economic capital for conglomerates

8/3/2019 Economic Capital for Conglomerates

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Use only approved Market Offering/Industry name

Economic capitalfor conglomerates


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Financial institutions recognise the importance of understanding and being able to measure

the risks associated with their business. This allows a company to more accurately determine

the amount of capital it needs to hold to cover these risks.

A measure of economic capital assists in quantifying the level of capital required to support

a business and its associated risks and understanding how these risks differ between

products, business divisions and business strategies.

Financial services companies have generally measured economic capital using various

methods which approximate risk based capital with a focus on the key risks for the entity.For example, banks have generally used value-at-risk approaches, while insurance companies

have historically focused on asset liability modelling, or more generally, Dynamic Financial

Analysis. These different approaches make it difficult for the management of conglomerates

to compare and understand the relative performance and capital needs of its entities. This

paper considers and compares the current approaches adopted by banks and insurers, and

discusses the challenges faced by conglomerates in applying a consistent framework across

all its entities while allowing for the various interactions between those entities.

Economic capital for conglomerates

Definitions of capital

The basic starting point in most companies is shareholder capital. For any financial services

company, part of this shareholder capital will be required to be held as regulatory capital.

This is currently a focus for companies given the environment surrounding regulatory capital

is changing in light of the new Basel II requirements, the possibility of the introduction ofSolvency II, and the impact of IFRS on existing APRA capital requirements.

Target surplus is effectively the amount of capital that you decide you need to hold

above the regulatory requirements to give you a buffer before reaching the regulatory

requirements. Any remaining capital is normally regarded as surplus capital.

Companies would like to know how much capital they need to hold to manage their

business within their own risk tolerance risk tolerance would allow for an amount of

acceptable loss, a probability of that loss, and a time horizon for that loss. This is generally

referred to as economic capital.


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Because target surplus is generally calculated in relation to regulatory capital, while

economic capital is intended to look at the underlying risks, the relationship between target

surplus and economic capital is not predictable. Economic capital could be lower than

regulatory capital (and would be for most bank mortgage books, for example), but could

also be higher than target surplus (and would probably be for most fund management

books).

Figure 1 Economic capital

The table below summarises the features of regulatory capital, target surplus and economic

capital. Economic capital is not necessarily a subset of shareholder capital, as there may well

be assets implicit in the balance sheet that can be used in the event of poor experience.

These could include such things as future profits or charges. Regulators usually have to trade

off between simplicity and detailed matching of the risks facing businesses in the industry

while economic capital is calculated looking at the risks specific to the company.

Figure 2 Features of different types of capital

Overview of economic capital

Economic capital is used to assess the level of capital required to support a business and

its associated risks. A measure of economic capital assists in quantifying these risks and

understanding how they differ between products, business divisions and business strategies.

To calculate economic capital, a company needs to quantify the risks it faces over a specified

time period that is appropriate to the risk and the business. This is done by analysing what

the potential losses could be, as well as the probability of a loss of that size. It also needs to

take into account the risk appetite of the companys owners and investors.

Why measure economic capital?

Companies want to be able to quantify the level of capital that ensures they are able to

cover the unexpected losses arising from all the risks faced by the business, while avoiding

the inefficiencies associated with overcapitalisation.

Trowbridge DeloitteEconomic capital

Regulatory capital Economic capital Target surplus

Defined by regulators Anything that can absorb

economic losses

Designed to provide a buffer

to regulatory capital

Uses (mainly) accounting

definitions of capital

Could include intangibles,

hidden reserves, pricing

changes etc

Uses same definitions of

capital as regulatory

Trade-off for regulators between

simplicity and detailed matching

with the business

Intended to support the

underlying risks of the

business

Can be similar to economic

capital (depending on risk

definitions)

Failure defined at a point of

regulatory action

Failure defined as

zero capital

Failure defined at

regulatory minimum


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Being able to measure the various risk components assists in identifying the key risks and

improving the understanding of how those risks influence the business, which in turn can

focus the business on the appropriate actions to reduce their impact.

Measuring economic capital also allows capital allocation to be managed on a basis whichreflects the risks faced by business units or products, while a consistent measurement of

economic capital enables a company to measure the relative performance

of products, customers or business units.

Economic capital can also be used to assess whether risk mitigation strategies, policies or risk

controls (e.g. hedging, guarantees, insurance and risk-pooling schemes) are cost-effective.

In addition, new regulatory regimes (like Basel II and potentially Solvency II) provide

companies with the opportunity to reduce the regulatory capital they are required to hold if

appropriate methods are used to measure risk.

In summary, economic capital helps to identify appropriate capital levels, and manage the

business allowing for appropriate returns for risk. Simple businesses with one product

line can do this instinctively using regulatory proxies. Complex businesses need formalisedprocesses, as the risks are not intuitive.

Figure 3 What questions can EC help answer?

Economic capital control cycle

Economic capital models are complex and will generally need to evolve over time as new

techniques are developed for the quantification of risks and as additional data becomes

available. The first step in the process of developing an economic capital model involves the

business identifying or reviewing their risk policy framework, which includes risk appetite

and risk definition. The company then goes to the detailed planning stage which includes

high level risk identification. It is important that this assessment includes all risks that could

result in unexpected losses for the company. It is common for companies to only consider

two or three key risks rather than include all risks.

Once all the risks have been identified, they need to be modelled and valued. Some risks are

well understood and the methods used to value them are established. However, for certain

risks the measurement techniques are less well developed and the data required is often not

readily available an example is the modelling of operational risk.



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Figure 5 The distribution of the impacts on capital are translated into

risk tolerance

Measuring risk based performance

Economic capital not only provides a company with a measure of the amount of capital

required, it can also be used as a framework for the performance measurement process.

There are a number of standard measures of risk based performance. The table below shows

how four of these measures relate to each other earnings per share, return on equity,

economic value added and Return on risk adjusted capital.

Figure 6 Scorecard of performance measures

While accounting profit is included under all four methods, only Economic value added and

return on risk adjusted capital include an allowance for the cost of capital. RORAC is the

only measure of the four that specifically allows for risk.

RORAC is normally defined as some derivative of the normal operating profit over a risk

adjusted capital, normally a measure of economic capital. EVA and RORAC provide some

correlation to shareholder value. The disadvantage of both EVA and RORAC is that they are

far more complex to calculate than the simple measures of ROE and EPS.

Return on risk adjusted capital is consistently used in much of the financial sector. It relies on

appropriate measurement of economic capital to allow for risk.

Scorecard of performance measures

Measure Accountingprofit included

Cost of capitalincluded

Allows forrisk

Correlationto value

Ease ofcalculation

EPS

ROE

EVATM

RORAC

EPS = Earnings per share; ROE = Return on equity; RORAC = Return on risk adjusted capital



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Economic capital versus shareholder value

There is often confusion surrounding the definitions of the terms economic capital and

shareholder value. In our view, economic capital as the level of capital required to meet the

risks over a given timeframe, while shareholder capital is the markets view of the discountedvalue of all future profits adjusting for the risk of actually receiving those profits.

The risk adjusted return on capital measure is widely accepted and is an appropriate

measure of performance. However, it only provides a measure of performance in respect of

the profits generated in the current financial year. These on their own, do not allow for the

potential impact of future earnings or management actions. This is particularly an issue for

companies that provide longer term contracts to their customers (e.g. life insurers).

Using some form of appraisal value performance measure (in addition to RORAC) also

provides useful management information, and allows for the impact of future years profits

from the business.

Appropriate economic capital and the allocation thereof across business units and products

allows shareholder value impacts to be measured more accurately.

Figure 7 Scorecard of performance measures

Specific issues for conglomerates

In practice, different businesses have a number of practical issues which make measurement

of capital and performance more difficult.

1. Regulatory capital at different risk levels

Regulatory capital for different businesses provides different coverage of the actual risks.Simple examples of differences include:

unit linked business has very similar operational risks to unit trust business, but requires

different levels of regulatory capital

the capital requirements for a bank selling mortgages (on balance sheet) are measured

differently from very similar risks incurred by a lenders mortgage insurer (although these

are getting closer together as APRA reviews their requirements)

regulatory capital does not always impact economic capital, but differences create

challenges in managing more than one balance sheet.

Source : Insurer Solvency Assessment, Towards a global framework, International Actuarial Association Insurer

Solvency Assessment Working Party, February 2004


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2. Accounting treatments

Accounting treatment should not, in theory, matter for economic capital we are, after all,

looking at the underlying risks. A few issues emerge, in practice, though.

shareholder capital has a different relationship to the underlying risks in different types of

entity (e.g. general insurers specifically hold liabilities more than their best estimate; life

insurers hold a reserve for future profits)

most people expect that economic capital will be a subset of shareholder capital, but the

shareholder capital shown on the balance sheet may include or exclude items you would

want to treat differently for economic capital.

profit can be defined in different ways, and for performance measurement, it is important

that profit is both consistent across the group, and understandable to management

it is important to be aware of accounting differences between businesses, even though

they shouldnt matter to the underlying economic risks.

3. Difference in significant risks

Different risks being important will create different emphases in the measurement process.

The diagram below shows the main sources of risks usually defined. If one particular risk is

the major source (e.g. insurance risk for a general insurer, or credit risk for a retail bank) then

that risk will generally be the source of focus in any economic capital framework.

When that framework is rolled out across different entities, it can be difficult to combine

with other types of companies with different risk emphases.

4. Detailed methodologies

Banks have tended to have a risk by risk focus, where insurance companies have a product

by product focus. In theory, the outcome would be the same, but in practice, difficulties in

approach will make compromise more difficult.

Figure 8 Methodologies

5. Time horizons

Time horizons between different types of product and financial services entity make a

difference to both the capital and the profit part of a risk adjusted performance measure.

The natural time horizon for different product types can be quite different. This will

naturally lead to a different time horizon within one product type, which will have to be

forced into a standard one across the whole conglomerate to enable meaningful capital

allocations to be made.



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Figure 9

A common compromise timeframe is one year.

6. Culture of measurement

In the table below, we set out some key cultural differences between different types of

institutions. Once again, these differences have arisen naturally owing to the nature of the

main products and risks within these institutions. But their existence makes the combination

of different economic capital frameworks a real challenge.

Figure 10 Measurement cultures

7. Correlation and diversification benefits

In a conglomerate, with many different risks, it is important to understand the correlation

between risks, and products, and also to allocate appropriate diversification benefits.

Figure 11 Diversification

The calculation of correlation benefits is complex in itself (there is usually inadequate

statistical evidence). But allocations of the benefit will also depend on the purpose of the

measurement. The existence of the diversification benefit will lead to competitive advantage

for both types of financial services company within the conglomerate, but it may be sensible

to keep that benefit for the centre, to reward the decision makers who have taken on the

challenges of managing a diverse conglomerate.

Total Capital requiredis lower because of

diversificationbenefits


Bank Life insurer General insurer Fund manager

Risk vs product Risks generally modelled

separately

Products generally modelled

separately

Products generally modelled

separately

Products very similar

Risk coverage Culture of covering all risks Tends to focus on the biggest

risks

Asset and insurance risks most

generally covered

Risk coverage often limited

Stochastic/analytic

approach

Tend to be analytic where

possible

Often view stochastic as best

practice

Stochastic approach particularly

for claims cost

Analytic approach

Time frames One month to a year One to three years Depends on insurance portfolio Risk coverage often limited

Value of intangible

assets considered

Future profits rarely valued

except for DAC

Future profits regularly valued Future profits rarely valued Often valued where life

insurer is associated


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Practicalities

Finally, there are a number of practical issues in setting up an economic capital framework.

There is no right answer to any of these issues, but it is important to recognise them, and

make active decisions about them.

centre vs the business unit

In all businesses, the tension between the centre (to keep control) and the business unit

(understanding their business) is strong. In a conglomerate with different types of business,

this becomes more emphatic.

Figure 12 Information flows

levels of allocation

There is a tension between allocating capital to many different areas (eg by product/

customer) and creating a measurement that the business can understand. The lower the

level of allocation, the more arbitrary it will seem to individual product managers.

understandability

Without an understandable framework and calculation process, the business is less

likely to buy into the process and the outcomes (particularly the measurement of their

own performance).

cultural change

Introducing economic capital as part of the performance management process of a

business is a profound cultural change.

modelling



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Figure 13 What is inside the Economic Capital models?

Our approachOur approach to implementation is shown in the diagram below.

It is vital that the business is involved enough in the process not just the central capital

management team to understand the risk profile implied for their business and understand

the capital implications of increasing or decreasing the risks of their business.

Figure 14 Six Proven in practice phases

Critical Success Factors

From observation, there are a few critical success factors to implementing an economic

capital framework.

change management orientation

senior management champion (e.g. CEO)

staying ahead of regulatory trends

detailed knowledge of your business, its markets, operating environment and regulation

combination of economic theory, actuarial practice and investment

stochastic techniques

sound project management

strong communication skills ability to identify the key financial and operational risks in your business

data availability.


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EC implementation challenges/lessons learned:

In our experience of economic capital implementations, there are common issues that can

derail the process. They can be categorised into three main issues:

Cultural

is the culture right? Needs empowerment for decision making and ownership/

accountability of risk

it is all about Operational integration and not implementation

Socialization - education and awareness of Board, Executive Directors, Senior

Management team, etc

resistance to introduction of risk-adjusted performance measurement across the business

knowledge transfer.

Technical

common agreement on definition of Economic Capital

difficulties in gathering, storing and manipulating the required data

time horizons for capital

treatment of mismatches between economic and regulatory capital

subjectivity of correlation matrix

increased complexity for capital processes (pricing, management reporting, capitalmanagement, risk management, ALM, etc).

External

lack of comparability to industry

lack of recognition by rating agencies and stock analysts.

Overwhelmingly, the hardest thing to get right is not the technical risk measurement, but

driving the concepts into the business and getting buy-in from all stakeholders.

For more information contact:

Jennifer Lang

Tel: +61 (0) 2 9322 5076

e-mail: [email protected]

Ian Jones

Tel: +61 (0) 2 9322 5081

e-mail: [email protected]

AM_SYD_11.05_015753

economic capital for conglomerates

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