1. © 2010 The Actuarial Profession  www.actuaries.org.uk Risk Management David Johnson DAL Actuarial Services 2 nd February 2011

2. Colour palette for PowerPoint presentations Actuarial Bright Green R148 G166 B31 Actuarial Slate R65 G89 B104 Secondary Olive Green R120 G162 B47 Secondary colour palette Primary colour palette Secondary Bottle Green R0 G147 B127 Secondary Turquoise R0 G138 B176 Secondary Aqua Blue R26 G160 B170 Secondary Pastel Green R126 G205 B195 Secondary Light Purple R185 G199 B212 Secondary Purple R97 G107 B156 Secondary Ecru R186 G163 B171 Secondary Yellow R215 G176 B18 Secondary Orange R213 G135 B43 Secondary Red R238 G52 B36 Secondary Rubine Red R226 G1 B119 Economic capital Finance and Economics In financial services firms, economic capital can be thought of as the capital level shareholders would choose in absence of capital regulation.financial services More specifically, it is the amount of risk capital, assessed on a realistic basis, which a firm requires to cover the risks that it is running or collecting as a going concern, such as market risk, credit risk, and operational risk. Firms and financial services regulators should then aim to hold risk capital of an amount equal at least to economic capital.risk capitalgoing concern market riskcredit riskoperational risk Typically, economic capital is calculated by determining the amount of capital that the firm needs to ensure that its realistic balance sheet stays solvent over a certain time period with a pre-specified probability. Therefore, economic capital is often calculated as value at risk. The balance sheet, in this case, would be prepared showing market value (rather than book value) of assets and liabilities.balance sheetsolventvalue at risk The concept of economic capital differs from regulatory capital in the sense that regulatory capital is the mandatory capital the regulators require to be maintained while economic capital is the best estimate of required capital that financial institutions use internally to manage their own risk and to allocate the cost of maintaining regulatory capital among different units within the organization.regulatory capital 1 © 2010 The Actuarial Profession  www.actuaries.org.uk

3. Colour palette for PowerPoint presentations Actuarial Bright Green R148 G166 B31 Actuarial Slate R65 G89 B104 Secondary Olive Green R120 G162 B47 Secondary colour palette Primary colour palette Secondary Bottle Green R0 G147 B127 Secondary Turquoise R0 G138 B176 Secondary Aqua Blue R26 G160 B170 Secondary Pastel Green R126 G205 B195 Secondary Light Purple R185 G199 B212 Secondary Purple R97 G107 B156 Secondary Ecru R186 G163 B171 Secondary Yellow R215 G176 B18 Secondary Orange R213 G135 B43 Secondary Red R238 G52 B36 Secondary Rubine Red R226 G1 B119 Economic capital Finance and Economics In financial services firms, economic capital can be thought of as the capital level shareholders would choose in absence of capital regulation. More specifically, it is the amount of risk capital, assessed on a realistic basis, which a firm requires to cover the risks that it is running or collecting as a going concern, such as market risk, credit risk, and operational risk. Firms and financial services regulators should then aim to hold risk capital of an amount equal at least to economic capital. Typically, economic capital is calculated by determining the amount of capital that the firm needs to ensure that its realistic balance sheet stays solvent over a certain time period with a pre-specified probability. Therefore, economic capital is often calculated as value at risk. The balance sheet, in this case, would be prepared showing market value (rather than book value) of assets and liabilities. The concept of economic capital differs from regulatory capital in the sense that regulatory capital is the mandatory capital the regulators require to be maintained while economic capital is the best estimate of required capital that financial institutions use internally to manage their own risk and to allocate the cost of maintaining regulatory capital among different units within the organization. 2 © 2010 The Actuarial Profession  www.actuaries.org.uk

4. Colour palette for PowerPoint presentations Actuarial Bright Green R148 G166 B31 Actuarial Slate R65 G89 B104 Secondary Olive Green R120 G162 B47 Secondary colour palette Primary colour palette Secondary Bottle Green R0 G147 B127 Secondary Turquoise R0 G138 B176 Secondary Aqua Blue R26 G160 B170 Secondary Pastel Green R126 G205 B195 Secondary Light Purple R185 G199 B212 Secondary Purple R97 G107 B156 Secondary Ecru R186 G163 B171 Secondary Yellow R215 G176 B18 Secondary Orange R213 G135 B43 Secondary Red R238 G52 B36 Secondary Rubine Red R226 G1 B119 Economic capital Finance and Economics In financial services firms, economic capital can be thought of as the capital level shareholders would choose in absence of capital regulation. More specifically, it is the amount of risk capital, assessed on a realistic basis, which a firm requires to cover the risks that it is running or collecting as a going concern, such as market risk, credit risk, and operational risk. Firms and financial services regulators should then aim to hold risk capital of an amount equal at least to economic capital. Typically, economic capital is calculated by determining the amount of capital that the firm needs to ensure that its realistic balance sheet stays solvent over a certain time period with a pre-specified probability. Therefore, economic capital is often calculated as value at risk. The balance sheet, in this case, would be prepared showing market value (rather than book value) of assets and liabilities. The concept of economic capital differs from regulatory capital in the sense that regulatory capital is the mandatory capital the regulators require to be maintained while economic capital is the best estimate of required capital that financial institutions use internally to manage their own risk and to allocate the cost of maintaining regulatory capital among different units within the organization. 3 © 2010 The Actuarial Profession  www.actuaries.org.uk

5. Colour palette for PowerPoint presentations Actuarial Bright Green R148 G166 B31 Actuarial Slate R65 G89 B104 Secondary Olive Green R120 G162 B47 Secondary colour palette Primary colour palette Secondary Bottle Green R0 G147 B127 Secondary Turquoise R0 G138 B176 Secondary Aqua Blue R26 G160 B170 Secondary Pastel Green R126 G205 B195 Secondary Light Purple R185 G199 B212 Secondary Purple R97 G107 B156 Secondary Ecru R186 G163 B171 Secondary Yellow R215 G176 B18 Secondary Orange R213 G135 B43 Secondary Red R238 G52 B36 Secondary Rubine Red R226 G1 B119 4 © 2010 The Actuarial Profession  www.actuaries.org.uk http://www.aviva.com/library/pdfs/presentations/2011/economic-capital.pdf

6. Colour palette for PowerPoint presentations Actuarial Bright Green R148 G166 B31 Actuarial Slate R65 G89 B104 Secondary Olive Green R120 G162 B47 Secondary colour palette Primary colour palette Secondary Bottle Green R0 G147 B127 Secondary Turquoise R0 G138 B176 Secondary Aqua Blue R26 G160 B170 Secondary Pastel Green R126 G205 B195 Secondary Light Purple R185 G199 B212 Secondary Purple R97 G107 B156 Secondary Ecru R186 G163 B171 Secondary Yellow R215 G176 B18 Secondary Orange R213 G135 B43 Secondary Red R238 G52 B36 Secondary Rubine Red R226 G1 B119 Mortality mis-estimation risk 1,000 policyholders each with £10,000 sum assured 0.1% mortality rate over one year Annual claim cost~ 10,000 * B(n, p) ~ 10,000 * N(np, npq) ~ N(10,000, 9,990) Expected annual claim cost= 10,000 99.5 th percentile claims cost= 10,000 + 2.58 * SQRT(9,990) = 10,257 Required economic capital= 257 5 © 2010 The Actuarial Profession  www.actuaries.org.uk

7. Colour palette for PowerPoint presentations Actuarial Bright Green R148 G166 B31 Actuarial Slate R65 G89 B104 Secondary Olive Green R120 G162 B47 Secondary colour palette Primary colour palette Secondary Bottle Green R0 G147 B127 Secondary Turquoise R0 G138 B176 Secondary Aqua Blue R26 G160 B170 Secondary Pastel Green R126 G205 B195 Secondary Light Purple R185 G199 B212 Secondary Purple R97 G107 B156 Secondary Ecru R186 G163 B171 Secondary Yellow R215 G176 B18 Secondary Orange R213 G135 B43 Secondary Red R238 G52 B36 Secondary Rubine Red R226 G1 B119 6 © 2010 The Actuarial Profession  www.actuaries.org.uk http://www.aviva.com/library/pdfs/presentations/2011/economic-capital.pdf

8. Colour palette for PowerPoint presentations Actuarial Bright Green R148 G166 B31 Actuarial Slate R65 G89 B104 Secondary Olive Green R120 G162 B47 Secondary colour palette Primary colour palette Secondary Bottle Green R0 G147 B127 Secondary Turquoise R0 G138 B176 Secondary Aqua Blue R26 G160 B170 Secondary Pastel Green R126 G205 B195 Secondary Light Purple R185 G199 B212 Secondary Purple R97 G107 B156 Secondary Ecru R186 G163 B171 Secondary Yellow R215 G176 B18 Secondary Orange R213 G135 B43 Secondary Red R238 G52 B36 Secondary Rubine Red R226 G1 B119 Reverse stress testing 7 © 2010 The Actuarial Profession  www.actuaries.org.uk “Examining the scenarios most likely to render a firm’s business model unviable” “Crystallising risks cause market to lose confidence in the firm” http://www.actuaries.org.uk/system/files/documents/pdf/ledlie-hot-topic-slides.pdf

9. Colour palette for PowerPoint presentations Actuarial Bright Green R148 G166 B31 Actuarial Slate R65 G89 B104 Secondary Olive Green R120 G162 B47 Secondary colour palette Primary colour palette Secondary Bottle Green R0 G147 B127 Secondary Turquoise R0 G138 B176 Secondary Aqua Blue R26 G160 B170 Secondary Pastel Green R126 G205 B195 Secondary Light Purple R185 G199 B212 Secondary Purple R97 G107 B156 Secondary Ecru R186 G163 B171 Secondary Yellow R215 G176 B18 Secondary Orange R213 G135 B43 Secondary Red R238 G52 B36 Secondary Rubine Red R226 G1 B119 Reverse stress testing – pandemic flu 8 © 2010 The Actuarial Profession  www.actuaries.org.uk http://www.dalactuarialservices.com/2011/11/solvency-ii-risk-exposure-presentation.html