side

– This diversification effect can be measured

• In this example the worst case scenarios are caused by the liability side

Profit Profile

-300

-200

-100

0

100

200

300

400

-800 -700 -600 -500 -400 -300 -200 -100 0 100 200 300

Profit Passiv

Pro

fit A

ktiv

Total result < - 400


15

Risk capital

-

100

200

300

400

500

600

Stand alone Diversification Diversified

m€ assets

liabilities

Risk capital

-

100

200

300

400

500

600

Stand alone Diversification Diversified

m€ assets

liabilities

Risk Matching

• „Stand alone“ adds both risk capitals which were calculated separately • „Diversified“ determines the risk capital on the aggregated risk profile

– Sub-additivity RK(A+B) ≤ RK(A)+RK(B)

– With capital allocation methods (here TVAR) the diversified capital can be allocated back

• How can you find the optimal diversification?

Net of RIGross of RILiabilities dominates the total

Risk capital is allocated

more equally


16

Risk Matching

• To compare different risk strategies a comparison of the risk capitals is insufficient

• The (expected) return has to be compared against to calculate the performance/efficiency of the capital

– Economic Value Added (EVA™) =return – cost of capital * risk capital

– Return On Risk Adjusted Capital (RORAC) =return / risk capital

• Other constraints have to be considered additionally

– Business policy

– Accounts

– …

Higher

risk

capit

al

Higher

exp

ecte

d re

turn

A

B

C

D

Risk liabilities (Reinsurance)

Ris

k A

sset

(S

AA

)

Strategy exp return risk capital EVA @10% RORACA 120 1.000 20 12%B 65 500 15 13%C 110 1.000 10 11%D 55 500 5 11%


17

Agenda


• Liquidity risk

• Risk Matching


• Summary


18

Dichte: vt. Bruttoergebnis

0

100

200

300

400

500

600

700

800

900

1.000

1.100

1.200

-800 -700 -600 -500 -400 -300 -200 -100 0 100 200 300

m€

Fre

quenz

Risk Matching – simplified example

Dichte

0

500

1.000

1.500

2.000

2.500

3.000

3.500

4.000

4.500

5.000

5.500

-100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100% 120%

Rendite

Fre

quenz

Aktien

Renten

• Asset risk– FI and equity– Managing via equity share

• Liabilities risk– Stochastic gross result– NatCat exposed– Managing via reinsurance


19

Asset "Standalone"

0

100

200

300

400

500

600

700

800

0% 5% 10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

60%

65%

70%

75%

80%

85%

90%

95%

100%

Equity

Ris

k ca

pit

al (

m€)

-20

-10

0

10

20

30

40

50

60

70

80

90

Risk capital Return EVA™


13

,9%

From 15 % equity the risk capital increases faster than the expected return


20

Gross of RI

0

100

200

300

400

500

600

700

800

900

0% 5% 10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

60%

65%

70%

75%

80%

85%

90%

95%

100%

Equity

Ris

k ca

pit

al (

m€)

-5

0

5

10

15

20

all. Capital Liab. all. Capital Asset EVA™


32

,2%

For lower equity exposure the asset risk is overlain by the u/w risk. There is a large diversification potential on the asset side.


21

Net of RI

0

100

200

300

400

500

600

700

800

900

0% 5% 10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

60%

65%

70%

75%

80%

85%

90%

95%

100%

Equity

Ris

k ca

pit

al (

m€)

-5

0

5

10

15

20



25

,7%

The diversification potential for the asset side decreases if the risk is mitigated on the liability side.


22

Net of RI (more RI)

0

100

200

300

400

500

600

700

800

0% 5% 10%

15%

20%

25%

30%

35%

40%

45%

50%

55%

60%

65%

70%

75%

80%

85%

90%

95%

100%

Equity

Ris

k ca

pit

al (

m€)

-15

-10

-5

0

5

10

15

20

25



14

,7%

If the risk on the liabilities side is decreased even more the risk on the asset side has to be reduced as well.


23

0,0%

5,0%

10,0

%

15,0

%

20,0

%

25,0

%

30,0

%

35,0

%

40,0

%

45,0

%

50,0

%

55,0

%

60,0

%

high RI protection 1RV 3

RV 5RV 7

RV 9low RI protection 11

0123456789

10111213141516171819202122

EV

A™

(m

€)

Equity

EVA™ (m€) by different reinsurance and equity scenarios


16

,1%


24

Agenda


• Liquidity risk

• Risk Matching


• Summary


25

Risk Matching - Summary

• Use the diversification potentials between risks– Between asset and liabilities– Within the asset side between the asset classes– Within the liabilities side between the lines of business

• The whole balance between several risk operators is important– A balanced influence on the overall result– Dependent on the risk aversion– In practice: Optimum at given risk capital

• Changes in the risk strategy have always consequences in all areas– Holistic ERM should be integrated in the company

• BUT: No blind trust in the models– Techniques are helpful to support decisions but not to replace them– Understanding the effects is essential – no Black-Box!– ERM must be lived – clear communication within the whole company is

necessary


26

Your contact for questions

Frank Sommerfeld

EMB

Tel.: +49 (0)221 35 66 26 41

[email protected]

emb.com