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Risk-Adjusted Capital
Management
CAS/SOA ERM Symposium
July 30, 2003
Sim Segal, FSA, MAAA
Senior Manager
Deloitte & Deloitte & Touche
Touche
Agenda
What is capital management?
The capital management process and its evolution
Practical application of capital management
Keys to success
Deloitte &
Touche
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Capital has two components
Capital is wealth . . .
. . . ”used” or ”available for use” . . .
. . . in the production of more wealth.
American Heritage Dictionary
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Total Capital = Required + Available
Liabilities
Assets
Required capital Used
Total
Available capital
Available capital
for use
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Capital management is managing both
required and available capital
Required capital Maximize risk-based capital
management performance measure, within
constraints
Maintain available capital at
optimal level, balancing:
Available capital a) Future growth needs
management
b) Drag on returns
c) Capital flexibility
Deloitte &
Touche
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Capital management is managing both
required and available capital
Focus of today’s Required capital Maximize risk-based capital
discussion management performance measure, within
constraints
Maintain available capital at
optimal level, balancing:
Available capital a) Future growth needs
management
b) Drag on returns
c) Capital flexibility
Deloitte &
Touche
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Agenda
What is capital management?
The capital management process and its evolution
Practical application of capital management
Keys to success
Deloitte &
Touche
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The Capital management process has five
steps
1. Define required capital
2. Allocate required capital
3. Select a capital measure to evaluate performance
4. Set a hurdle rate
5. Maximize capital measure, within constraints
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Capital management has evolved in the
insurance industry
1. Required Capital 2. Capital Allocation 3. Capital Measure 4. Hurdle Rate
Zero (ignored in pricing) Company level Internal Rate of Return Benchmark
(IRR)
Multiple of RBC Segment level Long-Term Weighted
(Statutory) Return on Investment Average Cost of Capital
(ROI) (WACC)
Line of business or
Multiple of RBC plus product line level
Return on Equity (ROE) WACC based on
accounting adjustments
(GAAP, but Stat-based) dynamic risk-free rate
Policy level Return on Capital (ROC)
Value-at-Risk (VaR) Customer level WACC based on
(GAAP) Producer level dynamic risk-free rate
and
Embedded Value (EV) or
Deloitte & dynamic risk premium
Fair Value (FV)
Touche
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Agenda
What is capital management?
The capital management process and its evolution
Practical application of capital management
Keys to success
Deloitte &
Touche
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Example: Public Multiline Financial, Inc.
Step 1: Define required capital
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Required capital is risk-based . . . but what
risk is being addressed?
?
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Required capital addresses multiple risks
related to disparate constituencies
To match the capital
Benchmark Capital level of a key
competitor
To maintain a given
Economic Capital probability of
Total
avoiding ruin
Required
Capital To maintain current
Rating Agency Capital debt or financial
strength ratings
Regulatory Capital To avoid regulatory
action
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Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Required capital is Value-at-Risk (VaR), using a one-year
time horizon and a 99.9% confidence level
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Value-at-Risk (VaR) is based on a stochastic
analysis of economic ruin
Illustrative
Confidence Level
95% 99% 99.9%
Loss Rate
Value-at-Risk Capital
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Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital
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Allocating capital further down in the
organization facilitates more decision-making
Segment Segment . . . Segment Strategic decisions, e.g.:
Growth
Market exit
Tactical decisions, e.g.:
Product Product . . . Product
Pricing
Mix of product portfolio
Transactional decisions, e.g.:
Policy Policy Policy . . . Policy Retention efforts
Cross-selling
Producer compensation decisions
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Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital
Capital is allocated down to the product level
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Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital
Step 3: Select a capital measure to evaluate performance
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Each capital measure offers a unique focus
ROI emphasizes rate of return
ROE measures efficiency of usage of equity capital
ROC illustrates the ability to generate earnings per dollar
of total capital
EV quantifies the dollar contribution to shareholder value
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Case study: ROE-based compensation has
disadvantages vs. EV-based compensation
Hurdle rate = 15%
Situation ROE-based* plan EV-based plan
Value is created: Penalized Rewarded
Management in a 20% ROE line of business
decides to add a 16% ROE project
Value is destroyed: Rewarded Penalized
Management grows a 12% ROE business
* Compensation plan based on ROE and earnings
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Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital
Step 3: Select a capital measure to evaluate performance
Capital measure is Embedded Value (EV)
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Embedded Value (EV) is a function of
distributable earnings / surplus from inforce
Discounted value of distributable Value of inforce
earnings from inforce business* business Embedded
Value (EV)
Distributable surplus Value of surplus
* Includes target surplus
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Distributable earnings reflects changes in total
surplus and target surplus
4
Adjusted statutory net income *
3
Target surplus released (consumed)
2
1
0
-1
-2
-3
0 1 2 3 4 5 6 7 8 9 10
Deloitte &
Touche * Adjusted to replace investment income on surplus with investment income on target surplus
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Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital
Step 3: Select a capital measure to evaluate performance
Step 4: Set a hurdle rate
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The hurdle rate is management’s estimate of
its risk-return position on the efficient frontier
?
Return ?
Rm X
X
Rf
0 m Risk
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Hurdle rate setting methods involve tradeoffs
between simplicity, accuracy and stability
Method Simplicity Accuracy Stability of
Measure
Benchmarking Easiest Poor Poor
Long-term weighted average Moderately Moderate Fair
cost of capital (WACC) complex
WACC based on dynamic Moderately High Good
risk-free rates complex
WACC based on dynamic Most Highest Best
risk-free rates and dynamic complex
risk premium
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Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital
Step 3: Select a capital measure to evaluate performance
Step 4: Set a hurdle rate
Hurdle rate is WACC based on dynamic risk-free rates, with
uniform hurdle rates throughout the enterprise
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Example: Public Multiline Financial, Inc.
Step 1: Define required capital
Step 2: Allocate capital
Step 3: Select a capital measure to evaluate performance
Step 4: Set a hurdle rate
Step 5: Maximize capital measure, within constraints
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Dynamic modeling clarifies potential impact of
projects on embedded value (EV)
($millions)
Product Projected Change in Assumptions EV EV
Line Investment Mortality Expense Lapse Baseline Chg
A -2% 245.3 2.5
B 0.10% -1% -5% -2% 174.9 5.6
C -5% 5% 60.2 (0.6)
D -10% 28.0 0.8
Total LOB 508.4 8.3
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Constraint of maintaining the RBC ratio is
more complex when using Value-at-Risk (VaR)
Statutor GAAP
y
Available capital
Available capital
0.1 B
0.3 B
Required capital
(200% RBC) Required capital
(VaRC)
1.2 B
1.0 B
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Summary: practical applications of capital
management
Strategic:
Manage stock analysts, e.g., reveal under-valued businesses
Strategic planning, e.g., project capital needs, quantify impact on capital ratios
Risk management, e.g., estimate probability of ruin and impact on stock price
Tactical:
Funding decisions, e.g., identify stock repurchase opportunities
Risk-return tradeoff decisions
Identifying highest value-added projects
Asset-liability management (ALM)
Provide incentive compensation aligned with increasing value
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Touche
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Agenda
What is capital management?
The capital management process and its evolution
Practical application of capital management
Keys to success
Deloitte &
Touche
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Keys to success
Define required capital with deference to all key constituencies
Allocate capital as far down in the organization as possible
Select a capital measure that aligns with your goals
Align incentive compensation with the capital measure
Avoid fallacy of the “correct” hurdle rate
Manage constraints carefully while maximizing capital measure
Employ a disciplined process to setting or changing assumptions
Provide management with the tools to understand the impact of
decisions on the capital measure
Deloitte &
Touche
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Risk-Adjusted Capital Management
Thank You!
CAS/SOA ERM Symposium
July 30, 2003
Sim Segal, FSA, MAAA
Senior Manager
Deloitte & Deloitte & Touche
Touche
35
