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Financial Services
GETTING RISK-ADJUSTED PERFORMANCE MEASUREMENT RIGHT FOR SOLVENCY II
AUTHORSAstrid Jaekel, Partner
Sean McGuire, Senior Manager
Insurers across Europe will soon begin calculating their regulatory capital requirements
under the new Solvency II regime. To date, most insurers have focused on building and
calibrating their Pillar I models, be it under the standard formula approach or using an
internal model. Now they are shifting their efforts towards using these models to run
their businesses.
This is partly for compliance purposes; Solvency II requires insurers to link the calculated
capital requirements to business decisions. But insurers should also see this as an ideal
opportunity to overhaul their performance measures and better align incentives with risk
and reward. Adopting risk-adjusted performance measures (RAPMs) is the obvious way to
achieve this. However, the design and use of such measures is not simple. A “one size fits all”
approach will not work and performance measures must be tailored to their different uses
within the business.
When designing and implementing RAPMs, there are many decisions to be made, each of
which will result in different practical challenges in implementation. To develop measures
that are right for their business, insurers should follow a three step process:
1. Design the new measures
2. Tailor the measures to specific business uses
3. Apply the measures across the organisation.
Copyright © 2012 Oliver Wyman 2
To ensure they create the right incentives, performance measures should:
A. Reflect the economic risks being taken on
B. Be broadly consistent at all levels of the organisation and across different lines of business
C. Be sufficiently transparent to be easily understood by Executives and staff
D. Be relatively easy to calculate
E. Be based on a profit measure that will be used to run the business in the future
F. Include an absolute measure of value creation as well as a relative measure.
A. REFLECTING THE
ECONOMIC RISKS
At the risk of stating the obvious, the
measures must reflect the economic risks
of the business and, hence, the economic
capital requirements. Economic risks and
capital requirements are well reflected by the
Solvency II Capital Requirement (SCR). This
means that the SCR calculations should feed
into the performance measures. One way
to do this is to use the change in Solvency II
Own Funds as the profit measure and then
make an explicit deduction for the cost of
holding the Solvency Capital Requirement
plus any target buffer over and above this.
B. CONSISTENCY AT ALL LEVELS OF
THE ORGANISATION AND ACROSS
DIFFERENT LINES OF BUSINESS
Solvency II allows the capital requirements
of different lines of business to be compared
on a like-for-like basis (or, at least, on a more
comparable basis than has historically been
the case). So, for example, life and non-life
businesses will have capital requirements
that are more closely aligned with one
another than they have been. Consistency
could be further improved by, for example,
incorporating expected levels of renewals
in non-life performance measures, akin
to the multi-year nature of life insurance
policies. Such comparability is important for
Executives in deciding how much capital to
allocate to different lines of business.
1 DESIGNING THE NEW RISK-ADJUSTED PERFORMANCE MEASURES
Copyright © 2012 Oliver Wyman 3
C. EASE OF UNDERSTANDING
AND TRANSPARENCY
Because the performance of Executives
and staff will be evaluated by RAPMs, they
must understand how they are derived and
how they can influence them. Since the
performance measures will be used as a
basis for staff compensation they must also
be robust, transparent and auditable.
D. EASE OF CALCULATION
The new performance measures will need
to be calculated and fed into performance
scorecards. Solvency II implementation
is already straining insurers’ resources,
systems and budgets, so new measures
should be built on work that is already
underway. This will avoid re-work and
manual “off-line” calculations.
E. CHOICE OF PROFIT MEASURE
When designing the new performance
measures, insurers must decide which
profit measure to base them on. There are
three broad options: IFRS profits, Solvency
II profits (equivalent to embedded value
profits under Solvency I) or “adjusted”
Solvency II profits. Exhibit 1 summarises the
main features of each option.
Many insurers currently have IFRS-based
or Embedded Value-based RAPMs in place.
Most are considering a shift to Solvency
II-based measures, with some planning to
adopt “adjusted Solvency II” measures. We
define an “adjusted Solvency II” measure
as one where the Solvency II balance sheet
or Solvency II profit measure is adjusted
to reflect the insurance company’s own
view of the world: e.g. their view on
EXHIBIT 1: CHOICE OF PROFIT BASIS FOR RISK-ADJUSTED PERFORMANCE MEASURES
EXAMPLEMEASURE
COMMENTARY
IFRS profits less cost of
holding SCR
Solvency II profit less
cost of holding Economic
capital (SCR plus buffer)
Solvency II profit less cost
of holding Economic
capital (SCR plus buffer)
Mixes accounting and
economic measures
Typically used where
company has strong
preference for IFRS
profits over embedded
value profits or change
in Solvency II own funds
(e.g. if parent is a bank)
Solvency II profit defined
as change in Solvency II
own funds (ignoring any
changes due to capital
raising or payments such
as dividends)
Consistent with Solvency
II balance sheet and
capital requirements
Adjustments to Solvency
II balance sheet made to
reflect company’s
internal view (e.g.
contract boundaries,
credit risk for annuities)
Adjustments made
should be specific to the
company, but consistent
across it
Consistent with decision
making by the company
IFRS SOLVENCY II “ADJUSTED SOLVENCY II”
Increasing complexity in design and embedding Increasingly “economic” measure
Increasing consistency with decision making
Copyright © 2012 Oliver Wyman 4
contract boundaries, if it differs from
where Solvency II ultimately lands. Once
the profit basis has been selected, other
considerations need to be taken into
account: e.g. whether the measure should
be pre- or post-tax and whether to include
investment variances.
F. ABSOLUTE AND
RELATIVE MEASURES
An absolute RAPM – that is, one expressed
as a euro (or other currency) amount – is
required to enable insurers to understand
how much risk-adjusted value is created
by an activity or business unit. This allows
management to reward staff accordingly.
A relative measure of risk-adjusted
performance, sometimes referred to as a
capital efficiency measure, is required to
make decisions where capital is a scarce
resource. Relative performance measures
can be used at the start of the year to rank
various activities, business units or product
lines and then make (marginal) capital
allocation decisions based on these rankings.
EXHIBIT 2: EXAMPLE MEASURES DEVELOPED FOR A EUROPEAN INSURER
EVC =
Δ SII own funds
– BEL adjustment
– Required return
– Economic capital
x frictional cost
of capital
Change in own funds due
to writing new business
Difference between SII and
“Economic” balance sheet
Expected return on each
asset class and expected
change in liabilities
Frictional cost of holding
economic capital
(including buffer)
ECONOMIC VALUE CREATION (EVC) ECONOMIC RETURN ON CAPITAL (EROC)
Used for deciding whether to grow Life or GI
business, calculated as:
Δ EVC / Δ PV (EC)
Where:
Δ EVC is the change in EVC due to selling additional
policies
Δ EC is the change in Economic Capital from selling
additional policies
For GI business, five years of EVC and EC are
included in the calculation, based on expected
renewal rates
1 2
Copyright © 2012 Oliver Wyman 5
2For RAPMs to make a difference in business steering and value management, they need to
contribute to decision making across the business. This means that risk-return trade-offs are
explicitly assessed in business decisions. Exhibit 3 provides an overview of the business processes
for which we recommend the use of RAPMs.
TAILORING THE NEW MEASURES
EXHIBIT 3: KEY BUSINESS PROCESSES FOR RISK-ADJUSTED PERFORMANCE MEASURES
RISK-ADJUSTED PERFORMANCE
MEASURES
Strategic
planning and capital
allocation
Performance
management and
compensation
Stress and
scenario testing
Reinsurance
strategy
Product
design and
pricing
ALM
management
Copyright © 2012 Oliver Wyman 6
Each of these applications presents its
own challenges and the measures must
be tailored to them. In this section, we list
key questions that need to be answered
and the challenges that are typically
faced in using RAPMs in three business
processes: (A) strategic planning and
capital allocation, (B) product design and
pricing, and (C) performance management
and compensation.
A. STRATEGIC PLANNING AND
CAPITAL ALLOCATION
The aim here is to decide how much capital
to hold over the planning cycle and allocate
capital to the opportunities (BUs, products,
investments, etc.) that generate the greatest
risk-adjusted value. Key questions and
challenges include:
How much buffer capital should be held
and how should it be accounted for in
target setting?
Insurers need to hold more than the
Solvency Capital Requirement to manage
the volatility of the Solvency II balance
sheet through the cycle. A strategic and
capital planning exercise must therefore
decide just how much buffer capital to
set aside. Then this buffer capital must
be accounted for in target setting, either
by explicitly allocating it to business units
and charging for it or by increasing the
cost of capital and hurdle rates to account
for the cost of holding buffer capital.
How should diversification benefits be treated?
When allocating capital to business
opportunities, diversification benefits
must be accounted for in a way that
gives the business the right incentives.
For example, if it is corporate strategy
to diversify the business, then activities
that take new risks – e.g. P&C risk
in a Life-focused company – should
be charged only for their marginal
capital requirements. There are several
techniques for allocating diversification
benefits, including the pro-rata approach,
game-theoretic approaches and marginal
contribution approaches.
How should the strategic planning and
capital allocation process work in practice?
Strategic planning and capital allocation
is typically an iterative process, looking at
different scenarios and business portfolio
options. For this to work in practice
within the planning timelines, companies
cannot run their full Pillar I models for a
range of scenarios and capital allocation
options. Hence, several of our clients use
simplified capital and RAPM models for
planning purposes.
B. PRODUCT DESIGN AND PRICING
RAPMs can be used to design capital-efficient
products that generate value over the policy
lifetime. Key questions and challenges include:
Which risks should be assessed and charged
for in new business design and pricing?
The risk profile of any insurance
product will change over time. This is
particularly true for the balance between
underwriting risks and market risks.
While underwriting risks are inherent
to the product, market risks can be
increased or decreased relatively easily
over time. New product design and
pricing should focus on the risks inherent
to the product: i.e. underwriting risks and
market risks that cannot be hedged, such
as long-term interest rate risk. The risk-
return trade-off for optional market risks
should be assessed as part of the ALM and
investment strategy.
Copyright © 2012 Oliver Wyman 7
At what level should diversification benefits
be accounted for?
As in strategic planning and capital
allocation, there are several ways to
deal with diversification benefits. In new
business product design and pricing,
the question is typically how much
capital diversification benefit to allocate
to products. Should diversification be
accounted for within the product line,
within the legal entity or across the
Group? The right answer depends on the
firm’s strategy. Some insurers may want
their business units to be economically
profitable on a stand-alone basis,
while others may decide to use Group
diversification as a source of competitive
advantage in local pricing.
How should “anchor” products and cross-
selling opportunities be dealt with?
One common criticism of RAPMs is that
they are too harsh on products that may
not be economically profitable but give
distribution access to customers and
generate additional sales later on. This is
a valid concern that needs to be solved
as part of product portfolio planning. If
a product is an important entry point to
generate further sales, this should be
reflected by adjusting RAPM targets for
this product – i.e. allowing a negative
economic value creation target or a below
hurdle target return on a stand-alone basis.
C. PERFORMANCE MANAGEMENT
AND COMPENSATION
When it comes to basing compensation on
RAPMs, there is usually one question that
dominates all others:
How can it be ensured that employees
can influence the RAPM in their
compensation scorecard?
To ensure that RAPMs are meaningful in
business steering and compensation,
measures flowing into compensation should
be based on factors that an employee
can influence. Hence, adjustments are
required to neutralise elements that the
individual cannot influence. For example
market movements should be included
in the investment team’s performance
measures, but it would be unfair to
penalise someone working in distribution
for equity market falls. Hence, RAPMs
should be broken down into value trees
as a basis for defining more specific
measures or holding constant certain
elements of the measures feeding
into compensation.
Copyright © 2012 Oliver Wyman 8
3We see three key challenges in implementing new RAPMs:
Educating the Board, management and staff to ensure they understand and accept the
new measures
Moving from the existing performance measures to the new measures, deciding how
quickly this happens and which performance measures to phase out
Managing the impact of the new performance measures on the business.
EDUCATION AND BUY-IN
Obtaining buy in to new performance
measures is always tricky. Performance and
compensation are emotive subjects and staff
want to understand how new measures
will work and how they will affect them.
Time must be invested in explaining the
new measures to all affected staff (starting
with the Executives) and employees need
to be given comfort that the measures will
not reduce their overall compensation level
without good reason. One way to encourage
Executives to buy into the new measures
is to involve them early in their design and
ensure that their concerns are addressed.
Calculating the new performance measures
on a best efforts basis as part of the design
process, or as part of a “pilot” phase following
their design, is also important in helping the
business understand the measures before
they are finalised.
MOVING TO THE NEW MEASURES
Some existing measures will continue to be
important in assessing performance while
others will be replaced by by the Solvency II
measures or new RAPMs. For instance,
MCEV or EEV will probably be replaced by
Solvency II own funds, whereas IFRS profits
are likely to continue to feature in Executive
scorecards and performance assessment.
This will raise questions about how to manage
the transition. For example, should new
measures be introduced on a shadow-basis
or should management over-ride or adjust
them in the first year of implementation if
there are teething troubles?
The introduction of RAPMs will also require
changes to payment systems and reporting.
Where possible, insurance companies
should integrate the changes required
by the introduction of RAPMs with those
already planned. To allow staff to gain
comfort with the new measures, many
insurers will want to temporarily run them in
parallel with those that are being replaced.
APPLYING THE NEW MEASURES
Copyright © 2012 Oliver Wyman 9
MANAGING THE IMPACT OF THE
NEW MEASURES
Introducing RAPMs will provide new insights
into the economics of the business. Some
products that looked highly profitable
under traditional measures may be value
destroying on an economic basis. An
obvious example of this would be products
with large guarantees and some lines of non-
life business, which under Solvency II will
attract much higher capital requirements.
Managers need to use this new lens on
profitability to make capital allocation
decisions, set prices and design products.
RAPMs should encourage the business to
design capital efficient products and set
prices that take account of the economic
risks that these products bring onto the
balance sheet.
* * *
RAPMs are an important lever for
embedding Solvency II capital requirements
into business decisions. But developing
appropriate measures is not a simple
process. There are many challenges in both
the design and implementation.
A “one size fits all” approach to designing
and embedding RAPMs is not appropriate.
What works for one insurer may be wrong
for another. Nor will a particular RAPM be
suitable for all performance measurement
purposes within a single firm. RAPMs need
to be tailored to their specific uses.
Yet it is impossible to solve all problems by
choosing the right measures. All measures
will have shortcomings in practice. Insurers
must design RAPMs that achieve a good
balance between theoretical purity and
practicality, and then add controls to
mitigate identified issues.
RAPMs are sure to receive much more
attention over the next 18 months. Insurers
should make changes now to put them in
place in time for the Solvency II switchover.
Copyright © 2012 Oliver Wyman 10
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