Responsibilities for capital management usually do not primarily reside with the enterprise risk management (ERM) function. But the strategic chief risk officer (CRO) can provide significant strategic assistance with capital management, both in the framework design and in decision making. Organizations should ensure that within the capital management framework, ERM assistance is sought and used. In redesigning or structuring a capital management framework, businesses can leverage the ERM framework template.
A first step in building or developing a capital management framework is to scope out the fundamentals — such as agreeing on the governance and program accountabilities and understanding the business model and balance sheet.
From there, companies will need to identify the constraints and goals, for example, around the risk appetite and other key performance indicators (KPIs), as well as stakeholder expectations. This allows for trade-off in the judgments between capital and other KPI metrics, providing a capital management framework to identify and prioritize opportunities upon which companies can act. The goal is to optimally allocate scarce capital resources, reflecting risk exposures, and to deliver improved value.
Ingredients for strong capital management
The organizational ingredients of a risk management framework are also foundations for strong capital management. They include:
- Governance and culture — The framework should identify the owners of the capital management program and the process for approval of management actions. These should be documented in a capital management policy and in relevant risk policies. Sound governance and culture support and facilitate transparency and open communication, as well as independent challenge. These are all needed to ensure that the interaction and engagement between lines one and two for capital management purposes are effective and beneficial.
- Risk policies and standards — Risk policies and standards, as well as the general governance and sign-off procedures, should support the capital management framework. For example, a business’ risk management framework should consider the impact on customers of any actions. As such, it should include principles to ensure that customers are not inappropriately disadvantaged by any capital management actions.
- Capital management framework — The capital framework is very much aligned to a successful risk appetite framework and the two need to be co-dependent, such that everyone in the company is working toward common goals.
The capital management framework can incorporate key elements of the risk appetite framework, to give a holistic view of how capital and risk are managed:
- Target areas for capital management activities, which should be aligned with the broader strategy of the company
- Key metrics that reflect the priorities of the company and are based on the financial and strategic position of the company
The capital management framework should include clear guidance, in line with the company’s broader strategy, on what metrics should be prioritized when considering capital management actions, along with the relative importance of each metric, such as capital strength, capital stability and capital fungibility as well as others such as IFRS profits or liquidity.
Any capital management action will have an impact on the risk profile of the company. The strategic CRO is in a unique position to assess and analyze the risk profile in order to ensure that any actions are in line with the company’s risk appetite and to propose areas where there are potential capital management opportunities.
For effective capital management and risk management, capital needs to be allocated between risks, product types and business units. Allocating capital at this level of granularity is somewhat theoretical, but a reasonable approach is required to ensure informed and practical decision-making.
Capital allocation is used in many elements of business, for example:
- Strategic capital and investment decisions — to assess how to best use, or manage capital within the business
- Pricing — to incorporate cost of capital into product prices
- Performance measurement — to compare actual income to the capital deployed to produce it
- Risk management — to measure the risk in terms of capital intensity
- Risk transfer decisions – to assess the impact of risk transfer decisions on capital allocation
Using capital allocation in this way needs to be supported by the other elements of the risk management framework to ensure it is successfully applied.
Risk identification and selection
Risk monitoring, carried out by the risk function, can help to identify “peak” risks that do not diversify significantly and could be placed elsewhere more efficiently. It can also identify when exposure to certain risks is close to breaching limits or when risk capacity is available. This can be particularly helpful where the risk and capital teams collaborate to identify that the return on capital for specific risks is out of line, and that the company is not being sufficiently rewarded (through return on capital) for those risks.
The strategic CRO is in a good position to assess and analyze the risk profile in order to ensure that any actions are in line with the company’s risk appetite.
Risk measurement, monitoring and management
Assessing the financial impact on a range of key metrics is crucial to a successful capital management program. Regular measurement and monitoring of risk is key to identifying attractive capital management actions, particularly on a forward-looking basis to identify any need for medium-term capital management actions.
The risk team can also consider and quantify any new risks resulting from capital management actions, ensuring that models and assumptions are updated appropriately.
A business might choose to manage, or more efficiently deploy, its capital by changing the capital allocation through product redesign and pricing — for example, into less capital intensive products, changes in business volume, expense control including outsourcing possibilities and underwriting and claims management. These strategic choices can enable a company to release capital required to meet a certain risk class or to benefit from increased diversification and use the gain (in the form of a reduced aggregate level of risk) for other purposes.
Sometimes, a more direct approach to restructuring capital may offer a solution. Raising new equity, restructuring debt, turning to sources of contingent capital or reorganizing group capital support arrangements are all options that should be considered when evaluating a company’s capital management strategy.
All companies should regularly investigate whether their existing reinsurance arrangements remain appropriate from the perspectives of both risk and capital management — for example consistency of risk retention across exposures and the use of quota share or stop-loss reinsurance.
Equally, revisiting risk transfer strategies in areas such as longevity risk, lapse risk and reinsurance arrangements, including more widely available financial reinsurance and securitization options, can support the capital management strategy.
In the risk transfer arena, the recent growth of insurance-linked securities (ILS) has helped to establish potential new sources of capital for insurers, while a generally soft reinsurance market over a number of years has also made traditional risk transfer options potentially more affordable and therefore more attractive.
From an organizational point of view, corporate restructuring, decisions about domiciles and branch structures, the use of captives and potential business sales or purchases can all contribute to capital management objectives (such as enhancement of risk diversification benefits and capital fungibility levels).
The strategic CRO can champion the idea that risk and capital are two sides of the same coin. Traditionally the risk and capital teams have often worked independently, but the benefits of supporting one another enhances strategic, capital management and risk management decisions, adding value to the enterprise.
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Matthew Ford leads the London life team of Willis Towers Watson’s Insurance practice, which offers a full range of consulting services and software to global, UK and EMEA insurers.
Kirsty Leece is a Director in Willis Towers Watson’s Insurance Consulting and Technology segment. She specializes in risk advice, having worked on a wide variety of ERM activities.