economic capital cia seminar for the appointed actuary september 20, 2004 speaker: darryl ivan

Economic CapitalCIA Seminar for the Appointed Actuary

September 20, 2004

Speaker: Darryl Ivan

CIA Seminar for the Appointed Actuary

September 20, 2004

2

Agenda

Capital (Bank Perspective): Importance & TypesEconomic Capital

DefinitionTenetsPerformance MeasurementRisk Types and Attribution Methodology

RBC Insurance: Economic Capital DevelopmentDistribution by Business & Risk


September 20, 2004

3

Importance of Capital (Bank Perspective)

The primary purpose of capital in a financial institution is to absorb risk.The absorption of risk is not just incidental to a bank’s business, but forms an integral part of the business itself.


September 20, 2004

4

Types of Capital

Book CapitalFinancial reporting

Regulatory CapitalRegulatory definition of capital

Economic CapitalRisk based attribution of capital


September 20, 2004

5

Economic Capital

Represents the total risk of RBC in one number and is a key measure of the RBC’s ability to withstand unexpected loss while enabling it to operate as a going concern.The amount of shareholder’s investment which is either at risk in a business or has already been utilized to purchase future earnings.


September 20, 2004

6

Principles of Economic Capital

Protect shareholdersEquity is needed to guard against unexpected lossesCovers all risksConsistent application of methodology across RBCMore risk = more economic capitalCapital should be attributed where risk is located


September 20, 2004

7

Benefits of Economic Capital

A robust economic capital framework provides management with an effective tool with respect to the following:

Decision support and pricingProvide a consistent measure of profitability across the organization – performance measurementEffective allocation of capital resourcesStrategic development – quantify the shareholder value within each business activityContributes to the assessment of bank’s capital adequacy


September 20, 2004

8

Economic Capital Tenets:Attribution vs. Allocation

‘Attribution’ creates the right incentives for resources:Bottom-up measurement approachRobust measure of capital adequacyAccurate measure of risk vs. return

‘Allocation’ of equity is the distribution of ‘all’ available capital:

Book or actual capital allocated top-down based on risk measures or regulatory requirementsEnsures consistency with GAAPCannot be used for capital adequacy, management and planningIncentives may not be aligned with economics


September 20, 2004

9

Economic Capital Tenets:Solvency Standard

AAA AA ATarget Debt Rating

Risk coverage as a function of target debt rating: • Choosing a target capital level is driven by the institutions desired target debt rating.

99.997%99.95% 99.65%Estimated risk coverage level (probabilitythat capital and earnings will cover potential loss)

Probability of default (approximate) 1 in 30,000 1 in 2,000 1 in 300

Time Horizon: 1 year


September 20, 2004

10

Economic Capital Tenets:Solvency Standard

Pro

bab

ilit

y o

f lo

ss

Loss Rate0% 100%

Zero Losses

ExpectedLosses

Unexpected losses for whichcapital should be held

Risk coverage level

Level too expensive

to hold capital

99.93%


September 20, 2004

11

Economic Capital Tenets:Diversification

EC for each risk type is calculated on a standalone basis.If stand-alone EC for each risk type was simply added, the sum would be significantly higher then RBC’s requirements at a given solvency standard.As a result, the benefits of diversification are calculated and attributed back to each BU.Diversification benefit is a function of the amount of risk and on the degree to which it is correlated with the other risks and businesses in RBC.


September 20, 2004

12

Economic Capital Tenets: Book Value of Equity & Capital Management

Capital you have vs. capital you require:‘Capital you have’ is equal to common equity + retained earningsEC represents the ‘capital you require’ to maintain a common solvency standard

The difference between EC and the book value of equity (either a net surplus or shortage) is held at the top of RBC Financial Group.


September 20, 2004

13

Performance Measurement: Return on Equity (ROE)

Economic Capital is the primary component for performance measurement, by defining risk/return relationship:

ROE = Product Spread + Other Income - PCL - NIE - Tax – Cost of Prefs Equity

Transfer pricing

Credit Portfolio

Management

Costing

Tax MGT

Fee Based

Preferred Shares Allocation

Economic Capital


September 20, 2004

14

Performance Measurement: Economic Profit (EP)

EP measures business unit contribution to shareholder valueEP measure strongly correlates to shareholder valuation

EP = NIAT – Non-Recurring Items – Amortization of Intangible Assets – (Equity)*(Cost of Equity)

Economic Capital


September 20, 2004

15

Risk Types

The identified risks for which RBC Financial Group calculates EC are:

Credit RiskMarket Risk

Trading Market RiskInterest Rate Risk (Non-Trading Book)

Operational RiskBusiness RiskFixed Asset RiskGoodwill RiskInsurance Risks


September 20, 2004

16

Attribution Methodology: Credit Risk

Is the loss associated with a counterparty’s inability to fulfill its payment obligations, after taking into account recovery values when seeking to mitigate losses.Loss in market value due to deterioration in counterparty’s credit worthiness.A counterparty may be an issuer, debtor, policyholder, reinsurer or guarantor.


September 20, 2004

17

Attribution Methodology: Credit Risk

Primary drivers of credit risk: BRR; LGD; term to maturity; commitment status; UGD; product typeCredit risk is calculated in three areas:

Retail: credit cards, residential mortgages, lines of credit etc

Capital rates applied against o/s balances

Loan Book: commercial/corporate loans, public sector loans etc

KMV Portfolio Model

Trading BookCARMA Portfolio Model


September 20, 2004

18

Attribution Methodology: Trading Market Risk

Associated with trading activities resulting from market-making, positioning and sales, and arbitrage activities in the interest rate, foreign exchange, equity and commodity markets. Risk of unexpected loss occurring due to adverse changes in the market value of trading instruments.

Market Risk

Commodity RiskCurrency RiskInterest Rate Risk Equity Risk


September 20, 2004

19

Attribution Methodology: Trading Market Risk

Calculated using a combination of:Internal Models Approach: proprietary VaR modelStandardized Approach: BIS Standardized Measurement Method

Internal model approach to phase out standardized approach


September 20, 2004

20

Attribution Methodology: Interest Rate Risk

The potential adverse impact on RBC’s economic value due to changes in interest rates and interest rate volatility.Categories of IRR are:

Neutral PositionALM DiscretionaryForeignBasisOption


September 20, 2004

21

Attribution Methodology: Business Risk

Risk of loss due to variances in volume, price and cost caused by competitive forces, regulatory changes, reputational and strategic risk (primarily uncontrollable risks).Benchmarking indicates that attribution of capital for both business and operational risk is best practice.Factor determined annually applied against annualized gross revenues to arrive at economic capital for business risk.


September 20, 2004

22

Attribution Methodology: Operational Risk

Risk of direct or indirect loss resulting from inadequate or failed processes, technology, human performance, or from external events (primarily controllable risks).Determined annually using a number of approaches including benchmarking and earnings volatility.Currently RBC is working towards implementing a Loss Distribution Approach for determining operational risk capital.


September 20, 2004

23

Attribution Methodology: Fixed Asset Risk

The potential for the value of fixed assets to be less then its net book value at any time.Implicit assumption is that the depreciation schedule represents expected loss and capital is required for unexpected loss.Fixed asset classes include: real estate; computers; capital software development costs etcPublicly traded firms with large investments in each respective fixed asset class were used as proxies to derive fixed asset risk factors.


September 20, 2004

24

Attribution Methodology: Goodwill Risk

Goodwill is an asset that arises when the purchase price paid for an acquisition is higher than the value of the net assets acquired.The value of goodwill is based on earning capacity. Where these earnings do not materialize, a lower then expected return on invested capital is incurred, which translates into a loss of shareholder value.RBC Financial Group attributes 100% equity to goodwill.


September 20, 2004

25

RBC Insurance: Economic Capital Development

Align RBC Insurance with the rest of RBC Financial Group from an economic capital perspective.Move from a top-down approach to a bottom-up approach.Identification of risks:

Those risks where current methodologies exist (e.g. credit, market etc)Risks unique to RBC Insurance (e.g. mortality, morbidity, lapse, P&C, IRR/reinvestment risk etc)

Challenges:Management buy-inActuarial support & model development for insurance specific risksAdjustment for liability conservatismEducating the ‘bankers’


September 20, 2004

26

Distribution by Business (YTD Q3 04)

RBC Banking39%

RBC CM20% RBC Investments

15%

RBC GS4%

Other16%

RBC Insurance6%


September 20, 2004

27

Distribution by Risk (YTD Q3 04)

Goodwill Risk28%

Fixed Assets Risk3% Business Risk

7%

Business specific2%

Interest Rate Risk10% Trading Risk

4%Operational Risk

13%

Credit Risk33%

Total Economic Equity Capital 15,750 (88%)Total Unattributed Capital 2,164 (12%)

Total Equity Capital 17,914(100%)

economic capital cia seminar for the appointed actuary september 20, 2004 speaker: darryl ivan

Documents