Risk Appetite & Capital Management...Risk Architecture: Risk Appetite & Capital Management Bogie Ozdemir, VP, Sun Life Financial Group [email protected] 2. Risk Architecture,

Risk Architecture: Risk Appetite & Capital Management

Bogie Ozdemir, VP, Sun Life Financial Group [email protected]

2. Risk Architecture, Washington, DC, March 18, 2012 2

Disclaimer and References

Adapting to Basel III and the financial crises, Re-engineering capital, business mix, and performance management practices, Bogie Ozdemir, Peter Miu, Forthcoming, Risk Books

Value Optimization in a Regulatory Constrained Regime – A New Look at Risk vs. Return Optimization, Bogie Ozdemir, Michael Giesinger, Journal of Risk Management in Financial Institutions, Winter 2011

Managing Capital Buffers in the Pillar II Framework - Designing an effective ICAAP/ORSA to manage procyclicality and reconcile short- and long-term views of capital, Peter Miu, Bogie Ozdemir, The Journal of Risk Model Validation, Winter 2010

Opinions expressed are those of the speaker and are not necessarily endorsed by the speaker’s employer.

Correspondence should be addressed to Bogie Ozdemir,[email protected] or [email protected].


Risk Strategy

Corporate Strategy

Financial Strategy

• Intersections of Risk, Business and Financial Strategies

– Stress on ROE and the evolving role of the ERM Function

– Integrated Capital Management

– Role of Risk Strategy in Capital and Business Mix Optimization

– Role of Economic Capital

– Organizational (re)alignment - Establishing effective partnerships with Corporate Finance (and Actuarial) in Capital Management

– Risk Appetite; static vs. dynamic measures. From Monitoring to Planning and Optimization

Topics of Discussion


Outline



• Environmental pressure

– Capital is more scarce than ever (shortfall of capital is expected under Basel III)

– Tremendous pressure on ROE

– Need to enhance capital utilization and “correct” the business mix, while managing the Income needs

• As capital and business mix management is becoming increasingly important, should we not utilize our tool set, eg. EC, ICAAP?

Some Observations


• Unintended Consequences of Basel III

– Regulatory capital is taking precedence over Economic Capital. In leading FIs

RC is replacing EC as the primary decision making tool

RC is pushed down to pricing and deal acceptance levels

– Basel III is taking precedence over ICAAP

– Both behavioral changes are attributed to Basel III’scapital being the binding constraint

More Observations


1. A requirement for ICAAP / ORSAwhich are useful, comprehensive, integrated capital management tools

2. Much better portfolio optimization tool

3. Captures diversification

4. Captures the true-economic riskbetter

5. Internal view capturing company specificities as apposed to one-size fits all

20

1. Some banks switched to ICAAP - light

2. Portfolio optimization opportunities are restricted under Basel III

3. Intra diversification is not easy to defend

4. Models are blamed for the crisis

5. Economic Capital is less standardizedand not fully validated

• Regulatory Capital is a fact of life!

More observations: Utilization of Economic Capital


• Capital Adequacy – “Earlier” Practices and Challenges:• Capital Adequacy ≡ Book Value of Equity > Max (Economic Capital,

Regulatory Capital, Rating Agency Capital)

• But what should be the size of the capital buffer (surplus) with respect to– Business cycle

– Short and long term view

– Expected and Potential Stressed Conditions

– Risk Appetite

– Corporate and Risk Strategy

– Liquidity Concerns

• Ad-hoc, non-standardized, non-creditable Stress Testing, not formally linked to Capital Adequacy assessment

• Liquidity not formally linked to Capital Adequacy assessment

• Insufficiently understood, defined and quantified Risk Appetite

• Capital and Liquidity Contingency Plans

More observations: Marginalization of ICAAP is very unfortunate…


• Managing the Capital buffer between “Available Capital” (the supply) and “Risk Capital” (the demand) with respect to the organization's Risk Appetite and Strategic Objectives considering both expected and stress business conditions

ICAAP/ORSA is an integrated, comprehensive capital and business planning tool


• Base case: “Expected” Capital Adequacy – An Example

Projection

Key Measures 2011 Actual 2012 2013 2014

Available Capital Tier 1 25 26 28 30

Risk Capital

EC (Pillar I+Pillar II) 20 23 24 26

RC 18 21 22 23

Forecasted Capital Adequacy

Tier 1 Ratio Forecast 11.10% 9.90% 10.20% 10.40%

Available Capital/EC 125% 113% 117% 115%

Available Capital - EC 5 3 4 4

Risk Appetite (Min)

Tier 1 Ratio 8.50% 8.50% 8.50% 8.50%



• Risk Strategy is the driver for both Available and the Risk-Based Capital

• How does Surplus Capital reconcile with our Risk Appetite and Corporate strategy?

ICAAP is a much needed fully integrated, comprehensive capital budgeting process…


Volume: Growth / New Business - Exit

Planned Risk Taking

EC Projection

Reg Capital Projection

Income Projection

Risk Strategy

Enterprise Strategy

Available Capital Projection

Financial Strategy

Expected Macro Economic Environment

• ICAAP integrates Business, Risk and Financial Strategies

ICAAP is a much needed fully integrated, comprehensive capital budgeting process…


“Clear link should exist between Risk Appetite Framework, Strategic, financial, capital processes and business decisions”

“Strategy should drive risk appetite ”

“ORSA examines the risk associated with future plans, rather than evaluating only risks associated with past performance .. And thus provides a dynamic view of each company’s risk profile

ORSA is a self-graded exam with the following key questions:

What is our strategy?

What level of risk are we willing to assume in pursuit of this strategy?

What are the key risks that could hinder our ability to achieve our strategy?

How much capital do we need to cover those key risks?

What risks — individually or collectively — would subject us to losses that exceed our tolerance levels?

What risk scenarios would cause us to fail or stop operating as a going concern?

Selected Quotes from US (NAIC) and Canada (OSFI) regulators for ORSA


Economic and regulatory capital that fully supports the risks inherent in a three-to-five year business plan.

The link between business strategy and required capital is a key element of ORSA.

New business sales are examined under base, optimistic and pessimistic scenarios. As part of the business planning process, companies need to understand how these scenarios affect risk and associated capital requirements. For example, scenarios may help management decide if there is sufficient capital to support organic growth under optimistic sales plans.

Need to look at the impact on their risk profile and decide if the Board’s agreed appetite and tolerances are honored.

Similarly, product pricing, design, risk transfer and ALM processes will need to be reviewed regularly to ensure consistency with Risk Appetite and capital constraints.

Ultimately, the state regulator should be able to review all three sections of the insurer’s risk policy and understand the link between risk policies, measurements, capital allocation and day-today operational decisions. This concept, known more commonly as the ”Use Test”, as proved to be a challenge to demonstrate.

NAIC Own Risk and Solvency Assessment (ORSA) Guidance Manual


• The buffer between “Available Capital” (the supply) and “Risk Capital” (the demand) is squeezed from both sides under stress.

Stress Available Capital

Current Risk Capital

AvailableCapital

Risk Capital

Available Capital

Appendix: Capital Adequacy under Stress


• Under severe stress, capital surplus would decline, can we weather the storm?

• Management Action?

Projection

Key Measures 2011 (Usage) 2012 2013 2014

Available Capital Tier 1 25 26 27 27.5

Risk Capital

EC (Pillar I+Pillar II) 20 24 26 27

RC 18 22 24 25

Forecasted Capital Adequacy

Tier 1 Ratio Forecast 11.11% 9.45% 9.00% 8.80%


Available Capital - EC 5 2 1 0.5

Stress Risk Appetite (Min)

Tier 1 Ratio 8.00% 8.00% 8.00% 8.00%



Appendix: Capital Adequacy under Stress, an example


Scenario impact needs to be quantified consistently for (increase) in Risk Capital (EC and Reg Cap) and (decrease) in Available Capital (via reduced Net Income).

1. Integrated EC and Reg Capital (representing the increase in Capital Demand after the stress event)

2. Integrated NI decline

a) Reduced fee income under stress (representing the decline in available Capital build-up due to the stress event)

b) Unexpected losses (representing the usage of Capital due to the stress event)

Some risks are always PIT (e.g. default) but how about MTM losses? Note NI=f(ΔReserves)

– Risk reduction, capital conservation, other management actions?

2.a

2.b

1

Available Capital

Risk Capital

Appendix: Impact of Integrated Stress Impact on Solvency


ORSA DCAT

ORSA is a fully integrated, forward‐looking capital planning, budgeting, reporting and management process. By dynamically balancing the required capital (Demand) with the available capital (Supply), it ensures capital adequacy required to execute our strategic objectives, business plans and risk strategy within the risk appetite.

Although DCAT is prescribed as a scenario test, it provides information similar to that from a sensitivity analysis. By assessing the impact of more or less standard shocks on the risk factors (interest rates, equity markets), sensitivities and vulnerabilities are assessed.

It is conducted in a dynamic, forward looking fashion, considering the current and expected phase of the business cycle. The base case is dynamically assessed, conditional on the current business cycle.

Typically, the base case assessment, aside from the current yield curve, is static. Regardless of where we are in the current and expected business cycle and Macro Economic conditions, for example, the same equity growth assumptions are used.

ORSA must be performed both under a dynamic, forward‐looking base case scenario and under selected stress scenarios. These scenarios are event‐based (e.g. European Union breaking up) that could likely occur within a one year horizon; the impact of which unfolds throughout the ORSA projection period. The stress scenarios areconditional on the prevailing economic outlook and thus are topical, relevant, forward‐looking sources of concern. As each event‐based scenario is unique, how it unfolds and manifests itself in terms of shocks to the risk factors over the projection period would be unique both to the scenario and the time period.

Typically, scenarios are not event‐based. Rather than starting with event‐based scenarios (e.g. European Union breaking up) that could likely occur within a one year horizon, and then translating these scenarios into the risk factors over the projection period, fairly standard shocks to the risk factors are considered without explicit linkages to the events.

ORSA is much wider in scope, including many elements of the ERM framework, such as Risk Culture and Governance, Risk Identification, Assessment and Prioritization and their quantification, and the entire model governance and validation processes. ORSA is a part of the ERM framework, and ERM framework supports the ORSA.

DCAT is conducted as an actuarial responsibility without clear connections to the wider ERM framework.

Appendix: ORSA vs DCAT


Estimation of Capital Supply (Available Capital) and risk‐based Capital Demand (Required Capital) must be done in an integrated fashion over a period of 3 to 5 years. These integrated assessments must be linked to prevailing strategic and business planning. When this is achieved, ORSA becomes a compressive and fully integrated capital planning and budgeting tool. This is nothing more the “use” test requirement.

The DCAT horizon is also 5 years for Lifecos. However the linkages to the prevailing strategic and business plans are typically weak. The base case is not a forward looking conditional best estimate of what can happen of over the projection period and thus very large deviations from the base case are only natural. This reduces a regulatory compliance exercise rather than a capital planning tool like ORSA.

As the ORSA represents an institution’s “Own” assessment of risk, internal models must be used wherever they are available in projecting the risk‐based capital demand through the base case and under stress conditions.

Regulatory Capital is used for DCAT.

ORSA scenarios should represent risks against which capital is asensible, and effective mitigating response. There are scenarios so severe and remote, against which holding additional capital would be a nonsensical response. In selecting scenarios the senior management will assess whether capital is an effective and sensible risk mitigating response.

More often than it should, DCAT scenarios are considered too severe and too hypothetical to be “taken it seriously”. This is because they are not driven by topical, forward‐looking event‐based stress scenarios, which would make them more relevant sources of concern that senior management can relate to. Havingsaid that, as a sensitivity test it can and does identify the specific vulnerabilities triggering useful risk mitigation action.

The corresponding capital adequacy in terms of the capital buffers between Supply and Demand for Capital must be assessed with respect to the tolerance limits outlined in the Risk Appetite. In assessing the capital buffers with respect to the tolerance limits, the impact of mitigating management action should be considered.

Typically, Risk Appetite and specific tolerance limits are not defined.

Scenarios defined and projected within ORSA must include at least one reverse scenario. This reverse scenario would consist of severe shocks that would jeopardize the solvency of the company under the Risk Appetite. By working backwards from the scenario, the purpose is to help identify and mitigate when possible potential vulnerabilities to the company, the associated contingent effects and fault‐lines.

Reverse scenario tests are not mandatory.

ORSA DCAT

Appendix: ORSA vs DCAT



• Can we ignore Economic Capital?– EC should reflect the true economic risk and value - help identify

“comparative advantage”. Example:

– Pricing Long Term insurance contracts: RC can be changed externally

EC > RC – RC based decisions will results in economic losses

RC > EC – RC based decisions may results in opportunity losses

– Actual losses are driven by Economic Risk over the long term…

• Can we ignore Regulatory Capital?– Like it or not, RC is a fact of life - we need to provide sufficient Return on

RC if it is the binding constraint – i.e. higher that EC

– But at what level do we need to manage Regulatory Capital?

Similar PD, LGD, Exposure Marginal RC Marginal EC

Bank of Nova Scotia 12.4 MM 19.33 MM

Canada Post 12.4 MM 6.99 MM

EC vs RC – a Dichotomy?


• Have 2 hurdle rates in deal pricing and performance management

• How about an RC tax?

• Still good deals could be rejected despite having RC room at the enterprise level.

• We do not need to manage EC and RC relationship at this granular level. This is an overstatement of the constraint which will lead to a sub-optimal solution!

• Moreover, this is not Capital/Business Mix Planning. We need tomanage EC and RC relationship at the Enterprise level

hRCECMax

NI≥

),(

hRCNIANDh

ECNI

≥≥

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ECECRCMaxkNI

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ekRCECMax

NI≥⇒

∑∑∑

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NI≥⇒

∑∑

),( ∑ ∑∑ ≥ ),(),( RCECMaxRCECMaxbut

Is there a simple way of reconciliation?

This would equate to:


• How to set up the optimization problem for capital utilization and how to operationalize it?

• Objective: Increase ROE by

– Optimizing the capital utilization

– Reconciling Economic and Regularly Capital at the right level

– Dynamically “Course correcting” by changing the business mix

– While meeting the income needs

Business/Capital Planning Process


Alternative Strategies Alternative

Strategies

Alternative Strategies

Alternative Strategies Optimal

Strategy

Strategic Planning Optimal Strategy is

selected among alternatives

Target Setting For the selected Strategy the

following targets are set per BU 1. Target ROECi

2. Target ECi Usage

3. Target RCi Usage

BUA o Target EC Usage o Target RC Usage o ROEC Target

BUB o Target EC Usage o Target RC Usage o ROEC Target

BUC o Target EC Usage o Target RC Usage o ROEC Target

Limit and Performance Monitoring

For each of the BU business Units the following is

monitored 1. Realized ROECi ≥ Target

ROECi

2. Realized ECi Usage ≥ Target ECi Usage

3. Realized RCi Usage ≥ Target RCi Usage

BUA o Realized EC Usage o Realized RC Usage o Realized ROEC

BUB o Realized EC Usage o Realized RC Usage o Realized ROEC

BUC o Realized EC Usage o Realized RC Usage o Realized ROEC

Alternative Strategies

3 Step Operating Model


• One way to approach the problem:

1. Starting Point Target Net Income

2. Allocate The Target Net Income among LOBs, to determine LOB level Target Income

3. Determine the required “growth” for LOBs to support the required Target Income

4. Given the growth rate, calculate the capital required to support the businesses

5. Capital usage is the “outcome” of the process

• But: how do we know we are using our capital most effectively?

– There are alternative ways of achieving total target income for the bank and some are more capital efficient than the others – due to larger diversification benefits –which EC can capture

– EC is the right tool for this optimization (used in the objective function)

– We need to take RC into account as a “constraint”, ensuring that an adequate rate of return is provided to the shareholders at the aggregate bank level (Note that EC and RC will be different for the LOBs)

Business and Capital Planning Process: Background


Alternative GrowthOpportunities

Alternative GrowthOpportunities

Net Income

Net Incom

e for Different R

isk Types and Portfolios

Net Income

Net Income

Net Income

Total EC After Diversification

EC & RC Limits

Objective: Among the alternative opportunities, to determine those

which maximize return on EC for the entire Bank, while ensuring sufficient income generation and return on RC if RC is larger than EC at the Bank level

Maximize Net Economic Profit

Subject to Total NI exceeding Target

[ ] [ ][ ]⎟⎠

⎞⎜⎝

⎛×−∑∑

n

iii

n

ii ECEkNIEmax

Subject to Return on Maximum of EC & RC at the Corporate Level exceeding the HurdleSubject to Strategic Considerations

Setting up the Optimization Problem


[ ] [ ][ ]⎟⎠

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⎛×−∑∑

n

iii

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[ ] NNIEn

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NI Growth & Risk Taking

EC

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n

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n

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,max

Why EC not RC?

We have income targets to meet

Growth & Risk Strategy determines both Income and Capital Usage

Some ways of achieving the target Income are more capital efficient than others.

The objective is to maximize NEP for the entire bank by allocating different amounts of EC among the LOBs while achieving the target income for the entire bank

We need to take RC usage into account, ensuring that despite the differences between EC and RC for the LOBs, an adequate rate of return is provided to the shareholders at the aggregate enterprise level.

Setting up the Optimization Problem


• During the strategic planning phase, we will optimally allocate our capital while taking into account the maximum of EC and RC at the Bank level as constraint.

• Although we will maximize return on EC, some RC friendly businesses will stay in the mix due to their ability to create RC room for those businesses which are contributing high return on EC. These businesses are likely to have a lower return on EC

• In the example below:

– Business BL_A and Business BL_B are more profitable. But they cannot exceed the corporate hurdle rate without BL_C, i.e. (10+10) / (100 + 150) = 8% < 10. With the inclusion of BL_C, the bank meets the constraint (30/300).

– Performance of the businesses should be measured against the target (planned) ROEC. For example for BL_C:

BL_A BL_B BL_C Total

NI - Plan 10 10 10 30

RC - Plan 100 150 50 300

EC - Plan 100 50 140 290

ROEC - Plan 10% 20% 7.1% 10.3%

%1.7)()(

)()(

=≥PlanECPlanNI

ActualECActualNI

If BL_C can return 7.1% ROEC at he end of the year, its mission is accomplished

Role of RC in optimization: A Stylized Example


1. Determine the level of Business Lines (BL) the analysis will be conducted for e.g. Operating Group level or even more granular—however, excessive granularity would overly complicate the analysis

2. Determine the appropriate scenarios

a) Determine a range between the maximum possible annual growth and reduction per BL (e.g. [-10%, 20%])

b) Divide this range into discrete outcomes (e.g. -10%, 0, 10%, 20%)

c) Establish a combination of all possible scenarios

3. Eliminate the scenarios outside the strategic objectives (e.g. BL_A cannot grow or BL_B cannot shrink), and those that do not meet the constraints at the bank level (resulting in too much RC usage)

BL_A BL_B BL_C

-10% 0 10%

0 10% 10%

10% 10% 10%

20% 10% 0%

Appendix: Process Steps


4. For each scenario estimate NI and EC (after diversification) for each BL considered.

5. Calculate the NEP at the total bank level using the equation below. Use differentiated hurdle rates when the BL has higher volatility, thereby requiring a higher rate of return from shareholders.

6. Note that under some scenarios the total EC at the bank level would be relatively lower due to the higher diversification benefits. The use of EC allows us to capture the capital efficiency of these opportunities. Under “capital efficient” scenarios, NEP for the bank will be higher. EC used (in terms of philosophy is consistent with EC used in ICAAP).

7. Rank order the scenarios in terms of their NEP: the higher the better.

8. Choose the right scenario to execute considering both NEP and the strategic objectives.

9. For the selected scenario, set plan EC, RC, NI and ROEC for each BL (targets).

10. Monitor the performance against these targets and make sure BL stays within its target EC and RC limits.

) (∑ ∑ ×−= ECHurdleatedDifferentiNIMaxNEP

Appendix: Process Steps, con’t


• Fairly typical (Canadian) bank portfolio

• Differentiated hurtle rate

• Constraints for growth and contraction rates of exposure over the next year:

Large Corporate SME Retail37% 18% 45%55% 25% 20%24% 27% 49%

ExposureECEL

MIN MAXLarge Corporate -10% 30%

SME -15% 25%Retail -15% 20%

Empirical Analysis, Portfolio Details


• Income Target over the next year is $4.00 billion (*).

• Alternative Risk Strategies:

– Scenarios 1-4: Maintain the existing risk profile. Generate extra income via portfolio growth.

– Scenarios 5-8: Uniform increase in risk profile to generate extra (spread) income.

– Scenarios 9-10: Non-uniform increase in risk profile to generate extra (spread) income. (Increased Risk in Risk Ratings 1 - 4 only and 5 – 11 only)

(*) If the bank maintains its current exposure, and risk profile, it can expect to have income of $3.72 billion over the next year.

After expenses but before EL

Empirical Analysis, “Risk Strategy”


Maximum Reduction in Large Corporate portfolios

Results: Although all scenarios produce $4.00 billion income, NEP and ROEC differs materially


Correlations matter. Certain combinations result in larger diversification benefits. For example, the difference in EC between Scenarios 1 and 2 are partially due to the increased diversification benefit in Scenario 2.

To improve the overall bank’s NEP, the Large Corporate portfolio must contract in size. The Large Corporate portfolio has a very good NI/EL ratio (due to low PDs) but suffers from high EC due to high correlations. It neither can handle an increase in exposure (Scenario 3) nor an increase in riskiness (Scenarios 5, 6, 9, 10). However, the annual contraction rate is limited to 10%.

Retail is a good area of growth for this bank. However, it is limited to 20% growth annually. While the exposure increase does cause NEP to grow significantly, it does not respond as well to moving up the risk curve - due to a further increase in EL which is already substantial given the higher average PD of the business. For moving up the risk curve, there is room for increasing the risk for RR 1 to RR4 (Scenario 9) but not the other way around (Scenario 10).

SME portfolio does not lend itself well to the moving up the risk curve as the already high EL increases too much.

The fact that neither the SME nor Retail portfolios benefit from an increase in risk levels of the portfolio is an interesting finding. As in these portfolios, the growth in business is typically achieved at the expense of an increase in risk.

Constraints on growth/contract or, more precisely, the need for income, diminish the ability to course correct. The bank can choose to reduce its Large Corporate business faster than 10% annually but as the retail business cannot grow fast enough to replace the income loss from this reduction, the bank would fall short of its income target. To course correct faster towards a more optimal business mix, income sacrifice is needed in the shorterterm.

Observations


Under the above scenarios, we do not violate the constraint that the return of the maximum of total EC and total RC is higher than 11.6% (the weighted average cost of capital of this bank).

However under the Basel III regime, a significant increase in RC is likely. Below we recalculate RC under these potential increases:

for all of the scenarios, RC now exceeds EC significantly

the return (on Maximum of total EC and total RC) is less than the bank’s weighted average cost of capital of the bank, for all scenarios but Scenario 9 (because RC is less sensitive to the risk increase in investment grade obligors in Risk Rating 1 to 4 on a relative basis, RC does not go up as much, making Scenario 9 the only viable scenario exceeding the constraint)

because we can no longer utilize Scenario 2 which provides the best economic alternative, Basel III results in an economic cost. The more RC exceeds EC at the aggregate level, the higher the cost.

There is systemic economic benefit if we increase confidence on EC and not impose RC as a binding constraint

Observations - Impact of Basel III


• Cost of Equity = RF + β × MRP

• See appendix for the data sources

• The answer should depend on the application

βPIT = 0. 9

βTTC = 1

βSTRESS = 1.12

MRPPIT = 6.0%

MRPTTC = 6.0%

MRPSTRESS = 15.0%

RFPIT = 0.70%

RFTTC = 4.50%

RFSTRESS = 1.37%

Cost of EquityPIT = 6%

Cost of EquityTTC = 10%

Cost of EquitySTRESS = 18%

What is the cost of equity anyway?


Data Source – Nov-11 RF

US Current 3 Month Treasury 0.02%

US Current 10 Year Treasury 1.92%

US Current 30 Year Treasury 2.91%

US Historical Average 3 Month Treasury 4.50%

US Historical Average 10 Year Treasury 6.34%

US Historical Average 30 Year Treasury 6.71%

US Historical Liquidity Premium (10 Year - 3 Month) 1.84%

US Historical Liquidity Premium (30 Year - 3 Month) 2.22%

US 2008 Recession 3 Month Treasury 1.37%

Market Risk Premium

Data Source MRP

CA 2011 MRP (Professional Survey Paper) 5.9%

US 2011 MRP (Professional Survey Paper) 5.5%

US Historical Insurance MRP (US Insurance Industry Paper) 6.2%

US 2008 Recession Insurance MRP (US Insurance Industry Paper) 15%+

Appendix – Data Sources for the Cost of Equity Calculation



• Effectively managing Capital Adequacy and Capital Utilization requires a full partnership model between the Risk and Finance functions and an appreciation of Risk Strategy as an input to capital management

• Risk Management owns the Risk Strategy thus the corresponding Capital demand

• Thus RM becomes a Co-pilot in Capital management in addition to effective Brakes

Evolving Role of the Risk Function

Risk Strategy

Corporate Strategy

Financial Strategy






Regional

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- Supply Regional

CFO Regional

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CFO Corporate

CFO

EC Regional CRO

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Risk

Capital - Demand Reg

Cap Regional Actuary

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Available Capital - Supply

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EC Regional CRO

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Capital - Demand Reg

Cap Regional

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IEW

1- Disintegrated Stage: No holistic and integrated management of capital. Supply and Demand sides of the capital have not been brought together. Moreover the two measures of Risk Capital (Demand): EC and RC, are not linked. Corporate and regional functions are relatively separate and there is no enterprise level optimization at the corporate level.

2- Initial Integration: The boundaries between supply and demand sides of the capital are opaque. The impact of Risk Strategy on capital demand is not yet understood. No joint management of both sides of the capital via a full partnership model between Risk and Finance (Treasury) functions is established.

Note that Regional Level can be Business Unit or Lines of Businesses depending on how FI manages its business.

Alignment of Risk and Finance, A New Partnership


3- Integrated StageIn this stage corporate functions begin to integrate as the corporate boundaries between Risk and Finance start to clear. Better coordination leads to better management of capital

4- Advanced Integration StageAt this stage, capital optimization at the corporate level is achieved by means of management of liquidity and fungibilityof Available Capital and diversification benefits of Demand measured in EC at the corporate level as well as increased understanding and management of EC and Reg Capital Relationship.

Regional

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Regional CFO

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Regional CFO Corporate CFO

EC Risk Capital - Demand Reg

Cap

Regional CRO

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CFO Regional CFO Regional

CFO Regional CFO Corporate CFO


Cap

Regional CRO Regional

CRO Regional CRO Regional

CRO Regional CRO Corporate CRO

CO

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Capital Reduction

Alignment of Risk and Finance, A New Partnership, con’t


5- Full Integration StageAt this final stage, a full partnership among the functions leads to optimization of capital utilization. Maximum Capital optimization at the corporate level is achieved via dynamic management of liquidity fungibility of Available Capital and diversification benefits of Demand measured in EC, and EC and RC Relationship.

6- A common pitfall:Finance owns both the Supply and Demand side (only RC) of capital adequacy without a comprehensive understanding of the risk drivers of RC. EC and RC are not aligned. A superior measure of Risk Capital, EC, is isolated. Risk Strategy is not a direct, well understood input to capital adequacy management. This structural misalignment results in sub optimal capital management.

Regional View

Regional View

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Available Capital - Supply Regional

CFO Regional

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CFO Regional CFO Corporate CFO


Cap

Regional CRO Regional

CRO Regional CRO Regional

CRO Regional CRO Corporate CRO

CO

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Risk Capital - Demand

Reg Cap

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Capital - Demand

EC Regional CRO

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Alignment of Risk and Finance, A New Partnership, con’t


Risk Appetite

• Risk Appetite is a comprehensive, multidimensional statement including

• Solvency

• Earnings at Risk

• Shareholders Value

• Liquidity

• Quantitative and qualitative statements

• Dynamic and Static measures


Solvency


Insurance Companies need to manage both Insurer Financial Strength Rating & Issuer Credit Rating

A Standard & Poor's insurer financial strength rating is a forward-looking opinion about the financial security characteristics of an insurance organization with respect to its ability to pay under its insurance policies and contracts in accordance with their terms. Insurer financial strength ratings do not refer to an organization's ability to meet nonpolicy (i.e. debt) obligations.. A Standard & Poor's issuer credit rating is a forward-looking opinion about an obligor's overall financial capacity (its creditworthiness) to pay its financial obligations. This opinion focuses on the obligor's capacity and willingness to meet its financial commitments as they come due. It does not apply to any specific financial obligation, as it does not take into account the nature of and provisions of the obligation, its standing in bankruptcy or liquidation, statutory preferences, or the legality and enforceability of the obligation. http://www.standardandpoors.com/ratings.

Implication in EC estimation

Target Financial Strength Rating CTE(e.g. AA)

Target Debt Rating (e.g. A)

EC

Equity Debt


Risk Tolerance for surplus capital ratio, a static measureStress Surplus capital ratio using a standard (e.g. 1 in 40-years) shock, recalculate the ratio and compare it against the risk tolerances. For instance, if after the shock the ratio

• remains above 2, it is considered green and no action is needed.• falls below 2 but above 1.8, it is considered Yellow (Alert) and specific

action is required to move it above 2 over a prescribed period. • falls below 1.8, it is considered Red (Alert) and more immediate and

specific management action is required (including immediate de-risking).


• Very useful on-going monitoring ensuring that at “any point in time”, the FI operated at a level of surplus capital that is large enough to withstand a 1 in 40-years shock.

• But it does not provide information about the future compliance with the minimum surplus capital tolerances with respect to the business plans and expected economic conditions. The alarm whistle blows only when we are dangerously close to our limits, not ahead of time. If our business plan and strategy require income which is possible only with aggressive growth and risk taking, and not achievable within our surplus capital tolerances, we would be not be aware of it as we are making these plans, but only become aware during the course of implementation of this strategy as we are about to exceed our tolerances. In this respect the test is static in nature.

• The other limitation of the framework is the 1-in-40-year shocks applied. While it provides a standard approach to the monitoring, they are time independent by construction. Unlike the standard “shocks”, the stress “events”, their impact and how they would unfold over time are specific to the event itself which is time dependent. FIs would need to scan the horizon to understand such potential, conditional events and assess the impact of these events on their surplus capital levels over their planning horizon.

• Therefore, while the on-going monitoring of the surplus capital ratios using standard shocks against the tolerance levels is required, it is not a substitute for proper capital planning and budgeting, and forward looking conditional ‘event-based’ stress testing required under ORSA and ICAAP. The risk appetite used for ICAAP and ORSA is dynamic in nature.

Risk Tolerance for surplus capital ratio, a static measure


Example drivers of Capital Buffer (Surplus Capital)

Higher bufferLow; capital demand is measured in terms of simplistic and one‐size‐fits all regulatory capital

Lower bufferHigh; capital demand is measured in terms of economic capital and well validated and benchmarked

Measurement Reliability

Higher bufferLow; capital cannot be transferred among different regions due to local regulatory restrictions

Lower bufferHigh; capital can be transferred among different regions etcFungibility of Available capital

Lower bufferLow

Higher bufferHighVolatility of Income

Higher bufferWeaker position to access to the capital markets especially under stress

Lower bufferStrong position to access to the capital markets even under stressAccess to the capital markets

Lower bufferLower dividend rate or higher tolerance to reduce dividend

Higher bufferHigh dividend rate, no tolerance to reduce dividendFinancial Strategy

Higher bufferNot in Place

Lower bufferIn PlaceLoss, exposure control measures like Stress EC, VaR, Stress VaR, EaR limits

Lower bufferLow

Higher bufferHighProcyclicality of the capital demand

Higher bufferLow

Lower bufferHighMeasurement Frequency

Low bufferContraction / run‐off

Higher bufferOpportunistic Growth

High bufferSteady growthBusiness Strategy

Lower bufferHigher tolerance to capital shortage and potential downgrade

Higher bufferNo tolerance to capital shortage and potential downgradeRisk Tolerance

ImpactDriver

Higher bufferLow; capital demand is measured in terms of simplistic and one‐size‐fits all regulatory capital

Lower bufferHigh; capital demand is measured in terms of economic capital and well validated and benchmarked

Measurement Reliability

Higher bufferLow; capital cannot be transferred among different regions due to local regulatory restrictions

Lower bufferHigh; capital can be transferred among different regions etcFungibility of Available capital

Lower bufferLow

Higher bufferHighVolatility of Income

Higher bufferWeaker position to access to the capital markets especially under stress

Lower bufferStrong position to access to the capital markets even under stressAccess to the capital markets

Lower bufferLower dividend rate or higher tolerance to reduce dividend

Higher bufferHigh dividend rate, no tolerance to reduce dividendFinancial Strategy

Higher bufferNot in Place

Lower bufferIn PlaceLoss, exposure control measures like Stress EC, VaR, Stress VaR, EaR limits

Lower bufferLow

Higher bufferHighProcyclicality of the capital demand

Higher bufferLow

Lower bufferHighMeasurement Frequency

Low bufferContraction / run‐off

Higher bufferOpportunistic Growth

High bufferSteady growthBusiness Strategy

Lower bufferHigher tolerance to capital shortage and potential downgrade

Higher bufferNo tolerance to capital shortage and potential downgradeRisk Tolerance

ImpactDriver


The other Dimensions

Documents

Risk Appetite & Capital Management...Risk Architecture: Risk Appetite & Capital Management Bogie Ozdemir, VP, Sun Life Financial Group [email protected] 2. Risk Architecture,