How to set risk appetite for an insurance company - a practical case study Andrew Hitchcox, Chair of the Risk Management Board Workshop Session A - 14 May 2015 Setting risk appetite - contents 1. Introduction: different stakeholders 2. Setting risk appetite - return targets 3. Capital at risk metrics 4. Earnings risk metrics 5. Risk limits and risk triggers Appendix: What do 1/200 and 1/1,000 mean? Colour palette for PowerPoint pPrreimseanryta ctioolnosu r palette 1. Setting risk appetite - introduction Dark blue R17 G52 B88 Gold Good risk appetite statements need to address the interests R217 G171 B22 Mid blue of several different stakeholders R64 G150 B184 Light grey R220 G221 B217 Topic/metric Example risk appetite undertakings Example key Secondary colour palette stakeholders Dark grey R63 G69 B72 Solvency Regulatory Solvency ratio >= 12% Regulator, investor, Pea green capital Core tier 1 ratio >=10% business lines R121 G163 B42 Capital efficiency Economic capital Utilisation of total risk-bearing capacity <= 80% Regulator, investor, Forest green Utilisation of total risk-bearing capacity under stress <= 90% business lines R0 G132 B82 Bottle green Earnings Dividends Probability of suspension of dividends <= 10% (1 yr in 10) Investor R17 G179 B162 P&L Probability of P&L of zero or worse <= 5% (1 yr in 20) Cyan Shareholder RAROC RAROC >= 5% Investor R0 G156 B200 value Light blue Creditworthiness Bond rating Maintain rating of ‘A’ (or better) Creditor, rating agency R124 G179 B225 Violet Liquidity Available liquidity Net liquidity gap corridor not breached Regulator, business lines R128 G118 B207 Probability of net liquidity breach under stress < 1% Purple Reputation Reputational risk Zero tolerance for permanent brand/reputational damage Investor R143 G70 B147 Fuscia R233 G69 B140 Red R200 G30 B69 Orange Workshop Session A - 14 May 2015 3 R238 G116 29 Colour palette for PowerPoint pPrreimseanryta ctioolnosu r palette 2. Setting risk appetite - return targets Dark blue R17 G52 B88 Gold • Return on Equity (ROE) targets are also part of your risk R217 G171 B22 Mid blue appetite statements: R64 G150 B184 Light grey R220 G221 B217 – You can only target a higher return if you are willing to take more risk Secondary colour palette Dark grey – Your ROE target shows how risky you want to be R63 G69 B72 Pea green • In the “old days” (before financial crisis of 2008), traditional R121 G163 B42 Forest green target ROE figures were: R0 G132 B82 Bottle green R17 G179 B162 – 5% from government bonds Cyan R0 G156 B200 – 10% from equity markets Light blue R124 G179 B225 • Typically in 2015 (when “risk free rates” are very low): Violet R128 G118 B207 – Global Banks (systematic risk): CoC 10%-12%, target ROE ~12%-15% Purple R143 G70 B147 Fuscia – Insurance(diversifying): CoC ~6%, target ROE ~10% R233 G69 B140 Red R200 G30 B69 Orange Workshop Session A - 14 May 2015 4 R238 G116 29 Colour palette for PowerPoint pPrreimseanryta ctioolnosu r palette Setting risk appetite - return targets Dark blue R17 G52 B88 Gold R217 G171 B22 Mid blue R64 G150 B184 Light grey R220 G221 B217 Secondary colour palette Dark grey R63 G69 B72 Pea green R121 G163 B42 Forest green R0 G132 B82 Bottle green R17 G179 B162 Cyan R0 G156 B200 Light blue R124 G179 B225 Violet R128 G118 B207 Purple R143 G70 B147 Fuscia R233 G69 B140 Red R200 G30 B69 Orange Workshop Session A - 14 May 2015 5 R238 G116 29 Colour palette for PowerPoint pPrreimseanryta ctioolnosu r palette Dark blue R17 G52 B88 3. Capital at risk metrics Gold R217 G171 B22 Mid blue R64 G150 B184 • When deciding how much capital to hold, need to Light grey R220 G221 B217 consider two key issues: Secondary colour palette Dark grey R63 G69 B72 – What to use as your core risk metric Pea green R121 G163 B42 – How much buffer capital to hold above required levels / Forest green R0 G132 B82 what is your desired ESR (Economic Solvency Ratio) Bottle green R17 G179 B162 Cyan R0 G156 B200 Light blue R124 G179 B225 Violet R128 G118 B207 Purple R143 G70 B147 Fuscia R233 G69 B140 Red R200 G30 B69 Orange Workshop Session A - 14 May 2015 6 R238 G116 29 Colour palette for PowerPoint Why are there so many risk measures pPrreimseanryta ctioolnosu r palette Dark blue R17 G52 B88 - which ones to use? Gold R217 G171 B22 Mid blue R64 G150 B184 Discussion Point 1: Light grey R220 G221 B217 Risk Metrics Secondary colour palette Dark grey R63 G69 B72 98.67%VaR Pea green 99%VaR 99.6%Va R121 G163 B42 R 99.5%VaR 99.97%VaR 99.93%Va 99%TVaR mean profit Forest green 99.95%VaR R0 G132 B82 ICA （99.5%VaR profit） Kiln, TMG Bottle green 99%TVaR of profit TMHD (Capital allocation) R17 G179 B162 Distance between 99.95%VaR profit and mean profit TMHD (Solvency) Cyan 99.93%VaR of profit TMR, Allianz (entity level) R0 G156 B200 99.97%VaR of profit Allianz (group level) Light blue 　　　　　×1.75 99.5%VaR of profit Munich Re, Aspen R124 G179 B225 　　　　　×2 99%TVaR of profit Swiss Re Violet 99.6%VaR of profit Axis, Arch (< 25% of capital) R128 G118 B207 Aspen, Endurance (< 17.5%, 25% of capital, 99%VaR of profit respectively) Purple 75 year of loss Partner Re (< 24% of capital) 5 R143 G70 B147 Fuscia R233 G69 B140 We need different measures for two different purposes: Red (1) For solvency & capital management R200 G30 B69 (2) For allocation and business management Orange 7 R238 G116 29 Colour palette for PowerPoint Why VaR versus TVaR? pPrreimseanryta ctioolnosu r palette Dark blue VaR looks at only one R17 G52 B88 Gold point on the curve R217 G171 B22 Mid blue • Doesn’t see cat exposures R64 G150 B184 above 1/200 Light grey R220 G221 B217 • Doesn’t see XL RI bought Secondary colour palette above 1/200 Dark grey R63 G69 B72 • Doesn’t see inward RI treaty Pea green limits exhausted R121 G163 B42 Forest green R0 G132 B82 TVaR sees all of the risks Bottle green R17 G179 B162 • Allows for more of the rare Cyan R0 G156 B200 risk Light blue R124 G179 B225 TVaR is better for Violet averages R128 G118 B207 Purple • If you want to allocate R143 G70 B147 between business units Fuscia R233 G69 B140 • VaR cannot be split in a Red natural way R200 G30 B69 Orange 8 R238 G116 29 Colour palette for PowerPoint pPrreimseanryta ctioolnosu r palette Why distance from breakeven versus Dark blue R17 G52 B88 distance from mean? Gold R217 G171 B22 Mid blue R64 G150 B184 Light grey Distance from Lose money: Who prefers this one? R220 G221 B217 breakeven Secondary colour palette Amount of money that Policyholder Dark grey (DFB) the company loses, i.e. Regulator R63 G69 B72 how much Pea green Rating agency R121 G163 B42 policyholders could Forest green lose and not get claims R0 G132 B82 paid Bottle green R17 G179 B162 Distance from mean Lose profits: Who prefers this one? Cyan R0 G156 B200 (DFM) Amount by which the Shareholder, because: Light blue company misses its R124 G179 B225 • Hits group dividend profit forecast, e.g. the Violet • Hits shareholder R128 G118 B207 impact on the Group value Purple dividend R143 G70 B147 Fuscia R233 G69 B140 Red R200 G30 B69 Orange 9 R238 G116 29 Colour palette for PowerPoint Two consistent risk measures pPrreimseanryta ctioolnosu r palette Dark blue R17 G52 B88 Gold Distance from breakeven Distance from mean R217 G171 B22 (DFB) (DFM) Mid blue R64 G150 B184 Light grey VaR P O Regulator likes VaR R220 G221 B217 Secondary colour palette Dark grey R63 G69 B72 P O Regulator likes DFB Pea green R121 G163 B42 Forest green R0 G132 B82 TVaR O P Shareholder likes TVaR Bottle green R17 G179 B162 Cyan R0 G156 B200 O P Shareholder likes DFM Light blue R124 G179 B225 Violet R128 G118 B207 Yes we can make risk measures consistent, but we still need two Purple R143 G70 B147 different measures for two different purposes: Fuscia (1) For solvency & capital management (regulator) R233 G69 B140 (2) For allocation and business management (shareholder) Red R200 G30 B69 Orange 10 R238 G116 29