Posted tagged ‘Capital’

Instructions for a 17 Step ORSA Process

May 19, 2014

There are 17 steps to completing your ORSA.  And here are 17 essays that describe all of those steps.

Stairs

1. Prepare for the ORSA

Five Intro to ERM Risk Control Cycle Topics

2.  Risk Identification

3. Risk Measurement

4. Risk Limits and Controlling

5. Risk Organization

6. Risk Management Policies and Standards

Advanced ERM Topics
7. Stress Testing

8. Risk Capital 

9. Risk Appetite and Tolerance

10. Emerging Risks

11. Interdependence of Risks

12. Risk Management Governance

13. Risk Management Culture

14. Change Risk

15. Risk Disclosure

16. Model Validation
Bringing it All Together
17. Writing the ORSA Report

Provisioning – Packing for your trip into the future

April 26, 2013

There are two levels of provisioning for an insurer.  Reserves and Risk Capital.  The two are intimately related.  In fact, in some cases, insurers will spend more time and care in determining the correct number for the sum of the two, called Total Asset Requirement (TAR) by some.

Insurers need an realistic picture of future obligations long before the future is completely clear. This is a key part of the feedback mechanism.  The results of the first year of business is the most important indication of business success for non-life insurance.  That view of results depends largely upon the integrity of the reserve value.  This feedback information effects performance evaluation, pricing for the next year, risk analysis and capital adequacy analysis and capital allocation.

The other part of provisioning is risk capital.  Insurers also need to hold capital for less likely swings in potential losses.  This risk capital is the buffer that provides for the payment of policyholder claims in a very high proportion of imagined circumstances.  The insurance marketplace, the rating agencies and insurance regulatory bodies all insist that the insurer holds a high buffer for this purpose.

In addition, many valuable insights into the insurance business can be gained from careful analysis of the data that is input to the provisioning process for both levels of provisioning.

However, reserves are most often set to be consistent with considerations.  Swings of adequate and inadequate pricing is tightly linked to swings in reserves.  When reserves are optimistically set capital levels may reflect same bias. This means that inadequate prices can ripple through to cause deferred recognition of actual claims costs as well as under provisioning at both levels.  This is more evidence that consideration is key to risk management.

There is often pressure for small and smooth changes to reserves and risk capital but information flows and analysis provide jumps in insights both as to expectations for emerging losses as well as in terms of methodologies for estimation of reserves and capital.  The business pressures may threaten to overwhelm the best analysis efforts here.  The analytical team that prepares the reserves and capital estimates needs to be aware of and be prepared for this eventuality.  One good way to prepare for this is to make sure that management and the board are fully aware of the weaknesses of the modeling approach and so are more prepared for the inevitable model corrections.

Insurers need to have a validation process to make sure that the sum of reserves and capital is an amount that provides the degree of security that is sought.  Modelers must allow for variations in risk environment as well as the impact of risk profile, financial security and risk management systems of the insurer in considering the risk capital amount.  Changes in any of those elements may cause abrupt shifts in the amount of capital needed.

The Total Asset Requirement should be determined without regard to where the reserves have been set so that risk capital level does not double up on redundancy or implicitly affirm inadequacy of reserves.

The capital determined through the Provisioning process will usually be the key element to the Risk Portfolio process.  That means that accuracy in the sub totals within the models are just as important as the overall total.  The common practice of tolerating offsetting inadequacies in the models may totally distort company strategic decision making.

This is one of the seven ERM Principles for Insurers.

Countercyclical Capital Regime

April 4, 2011

There has been much talk about the procyclicality of the Basel II and Solvency II type capital regimes.

There is a very simple alternative that was used for many years in Canada that would work most of the time.

The system was very simple.  It applied to common stocks as well as real estate.  In the following discussion, the common stock application will be the focus. It was not thought of as a risk capital system.  But it can be used for such, and can be quite effective to create a capital regime that accumulated more capital during booms and that can require less capital after a bust.  That is what is wanted for a Countercyclical Capital Regime.

For common stocks, the process was to add all capital gains and losses to the requires capital balance and then to release a steady percentage of the required capital balance into earnings each year.

To illustrate, lets look at a firm that in 1991 acquires $100M of equities in a S&P500 index fund that beats the index by exactly its expenses each year.  They use those assets to fund $65 M of fixed liabilities that for this illustration never change in amount.

Each year, they intend to dividend out 90% of the funds that they are not required to hold to support the $65 Million of liabilities or the required capital.   Their returns are as follows:

Now if the regulatory regime says that they need to hold 34% of their position as capital each year.  That regime is PRO CYCLICAL because when they have losses, they will also need to find funds somewhere to add to their capital in the years when they have large losses.  This sort of system usually means that they will need to liquidate some risky assets somewhere to release capital to fund this or some other shortfall.  They might just choose to stop funding this liability with equities therefore meaning that they sell their entire position into a down market thereby adding to the sales that drive down prices.

The table below shows what happens in that situation.

Now with the counter cyclical system that is described above, that situation does not happen.  For this illustration, the rule is set that the initial capital requirement is the same 34% as the previous example.  But after that, the capital requirement moves up and down with the gains and losses and releases from the capital.   The same rule of paying dividends with 90% of excess assets.

With this COUNTERCYCLICAL CAPITAL REGIME, you can see two things.  (1) What sort of countercyclical rule might have worked and (2) Why there will never ever be anywhere near enough will for an adequate countercyclical regime to actually be put into place.

  • The sort of regime that is needed is one that will build up capital in good times and allow lower capital in bad times.  In this illustration, the capital build up went as high as 72.3% of assets in 1999.  The bursting of the dot com bubble losses were all absorbed by the enormous capital cushion.  Then the Global Financial Crisis bubble burst in 2008 was also absorbed by the capital, driving the capital level down below 20%.
  • And that is why it will never happen.  Regulators will never be able to withstand the pressure to allow release more of the capital when it gets as high as 70%.  And they will never be able to agree that less than 20% capital is sufficient right after the market has shown that it can lose 37% in a calendar year (almost 50% for the 365 day maximum peak to trough.)

So here is a simple, practical countercyclical capital regime that was actually part of the Canadian system for many years.  It can work.

But if you try to propose something along these lines to one of the regulators who claim to be seeking an answer to this problem, they will say that they do not want something this formulaic.  They want there to be some discretion.

Does that mean that they think that they will be able to do better than this simple tested process?

Or are they simply being realistic and admitting that they have no political chance of staying the course with such a system so there is no reason to adopt.

Window Dressing

May 26, 2010

The Wall Street Journal reported today that banks are again very actively doing significant amounts of end out the quarter clean-up that is otherwise known as “window dressing“.

This is a practice that works well, allowing banks to hold capital (figured on their quarter end balance sheets) that is much lower than the risk levels that they are using to create their profits.  This makes them look safer to investors in addition to boosting their ROE.

And while it probably is within the rules of Basel II, it violates the underlying idea behind Pillar 1 and Pillar 3.

The idea behind Pillar 1 is that the banks should hold capital for their risks.  This window dressing practice clearly illustrates one of the major logical flaws in the application of Pillar 1.

To understand the flaw, you need to think for a minute about what the capital is for.  It is not actually for the risks that the bank held during the quarter, nor is it mostly for the risks that happen to be on the balance sheet as of the end of the quarter.  It is primarily to protect the bank in the event of losses form the risks that the banks will be exposed to during the next quarter.  The beginning of quarter balance sheet is being used as a proxy for the risks over the coming quarter.

For a firm that has a highly disciplined risk management process, it would actually make more sense for the firm to hold capital for the RISK LIMITS that it has extended for the coming quarter.  That would be a firm where you could rely upon them to keep their risks within their risk limits for the most part. This makes more sense than holding capital for some arbitrary point in time.  The window dressing proves that point better than any possible theoretical argument.  Besides being the wrong idea, it is subject to easy manipulation.

For firms that are not disciplined in keeping their risks within their risk limits, something higher than the level of capital on their risk limits would be the logical level.  For these firms it would make sense to keep track of the degree to which they exceed their limits (at maximum) and charge them for capital at a level above that.  Say for example 200%.  So if a firm exceeds its risk limits by 10% at maximum in a quarter, their capital for the next quarter would be 120% of the capital needed to support their risk limits for the following quarter.

This check on risk discipline would have several benefits.  It moves the easy possibility of manipulation away from the capital level.  The “legal” window dressing would have to be replaced by fraudulent manipulation of risk reports to fix the capital level.  In addition, disclosure of the degree to which a bank exceeds its risk limit could be disclosed under Pillar 3 and then investors and counterpraties could give their reaction to a bank that cannot control its risks exposures.

In addition, this same logic could be applied to insurers under Solvency II.  There is no reason why insurance regulators need to follow the flawed logic of the banking regulators.

Addendum:  Above I say that the window dressing works well.  That is only partly true.  Sometimes, it does not work at all.  And banks can become stuck with risks and losses from those risks that are far larger than what they had been disclosing.  That happens when markets freeze up.

You see, if many banks are doing the same sorts of window dressing, they all run the risk that there will be too many sellers and not enough buyers for those couple of days at the end of the quarter.  Or maybe just for that one night.  And the freeze is likeliest when the losses are about tho strike.

So in reality, window dressing is not a good plan if you believe that things can ever go poorly.

ReCapitalization Fantasy

December 17, 2009

Guest Post from Larry Rubin

I question whether sufficient attention is being paid to the definition of risk in most risk measures and in solvency II. In this case the use of 1-year VAR. Insurance companies makes long term promises as compared to other financial institutions. Yet we have seen the inadequacies of this risk measure for these other institutions. 1-year VAR is based on the assumption that if a company can survive a year it can re-capitalize. The credit crisis has shown that in a period of economic distress when it is most likely that many companies will be “in the tail” the ability to re-capitalize is suspect if non-existent. Companies such as, Lehman Brothers, Northern Rock, AIG and INDYMac could not re-capitalize. Bear Stearns, Merrill Lynch and WaMU required government support to facilitate the sale of their liabilities.
I believe one of the lessons of the credit crisis is that is that either the 1-year VAR analysis needs to reflect the potential drying up of capital during a tail event or insurance companies need to re-think the 1-year VAR measure. US Risk Based Capital, while an imperfect measure, has had ruin theory as its fundamental premise. This measure has held up well as most US life insurance operating companies maintained sufficient capital to survive to the point where it was possible to re-capitalize

Larry H. Rubin


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