Financial Services

GETTING RISK-ADJUSTED PERFORMANCE MEASUREMENT RIGHT FOR SOLVENCY II

AUTHORSAstrid Jaekel, Partner

Sean McGuire, Senior Manager

Insurers across Europe will soon begin calculating their regulatory capital requirements

under the new Solvency II regime. To date, most insurers have focused on building and

calibrating their Pillar I models, be it under the standard formula approach or using an

internal model. Now they are shifting their efforts towards using these models to run

their businesses.

This is partly for compliance purposes; Solvency II requires insurers to link the calculated

capital requirements to business decisions. But insurers should also see this as an ideal

opportunity to overhaul their performance measures and better align incentives with risk

and reward. Adopting risk-adjusted performance measures (RAPMs) is the obvious way to

achieve this. However, the design and use of such measures is not simple. A “one size fits all”

approach will not work and performance measures must be tailored to their different uses

within the business.

When designing and implementing RAPMs, there are many decisions to be made, each of

which will result in different practical challenges in implementation. To develop measures

that are right for their business, insurers should follow a three step process:

1. Design the new measures

2. Tailor the measures to specific business uses

3. Apply the measures across the organisation.

Copyright © 2012 Oliver Wyman 2

To ensure they create the right incentives, performance measures should:

A. Reflect the economic risks being taken on

B. Be broadly consistent at all levels of the organisation and across different lines of business

C. Be sufficiently transparent to be easily understood by Executives and staff

D. Be relatively easy to calculate

E. Be based on a profit measure that will be used to run the business in the future

F. Include an absolute measure of value creation as well as a relative measure.

A. REFLECTING THE

ECONOMIC RISKS

At the risk of stating the obvious, the

measures must reflect the economic risks

of the business and, hence, the economic

capital requirements. Economic risks and

capital requirements are well reflected by the

Solvency II Capital Requirement (SCR). This

means that the SCR calculations should feed

into the performance measures. One way

to do this is to use the change in Solvency II

Own Funds as the profit measure and then

make an explicit deduction for the cost of

holding the Solvency Capital Requirement

plus any target buffer over and above this.

B. CONSISTENCY AT ALL LEVELS OF

THE ORGANISATION AND ACROSS

DIFFERENT LINES OF BUSINESS

Solvency II allows the capital requirements

of different lines of business to be compared

on a like-for-like basis (or, at least, on a more

comparable basis than has historically been

the case). So, for example, life and non-life

businesses will have capital requirements

that are more closely aligned with one

another than they have been. Consistency

could be further improved by, for example,

incorporating expected levels of renewals

in non-life performance measures, akin

to the multi-year nature of life insurance

policies. Such comparability is important for

Executives in deciding how much capital to

allocate to different lines of business.

1 DESIGNING THE NEW RISK-ADJUSTED PERFORMANCE MEASURES

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C. EASE OF UNDERSTANDING

AND TRANSPARENCY

Because the performance of Executives

and staff will be evaluated by RAPMs, they

must understand how they are derived and

how they can influence them. Since the

performance measures will be used as a

basis for staff compensation they must also

be robust, transparent and auditable.

D. EASE OF CALCULATION

The new performance measures will need

to be calculated and fed into performance

scorecards. Solvency II implementation

is already straining insurers’ resources,

systems and budgets, so new measures

should be built on work that is already

underway. This will avoid re-work and

manual “off-line” calculations.

E. CHOICE OF PROFIT MEASURE

When designing the new performance

measures, insurers must decide which

profit measure to base them on. There are

three broad options: IFRS profits, Solvency

II profits (equivalent to embedded value

profits under Solvency I) or “adjusted”

Solvency II profits. Exhibit 1 summarises the

main features of each option.

Many insurers currently have IFRS-based

or Embedded Value-based RAPMs in place.

Most are considering a shift to Solvency

II-based measures, with some planning to

adopt “adjusted Solvency II” measures. We

define an “adjusted Solvency II” measure

as one where the Solvency II balance sheet

or Solvency II profit measure is adjusted

to reflect the insurance company’s own

view of the world: e.g. their view on

EXHIBIT 1: CHOICE OF PROFIT BASIS FOR RISK-ADJUSTED PERFORMANCE MEASURES

EXAMPLEMEASURE

COMMENTARY

IFRS profits less cost of

holding SCR

Solvency II profit less

cost of holding Economic

capital (SCR plus buffer)

Solvency II profit less cost

of holding Economic

capital (SCR plus buffer)

Mixes accounting and

economic measures

Typically used where

company has strong

preference for IFRS

profits over embedded

value profits or change

in Solvency II own funds

(e.g. if parent is a bank)

Solvency II profit defined

as change in Solvency II

own funds (ignoring any

changes due to capital

raising or payments such

as dividends)

Consistent with Solvency

II balance sheet and

capital requirements

Adjustments to Solvency

II balance sheet made to

reflect company’s

internal view (e.g.

contract boundaries,

credit risk for annuities)

Adjustments made

should be specific to the

company, but consistent

across it

Consistent with decision

making by the company

IFRS SOLVENCY II “ADJUSTED SOLVENCY II”

Increasing complexity in design and embedding Increasingly “economic” measure

Increasing consistency with decision making

Copyright © 2012 Oliver Wyman 4

contract boundaries, if it differs from

where Solvency II ultimately lands. Once

the profit basis has been selected, other

considerations need to be taken into

account: e.g. whether the measure should

be pre- or post-tax and whether to include

investment variances.

F. ABSOLUTE AND

RELATIVE MEASURES

An absolute RAPM – that is, one expressed

as a euro (or other currency) amount – is

required to enable insurers to understand

how much risk-adjusted value is created

by an activity or business unit. This allows

management to reward staff accordingly.

A relative measure of risk-adjusted

performance, sometimes referred to as a

capital efficiency measure, is required to

make decisions where capital is a scarce

resource. Relative performance measures

can be used at the start of the year to rank

various activities, business units or product

lines and then make (marginal) capital

allocation decisions based on these rankings.

EXHIBIT 2: EXAMPLE MEASURES DEVELOPED FOR A EUROPEAN INSURER

EVC =

Δ SII own funds

– BEL adjustment

– Required return

– Economic capital

x frictional cost

of capital

Change in own funds due

to writing new business

Difference between SII and

“Economic” balance sheet

Expected return on each

asset class and expected

change in liabilities

Frictional cost of holding

economic capital

(including buffer)

ECONOMIC VALUE CREATION (EVC) ECONOMIC RETURN ON CAPITAL (EROC)

Used for deciding whether to grow Life or GI

business, calculated as:

Δ EVC / Δ PV (EC)

Where:

Δ EVC is the change in EVC due to selling additional

policies

Δ EC is the change in Economic Capital from selling

additional policies

For GI business, five years of EVC and EC are

included in the calculation, based on expected

renewal rates

1 2

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2For RAPMs to make a difference in business steering and value management, they need to

contribute to decision making across the business. This means that risk-return trade-offs are

explicitly assessed in business decisions. Exhibit 3 provides an overview of the business processes

for which we recommend the use of RAPMs.

TAILORING THE NEW MEASURES

EXHIBIT 3: KEY BUSINESS PROCESSES FOR RISK-ADJUSTED PERFORMANCE MEASURES

RISK-ADJUSTED PERFORMANCE

MEASURES

Strategic

planning and capital

allocation

Performance

management and

compensation

Stress and

scenario testing

Reinsurance

strategy

Product

design and

pricing

ALM

management

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Each of these applications presents its

own challenges and the measures must

be tailored to them. In this section, we list

key questions that need to be answered

and the challenges that are typically

faced in using RAPMs in three business

processes: (A) strategic planning and

capital allocation, (B) product design and

pricing, and (C) performance management

and compensation.

A. STRATEGIC PLANNING AND

CAPITAL ALLOCATION

The aim here is to decide how much capital

to hold over the planning cycle and allocate

capital to the opportunities (BUs, products,

investments, etc.) that generate the greatest

risk-adjusted value. Key questions and

challenges include:

How much buffer capital should be held

and how should it be accounted for in

target setting?

Insurers need to hold more than the

Solvency Capital Requirement to manage

the volatility of the Solvency II balance

sheet through the cycle. A strategic and

capital planning exercise must therefore

decide just how much buffer capital to

set aside. Then this buffer capital must

be accounted for in target setting, either

by explicitly allocating it to business units

and charging for it or by increasing the

cost of capital and hurdle rates to account

for the cost of holding buffer capital.

How should diversification benefits be treated?

When allocating capital to business

opportunities, diversification benefits

must be accounted for in a way that

gives the business the right incentives.

For example, if it is corporate strategy

to diversify the business, then activities

that take new risks – e.g. P&C risk

in a Life-focused company – should

be charged only for their marginal

capital requirements. There are several

techniques for allocating diversification

benefits, including the pro-rata approach,

game-theoretic approaches and marginal

contribution approaches.

How should the strategic planning and

capital allocation process work in practice?

Strategic planning and capital allocation

is typically an iterative process, looking at

different scenarios and business portfolio

options. For this to work in practice

within the planning timelines, companies

cannot run their full Pillar I models for a

range of scenarios and capital allocation

options. Hence, several of our clients use

simplified capital and RAPM models for

planning purposes.

B. PRODUCT DESIGN AND PRICING

RAPMs can be used to design capital-efficient

products that generate value over the policy

lifetime. Key questions and challenges include:

Which risks should be assessed and charged

for in new business design and pricing?

The risk profile of any insurance

product will change over time. This is

particularly true for the balance between

underwriting risks and market risks.

While underwriting risks are inherent

to the product, market risks can be

increased or decreased relatively easily

over time. New product design and

pricing should focus on the risks inherent

to the product: i.e. underwriting risks and

market risks that cannot be hedged, such

as long-term interest rate risk. The risk-

return trade-off for optional market risks

should be assessed as part of the ALM and

investment strategy.

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At what level should diversification benefits

be accounted for?

As in strategic planning and capital

allocation, there are several ways to

deal with diversification benefits. In new

business product design and pricing,

the question is typically how much

capital diversification benefit to allocate

to products. Should diversification be

accounted for within the product line,

within the legal entity or across the

Group? The right answer depends on the

firm’s strategy. Some insurers may want

their business units to be economically

profitable on a stand-alone basis,

while others may decide to use Group

diversification as a source of competitive

advantage in local pricing.

How should “anchor” products and cross-

selling opportunities be dealt with?

One common criticism of RAPMs is that

they are too harsh on products that may

not be economically profitable but give

distribution access to customers and

generate additional sales later on. This is

a valid concern that needs to be solved

as part of product portfolio planning. If

a product is an important entry point to

generate further sales, this should be

reflected by adjusting RAPM targets for

this product – i.e. allowing a negative

economic value creation target or a below

hurdle target return on a stand-alone basis.

C. PERFORMANCE MANAGEMENT

AND COMPENSATION

When it comes to basing compensation on

RAPMs, there is usually one question that

dominates all others:

How can it be ensured that employees

can influence the RAPM in their

compensation scorecard?

To ensure that RAPMs are meaningful in

business steering and compensation,

measures flowing into compensation should

be based on factors that an employee

can influence. Hence, adjustments are

required to neutralise elements that the

individual cannot influence. For example

market movements should be included

in the investment team’s performance

measures, but it would be unfair to

penalise someone working in distribution

for equity market falls. Hence, RAPMs

should be broken down into value trees

as a basis for defining more specific

measures or holding constant certain

elements of the measures feeding

into compensation.

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3We see three key challenges in implementing new RAPMs:

Educating the Board, management and staff to ensure they understand and accept the

new measures

Moving from the existing performance measures to the new measures, deciding how

quickly this happens and which performance measures to phase out

Managing the impact of the new performance measures on the business.

EDUCATION AND BUY-IN

Obtaining buy in to new performance

measures is always tricky. Performance and

compensation are emotive subjects and staff

want to understand how new measures

will work and how they will affect them.

Time must be invested in explaining the

new measures to all affected staff (starting

with the Executives) and employees need

to be given comfort that the measures will

not reduce their overall compensation level

without good reason. One way to encourage

Executives to buy into the new measures

is to involve them early in their design and

ensure that their concerns are addressed.

Calculating the new performance measures

on a best efforts basis as part of the design

process, or as part of a “pilot” phase following

their design, is also important in helping the

business understand the measures before

they are finalised.

MOVING TO THE NEW MEASURES

Some existing measures will continue to be

important in assessing performance while

others will be replaced by by the Solvency II

measures or new RAPMs. For instance,

MCEV or EEV will probably be replaced by

Solvency II own funds, whereas IFRS profits

are likely to continue to feature in Executive

scorecards and performance assessment.

This will raise questions about how to manage

the transition. For example, should new

measures be introduced on a shadow-basis

or should management over-ride or adjust

them in the first year of implementation if

there are teething troubles?

The introduction of RAPMs will also require

changes to payment systems and reporting.

Where possible, insurance companies

should integrate the changes required

by the introduction of RAPMs with those

already planned. To allow staff to gain

comfort with the new measures, many

insurers will want to temporarily run them in

parallel with those that are being replaced.

APPLYING THE NEW MEASURES

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MANAGING THE IMPACT OF THE

NEW MEASURES

Introducing RAPMs will provide new insights

into the economics of the business. Some

products that looked highly profitable

under traditional measures may be value

destroying on an economic basis. An

obvious example of this would be products

with large guarantees and some lines of non-

life business, which under Solvency II will

attract much higher capital requirements.

Managers need to use this new lens on

profitability to make capital allocation

decisions, set prices and design products.

RAPMs should encourage the business to

design capital efficient products and set

prices that take account of the economic

risks that these products bring onto the

balance sheet.

* * *

RAPMs are an important lever for

embedding Solvency II capital requirements

into business decisions. But developing

appropriate measures is not a simple

process. There are many challenges in both

the design and implementation.

A “one size fits all” approach to designing

and embedding RAPMs is not appropriate.

What works for one insurer may be wrong

for another. Nor will a particular RAPM be

suitable for all performance measurement

purposes within a single firm. RAPMs need

to be tailored to their specific uses.

Yet it is impossible to solve all problems by

choosing the right measures. All measures

will have shortcomings in practice. Insurers

must design RAPMs that achieve a good

balance between theoretical purity and

practicality, and then add controls to

mitigate identified issues.

RAPMs are sure to receive much more

attention over the next 18 months. Insurers

should make changes now to put them in

place in time for the Solvency II switchover.

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