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					      Regulatory capital



Managing post-convergence
risks in financial conglomerates
Bruce Porteous looks at how financial conglomerates are rising to the challenge of managing
the potential capital requirements associated with the diversity of products on their books
                              s financial services firms converge,     ulatory environment will attempt to har-       glomerate may ‘sit better’ – or be better

                      A       the range of products they offer nat-
                              urally increases. The next task is to
                      choose the best methods to most effec-
                                                                       monise the regulatory capital required to
                                                                       back a particular risk, irrespective of
                                                                       where that risk is written in a financial
                                                                                                                      matched – on the balance sheet of a
                                                                                                                      different component within the group.
                                                                                                                          For example, it may be more appro-
                      tively manage risk and economic capital.         services company. This is reasonable,          priate for the mortality/morbidity risks
                      This article, prepared under the auspices        provided the amount of capital required        collected by a reversion company to be
                      of the UK actuarial profession’s Action          to be held against a risk is ‘fair’, bearing   held by a life assurance company.
                      Group for Banking, looks at the various          in mind the size and type of risk.                 Moreover, a risk collected by one com-
                      developments that occur as such conver-                                                         ponent company within the group may
                      gence progresses.1                               Risk collection, hedging                       form a ‘natural hedge’ (see later) for a risk
                          First, we outline how significant regu-      and management                                 on another component company’s bal-
                      latory capital arbitrage opportunities may       Examples of the types of risks financial       ance sheet.
                      exist due to the way the existing regula-        services firms collect as a result of their        As financial services conglomerates
                      tions have evolved in an arbitrary fash-         product offerings and distribution chan-       move risks between their component
                      ion, with little or no regard given to similar   nels, together with typical types of col-      company balance sheets, the amount of
                      risks written by different types of finan-       lectors, are shown in table A (page 15).       regulatory capital required to back the risk
                      cial services entities.                             Once these risks have been collect-         will generally vary across balance sheets,
                          We also seek to show that if regula-         ed, firms essentially have three possible      opening up the possibility of regulatory
                      tory capital is set equal to economic cap-       approaches:                                    capital arbitrage. The position we take in
                      ital (possibly plus a margin), with                                                             this article is that:
                      economic capital determined relative to          ■ Keep the risk on their own balance
                      both aggregate assets and liabilities              sheet, without fully hedging it – for        ■ the economic capital required to back
                      (rather than relative to just the assets or        example, life assurance with profits           a particular risk should not depend on
                      the liabilities of a single business line),        funds investing in equities; retail banks      the balance sheet on which the risk is
                      it may be possible to significantly reduce         promoting mortgages; and reversion             held; and
                      capital arbitrage opportunities.                   companies purchasing reversions.             ■ regulatory capital should broadly
                          Finally, we demonstrate how ‘natural         ■ Keep the risk on their own balance             equal economic capital – although
                      hedges’ may be exploitable for certain             sheet, but hedge it internally – for ex-       often regulators may require an addi-
                      risks, thereby reducing hedge costs and            ample, life assurance unit-linked funds        tional margin over and above this.
                      increasing capital efficiency.                     investing in equities and passing the
                          For the purposes of this article, we as-       market risk onto their unit-linked pol-      The only exception to this position is
                      sume a financial services company com-             icyholders; or general insurer/whole-        where a natural hedge exists on a partic-
                      prises at least a life assurance company           sale bank groups offering catastrophe        ular component company balance sheet
                      and a retail/wholesale bank operating              insurance and passing the catastrophe        and the risk requires less economic cap-
                      under UK regulation.                               risk onto bond investors.                    ital there as a result.
                                                                       ■ Remove the risk from their balance
                      Regulatory changes                                 sheet, at least in part, by hedging the      Capital links
                      The regulatory landscape is set to change          risk externally – for example, reinsur-      As mentioned earlier, the regulatory en-
                      for UK financial firms, with the intro-            ance of life assurance annuitant             vironment is moving towards one where
                      duction of principal UK financial regu-            longevity risk, ie, the risk that annui-     regulatory capital is more closely linked
                      lator the Financial Services Authority’s           tants live longer than has been priced       with the amount and type of risks a fi-
                      (FSA) consultation paper CP97, which               into a life assurance company’s annu-        nancial services firm takes on. In short,
                      sets out new rules governing the regu-             ity rates; or asset securitisations of re-   regulatory capital is moving closer to eco-
                      lation of financial services firms, the new        tail bank residential mortgages.
                      Basel Accord2, fair-value accounting and                                                        1 Anyone interested in participating in
                      other potential new legislation/regula-          This article is concerned mainly with the        further/related work should contact Mark
                                                                                                                        Symons at marks@actuaries.org.uk
                      tions – such as that eliminating the use         second of these approaches. In particu-        2The new Basel Accord – Basel II – stipulates
                      of capital to cover the solvency of both         lar, as financial services firms evolve into    new risk-based rules that set out the amount
                      a subsidiary and a parent.                       financial services conglomerates, risks         of capital that banks must hold to cover their
                          It is to be expected that the new reg-       collected by one component of a con-            banking risks


S16   INSURANCE RISK ● RISK JUNE 2002 ● WWW.RISK.NET
                                                                                                                        Regulatory capital

 Specific product examples

 Here we consider two specific examples of financial ser-           with the income, or annuity, as a corresponding liability.
 vices products that require different amounts of regulatory           So, an effective HPI-linked zero-coupon bond may be used
 capital, depending on where they are written or how they           to back an annuity, resulting in a potential asset/liability mis-
 are structured within a UK financial services firm.                match, ie, the volatility of the liability may be greater than
                                                                    that of the asset under bond-yield movements – assuming
 A property reversion                                               that bond yields net of HPI, and so reversion market values,
 Consider a financial services firm offering a reversion            are relatively stable under pure bond-yield movements.
 equity release plan (ERP) product to asset-rich, income-              Nevertheless, specimen calculations show that a life
 poor pensioners who own their home.                                assurance company will hold capital of less than 14% of the
    The company receives a share in the capital value of the        market value of the reversion, provided the associated
 home, valued at a discount to its market value and realis-         resilience reserve – the additional reserve that life assurance
 able only when the property is vacated by the pensioners.          companies are required to hold to cover the resilience test,
    The pensioners, in return, receive an income for life           an asset/liability mismatch test prescribed by the FSA from
 and/or a cash lump sum, together with the right to live in         time to time – is less than around 250% of the annuity
 their home for life – or until they are unable to look after       mathematical reserve, and this will certainly be the case.
 themselves and must go into care.                                     This example shows that if a life assurance company
    For the purposes of this article, we will consider the          writes a reversion ERP in its life fund, it will generally
 pure income variant of the product where, for a retail             require less regulatory capital than a bank/life assurance
 bank, the income is provided by the purchase of a life             company combination product would – assuming a product
 annuity. In this instance, the product asset is the rever-         structure that is more appropriate for a bank/life assur-
 sion and the product liability is, broadly, the funding            ance company product.
 required to purchase the annuity.                                     The products and risks are identical and, at least in
    The reversion is, in effect, a house price inflation (HPI)-     principle, the regulatory capital ought to be independent of
 linked zero-coupon bond of uncertain term, and the fund-           the product structure.
 ing might take the form of a retail price index (RPI)-linked
 zero-coupon bond with the excess (HPI minus RPI) expo-             Gilt/mortgage swap
 sure hedged.                                                       Under Basel I, the current Basel Accord, retail mortgages
    In this example, therefore, the retail bank’s assets and        are risk-weighted at 50%. For example, a bank with a risk-
 liabilities are reasonably well matched. There is, however, a      asset ratio of 10% has to hold 0.1 x 0.5 = 0.05 of capital
 cashflow mismatch, as the reversion does not generate any          per unit of mortgage issued.
 income until the property is vacated and sold, but this is of         Under Basel II, the amount of capital required to back a
 secondary interest here.                                           mortgage is likely to fall significantly (Porteous, 2001), but
    When the bank writes this product on its balance sheet,         capital will still be required. Gilts, on the other hand, can
 the amount of regulatory capital that will be required is          be risk weighted at 20% under Basel I, but will require no
 around 10% of the market value of the booked reversion –           capital at all under Basel II.
 direct investments in residential properties are 100% risk-           Provided assets and liabilities are duration-matched, the
 weighted, and we assume that the bank has a risk asset             amount of regulatory capital a life assurance company
 ratio of around 10%.                                               must hold to back a particular class of business will be
    We will assume no additional capital is required for interest   insensitive to whether the assets are gilts or mortgages.
 rate risk as the assets and liabilities are broadly matched,          It seems likely, therefore, that under Basel II, bank/life
 and this is consistent with the treatment of banking-book          assurance firms could exchange ownership of the mortgages
 interest rate risk under Basel II, the new Basel Accord.           written by the bank for gilts held by the life assurance com-
    To this initial 10% we now add the capital that must be         pany, thereby significantly reducing the capital requirements
 held by a life assurance company to back the income annu-          of the bank, but with broadly neutral effects otherwise.
 ity – that is, 4% of mathematical reserves. So, assuming              This means that a structuring may be achievable where
 the annuity reserve is about equal to the initial booked           the mortgages/gilts switch from the bank/life assurance
 market value of the reversion, and that it is well matched         company balance sheet to the life assurance/bank balance
 in the life fund of the assurance company, the total initial       sheet, in such a way that the investment return earned by
 capital required to write a reversion ERP product is around        the bank/life assurance company is broadly unaltered.
 14% of the initial market value of the reversion.                     As the risks taken on by the firm in aggregate are unaf-
    If a life assurance company writes a reversion ERP, it is       fected by this arrangement, the aggregate capital require-
 more likely to treat the reversion as an asset of the life fund,   ment should also be unaffected by it.


nomic capital. The new Basel Accord,         firms may require different regulatory          investment of a life fund may require
Basle II, which will eventually apply to     capital charges.                                a different amount of regulatory cap-
banks worldwide, is perhaps the best cur-       To create a clearer picture, consider        ital compared to a retail bank writing
rent example of this.                        the following examples:                         the same mortgage.
   However, since UK life assurance and      ■ For UK life assurance companies, reg-       ■ Interest rate risk written by a UK life
banking regulations, for example, have          ulatory capital is measured mainly           assurance company requires regula-
evolved and developed in arbitrary and          relative to liabilities, whereas, for        tory capital via the ‘resilience test’ –
unilateral ways, the same risk written          banks, it is measured mainly relative        an asset/liability mismatch test pre-
in different types of financial services        to assets. So a mortgage written as an       cribed by the FSA from time to time

                                                                                                      WWW.RISK.NET ● JUNE 2002 RISK     ●
                                                                                                                                            INSURANCE RISK S17
      Regulatory capital

                                                                                                                           stitute of Actuaries). However, such
                        A. Types of financial risk                                                                         firms may be reluctant to keep this risk
                                                                                                                           on their own balance sheets, but at the
                         Type of risk                                   Collector                                          same time may find it difficult to hedge
                         Mortality/morbidity                            Life assurance, health insurance, pension          the risk externally in sufficient volume
                                                                        funds, reversion companies
                                                                                                                           at the right price.
                         Business retention                             All
                         Expense                                        All
                                                                                                                               Possible natural hedges might include
                         Market risk (for example, equity investment)   Life assurance, asset management, pension          the following:
                                                                        funds, investment banks                            ■ A life assurance company that is a part
                         House price inflation                          Life assurance, retail banks, reversion                of the same firm may be able to use
                                                                        companies                                              the HPI risk to back HPI-linked prod-
                         Credit                                         Life assurance, asset management, pension              uct offerings.
                                                                        funds, retail/wholesale/investment banks           ■ As HPI is normally highly correlated
                         Interest rate                                  Life assurance, retail/wholesale/investment            with average earnings, the HPI risk
                                                                        banks                                                  might be usable by pension funds,
                         Currency                                       Life assurance, pension funds,
                                                                                                                               with the residual risk hedged outside
                                                                        wholesale/investment banks
                         Retail price or earnings inflation             Life assurance, pension funds
                                                                                                                               the firm.
                         Liquidity                                      All
                         Claims experience risk                         General insurance, health insurance                It may therefore be possible for banks
                                                                        companies                                          and building societies to hedge the
                         Operational                                    All                                                HPI risks present in their reversion
                                                                                                                           assets with those present in liabilities
                                                                                                                           held elsewhere in the group. The
                                                                                                                           economic/regulatory capital required
                         – whereas interest rate risk written in                and liabilities will, as a result, have    to back this risk will, as a result, be
                         a banking book may not require any                     valuations that are dynamic and con-       greatly reduced.
                         additional capital at all, depending on                sistent relative to each other.                Firms have the option of hedging risks
                         the view of the regulator.                             The aggregate economic capital re-         via arrangements with third parties, but
                                                                            quirement of the firm is then deter-           if a natural hedge exists:
                         These two examples show that reg-                  mined as the amount of capital required
                      ulatory capital should be based on eco-               by the firm to achieve a target level          ■ firms will be able to avoid the cost of
                      nomic capital, where economic capital                 of solvency following a series of                the third-party hedge; and
                      is measured relative to both sides of the             prescribed shocks to the aggregate             ■ less aggregate capital will be
                      balance sheet. What is important is how               balance sheet. These shocks can be               needed across the financial services
                      robust the balance sheet is as a whole                deterministic, stochastic, or a mixture          system, thereby increasing the capi-
                      in terms of high-risk events – that is,               of the two.                                      tal efficiency of the financial services
                      events that may have a low probability                    If we consider the equity release plan       markets.
                      of occurrence but a big impact on the                 (ERP) reversion product discussed in the
                      balance sheet.                                        box (previous page), we can see that,          Bruce Porteous is financial risk manager
                                                                            under the approach outlined here, the              at Standard Life Bank in Edinburgh.
                      Determining economic capital                          economic capital requirements of the                                             e-mail:
                      It will be useful at this point to outline            product will be broadly the same under              bruce_porteous@standardlife.com
                      how a company might determine its                     the two proposed product structures.
                      aggregate economic capital requirement                    This is because under the bank’s
                      – this approach may also assist financial             product structure, its liability in respect
                      services firms in allocating economic                 of the loan used to purchase the annu-
                      capital across their separate businesses.             ity will be broadly equivalent to the           References
                          The following method is one that UK               life company assets backing the annu-
                      life assurance companies often use for                ity, and these two items will then broad-        The Actuarial Profession, 2001
                      managing their capital:                               ly cancel each other out. Similarly, the         Report on equity release mechanisms
                                                                            effect of the gilt/mortgage asset                Basel Committee on Banking
                      ■ All assets and liabilities are consoli-             exchange will also be neutralised.               Supervision, 2001
                                                                                                                             Risk management practices and
                        dated into one balance sheet, possibly                                                               regulatory capital: cross-sectoral
                        sub-aggregated by business line.                    Natural hedges                                   comparison
                                                                                                                             Bank for International Settlements
                      ■ Assets and liabilities are valued at mar-           Finally, as we have mentioned the term
                        ket value, or at a value approximating              ‘natural hedges’ in this article, it will be     Porteous B, 2001
                                                                                                                             The Basel capital Accord
                        to market value, so any conservatism                useful to consider an example of such            The Actuary magazine, September
                        or margins built into the asset/liabili-            a hedge.
                                                                                                                             Rule D, 2001
                        ty valuations should be removed.                       Reversion companies, banks and                Risk transfer between banks, insurance
                      ■ Associated assets and liabilities should            building societies may become very               companies and capital markets: an
                        be valued consistently relative to each             large collectors of housing price index          overview
                                                                                                                             Financial Stability Review, Bank of
                        other. For example, the discount rate               (HPI) risk through equity release re-            England, December
                        used to value a liability/asset should              version products (see the Report on Eq-
                        be consistent with the associated                   uity Release Mechanisms (2001)
                        asset/liability’s market value. Assets              prepared by the UK’s Faculty and In-

S18   INSURANCE RISK ● RISK JUNE 2002 ● WWW.RISK.NET

				
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