Use only approved Market Offering/Industry name

Economic capital
for conglomerates
Financial institutions recognise the importance of understanding and being able to measure
the risks associated with their business. This allows a company to more accurately determine
the amount of capital it needs to hold to cover these risks.
A measure of economic capital assists in quantifying the level of capital required to support
a business and its associated risks and understanding how these risks differ between
products, business divisions and business strategies.
Financial services companies have generally measured economic capital using various
methods which approximate risk based capital with a focus on the key risks for the entity.
For example, banks have generally used value-at-risk approaches, while insurance companies
have historically focused on asset liability modelling, or more generally, Dynamic Financial
Analysis. These different approaches make it difficult for the management of conglomerates
to compare and understand the relative performance and capital needs of its entities. This
paper considers and compares the current approaches adopted by banks and insurers, and
discusses the challenges faced by conglomerates in applying a consistent framework across
all its entities while allowing for the various interactions between those entities.
Economic capital for conglomerates
Definitions of capital
The basic starting point in most companies is shareholder capital. For any financial services
company, part of this shareholder capital will be required to be held as regulatory capital.
This is currently a focus for companies given the environment surrounding regulatory capital
is changing in light of the new Basel II requirements, the possibility of the introduction of
Solvency II, and the impact of IFRS on existing APRA capital requirements.
Target surplus is effectively the amount of capital that you decide you need to hold
above the regulatory requirements to give you a buffer before reaching the regulatory
requirements. Any remaining capital is normally regarded as surplus capital.
Companies would like to know how much capital they need to hold to manage their
business within their own risk tolerance risk tolerance would allow for an amount of
acceptable loss, a probability of that loss, and a time horizon for that loss. This is generally
referred to as economic capital.
3
Because target surplus is generally calculated in relation to regulatory capital, while
economic capital is intended to look at the underlying risks, the relationship between target
surplus and economic capital is not predictable. Economic capital could be lower than
regulatory capital (and would be for most bank mortgage books, for example), but could
also be higher than target surplus (and would probably be for most fund management
books).
Figure 1 Economic capital
The table below summarises the features of regulatory capital, target surplus and economic
capital. Economic capital is not necessarily a subset of shareholder capital, as there may well
be assets implicit in the balance sheet that can be used in the event of poor experience.
These could include such things as future profits or charges. Regulators usually have to trade
off between simplicity and detailed matching of the risks facing businesses in the industry
while economic capital is calculated looking at the risks specific to the company.
Figure 2 Features of different types of capital
Overview of economic capital
Economic capital is used to assess the level of capital required to support a business and
its associated risks. A measure of economic capital assists in quantifying these risks and
understanding how they differ between products, business divisions and business strategies.
To calculate economic capital, a company needs to quantify the risks it faces over a specified
time period that is appropriate to the risk and the business. This is done by analysing what
the potential losses could be, as well as the probability of a loss of that size. It also needs to
take into account the risk appetite of the companys owners and investors.
Why measure economic capital?
Companies want to be able to quantify the level of capital that ensures they are able to
cover the unexpected losses arising from all the risks faced by the business, while avoiding
the inefficiencies associated with overcapitalisation.
Trowbridge Deloitte
Economic capital
Surplus capiIal
5
h
a
r
e
h
o
I
d
e
r

c
a
p
i
I
a
I
1argeI
surplus
Lcohomic
capiIal
RegulaIory
mihimum
capiIal
Regulatory capital Economic capital Target surplus
Defined by regulators Anything that can absorb
economic losses
Designed to provide a buffer
to regulatory capital
Uses (mainly) accounting
definitions of capital
Could include intangibles,
hidden reserves, pricing
changes etc
Uses same definitions of
capital as regulatory
Trade-off for regulators between
simplicity and detailed matching
with the business
Intended to support the
underlying risks of the
business
Can be similar to economic
capital (depending on risk
definitions)
Failure defined at a point of
regulatory action
Failure defined as
zero capital
Failure defined at
regulatory minimum
4
Being able to measure the various risk components assists in identifying the key risks and
improving the understanding of how those risks influence the business, which in turn can
focus the business on the appropriate actions to reduce their impact.
Measuring economic capital also allows capital allocation to be managed on a basis which
reflects the risks faced by business units or products, while a consistent measurement of
economic capital enables a company to measure the relative performance
of products, customers or business units.
Economic capital can also be used to assess whether risk mitigation strategies, policies or risk
controls (e.g. hedging, guarantees, insurance and risk-pooling schemes) are cost-effective.
In addition, new regulatory regimes (like Basel II and potentially Solvency II) provide
companies with the opportunity to reduce the regulatory capital they are required to hold if
appropriate methods are used to measure risk.
In summary, economic capital helps to identify appropriate capital levels, and manage the
business allowing for appropriate returns for risk. Simple businesses with one product
line can do this instinctively using regulatory proxies. Complex businesses need formalised
processes, as the risks are not intuitive.
Figure 3 What questions can EC help answer?
Economic capital control cycle
Economic capital models are complex and will generally need to evolve over time as new
techniques are developed for the quantification of risks and as additional data becomes
available. The first step in the process of developing an economic capital model involves the
business identifying or reviewing their risk policy framework, which includes risk appetite
and risk definition. The company then goes to the detailed planning stage which includes
high level risk identification. It is important that this assessment includes all risks that could
result in unexpected losses for the company. It is common for companies to only consider
two or three key risks rather than include all risks.
Once all the risks have been identified, they need to be modelled and valued. Some risks are
well understood and the methods used to value them are established. However, for certain
risks the measurement techniques are less well developed and the data required is often not
readily available an example is the modelling of operational risk.
LeveI of capiIaIizaIion
usiness uniI performance
einsurance & Hedging
programs
AsseI aIIribuIion and ALM
How much capiIal is currehIly Iied up ih my busihess?
Do I have ehough capiIal !or my growIh ob|ecIives?
Will Ihe reIurh oh Ihis capiIal be saIis!acIory?
WhaI should we do wiIh excess capiIal, i! ahy? (e.g. share repurchase, dividehds,
acquisiIiohs or orgahic growIh)
Is pro!iIabiliIy su!!iciehI Io give a compeIiIive reIurh oh capiIal, overall ahd per busihess
uhiI giveh Ihe level o! risk?
I! hoI, whaI is Ihe gap?
How should capiIal be reallocaIed beIweeh busihess uhiIs?
WhaI hedgihg/reihsurahce sIraIegy gives Ihe besI risk/reIurh pro!ile?
Is Ihe porI!olio well diversi!ied?
Cah ahd should we Iake more risk?
How does Ihe duraIioh, currehcy mix ahd guarahIees o! Ihe liabiliIies ih!luehce
Ihe sIraIegic asseI mix?
Trowbridge Deloitte
Economic capital
5
The risks are then aggregated allowing for any correlation or diversification benefits as
appropriate to determine the economic capital for the business and how it is allocated
across business units or products.
The actual business performance over a period will then be considered against the economic
capital backing the business unit or product to evaluate the business performance using
risk adjusted performance measures. The business would monitor and report on the
performance and these results would be used in redefining the strategy of the business as
well as reconsidering the initial risk policy and assessment carried out. The results of the
revised strategy and risk assessment would then feed back into the risk models and the
process starts again.
Figure 4 How EC fits into ERM framework
Economic capital framework
Developing an economic capital framework requires:
an understanding of the companys appetite for risk. This requires a framework around
such things as:
risk measure for example, failure to meet regulatory capital requirements, failure to
pay policyholders/ debtholders, a level of profit over a particular time horizon
time Horizon e.g. one month, one year, lifetime of current contracts
level of confidence e.g. % probability of the risk measure occurring
identification of the risks in the business
measurement of the risks
combining risks and businesses to determine economic capital.
There is a link between the economic capital methodologies
with Solvency II (EU solvency standard for insurers expected to
be implemented in 2008) and Basel II.
PoIicy
Risk de!ihiIioh
Risk prihciples
Risk appeIiIe
Risk goverhahce model
AuIhoriIies
EnIerprise risk
managemenI process
ObjecIives AggregaIion
& performance
PIan
Risk sIraIegy
SIraIegic plahhihg
CapiIal aIIribuIioh
Shareholder value
cohIribuIioh
ExecuIe
EvaIuaIe
Risk pro!ile
Risk process
SIress IesIihg
LC
SVA
InformaIion for
decision making
Insurance
MarkeI
CrediI
Group
OperaIionaI
LiquidiIy
OIhers
InfrasIrucIure
1echhology & daIa
People
Policies & procedures
MeIhodology
InIernaI environmenI
CulIure
1raihihg
Per!ormahce measures
Rewards/compehsaIioh
CommuhicaIioh
Chahge mgI. & values
ExIernaI environmenI
RaIihg agehcies
Fihahcial ahalysIs
CompeIiIioh
Lcohomy
DisasIers
Law & regulaIioh
IdehIi!y Assess
MiIigaIe/
exploiI
Measure &
reporI
Trowbridge Deloitte
Economic capital
6
Figure 5 The distribution of the impacts on capital are translated into
risk tolerance
Measuring risk based performance
Economic capital not only provides a company with a measure of the amount of capital
required, it can also be used as a framework for the performance measurement process.
There are a number of standard measures of risk based performance. The table below shows
how four of these measures relate to each other earnings per share, return on equity,
economic value added and Return on risk adjusted capital.
Figure 6 Scorecard of performance measures
While accounting profit is included under all four methods, only Economic value added and
return on risk adjusted capital include an allowance for the cost of capital. RORAC is the
only measure of the four that specifically allows for risk.
RORAC is normally defined as some derivative of the normal operating profit over a risk
adjusted capital, normally a measure of economic capital. EVA and RORAC provide some
correlation to shareholder value. The disadvantage of both EVA and RORAC is that they are
far more complex to calculate than the simple measures of ROE and EPS.
Return on risk adjusted capital is consistently used in much of the financial sector. It relies on
appropriate measurement of economic capital to allow for risk.
Scorecard of performance measures
Measure Accounting
profit included
Cost of capital
included
Allows for
risk
Correlation
to value
Ease of
calculation
EPS
ROE
EVA
TM
RORAC
EPS = Earnings per share; ROE = Return on equity; RORAC = Return on risk adjusted capital
Trowbridge Deloitte
Economic capital
A AA
Minimum eguIaIory
CapiIaI equiremenIs
Loss aIe
P
r
o
b
a
b
i
I
i
I
y
CapiIaI 5Iandard
95% 99% 99.9%
Confidence IeveI
7
Trowbridge Deloitte
Economic capital
Economic capital versus shareholder value
There is often confusion surrounding the definitions of the terms economic capital and
shareholder value. In our view, economic capital as the level of capital required to meet the
risks over a given timeframe, while shareholder capital is the markets view of the discounted
value of all future profits adjusting for the risk of actually receiving those profits.
The risk adjusted return on capital measure is widely accepted and is an appropriate
measure of performance. However, it only provides a measure of performance in respect of
the profits generated in the current financial year. These on their own, do not allow for the
potential impact of future earnings or management actions. This is particularly an issue for
companies that provide longer term contracts to their customers (e.g. life insurers).
Using some form of appraisal value performance measure (in addition to RORAC) also
provides useful management information, and allows for the impact of future years profits
from the business.
Appropriate economic capital and the allocation thereof across business units and products
allows shareholder value impacts to be measured more accurately.
Figure 7 Scorecard of performance measures
Specific issues for conglomerates
In practice, different businesses have a number of practical issues which make measurement
of capital and performance more difficult.
1. Regulatory capital at different risk levels
Regulatory capital for different businesses provides different coverage of the actual risks.
Simple examples of differences include:
unit linked business has very similar operational risks to unit trust business, but requires
different levels of regulatory capital
the capital requirements for a bank selling mortgages (on balance sheet) are measured
differently from very similar risks incurred by a lenders mortgage insurer (although these
are getting closer together as APRA reviews their requirements)
regulatory capital does not always impact economic capital, but differences create
challenges in managing more than one balance sheet.
isk aggregaIion
1. IdehIi!y all
sources o! risk
2. CharacIerise Ihe
disIribuIiohs
3. Combihe
disIribuIiohs
4. Measure
required capiIal
5. CalculaIe
cohIribuIiohs o!
busihess lihes ahd
ihdividual risks
%, 3OLVENCY
STANDARD
%CONOMICCAPITAL
CorrelaIiohs, depehdehcies
AsseI risk
CrediI risk MarkeI risk Ihsurahce risk ALM risk 8usihess risk
OperaIiohal risk
LvehI risk
Risk
Source : Insurer Solvency Assessment, Towards a global framework, International Actuarial Association Insurer
Solvency Assessment Working Party, February 2004
8
2. Accounting treatments
Accounting treatment should not, in theory, matter for economic capital we are, after all,
looking at the underlying risks. A few issues emerge, in practice, though.
shareholder capital has a different relationship to the underlying risks in different types of
entity (e.g. general insurers specifically hold liabilities more than their best estimate; life
insurers hold a reserve for future profits)
most people expect that economic capital will be a subset of shareholder capital, but the
shareholder capital shown on the balance sheet may include or exclude items you would
want to treat differently for economic capital.
profit can be defined in different ways, and for performance measurement, it is important
that profit is both consistent across the group, and understandable to management
it is important to be aware of accounting differences between businesses, even though
they shouldnt matter to the underlying economic risks.
3. Difference in significant risks
Different risks being important will create different emphases in the measurement process.
The diagram below shows the main sources of risks usually defined. If one particular risk is
the major source (e.g. insurance risk for a general insurer, or credit risk for a retail bank) then
that risk will generally be the source of focus in any economic capital framework.
When that framework is rolled out across different entities, it can be difficult to combine
with other types of companies with different risk emphases.
4. Detailed methodologies
Banks have tended to have a risk by risk focus, where insurance companies have a product
by product focus. In theory, the outcome would be the same, but in practice, difficulties in
approach will make compromise more difficult.
Figure 8 Methodologies
5. Time horizons
Time horizons between different types of product and financial services entity make a
difference to both the capital and the profit part of a risk adjusted performance measure.
The natural time horizon for different product types can be quite different. This will
naturally lead to a different time horizon within one product type, which will have to be
forced into a standard one across the whole conglomerate to enable meaningful capital
allocations to be made.
Assess daIa
requiremehIs
ahd
availabiliIy
Model
markeI
risk
Model
crediI
risk
Model
operaIiohal
risk
AggregaIe
capiIal
requiremehIs
1esI
ouIcomes
wiIh key
sIakeholders
Agree capiIal
aIIribuIioh
meIhodology
Insurance sIyIe DfA approach
CIassicaI banking approach
SeI model
assumpIiohs
Develop base
case sIaIic
model
Develop besI
/ worsI case
sceharios
Per!orm
dyhamic /
sIochasIic
modellihg
Trowbridge Deloitte
Economic capital
9
Figure 9
A common compromise timeframe is one year.
6. Culture of measurement
In the table below, we set out some key cultural differences between different types of
institutions. Once again, these differences have arisen naturally owing to the nature of the
main products and risks within these institutions. But their existence makes the combination
of different economic capital frameworks a real challenge.
Figure 10 Measurement cultures
7. Correlation and diversification benefits
In a conglomerate, with many different risks, it is important to understand the correlation
between risks, and products, and also to allocate appropriate diversification benefits.
Figure 11 Diversification
The calculation of correlation benefits is complex in itself (there is usually inadequate
statistical evidence). But allocations of the benefit will also depend on the purpose of the
measurement. The existence of the diversification benefit will lead to competitive advantage
for both types of financial services company within the conglomerate, but it may be sensible
to keep that benefit for the centre, to reward the decision makers who have taken on the
challenges of managing a diverse conglomerate.
Capital associated
with small line (eg G|)
Capital associated
with large line (eg PM)
Tot al Capit al required
is lower because of
diversificat ion
benefit s
How to allocate the
diversification
benefitI
Total Capital required
is lower because of
diversification
benefits
Trowbridge Deloitte
Economic capital
Bank Life insurer General insurer Fund manager
Risk vs product Risks generally modelled
separately
Products generally modelled
separately
Products generally modelled
separately
Products very similar
Risk coverage Culture of covering all risks Tends to focus on the biggest
risks
Asset and insurance risks most
generally covered
Risk coverage often limited
Stochastic/analytic
approach
Tend to be analytic where
possible
Often view stochastic as best
practice
Stochastic approach particularly
for claims cost
Analytic approach
Time frames One month to a year One to three years Depends on insurance portfolio Risk coverage often limited
Value of intangible
assets considered
Future profits rarely valued
except for DAC
Future profits regularly valued Future profits rarely valued Often valued where life
insurer is associated
5horI Iime
frame
Long Iime
frame
Mohey markeI
producIs
MorIgages ShorI Iail
geheral
ihsurahce
Li!e Iime
AhhuiIies
YR1
busihess
10
Practicalities
Finally, there are a number of practical issues in setting up an economic capital framework.
There is no right answer to any of these issues, but it is important to recognise them, and
make active decisions about them.
centre vs the business unit
In all businesses, the tension between the centre (to keep control) and the business unit
(understanding their business) is strong. In a conglomerate with different types of business,
this becomes more emphatic.
Figure 12 Information flows
levels of allocation
There is a tension between allocating capital to many different areas (eg by product/
customer) and creating a measurement that the business can understand. The lower the
level of allocation, the more arbitrary it will seem to individual product managers.
understandability
Without an understandable framework and calculation process, the business is less
likely to buy into the process and the outcomes (particularly the measurement of their
own performance).
cultural change
Introducing economic capital as part of the performance management process of a
business is a profound cultural change.
modelling
Trowbridge Deloitte
Economic capital
CfO
"isk and capiIaI managemenI commiIIee"
isk managemenIlperformance measuremenI
usiness UniI Heads
usiness managemenI
LimiIs
AsseIs (PosiIionsl
exposures)
CapiIaI consumpIion CapiIaI aIIribuIion
CO
CorporaIe governance
usiness acIiviIies
11
Trowbridge Deloitte
Economic capital
Figure 13 What is inside the Economic Capital models?
Our approach
Our approach to implementation is shown in the diagram below.
It is vital that the business is involved enough in the process not just the central capital
management team to understand the risk profile implied for their business and understand
the capital implications of increasing or decreasing the risks of their business.
Figure 14 Six Proven in practice phases
Critical Success Factors
From observation, there are a few critical success factors to implementing an economic
capital framework.
change management orientation
senior management champion (e.g. CEO)
staying ahead of regulatory trends
detailed knowledge of your business, its markets, operating environment and regulation
combination of economic theory, actuarial practice and investment
stochastic techniques
sound project management
strong communication skills
ability to identify the key financial and operational risks in your business
data availability.
Phases
Program ManagemenI
ImplemehIaIioh
sIreams
ImplemehIaIioh
sIraIegy
DeIailed
ahalysis
ahd desigh
RequiremehIs
!ramework
Program
ihiIiaIioh
Oh-goihg
behe!iIs
realizaIioh
Program
de!ihiIioh
workshop
Program
ih!rasIrucIure
High level plah
ahd resource
requiremehIs
IhiIiaIioh
meeIihg
De!ihiIioh o!
'as-is' PrudehIial
sysIems, processes
ahd daIa
De!ihiIioh ahd
validaIioh o!
'Io-be' PrudehIial
sysIems, processes
ahd daIa
DocumehIaIioh
o! Program
behe!iIs ahd
success criIeria
UhderIake gap
ahalysis - daIa,
!uhcIioh ahd
processes
DeIailed
documehIaIioh
PiloI or phased
approach
DeIailed
Program plahs
Fihalized
budgeIs
Fihalized
busihess case
Di!!erehI
sIreams
ihcludihg
DaIa SysIem
developmehI
1esIihg
Processes ahd
procedures
Khowledge
Irahs!er ahd
commuhicaIiohs
Lauhch
Achieve sigh
o!! o!
Program
deliverables
Compare
behe!iIs Io
busihess case
IdehIi!y ahy
!urIher acIioh
required
CapiIaI - differenI definiIions
Company sIrucIure
ConsoIidaIion ruIes
ProfiIabiIiIy by ProducI CIass
OuIpuIs
ProducI cIass IeveI ouIpuI
Income sIaIemenIs and
baIance sheeIs
AggregaIor and anaIyser
CashfIov
5cenario
GeneraIor modeIs
InpuIs
Economic scenarios
LiabiIiIy daIa
AsseI daIa
usiness pIans
5IraIegies
Comparison of differenI
scenarios (5VA)
OIher as defined
(Life DfA)
12
Trowbridge Deloitte
Economic capital
EC implementation challenges/lessons learned:
In our experience of economic capital implementations, there are common issues that can
derail the process. They can be categorised into three main issues:
Cultural
is the culture right? Needs empowerment for decision making and ownership/
accountability of risk
it is all about Operational integration and not implementation
Socialization - education and awareness of Board, Executive Directors, Senior
Management team, etc
resistance to introduction of risk-adjusted performance measurement across the business
knowledge transfer.
Technical
common agreement on definition of Economic Capital
difficulties in gathering, storing and manipulating the required data
time horizons for capital
treatment of mismatches between economic and regulatory capital
subjectivity of correlation matrix
increased complexity for capital processes (pricing, management reporting, capital
management, risk management, ALM, etc).
External
lack of comparability to industry
lack of recognition by rating agencies and stock analysts.
Overwhelmingly, the hardest thing to get right is not the technical risk measurement, but
driving the concepts into the business and getting buy-in from all stakeholders.
For more information contact:
Jennifer Lang
Tel: +61 (0) 2 9322 5076
e-mail: jelang@deloitte.com.au
Ian Jones
Tel: +61 (0) 2 9322 5081
e-mail: iajones@deloitte.com.au











AM_SYD_11.05_015753