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					MANAGEMENT




LTCI Risk Management in the New Era

Ellen Cooper, AEGON USA
David Plumb, John Hancock Life Insurance Co.
Valdimar Armann, ABN AMRO

Ross Bagshaw, AEGON USA, Moderator


                            The Pace Picks Up: The 8th Annual Intercompany LTCi Conference
MANAGEMENT




ERM and LTC

Ellen Cooper, FSA, CFA
Chief Risk Officer, AEGON USA


LTCI Conference
March 18, 2008
                     The Pace Picks Up: The 8th Annual Intercompany LTCi Conference
MANAGEMENT

Key Messages
   Companies are strengthening their ERM
   frameworks – tying into appropriate governance,
   controls and limits for LTCi
   Internal economic capital models more
   appropriately define risk based capital




                            The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   3
MANAGEMENT




       ERM Framework




                The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   4
MANAGEMENT

Enterprise Risk Management

                       Risk Governance                    Risk
                         & Tolerance                   Management
   To be effective,
   all pieces to the
   Enterprise Risk                                        Risk &
                       Risk Control                     Compliance
    Management                                           Reporting
   puzzle must be
       complete
                        Economic                  Operational Risk
                         Capital                    Framework


                                The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   5
MANAGEMENT

Enterprise Risk Management Definition
 Risk Management is the process of:
 • Understanding which risks an organization has the ability to
    underwrite;
 • The assessment of the risk return tradeoffs for taking these risks;
 • Establishing limits for the level of exposure to any risk or
    combination of risks;
 • The measurement of exposure to risks taken
 • The active management of the company’s risk and solvency
    position;
 • All for the purpose of maximizing profitability within acceptable risk
    tolerances


                                       The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   6
MANAGEMENT

Traits of a strong risk management
company
   Culture              Part of the organizational culture


  Integrated              Integrated with the business

                Considered an investment in the organization and
  Investment
                   considered a possible strategic advantage

  Incentives          Incentives linked to value – not sales

                    Independence in reporting structure and
 Independence
                               compensation

                 Risk professionals have the authority to stop a
   Authority
                     process until concerns are addressed
                              The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   7
MANAGEMENT

Risk Governance
 •   Risk governance establishes the risk management structure
     including:
      – Risk roles
      – Risk responsibilities and accountabilities and
      – Risk tolerance
 •   Establishes the overall risk tolerance for the organization and
     businesses
 •   Allocates the overall risk tolerance to the risks the organization
     faces (risk limit policies)




                                           The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   8
MANAGEMENT

Risk Controls
Credit              •Guidelines and policies for credit-underwriting decisions
                    •Aggregate exposures vs. limits
Liquidity           • Forecasting of cash needs
                    • Use of sources to minimize volatility
ALM                 •Guidelines and policies
                    •Regular monitoring – reporting on multiple metrics
                    •Derivative programs in place for unwanted ALM
Underwriting Risk   • Regular experience studies
                    •Strong underwriting controls
New Product Risk    •Pricing approval process and reviews
                    •Pricing policies
Reinsurance         •Optimal retention levels
                    •Guidelines and limits for reinsurance use
Operational         • Identification and mitigation of non-financial risks
                                             The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   9
MANAGEMENT




 Internal Economic Capital Models




                   The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   10
MANAGEMENT

 Need for Economic Capital Models
Regulatory and Rating Agency Models                         Economic Capital Models

                   Pros                                 Comprehensive economic risk
                                                        assessment
     Easy to understand and apply
                                                        –     Tie economic risk to economic capital
     Aligns internal requirements
                                                              assessment
     with regulatory or rating agency
                                                        –     Creates deeper understanding of risks
     models
                                                              we take and the capital we need to
                                                              support these risks
                                                   •    Consistent internal model
                   Cons                                 –     Level playing field for capital allocation,
     Not all risks are covered                                pricing and performance
     Products are not priced                       •    Regulators are moving in this direction
     economically                                       (FSA, Solvency II)
     No credit or incentive for strong risk        •    Benefits with external constituencies
     management
                                                        –     Rating agencies, Investors, Regulators,
     No internal level playing field since                    Institutional clients
     models vary by region and business
                                              The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   11
MANAGEMENT

Internal Economic Capital Models-
Risk Identification
                                  Enterprise Risk Identification


   Investment &            Mismatch Risk                 Operational                    Underwriting Risk
 Counterparty Risk                                          Risk

 IR1 Fixed income        MR1 Interest Rate          OR1 Business                        UR1 Mortality
 IR2 Equity              MR2 Interest Rate          OR2 Legal / Compliance              UR2 Morbidity
 IR3 Alternative         Volatility                 OR3 Fraud                           UR3 Persistency
 Investment              MR3 Currency               OR4 Administration                  UR4 Property
 IR4 Counterparty                                   OR5 Staff                           Casualty
 IR5 Equity Volatility                              OR6 Physical Assets
                                                    OR7 Systems
                                                    OR8 Tax




                                                    The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   12
MANAGEMENT

Internal Economic Capital Models –
Risk Measurement
 Develop a consistent measure of risk using Economic Capital Models

    “Economic required capital (ERC) is defined as the level of capital
    required to ensure some likelihood of economic solvency [99.5%] over a
    specified time horizon [1 year]”


                                                ERC is determined by the change
                          Worst-case
                           risk level
                                                   in market consistent value
                                                          between the
                                                      a)The current value
                                                 b)The value in the worst-case
                                                            scenario

     Current risk level                 99.5%
                                                The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   13
MANAGEMENT

Hypothetical Unhedged Long Term Care
Product – Economic Capital
                                         Operational Risk      Investment Risk
                                              8%                     5%
         Total
         Underwriting
         Risk           Morbidity Risk
                            13%
         17%


                     All Other
                   Underw riting
                       Risk
                        4%




                                                                                  Mismatch
                                                                                     Risk
                                                                                    70%
                                                    The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   14
MANAGEMENT

Long Term Care ALM Mismatch
   LTC is a long maturity product line that is exposed to falling interest
   rates. LTC issues recurring premium products that pay benefits
   when the insured requires assisted living. The expected benefit
   payments extend far into the future (50+ years). The investment
   requirements of these contracts are beyond a realistic investable
   time horizon.
     • Exposure derives from the need to reinvest cash flow in the future
     • If rates fall, reinvestment will be at lower rates and the product line
       suffers
        - Approximately two-thirds of economic required capital for long term care
          is due to interest rate mismatch
        - The risk to falling rates accounts for almost all of the mismatch risk capital

   Solution: Enter into a series of forward starting swaps.



                                             The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   15
MANAGEMENT

Forward starting swaps hedge
the risk exposure
 Forward starting swaps were used to hedge this risk exposure
   • Assume a $300M cash flow is going to be invested in 2011
   • Assume this $300M is going to be invested in a mix of 10 year and 30 year maturity bonds, $100M
     and $200M respectively
   • Enter into a $100M notional 10 year receive-fixed swap that starts in 2011. Also enter into a
     $200M notional 30 year receive-fixed swap that begins in 2011. These swaps have zero cost at
     purchase
   • As 2011 approaches, if interest rates fall, the swaps will have a gain. This gain will offset the
     lower asset yields on the bonds purchased in 2011.
   • If rates rise, the swaps will have a loss which will be offset by the higher asset yields on the 2011
     purchases
 Ensure effective risk monitoring: examples
   • Monitor the hedge notional amounts relative to the target swap portfolio to ensure the program is
     within tolerances
   • Monitor the dollar duration of the program relative to the objectives to ensure the hedge program
     is within risk reduction tolerances
   • Ensure start dates and maturity dates of swaps match those of the target portfolio


                                                       The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   16
 MANAGEMENT

   Hypothetical Long Term Care Economic Capital
   – with a Forward Starting Swap Program
                                         Investment Risk
                      Operational Risk
                           8%                  5%                                             LTC with Swaps
                                                                                          Operational Risk    Investment Risk
     Morbidity Risk                                                                            8%                   9%
         13%




 All Other
Underw riting
   Risk                                                               Morbidity Risk
                                                                          25%
    4%




                                                                                                                                Mismatch
                                                                                                                                   Risk
                                                           Mismatch
                                                                                                                                  50%
                                                              Risk              All Other
                                                             70%              Underw riting
                                                                                  Risk
                                                                                   8%




                                                                           The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   17
MANAGEMENT

Risk Diversification
  Risk classes well spread                      Diversification benefit
        14%
                          27%

                                                                            - 20-30%


  24%



                                     Undiversified Required                    Required
                           35%
                                         Economic Capital                Economic Capital




  Operational Risk   Investment & Counterparty Risk
                     Underwriting Risk
  Mismatch Risk                          The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   18
MANAGEMENT

Economic Framework Strategic Implications


 Operational Risk     Risk Management                         Pricing
  Management


                         Product                         Performance
 Market Consistent
                       Development                       Measurement
      Value


                         Capital                          Mergers &
    Economic
                       Management                        Acquisitions
  Required Capital

                         The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   19
MANAGEMENT

Key Messages
   Companies are strengthening their ERM frameworks –
   tying into appropriate governance, controls and limits for
   LTCi
   Internal economic capital models more appropriately
   define risk based capital




                                  The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   20
MANAGEMENT


Risk Management in Long-Term
Care Insurance

David Plumb, FSA, MAAA
Vice President, John Hancock Life Insurance Co.




                                  The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   21
MANAGEMENT

Risk Management in Long-Term Care Insurance
 •Claim Utilization
 •Investment
 •Product Design
 •Reputation




                           The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   22
MANAGEMENT

Claim Utilization Risk
  •Much more actual insured data available each year
      –Need to carefully analyze
      –Look closely at lifetime benefit period incidence and continuance

  •Inforce rate increases
      –Cannot fully restore target profitability
      –New Business Cap
      –58/85 Loss Ratio

  •Marital Discounts
      –Need to model a wear-off

  •Lapse rates
      –Most companies are correct or close to being correct now

  •Mortality
      –Should vary by underwriting class

                                                   The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   23
MANAGEMENT

Investment Risk
 •Major risk for LTCi
     –Very long duration product
     –Can hedge a significant portion of fixed income returns
     –May not want to for inforce
     –Should hedge for new business
          •Even on business not yet sold


 •Inflation Linked Plans
     –Inflation is a very large risk
     –Investment policy that exposes inforce to rate increases due to high inflation
     would be ridiculous
     –Can/must hedge a significant portion of the impact of future inflation




                                               The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   24
MANAGEMENT

Product Design Risk

 Cash Plans

    •Moral Hazard
    •“ADL Creep” may be more of a sprint
    •80 year olds start running short of retirement funds
    •May suddenly “need” help with bathing/toileting/dressing
    •If people can profit from “needing” help, a lot more people will need help
    •Marital discounts on cash plans?




                                              The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   25
MANAGEMENT

Product Design Risk

 Restoration of Benefits

     •How do you prove that someone needs care who says they don’t?
     •How do you verify that someone did not receive care during the recovery
     period?
     •Need controls to look more closely at recoveries near the end of the benefit
     period
     •Much larger problem when automatically included in all policies




                                              The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   26
MANAGEMENT

Product Design Risk

 Inflation Calculation (original vs. remaining policy limit)

     •Applying to original policy limit extends benefit period beyond what is stated
     or expected
     •Need to price for
     •Does anyone understand this (producers/customers)?
     •Is it worth the price?
     •Customer should keep $1 in policy limit
     •Will get significant increase at next anniversary
            •Irrational




                                               The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   27
MANAGEMENT

Product Design Risk

 Nursing Home Only and Home Health Only Policies

     •Estimated impact of policy on customer behavior
     •People will seek care that the policy covers
     •May not be the most appropriate care




                                             The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   28
MANAGEMENT

Reputation Risk
 •Claim practices
 •Recent media scrutiny
     –Data reporting related to claims

 •Inforce rate increases
      –200%+
      –Recouping past losses




                                         The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   29
MANAGEMENT

Managing Inflation Risks

 Valdimar Armann
 Head of Inflation Products USA, ABN AMRO
 212-409-6230
 valdimar.armann@abnamro.com
 Bloomberg: AILS <go>




                                        The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   30
MANAGEMENT

Content

 • Inflation is no game, it is the real thing

 • Inflation within LTC products

 • How to price & hedge future inflation




                                  The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   31
MANAGEMENT

Inflation is no game, it is the real thing




                            The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   32
MANAGEMENT

What is inflation?

     “Inflation is as violent as
     a mugger, as frightening
     as an armed robber and
      as deadly as a hit man”
                 - Ronald Reagan




                                   The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   33
MANAGEMENT

How to estimate/price/hedge future inflation?
Predictions and assumptions                    With an inflation swap the
are uncertain                                  future inflation can be fixed
                                    $48.00
              4.0% pa ?
                                    $34.40
                                                                                                    $29.90
  3.0% pa ?
                                    $21.90

                 2.0% pa ?                                             2.65% pa

              $100                  $100                         $100                                $100




    2008                     2018                     2008                               2018
                                             The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   34
MANAGEMENT

Historical US inflation
• US inflation is volatile
• How can future inflation
  be estimated?
• 10 years ago the US
  government started
  issuing inflation linked
  bonds
• Inflation derivative
  market started evolving
  around 2003 but has only
  recently improved in
  depth and liquidity


                             The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   35
MANAGEMENT

Inflation within LTC products




                          The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   36
MANAGEMENT

Demographics changing
                   There is a shift from social risk sharing
                    safety net to individual responsibility



                   Shift in pension regulations from defined
                         benefit to defined contribution



      Real Asset                                                      Asset risk
   Preservation:                                                      taking:
   Protection of                                                      High expected
     purchasing                                                       return with
     power with                                                       risk of not
   very low risk                                                      keeping up
                                                                      with inflation
                                          The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   37
MANAGEMENT

Inflation linked payouts within insurance
Long term care
•   Future consumption of services and commodities is exposed to inflation risks
Annuity products
•   Fixed annuity stream as an retirement income results in decreasing purchasing power
Pension plans
• Some defined benefit plans offer COLA on benefit payout and some have final
    salary adjustment exposing the plans to inflation risks
Disability income
•   Decreasing real value of benefits decreases the purchasing power
Life insurance payout - the death benefit
•   Long dated nature of life insurance means death benefit, to cover expenses & provide
    income replacement, is sensitive to inflation


                                                  The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   38
MANAGEMENT

Current LTC products
 Of the 23 companies in the July 2007 Broker World Ninth
 Annual LTCI Survey:
 • Already 3 insurance companies offer Automatic Benefit
   Increases indexed to CPI
 • Also 3 insurance companies offer Future Purchase Option
   indexed to CPI
 • Almost 50% of 2006 LTC sales had 5% Fixed Compound for
   Life ABI




                               The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   39
MANAGEMENT

LTC Inflation benefit options
Fixed 3%, 4%, 5% Inflation               CPI-Indexed Benefit Increase
Benefit Increase Options                 Options
• Benefit fixed                          • ABI linked to independent index
• Insurer must hedge or risk             • Insurer must hedge or risk manage
  manage fixed accrual rates               inflation-linked accrual rates
• Policyholder may be overhedged         • Insurers hold inflation risk but
  for inflation component if actual        inflation component can be exactly
  inflation runs less than fixed           hedged with inflation swaps
• Insurers not offering real inflation   • Insurers can offer more competitive
  hedge with fixed accruals                and better priced products
• Policyholders holding real             • Policyholders insulated from
  inflation risk                           inflation risk

                                          The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   40
MANAGEMENT

LTC Inflation hedging
 • All Items CPI – average change in price of basket of goods
   and services
 • Medical Care CPI – average change in price of life-saving
   devices, complex medical procedures, physician charges,
   research, prescription drugs and malpractice insurance
 • Which is the better proxy for LTC?
 • LTC inflation mostly related to salaries and facilities
 • What about Inflation + 1% or Inflation +2%?




                                  The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   41
MANAGEMENT

How to price & hedge inflation




                          The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   42
MANAGEMENT

TIPS of the Iceberg …
 • The US Government is                                   TIPS
   the largest payer of US
   inflation through TIPS
                                    Inflation Swaps          Inflation Options
 • Many more alternatives
   available that offer more
   flexibility
                                   Structured Notes                Hybrids


 • This can be in the form
   of a structured note,                         Real Rate Swaps
   swap or an option


                               The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   43
MANAGEMENT

Inflation linked swap to fix future inflation

             Expected             Actual                              Actual
             Inflation           Inflation                           Inflation

Nominal
 Yield           +                  +                                    vs

                                                                                                  Price for
                Real              Real                              Expected                       future
                Yield             Yield                             Inflation                     inflation


              Nominal       Inflation Linked                    Inflation Linked
               Bonds              Bonds                               SWAP




 Expected Inflation = Break-Even Inflation

                                               The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   44
MANAGEMENT

Inflation curves published in Bloomberg




                         The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   45
MANAGEMENT

Allows for precise inflation hedging
 • The basic swap instrument is the Zero-Coupon Break-Even
   Inflation swap
 • This can be structured to customer’s need
 • Example is an annuity style swap that is effectively a string
   of Zero-Coupon swaps

                                                         Notional(0) * [(1+X%)t – 1]


                                             Insurance                                    Swap
    Policy buyer
                                             Company                                   counterparty

             Notional(0) * [CPI(t)/CPI(0)]          Notional(0) * [CPI(t)/CPI(0) - 1]




                                                     The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   46
MANAGEMENT

Government supply growing rapidly


                               AU CPI                                              UK               Oct-81
                                      CA CPI
                               $4,5bn
   US CPI                             $19bn                                     Australia           Aug-85
                                0.6%              EMU HICP
   $344bn                              2.5%
                                                   $146bn                       Canada              Dec-91
    44.8%
                                                    19.0%
                                                                                Sweden              Apr-94
                                                                                  USA               Jul-97
                                                                                 France             Jul-98
                                                                                 Greece             Mar-03
                                                    FR CPI
                                                                                  Italy             Sep-03
                                                     $77                         Japan              Mar-04
                                             IS CPI
            PLN CPI   UK RPI   SW CPI JP CPI        10.0%                       Germany             Mar-06
                                             $6,4bn
             $1,9bn    $108     $28bn $34bn 0.8%
              0.3%    14.0%     3.6%   4.4%




                                                 The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   47
MANAGEMENT

Participants in US inflation market
                Inflation Payers   Inflation Receivers              Products

                                     Asset Managers                                          Bond Market
                  US Treasury
   Until 2004




                                                                    IL Bonds
                                                                   Asset Swaps
                                       Insurance                                          Derivatives Market
                 Municipalities       Hedge Funds

                                     Retail Products                  IL MTN
  2004 -
   2007




                                                                     IL Swaps
                                    Real Yield Funds


                 Corporate ALM       Pension Funds
                                                                    IL Swaps
   Coming




                 Infrastructure     Real Yield Funds
                                                                     Futures
                   Real Estate          Insurance

                   Bank ALM            Bank ALM                      Options

                                              The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   48
MANAGEMENT




             QUESTIONS




                  The Pace Picks Up: The 8th Annual Intercompany LTCi Conference   49

				
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