Article from: Risk Management Newsletter March 2004 – Issue No. 1 March 2004 Q Risk Management Risk Management of a Financial Conglomerate by Luc Henrard, chief risk officer Fortis and Ruben Olieslagers, head of research and development 1. A NECESSITY consistent view on risk measurement across the The emergence of large European financial entire financial services industry. The Joint groups has been one of the principal features of Forum (formerly known as the Joint Forum on the latest banking and insurance consolidation Financial Conglomerates) has been a focal point wave. Financial deregulation, globalization of of the efforts of the international supervisory financial markets and increased shareholder community in meeting this need. pressure for financial performance are the main forces that fueled the mergers and acquisitions The concept of “Economic Capital,” which trend over the past few years. In order to meas- measures risk based on a company’s own unique Luc Henrard is ure, monitor and manage risk and ultimately op- risk profile, is developing as the common meas- general manager and timize risk versus return within a conglomerate ure of risk, sought by many financial conglomer- chief risk officer of at both operating entity and aggregate group ates as well as regulatory bodies. Economic Fortis in Belgium. level, the financial conglomerate needs excel- capital enables financial institutions to estab- He can be reached at lent risk-management processes and internal lish a capital framework that allows for consis- [email protected] control mechanisms. This should also be en- tent translation of risk taking into capital . couraged by the regulatory structures, which requirement, making “apples-to-apples” com- are unfortunately still largely focused on indi- parisons possible. An economic capital frame- vidual operating entities within a group and work does not only allow for the capture of treat each of these as independent silos in set- netting and diversification effects within a fi- ting capital requirements. This silo approach nancial conglomerate, it also addresses many of fails to deal adequately with aggregate risks the current limitations of regulatory capital across different regulated businesses. models (e.g., silo view, standardized risk model- ling approaches). Accurate and consistent risk measurement is a prerequisite for good risk management. Risk 2. THE INTERNAL CHALLENGE: measurement typically starts bottom-up in the SIX STEPS different businesses within a financial con- The development of comparable measures of Ruben Olieslagers is glomerate. As a result, many different ap- capital and value is not an easy task. Fortis, as a Head of Research and proaches to risk measurement have been bancassurance group facing a wide range of Projects at Fortis Central developed between insurance and banking risks, has applied the following six-step ap- Risk Management. businesses and even within each of these areas proach: He can be reached at (e.g., life and non-life insurance). For a finan- ruben.olieslagers@ cial group, especially a conglomerate covering • Define and communicate fortis.com. many business areas, arriving at a common risk your risk taxonomy measure is quite a challenge. • Make sure banking and insurance officers Externally too, the growing emergence of understand each other financial conglomerates and the blurring of • Define the models to be used for each distinctions between the activities of firms in risk type (business, event, credit, etc.) each financial sector had also increased the in a consistent way need for joint efforts to improve the efficacy of • Model each risk and aggregate to arrive supervisory methods and approaches. Basel II at an overall capital figure has focused on improving consistency and • Define a regulatory solvency corridor accuracy of setting solvency requirements • Look at the risk/return “Framework” across banking businesses and now Solvency II will aim to do the same for insurance. A key aim of the regulatory bodies is also to develop a continued on page 14 Q Page 13 Q Risk Management Q March 2004 Financial Conglomerate ity correlated loss) differs significantly from the Q continued from page 13 distribution for market risk (high frequency, low severity). Step 1: Define and communicate 2. Insurance Risk your risk taxonomy • P&C risk: the variability in future claims and loss-adjusted expenses (LAE) paid Many different ways of classifying risk are (whether in size of claims, number of claims or possible, and no single taxonomy is inherently timing of payments) and the variability in the better than another. The classification of risk liabilities for outstanding claims overtime. types often follows the relative importance of • Life risk: the risk exclusively associated risk types to a financial services provider. The with a life insurer. The risk is especially the risk taxonomy used at the level of Fortis Group result of deviations in timing and amount of seeks to establish a common risk language the cashflows due to the (non-) incidence of across the group, while ensuring that all risk death. types are adequately captured. Figure 1 distin- guishes six broad types of risks. 3. Operational Risk Figure 1 • Business risk refers to the risk due to oper- ating leverage (in particular, volatile revenues RISK TAXONOMY and an inflexible expense base). • Event risk refers to the risk of experiencing Risk vs. Risk vs. one-off adverse non-financial events such as Debtholders Capital Return fraud and punitive damages. Rating Agencies RISK=Volatility Shareholders Regulators Stock Analysts Given that a financial conglomerate is by defini- tion a combination of diverse businesses operat- Operational Investment Insurance Risk Risk Risk ing under a common ownership structure, each of these has a distinct risk profile. From this point of view, an ordering of risks in function of Business Event Credit Market Property & Life the consumption of economic capital is Risk Risk Risk Risk Casualty Risks Risks required, taking into account the fact that a l Changes in l Fraud l Loans l Equities l Claims for l Life policies conglomerate must not be overcapitalized to the business 'normal' events Unintentional Derivative Bonds Annuities volumes l l l l point where it would cause undue harm to share- errors counterparts l Losses due to l Foreign l Health l Changes in catastrophes/ Legal risk Reinsurance Exchange holders or undercapitalized to the point where it margins and l l natural disasters counterparts costs l Man-made l Real Estate (e.g. earthquakes, would cause undue risk of insolvency to debtors shocks l Settlement hurricanes, l ALM risk floods, etc) and policyholders. In other words, lower capital l Liquidity risk for a given degree of risk taking will make an institution less solvent, but more profitable, and vice versa. 1. Investment risk • Credit risk: the risk that a borrower/coun- Figure 2 gives an illustrative example of order- terparty will fail to repay the amount owed to ing and is therefore not valid for every business the Fortis Group. within a financial conglomerate because it • Market risk: the potential for loss resulting depends on the relative importance of each of from unfavorable market movements (from the banking and insurance businesses within trading to holding positions in financial the conglomerate. In general, universal banking instruments). Market risk might be treated as activities are mainly dominated by credit risk, one aggregated risk or separately as interest but this is not the case for life insurance activi- rate, equity, foreign exchange, real estate and ties. ALM is invariably the largest consumer of commodity risk. Within market risk we identi- capital in insurance companies (especially in fy ALM risk. Fortis Group is exposed to inter- life) given that insurance risks diversify away in est rate, share price and real estate risk via its large portfolios. P&C activities are mainly dom- investment portfolio. Credit risk and market inated by insurance risk while the non-licensed risk are measured separately because the distri- subsidiary encounters operating risk. bution for credit risk (low frequency, high sever- Insurance risks (mortality and underwriting) Q Page 14 March 2004 Q Risk Management Figure 2 nancial con- ILLUSTRATION OF RELATIVE CAPITAL CONSUMPTION glomerate, dif- ferences in the First Second Third Capital order order order sector-specific 100% frameworks should be identi- fied and, agree- ment should be reached consis- tently covering all relevant risks. For example, one 0% ity of the key chal- Bank iting –Bank –Bank – ding Insurance Insurance Tra erwr lenges in a con- – ALM – –Insurance Credit Und ALM ality/morbid Operating Credit glomerate is Mort Operating specifying a uni- form time hori- will diversify away substantially in large portfo- zon. In banks, the convention for modeling risks lios because they are not correlated with the and assessing capital is to adopt a one-year hori- other (financial) risks and because a lot of the zon. Alternatively, insurance companies are typi- volatility is already reserved in the provisions. cally capitalized for longer decision horizons. In order to have a “common currency” for risk, a com- Step 2: Make sure banking and Figure 3 insurance officers understand each other Step 2 consists of improving the understand- DIFFERENT APPROACHES USED IN BANKING AND INSURANCE ing by bankers and actuaries of mutual ap- proaches and terminology. Figure 3 Banking Insurance summarizes the typical banking and insur-