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Optimising Risk Adjusted Performance to Achieve Commercial Advantage

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					Optimising Risk Adjusted Performance
 to Achieve Commercial Advantage.

                    Bruce T Porteous
         Head of Financial and Operational Risk,
                  Standard Life Bank.


             Risk Management and Solvency 2:
                   Theory and Practice.
         5 – 6 September 2007, University of Kent.




                                                     1
  Details Are Important,
    But Exciting…. ?




zzzzz



                Risk and Solvency 2.




                                       2
               Introduction and Agenda.


l   Why is risk adjusted performance measurement important?
l   Economic capital as a risk measure.
l   The effect of capital gearing on risk adjusted performance.
l   The effect of asset allocation on risk adjusted performance.
l   Allocating capital to optimise risk adjusted performance.
l   Conclusions.




                                                                   3
        Why is Risk Adjusted Performance
            Measurement Important?
l   Firm management judged on a risk consistent basis.
l   Capital providers should earn full and fair risk adjusted
    returns.
l   Rigour and optimality in decision making => compete
    better.
l   Bad regulations cause market distortions and capital
    inefficiencies => bad for the whole economy.



l   I rest my case.


                                                                4
    Economic Capital as a Risk Measure.

l   Fundamental risk measure with wide applicability
    across firms and risk types.
l   Component of risk adjusted performance measurement
    (“ROEC”).

l   Users:
    –   Firms: comparison with actual capital.
    –   Capital providers: security and risk consistent returns.
    –   Regulators: comparison with regulatory capital.
    –   Ratings agencies: security and serviceability of capital.




                                                                    5
      Economic Capital as a Risk Measure.
                 Definition.

l   The total amount of capital, or excess assets, to ensure:

    1. The realistic balance sheet of the firm’s business remains solvent.
    2. The firm is able to meet its capital contractual obligations (Tier 2).
    3. The risks associated with the assets in which the firm’s capital is
       invested are covered.

l   all following unexpected events that occur over a specified
    time horizon, with a prescribed probability.




                                                                                6
     Economic Capital as a Risk Measure.
        Examples and Assumptions.


l   Retail bank and life insurance annuity firm examples.
l   Actual capital = 99.5th percentile economic capital.
l   Actual capital a mix of Tier 1 (equity) and Tier 2 (debt).
l   Business and capital assets are ring fenced and invested
    separately.




                                                                 7
        The Effect of Capital Gearing on
          Risk Adjusted Performance.

l   What happens as we gear up Tier 1 capital with Tier 2?


l   Tier 1 capital earns more profit.
l   Tier 1 capital carries more risk.
l   Economic capital increases.


l   Is this good, or bad?
l   Non trivial question.


                                                             8
Gearing and Risk Adjusted Performance.
            Bank Example.




                                         9
Gearing and Risk Adjusted Performance.
            Bank Example.




                                         10
Gearing and Risk Adjusted Performance.
   Life Insurance Annuity Example.




                                         11
Gearing and Risk Adjusted Performance.
   Life Insurance Annuity Example.




                                         12
The Effect of Capital Gearing on
  Risk Adjusted Performance.

            Clear?




                                   13
        The Effect of Asset Allocation on
          Risk Adjusted Performance.

l   What happens when we switch business assets into more
    risky assets?

l   Higher returns are expected.
    – Economic capital decreases.
l   Returns are more volatile.
    – Economic capital increases.


l   Is this good, or bad?
l   Non trivial question.


                                                            14
       Asset Allocation and
  Risk Adjusted Performance.
Life Insurance Annuity Example.




                                  15
       Asset Allocation and
  Risk Adjusted Performance.
Life Insurance Annuity Example.




                                  16
Hold the Bus!




                17
    Allocating Capital to Optimise Risk
          Adjusted Performance.

l   Banking product ROEC > life insurance product
    ROEC.
l   Banking product EC < life insurance product EC.


l   Optimal capital strategy:
    – write only banking products.




                                                      18
Allocating Capital to Optimise Risk
      Adjusted Performance.

        Seems sensible?




                                      19
      Allocating Capital to Optimise Risk
            Adjusted Performance.

l   Too simplistic:
    – Diversification benefits have real value.
    – Possible to write more banking business at same ROEC?
    – Banking only business model?


l   In practice:
    – Need a holistic view.
    – Need to experiment/iterate with different business mixes and
      pricings.
    – Evolution or revolution?



                                                                     20
                        Conclusions.

l   Economic capital gives useful insights into risk
    adjusted performance.
l   Gearing and asset allocation questions are non
    trivial.
    – Optimal solutions are business specific and challenge
      conventional wisdom.
l   Shape of ROEC distribution is important, but under
    recognised.
l   Optimal capital allocation requires a holistic/iterative
    approach.




                                                               21
Questions?




             22

				
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