Annual Financial Report 2009
Ref 18/10 (Part 5)
Risk and capital management
Every business activity in our Group requires us to put capital at risk, in exchange for the prospect of earning a return. In some activities, the level of return is quite predictable, whereas in other activities the level of return can vary over a very wide range, ranging from a loss to a profit. Accordingly, over the past year we have expended substantial energy on improving our risk and capital management framework, to focus on taking risks where we:
· Understand the nature of the risks we are taking, and what the range of outcomes could be under various scenarios, for taking these risks
· Understand the capital required in order to assume these risks
· Understand the range of returns that we can earn on the capital required to back these risks
· Attempt to optimise the risk-adjusted rate of return we can earn, by reducing the range of outcomes and capital required arising from these risks, and increasing the certainty of earning an acceptable return.
We have embarked on a journey, which requires us to undertake this analysis on an ongoing and rigorous basis. We believe that this process will add value for our shareholders, and provide security to our other capital providers and clients. Value is added for shareholders if our process allows us to demonstrate sustainable risk adjusted returns in excess of our cost of capital. The process provides security to our capital providers and clients by assuring them that we are not taking on incremental risks which adversely affect the outcomes we have contracted to deliver to them.
This section of the Annual Report discusses how our Group manages Risk and Capital to generate value. These methodologies are embedded into the Group and business unit management decision making process, our 'first line of defence'. The role of the Group and Business Unit Chief Risk Officers (CROs) is to provide robust challenge to the management teams based on quantitative and qualitative metrics as part of their 'second line of defence' mandate. The Group Internal Audit team provides the 'third line of defence' challenge.
The pursuit of value requires us to balance risk assumed with capital required:
· If risk assumed is greater than the capital we have available, an adverse outcome will prejudice solvency
· If capital available is greater than the risk assuming opportunities that can be identified, the result will be a low risk but low return business
· It is possible to have a high risk, low return business, which represents the worst of all outcomes
· Our objective is an appropriate risk/capital balance, which seeks to provide higher certainty of achieved risk-adjusted returns within an acceptable level of risk assumed and capital required, but which does not expose us to unacceptably high risk of capital depletion in the event of adverse outcomes.
Our objective of balancing risk, return and capital has led us to enhance substantially our risk and capital management methodologies, in order to be able to identify threats, uncertainties and opportunities and in turn develop mitigation and management strategies to achieve an optimal outcome. The risk management community within the businesses have worked alongside management to develop and implement tools that assist in identifying risk appetite, setting risk strategy and making difficult decisions about which products and businesses are likely to provide acceptable risk adjusted returns, with an acceptable capital requirement and level of confidence about their achievement, and to exit from all of those which are not. Many of the outcomes of this work are discussed elsewhere in the Annual Report, while others will only emerge over time as the Group implements its preferred strategy.
We view risk not only as a threat or uncertainty, but also as a potential opportunity to grow and develop the business, within the context of risk appetite. Hence our approach to risk management is not limited to considering downside impacts or risk avoidance; it also encompasses taking risk knowingly for competitive advantage. The requirements of Solvency II will demand that companies consider their approach to risk, capital and value management more robustly and we believe that our initiatives to date fit well with these requirements.
Risk management is integral to the Group's decision making and management process. The Group's ambition is to embed it in the role and purpose of all employees via the organisational culture, thus enhancing the quality of strategic, capital allocation and day-to-day business decisions.
The past year has tested all companies' ability to minimise downside risk resulting from upheavals in the financial sector. Old Mutual's own risk management frameworks provided essential tools to enable us to take timely and informed decisions to maximise opportunities and mitigate potential threats. I believe that our activities, as outlined in this report, will provide you with a better understanding of these frameworks, as well as providing some insight as to how we intend to build on these to create better outcomes and fulfil the requirements of Solvency II.
Andrew Birrell
Group Risk and Actuarial Director
Achievements of 2009 and objectives for the future
In the following section we set out our progress over the past year and our objectives for the future, as we instil risk management techniques to generate value.
Achievements of 2009
Events during the past year tested the ability of financial sector participants to respond quickly to significant market shifts. Old Mutual's capability has been evident in our response to the financial crisis and the consequent events during 2009 which shook investor confidence. We faced risks head on and came through stronger than before. Our consistent Group-wide 'three lines of defence' approach enabled us to quantify exposures quickly and, where appropriate, implement strategies to mitigate levels of risk deemed to be beyond our appetite. It is important to note that certain risk exposures are still higher than we would like, and that it is difficult to take action to reduce them immediately. In these instances we have implemented arrangements that allow us to monitor exposures continuously, implement proactive measures and ensure that they do not increase further.
In March 2009 our Group Chief Executive set out the Group's strategic priorities. One of these was to improve governance and risk management. The objectives of the Group's risk management community were wholly aligned with this requirement. In the risk report contained in the 2008 Annual Report and Accounts we stated our risk management priorities for 2009 were to embed the enhancements made to the risk management system during 2008 and strengthen our risk management framework. During 2009 we have taken significant strides in achieving those priorities, particularly in quantifying exposures, increasing the sophistication of the methodologies we use to balance risk, capital and return, and implementing three year exposure determinations as part of our business-planning processes. These processes ensure risk exposure levels are effectively monitored and managed in relation to the limits set. Over the past year, Old Mutual's capital and liquidity positions have both strengthened substantially.
Objectives for the year ahead
We are committed to the continued development of our risk management framework. Old Mutual's integrated Capital, Risk and Financial Transformation programme ('iCRaFT') is at the heart of our objective to embed a culture of managing for value. As a business owned initiative, rather than a risk and actuarial programme, iCRaFT will deliver positive benefit to the Group, with the additional benefit of full compliance with the requirements of Solvency II. We began the programme in April 2008 and it is intended to be fully delivered by October 2012. Our Financial Controls Initiative, now a project in its own right since having become distinct from the Finance 2010 project, began implementation in 2008 and is intended to ensure that the information that we produce for internal and external stakeholders is accurate and error free, as a result of a thorough review of all processes and controls in producing such information and the application of best practice in financial controls. Details of these projects are discussed later in this report.
Accountability for risk management, and transparency of risk issues are crucial to our success. Responsibilities for managing risk are allocated to all managers within the Group and risk management requirements have been embedded in our performance management programme.
Ultimately the success of risk management will be determined by the extent to which it embeds in the corporate culture and leads to demonstrably better outcomes. The Group Operating Model work, referred to in the Governance section of this report, is designed to reinforce the governance structures in place to support risk management across the Group, and the transparency of information flows. By setting minimum standards for business units to adhere to, we aim to achieve consistency in our approach across the Group.
Robust, evolving enterprise risk management
We believe effective risk management is more than just the collection and analysis of data. It also encompasses the insights delivered by information which facilitate appropriate actions. Old Mutual benefits from having enhanced its Group risk management framework, which gives full Group-wide coverage of a variety of risks.
Our annual risk cycle is designed to give management relevant, up-to-date information from which trends can be observed and assessed. The governance structure supporting our risk cycle is designed to deliver the right information, at the right time, to the right people. In line with the industry's increasingly sophisticated management of risk, we continued to develop and embed our risk appetite framework during 2009 particularly our risk appetite assessment techniques.
The following sections set out our risk management framework, illustrating each layer of tools and systems provide us with assurance to manage the upside of risks better by maximising opportunities while minimising the downsides, or threats. In this context, this section covers:
· Risk management governance
· Group oversight, including:
o Strategy and business planning
o Risk appetite
o Stress and Scenario testing
o Policy setting
· The risk framework employed by each of our business units to provide consistent information.
Risk Management Governance
We strengthened our risk governance framework in 2009 to encourage greater discipline, transparency and discussion in relation to risk. This involved consolidating our 'three lines of defence' approach to provide greater solidarity within each of the lines. Changes included:
Reviewing and enhancing the Group's risk governance structure by strengthening the mandate of the Group Risk & Capital Committee (GRCC), now renamed as the Group Executive Risk Committee (GERC).
Creating stronger risk and capital interactions between the key committees at Group level: Group Executive Committee, the GERC, the Group Capital Management Committee (GCMC) and the Group Audit and Risk Committee, clarifying the business unit mandate and authority to execute risk responsibilities effectively.
Strengthening the risk management role within the business units by ensuring that each unit has a Chief Risk Officer with direct access to the Group Risk Director.
In this report, we focus on the responsibilities of the two second line of defence committees illustrated below, being the GERC and the GCMC. The responsibilities and remit of the first and third line forums can be found in the Governance section of this report.
Group Executive Risk Committee
The GERC was established in July 2008. During 2009 it has proven to be a key decision making and oversight body, proactively setting risk appetite limits, ensuring risk exposures are within established parameters and overseeing the Group risk profile. It has added value by overseeing the resolution of Group issues in a timely and effective manner, ensuring both short and long-term business strategy is in line with our agreed risk appetite.
The GERC committee comprises senior Group executives, from Risk, Actuarial, Capital, Compliance, and Internal and External Audit. Its main responsibility is to support the Group Risk and Actuarial Director in understanding and overseeing the implementation of the Group's risk framework, including risk appetite and capital management.
The GERC key responsibilities are:
· Monitoring and reviewing the Group's risk profile including losses and control breakdowns
· Setting risk appetite limits, allocating these to the Group's respective business units to optimise results
· Providing assurance that effective risk optimisation is being fully achieved both within business units and across the Group
· Providing oversight of capital management to ensure allocation is consistent with risk appetite limits.
The GERC receives reports from Group Risk and Actuarial, GCMC, Group Finance, Treasury and iCRaFT. It provides input to the Group Executive Committee and the Group Audit and Risk Committee. The GERC works closely with the GCMC.
Group Capital Management Committee
The GCMC ensures that the Group's capital is managed in a consistent manner, aligned to the expectations of our shareholders, and that this capital is provided on the basis of the appropriate level of prospective return versus risk, as identified by the GERC. It is the mechanism by which the Group ensures that capital is allocated to business units in line with the Group's strategy, and that appropriate return rates are set and monitored. If necessary it will reallocate capital where appropriate for greater reward.
The GCMC committee comprises senior Group executives, including the Group Chief Executive, Group Finance Director and the Group Risk and Actuarial Director, along with representatives from Capital, Treasury, Strategy and Compliance.
The GCMC key responsibilities are:
· Recommending to the Board the Group's capital allocation, capital structure and investment strategy
· Setting an appropriate framework for managing capital
· Issuing guidelines and/or recommending targets to ensure the appropriate management of capital within the agreed risk appetite limits.
These committees support the second line of defence to ensure that the Group Executive Committee maintains clear sight of the risk exposure and capital allocation across the Group to facilitate first line of defence decisions.
In 2010 we expect the roles of these committees to strengthen further, particularly in their interactions with business unit risk and capital committees. Recommendations arising from the Walker Review of "Corporate governance in UK Banks and other financial industry entities" were published on 29 November 2009. Old Mutual already has in place a number of the recommendations proposed by the Walker Review, such as the role of the Board. We anticipate further benefits as we adopt the recommendations to implement a Board Risk Committee, distinct from the Board Audit Committee, in April 2010. The separation of the disciplines will reinforce the risk culture and increase risk specific challenge to the benefit of the organisation, shareholders and other stakeholders. The major business units will mirror the Group governance structure through business unit level Board Risk Committees.
These changes are incorporated into the wider Group Operating Model changes, details of which are included in the Governance section of this report.
Group oversight approach
Setting the tone from the top is important for us, providing the parameters within which we are able to manage our capital and value objectives on a risk sensitive basis. Our oversight starts with the strategy setting and business planning process. These plans help us articulate our appetite for risk, which is then set as risk appetite limits for each business unit to work within. Group also set out parameters in policies for all business units to adhere to. Details of these tools are set out below.
Strategy and business planning
Risk management is embedded in our business strategy and planning cycle. Testament to this is the inclusion of risk management as one of our strategic priorities. By setting the business and risk strategy, we are able to determine appropriate capital allocation and target setting for the Group and each of our businesses.
All business units are required to consider the risk implications of their annual plans. As the following section highlights, these plans include analysis of the impact of objectives on risk exposure. Throughout the year, we monitor business performance regularly focussing both on financial performance and risk exposure. The aim is to continue the process of integrating risk management into the planning and management process and to facilitate informed decisions. Through ongoing review, the links between risk appetite, risk management and strategic planning are embedded in the business-as-usual environment so that key decisions are made in the context of the risk appetite for each business unit.
Risk appetite limits
Risk appetite provides us with a basis for formally reviewing and controlling business activities by setting boundaries that ensure that business activities are aligned to stakeholder expectations and are of an appropriate scale, relative to the risk and potential reward.
In 2009 we required all business plans to include an analysis of risk appetite impact throughout the 3 year plan period. This increased transparency highlighted where management actions have an impact on our risk-adjusted performance, allowing us to maximise our risk adjusted return and shareholder value. Early identification of areas that could potentially breach limits has allowed the timely formulation of action plans to avoid this.
Setting risk appetite limits for the businesses and measuring their exposure against those limits allows us, amongst other things, to:
· Allocate capital on a risk adjusted performance basis
· Consider risk based pricing and product development to set product pricing terms and charging structures
· Improve decisions regarding portfolio management and optimisation.
This not only allows us to balance risk, capital and return across the Group but also provides us with an enhanced understanding of the risks embedded in our business. It provides a framework for capital allocation decisions taken by the Group Capital Management Committee.
Throughout the year, business units calculate their risk exposures against the appetite set by the Group. The five quantitative measures we use to express our risk appetite limits and exposures are:
· Economic capital at risk (ECaR)
· Earnings at risk (EaR)
· Cash flow at risk (CFaR)
· Operational risk (OpRisk)
· Financial Group Directive (FGD) surplus capital at risk (FCaR).
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Risk appetite metric definitions |
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Metric |
Definition |
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ECaR |
The value of assets required to ensure that the business concerned can meet in full its obligations to policyholders and senior creditors at a 99.93% confidence level, which is the probability placed on a target A-rated bond not defaulting in the next year |
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EaR |
The reduction in pre-tax IFRS adjusted operating profit over a one-year forward-looking time horizon following a 1 in 10 year loss event |
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CFaR |
The reduction in the potential cash remittable to Old Mutual Group on a 1 in 10 year basis |
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OpRisk |
The reduction in economic value due to 1 in 10 year operational loss events and expected day-to-day losses and reputational impacts |
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FCaR |
The reductions in FGD surplus at the reporting date. This is tested following both 1 in 10 years and once in 200 years loss events |
The embedding of our risk appetite methodology is a cornerstone of our risk analysis capability. Using one of the metrics as an example, our economic capital calculations provide a long-term view of the risks in the business and oversight of the key threats facing the Group if an extreme event occurs. ECaR indicates the reduction in post-tax economic value (broadly defined as market consistent embedded value for life companies or IFRS equity for other Group companies) over a one-year forward-looking time horizon that should only be exceeded seven times in 10,000 years (a 99.93% confidence level consistent with our target 'A' rating).
ECaR helps us to optimise risk-based decisions. The stress test allows us to monitor overexposures and deepens our understanding of where the business could further improve its capital allocation. We have set appetite limits for economic capital based on the ratio of available financial resource divided by economic capital.
FCaR was added as a new risk appetite metric during the year, measuring the potential reduction in FGD surplus capital in various adverse economic scenarios. We recognise that FGD is a key regulatory measure which it is particularly important to monitor in volatile economic conditions where our policyholder and shareholder assets can significantly impact our position particularly since we hold these assets in a variety of currencies.
Stress and scenario testing
We perform regular stress tests and sensitivity analysis to monitor the robustness of our regulatory and capital position. These assessments give management a view on the capital that would be required if any of the scenarios became reality. They help management to prepare for significant changes in the environment and protect shareholders and investors from unexpected loss. Information on stress testing is reported to the GERC, and to management so that decision making is based on an understanding of potential impacts.
Policy setting
Group policies set out our mandatory minimum requirements that business units must follow. At the end of 2009 there were 27 Group policies in place covering a range of topics, including Liquidity Risk, Market Risk, New Product and Business Approval, Capital and Treasury Risk and Business Continuity.
Business units ensure that their local policies and procedures are aligned to the Group policy suite. In many cases business unit policies include requirements beyond the Group's mandatory minimum requirements and incorporate applicable local regulations. The Group policies are mapped to our risk categorisation model and form a key part of our governance framework. Their implementation allows the Group to establish a common framework of control across the business units.
Collectively known as the Group Policy Suite, these policies are agreed by the GERC and approved by the Group Audit & Risk Committee. Once approved, policies are communicated to each business unit for compliance. Every six months, business units must provide an attestation to the Group on compliance with these policies.
Consistent business unit risk methodology
Supporting the planning cycle, risk appetite setting and stress testing, we use a number of risk management tools to manage the identification, management and escalation of risk within the businesses. All business units adopt a consistent methodology ensuring that information can be reviewed and analysed on a like-for-like basis. The methodology employed by the business units includes:
· Product development process
· Risk categorisation
· Risk and control self-assessment (RCSA)
· Monitoring
o Operational risk event data
o Key risk indicators
· Market consistent embedded value (MCEV).
Product development process
Risk assumption frequently starts in the product development process, where new products are designed, priced, implemented on administration systems and sold to customers. The Board implemented a centralised approval process for all products which may have implicit or explicit guarantees, in order for product design to be better understood and for aspects such as pricing, administration arrangements, marketing material and investment requirements to be rigorously challenged by an independent party. The Group Risk & Actuarial Director is responsible for approving products which contain guarantees.
Risk categorisation
Since 2008, risk categorisation has promoted and established the consistent use of a common risk language across the Group allowing meaningful aggregation and comparison of risks and issues and enhanced risk reporting to the Audit and Risk Committees and data sharing between business units. We will review our categorisation model in the coming months to ensure it is still appropriate in the current environment.
Risk and control self-assessment (RCSA)
This industry standard approach to identifying, assessing and controlling risk is used by our business units to consider all risks consistently. Each business unit completes an RCSA regularly and escalates any significant new risks or issues to senior management immediately. This gives Group management an up-to-date view of risks and ensures that decision makers are aware of areas of concern promptly so that appropriate action can be taken.
The RCSA process incorporates:
· Ongoing identification of risks that threaten the achievement of objectives
· Assessing these risks in terms of financial and qualitative impacts such as reputational, regulatory or customer
· Determining whether the level of risk being taken is acceptable
· Determining and implementing management action plans to bring risk exposures to an acceptable level if required
· Ongoing monitoring and reporting of risks, control effectiveness and actions.
RCSA has strengthened our Group oversight and enhanced the flow of information resulting in increased transparency, timely identification of risk trends across the Group and control improvements. The improved consistency of risk assessment in business units has enabled aggregation at a Group level to gain a much better informed picture of the overall Group profile.
Monitoring
Operational risk event data
We have successfully improved transparency and data sharing by rolling out the formal loss data collection standards developed in 2008 for the operational and strategic risk categories and embedding them across the Group. Standardisation of loss information across the Group has facilitated early identification of trends leading to control improvements, enhanced risk mitigation and improved aggregation of losses.
Our aim is to mitigate further operational risk events that lead to losses, within reasonable expectations, and to learn from all losses to improve processes and prevent recurrence.
The Group subscribes to a database outlining significant operational losses experienced by other companies. Data from this source helps us to take mitigating actions proactively, to avoid incurring similar losses.
Loss data collection has provided us with excellent ways to improve our customer experience. For example, during 2009, we observed a number of operational losses resulting from simple process errors. By collecting data systematically and consistently we have been able to pinpoint repetitive process failures and actively improve controls in these areas. This is an area that we are now focusing on, to make rapid changes that will provide a better customer experience and reduce unexpected losses.
Key risk indicators (KRIs)
KRIs provide data on whether a risk is trending up or down, or is stable, both now and in the future. This acts as an early warning system, enabling management to take preventative action against the risk materialising.
During 2009 we identified KRIs against each of the Group's top risks. We see KRIs as a vital step forward in making risk information more transparent, and have begun data collection from the business units. In 2010 we will continue to enhance these processes through trend analysis and threshold setting.
Market consistent embedded value (MCEV)
In addition to the other tools described here, we use MCEV extensively as a tool for forward-looking assessment and monitoring of risk in the Group's life insurance companies. By analysing the source of MCEV operating earnings we can assess where emerging experience is significantly different from expectations. This allows senior management to identify emerging risks and trends and take remedial action where necessary. The MCEV sensitivities allow us to understand the impact of changes in economic, demographic and operating conditions on the Group's embedded value. Finally, the market consistent value of new business (MCVNB) provides information on the extent of investment risk that is embedded in new products.
Significant risks to Old Mutual
Old Mutual's weakness in certain business units in the past was caused by a combination of a small number of poor investment decisions, insufficient consideration of the volatility of certain guaranteed products and executive short-term reward for sales growth in certain businesses resulting in incorrect long-term business decisions. Although these instances were limited to a small part of the Group, Old Mutual was not alone in this regard. All financial service organisations were required to act quickly in the recent tough environment. Although these conditions brought many of these shortcomings to light, they have made it even more critical for organisations to ensure they fully understand the risks they are taking on - and the interdependencies between them - in order to hold sufficient capital and liquidity to cover a combination of risks occurring at once.
We do not only look at risk as presenting threats. They also present opportunities and are impacted by uncertainties. When considering risk, we need to consider not only the downside risk, but also the potential upside in order to make the right decisions.
The following table lists some of the most significant risks Old Mutual faced during 2009:
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KRI Examples: |
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KRI |
Related risk type |
What it tells us |
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Expense levels - actual v forecast |
Business risk |
If trending up, the Group's costs will be higher than planned, which if not compensated by a rise in income will mean profits will be lower than forecast. This trend will also show in increased exposure to business risk. The indicator allows proactive analysis to identify the reasons for the increase in expenses and to put appropriate management actions in place. |
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Level (%) of voluntary turnover in key jobs |
Operational risk |
If trending up, this indicator can highlight a failure to retain key talent, which could mean recruitment costs are higher than planned and an increased exposure to this risk as key jobs are left vacant for a time. The indicator allows analysis of the reasons for the leavers and facilitates actions to be put in place to prevent repetition. |
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Assets in excess of local regulatory capital requirements |
Liquidity risk |
If trending down, this indicator provides Group with knowledge that the solvency position is worsening and the risk of regulatory intervention is increasing. The reasons for the reduction in surplus assets can be identified and management actions taken to ensure the trend does not continue. |
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SIGNIFICANT RISKS TO THE OLD MUTUAL GROUP |
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Risk type |
Risk as a threat and uncertainty |
Mitigating actions and opportunities |
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Credit risk |
The Group is exposed to the risk of credit defaults. This includes counterparty risk where an asset (in the form of a monetary claim against a counterparty) is not repaid in accordance with the terms of the contract. Credit risk also encompasses lending risk (for example within our banking businesses) where a borrower may be unable to repay amounts owed.
Credit risk also arises from financial guarantees that the banking businesses have to act upon where clients default on their obligations with respect to the financial guarantees. |
Although in some instances it does not pay to take credit risk, there are situations when expected returns mean that there are significant rewards for assuming this risk.
We monitor credit exposures and set limits in each business unit, reducing our risk exposure by requiring counterparties to have a specified credit rating.
We also check to ensure that we do not have a concentration of exposure to single issuers, sectors or investment types. |
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Business risk |
We operate in a highly competitive environment. If we are not able to compete successfully there is a risk of reduced market share, revenues or profitability.
The profitability of our businesses could be adversely affected by a worsening of economic conditions. Changes to the distribution environment (for example through regulation or a failure of distribution providers) could have an impact on our business.
This risk also covers the risk of terminations and expenses being higher than expected, which would prejudice product profitability and sustainability. |
We offer innovative products to suit different clients and different client needs, enabling us to find opportunities even in challenging market conditions. We closely monitor lapse rates and persistency information, adapting our business approach as necessary. Old Mutual is diversified across geographies and product lines, minimising the impact of sector or territory specific economic downturns.
We monitor developments in the distribution sectors across all geographies and our strategic planning and research teams help position us to reduce this risk. |
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Market risk |
The risk of loss as a result of adverse changes in the market value of assets and liabilities. This includes the risk of falling equity values or losses due to volatility in asset values as well as the impact of changing interest rates, credit spreads and currency fluctuations.
Some of our life assurance businesses contain investment guarantees and options. A reduction in interest rates and equity markets can cause more of these to be in-the-money, with a potentially adverse impact on profit. |
The upside presented by market risk is evident when equity values rise, or interest rates move favourably. Then the Group is well positioned to gain over and above the benchmark, particularly in retail and institutional asset management products and activities, since fee income will rise faster than associated expenses.
Business units exposed to downside market risk as a consequence of the liabilities they have underwritten are required to take account of the structure of their asset and liability portfolios as well as the local regulatory environment and Group policy requirements. Actions used by individual business units to manage market risk include asset liability matching, interest rate swaps and hedges to manage interest rate risk, equity hedges to manage equity risk and currency swaps, currency borrowings and forward foreign exchange contracts to mitigate currency risk. |
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Liquidity risk |
The risk that available liquid assets will be insufficient to meet changing market conditions, liabilities, funding of asset purchases or an increase in client demands for cash. |
We aim to maintain a prudent level of liquidity consistent with regulatory expectations. Our Group-wide liquidity policy sets out the parameters within which all business units must operate in order to identify, measure and manage liquidity risk. The Group Capital Management function reviews capital and liquidity positions, with the Group Risk Executive Committee providing additional oversight and challenge.
By monitoring our liquidity position prudently, we are well positioned to identify surplus liquid assets available. |
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Operational risk |
The risk arising from operational activities, for example a failure of a major application, or losses incurred as a consequence of negligence or fraud. |
Taking greater operational risk rarely gives the Group greater reward and therefore we aim to minimize our operational risk exposure across the Group.
The Group is currently developing a strategic risk management system which will increase our understanding of the operational risks in the business and facilitate the improvement in the controls to reduce losses. The Group has purchased a database of operational risk losses in other organisations, which ensures we are proactive in mitigating risks that have crystallised in other companies before they affect Old Mutual. Operational risk is one of the metrics in our risk appetite framework and is monitored with actions taken if it approaches the limit. |
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Underwriting risk |
We are exposed to underwriting risk by issuing insurance contracts. The business units which incur significant underwriting risk are Old Mutual Bermuda, Old Mutual Specialised Finance, Old Mutual Life Assurance Company of South Africa Limited, Nedgroup Life Assurance Company Limited and Old Mutual Financial Life Insurance Company (OMFLIC) which provide long-term insurance and Nedgroup Insurance Company Limited and Mutual & Federal, which provide short-term insurance.
In respect of long-term insurance, the risk of loss is caused by insurance claim frequencies and sizes being larger than expected. This includes the risk of mortality/ morbidity being higher than expected.
With short-term insurance the risk relates to an increased number of claims due to accidents or adverse weather conditions. |
Our Group level liability risk policy sets out the internal controls and processes that we must follow in long-term and short-term insurance. Business units have more detailed underwriting policies. Actuarial modelling is used to calculate premiums and monitor claims patterns. The internal controls designed to mitigate operational risks help ensure that we feed robust data into our models. Analysis of MCEV plays a key role in ensuring we are managing these risks pro-actively.
In banking, our risk management standards require strict limits to be set in relation to underwriting limits, and mandates the review of gross as well as net exposures, to understand the impact of hedge failure. |
Credit risk
Business units are responsible for establishing appropriate systems and governance structures to ensure that they actively monitor credit risk in a manner consistent with the level of credit risk they face and in line with Group policies and principles. Business units are responsible for ensuring their credit risk exposures stay within the risk appetite limits set by the Group.
Our in-house Risk Exposure Aggregation System (REAS) allows us to monitor Group-wide counterparty risk. It aggregates nominal exposures reported by the business units but does not collect any VaR-related data (such as probability of default). In 2010, we will further enhance our oversight of Group credit risk by implementing a new counterparty exposure system through the iCRaFT project.
The new counterparty exposure system will facilitate a VaR approach to setting Group level counterparty exposure limits as well as providing the concentration risk capital requirement for the Group's internal capital model. It will also allow more timely and proactive monitoring of the additional risk arising from the aggregation of counterparty exposures across different business units and geographies.
The Group Executive Risk Committee monitors and challenges accumulations of credit exposures across the Group, arising due to same-name exposure held in different business units. As at 31 December 2009, the Group's top exposures by sector are:
Banks & Financial Services 30%
National & Local Government 17%
Real Estate 7%
Telecommunications Services 6%
Mining 4%
Commercial Mortgage Backed Securities 4%
Electricity 3%
Diversified Industrials 3%
Other 26%
The two main sectoral exposures are both driven by the inclusion of Nedbank's banking book exposures:
· As a bank, Nedbank inevitably has large exposures to the other South African banks; this sector also includes the Skandia Money Market Fund and the financial sector corporate bond portfolio of the US Life business
· The exposure to government debt includes a substantial amount of South African government debt which Nedbank holds in respect of its reserve requirements.
The main change in the sectoral exposures during 2009 has been a reduction in banking and financial exposure, offset by an increase in government exposure. This is a consequence of, inter alia, the proactive de-risking of the US Life bond portfolio through a shift out of corporate bonds into US Treasuries.
Market risk
Market risk is the risk of changes in the value of our financial assets or financial liabilities arising from changes in equity, bond and real estate prices, credit spreads, interest rates and foreign exchange rates. Market risk arises differently across the Group's businesses depending on the types of financial assets and liabilities held.
Market equity risk is the most significant market risk type across the Group. We monitor our market exposures for early identification and management of these risks. We conduct separate analyses to understand the impacts on both shareholder and policyholder assets.
In respect of the investment of shareholder funds, equity price risks are addressed in the Group's various investment policies, which tightly limit the opportunity for business units to invest their own capital in equities or equity funds. As a result, the shareholder assets invested to back the statutory capital requirements across the Group are typically invested in sovereign bonds and cash. There is some remaining shareholder exposure to equity markets within OMLAC(SA). To mitigate the risk of falling equity markets adversely impacting the shareholder capital position, we use extensive equity hedging. We regularly evaluate the protection offered by the hedges that we operate in order to decide the appropriate level and extent of hedging that we need.
Sensitivities to adverse impacts of changes in market prices arising in our insurance operations are set out in the Old Mutual market consistent embedded value supplementary basis information section of this report. For our insurance operations, equity, property price, credit spread and interest rate risk are modelled in accordance with the Group's risk based capital practices, which require sufficient capital to be held in excess of the statutory minimum to allow us to manage significant exposures in line with the Group risk appetite.
Each of the Group's business units has its own policies, principles and governance to manage its market risk in accordance with local regulatory requirements. These are supplemented by Group-level monitoring as part of the risk appetite framework. The impacts of changes in market risk are monitored and managed using sensitivity analyses, through the business units' own regulatory processes, with reference to the Group's risk appetite framework, and by other means. This work is complemented by the Group's market consistent embedded value reporting processes, which include assessments of the sensitivity of our capital position and embedded value to various market changes.
Business risk
A significant component of the regular management information communicated at Group level relates to ongoing measurement of the level of sales of each business, the level of expenses in that business against planned expenses and the expenses in previous years, as well as the level of lapse and surrender activity.
All new life assurance products with financial guarantees within the Group are subject to a rigorous approval process, culminating in the Group Risk and Actuarial Director either approving or rejecting the product prior to it going to launch. In all cases there are a series of product development committees and stringent requirements which must be passed before the new product can proceed to launch. Many of these additional requirements have been introduced following experience relating to the Old Mutual Bermuda Variable Annuity product. All potential risks to the Group as a result of writing the new product are considered prior to the product being escalated to the Group Risk and Actuarial Director for approval. These risks include, but are not limited to: investment, expense, surrender, mortality and operational risk (including reputational effects) impacts. An assessment of the cost of offering the financial guarantee is also included. Extensive scenario and stress testing is undertaken for all new product developments, so that the new business margin and market consistent value of new business can be assessed under a range of different adverse scenarios, including a worst-case scenario as well as the base case. We also evaluate all new product developments in light of our commitment to treat customers fairly.
Quarterly Business Reviews chaired by Group with each of the businesses, ensures regular dialogue and oversight of business performance. At each meeting business risk is monitored and, where appropriate, actions are agreed to mitigate negative trends. MCEV is a particularly useful tool that is used to monitor ongoing experience as it emerges.
Insurance risk
The Group assumes insurance risk by issuing insurance contracts under which it agrees to compensate the policyholder or other beneficiary if a specified uncertain future event affecting the policyholder occurs. This risk includes mortality and morbidity risk in the LTS business and a risk of loss from fire, accident and other sources in our short-term insurance business. The table below shows our key insurance risks along with risk management actions within the LTS and short-term insurance businesses:
|
KEY INSURANCE RISKS |
|
|
|
Risk |
Definition |
Risk management |
|
Underwriting risk |
Misalignment of policyholders to the appropriate pricing basis or impact of anti-selection, resulting in a loss. |
Experience is closely monitored. For universal life business, we can reset mortality rates. Underwriting limits, health requirements, spread of risks and training of underwriters all mitigate the risk. |
|
HIV/AIDS risk |
Impact of HIV/AIDS on mortality rates and critical illness cover. |
Wherever possible we write products that allow for regular repricing or are priced to allow for the expected effects of HIV/AIDS. We require tests for HIV/AIDS and other tests for lives insured above certain values: a negative test result is a prerequisite for acceptance at standard rates. |
|
Medical developments risk |
Possible increase in annuity costs due to policyholders living longer. |
For non-profit annuities, improvements to mortality are allowed for in pricing and valuation. Experience is closely monitored. For with-profit annuity business, the mortality risk is carried by policyholders and any mortality profit or loss is reflected in the bonuses declared. |
|
Changing financial market conditions risk |
Lower swap curves and higher volatilities cause investment guarantee reserves to increase. |
A discretionary margin is added to the value of guarantees, determined on a market consistent stochastic basis and included in current reserves. A partial hedge is in place (South Africa). Fewer and lower guarantees are typically provided on new business (South Africa). |
|
Policyholder behaviour risk |
Selection of more expensive options, or lapse and re-entry when premium rates are falling, or termination of policy, which may force the sale of assets at inopportune times. |
Experience is closely monitored, and policyholder behaviour is allowed for in pricing and valuation. |
|
Catastrophe risk |
Natural and non-natural disasters, including war and terrorism, could result in increased mortality risk and payouts on policies. |
We have a catastrophe stop loss and excess of loss reinsurance treaty in place which covers claims from one incident occurring within a specified period between a range of specified limits. |
|
Policy lapse risk |
Where policyholders have an option to terminate the policy, this could force the sale of assets at inopportune times. This creates the risk of capital losses and/or reinvestment risk if market yields have decreased. |
Experience is closely monitored, and policyholder behaviour is allowed for in pricing and valuation. |
Our insurance risk exposure is relatively low as we effectively manage this through:
· Diversification of the business over several insurance classes and a number of geographical segments
· The relatively weak correlation of insurance risk with our other risk types, which reduces our exposure after diversification
· Maintenance and use of management information systems which provide current data on the risks to which we are exposed
· Use of actuarial models to calculate premiums and monitor claims patterns using past experience and statistical methods
· Guidelines for concluding insurance contracts and assuming insurance risks, eg underwriting principles and product pricing procedures
· Reinsurance to limit our exposure to large single claims and catastrophes
· An effective mix of assets that back insurance liabilities based on those liabilities' nature and term.
Reinsurance plays an extremely important role in the management of risk and exposure in our short-term insurance business, Mutual & Federal. The Group makes use of a combination of proportional and non-proportional reinsurance to limit the impact of both individual and event losses and to provide insurance capacity.
Involvement in any property catastrophe loss is limited to approximately £6.3 million for any one event and the level of catastrophe cover purchased is based on estimated maximum loss scenarios, in keeping with accepted market norms (this is based on a limit of R75 million for one event at an estimated exchange rate of R11.90 to the pound).
General insurance risk includes the following risks:
· Occurrence risk - the possibility that the number of insured events will differ from those expected
· Severity risk - the possibility that the costs of the events will differ from those expected
· Development risk - the possibility that the amount of an insurer's obligation may change at the end of a contract period.
The majority of the Group's general insurance contracts are classified as 'short-tailed', meaning that any claim is settled within a year after the loss date. This contrasts with 'long-tailed' classes where claims costs take longer to materialise and settle. Our long-tailed business is generally limited to personal accident, third party motor liability and some engineering classes; in total it comprises less than 5% of an average year's claim costs.
Operational risk
Operational risk represents approximately 10% of our aggregate Group risk profile. This risk could result in losses from internal failures relating to processing, systems and people as well as losses relating to external triggers such as flooding or retrospective changes in legislation. By its nature, operational risk is difficult to eliminate entirely. But we aim to keep it to a minimum and certainly within our risk appetite as we are unlikely to gain significant reward from taking operational risk. That is why operational risk is one of the metrics in our risk appetite framework.
Our highest operational risk exposures arise within LTS because of its size relative to the other divisions and business units, which are all currently within their operational risk appetite.
The Group RCSA process places responsibility directly onto line management for identifying, monitoring and managing operational risk within each business unit. This is supplemented by the operational risk event identification and recording process which was embedded across the Group in 2009. The improvement in data will facilitate identification of areas where controls need to be more robust. Identifying the level of losses in relation to a particular risk will start to help us assess more accurately the potential impact of any further occurrences and improve the accuracy of the RCSA assessment. Our management of risk will only be effective if the RCSA and loss event recording drives management action, often in the area of process re-engineering, to minimise the scope for recurrence.
The RCSA process has helped us identify a significant number of operational risks ranging from failures in our underwriting processes to the effects of a pandemic on business operations. These are reassessed and monitored by the GERC and Group Executive Committee at least quarterly.
One key factor in our future success will be our ability to analyse the increased level of risk data collected. This is dependent on IT capability. We recognise that now is the right time to review our risk management system to gain the greatest benefit and after much due diligence on a number of systems we have chosen Open Pages as our long-term strategic system. The new system is now in the development phase: roll-out starts in Q2 2010 and is scheduled to complete in 2011. We expect operational risk management to become increasingly robust throughout H2 2010 as the system embeds.
The main operational risks facing the Group are:
KEY OPERATIONAL RISKS
|
Risk description |
2009 commentary |
Key mitigations |
|
Strategy/change risk This was identified as a principal risk by the Board and Group Executive Committee. It arises if the Group is unable to effect the necessary culture shift to implement its change initiatives effectively, in response to the changing market environment. |
We set new strategy in 2009, which identified a number of change initiatives to position the Group for sustainability and growth in the future. |
To manage these change initiatives, we appointed a Head of Strategic Implementation in February 2009 as part of the Group Executive Committee and set up a Strategic Implementation Department to monitor and guide the strategic programmes. As part of this process regular progress reports are made to the Group Executive Committee. |
|
Regulatory risk Regulatory requirements and changes are increasing, and are likely to continue to do so over the time ahead: compliance with the new Solvency II requirements is due in 2012. If we do not correctly assess the impact of these changes or implement them in a timely manner a fine, penalty or regulatory censure could result. |
This risk is increasing for the Group for a number of reasons.
2009 market events have increased regulatory expectations across the industry, with particular emphasis on capital and liquidity issues. |
Old Mutual is well positioned to meet increased regulatory expectations. |
|
Processing risk Our businesses rely on their systems, operational processes and infrastructure to help process numerous transactions daily across various different markets. With a large number of such processes comes significant operational risk arising from breakdowns in the processes, human error or IT systems issues. |
Implementation of the operational risk event reporting process during 2009 has highlighted that this risk is crystallising regularly. This has led to a number of actions and improvements to the framework which should embed and start to reduce losses in 2010. |
We have established a number of Group strategic implementation programmes to review, evaluate and document key business processes, facilitating a thorough understanding of the relationships between these processes and highlighting areas where process or control improvements are required. |
|
IT infrastructure During 2009 a Group-wide IT benchmarking exercise identified some areas for improvement across our IT infrastructure and control environment. There is a risk that if these are not completed within an appropriate timescale we could experience problems with the current IT systems. |
The consolidation of our long-term savings business presents opportunities to further enhance our IT infrastructure and exploit IT synergies. This work started in 2009. |
We have established a Group strategic implementation programme to address these issues and identify and implement IT synergies across the Group. This will be further supported by the iCRaFT initiative, and will be tested on the risk management system as one of the initial Group-wide IT roll outs. |
|
HR risk This was identified as a principal risk in 2008. The demand for staff in a number of key disciplines in the industry has increased, particularly driven by increasing regulatory change, which could lead to Old Mutual employees resigning and joining competitors. |
During 2009 our turnover of key management reduced. Market conditions and the reorganisation of the business promoted stability and contributed towards this reduction. |
Group-wide management development programmes and formal succession planning are in place. |
Other risks impacting the Group risk profile
Liquidity risk
Our liquidity position remains sound at both Group holding company and business unit level. The Group holding company is funded through a combination of internal cash resources and undrawn bank credit facilities. Business units' liquidity needs are met from their own internal resources, and where appropriate, either locally arranged external lines or funding lines from the holding company.
In aggregate the Group has £1.2 billion liquidity headroom, comprising £447m of cash and £773m of undrawn committed facilities; this includes the proceeds of a £500 million senior bond issued last October.
Financial Groups Directive surplus
As part of the Group's regular and ongoing risk appetite submissions, business units are asked to assess the impact of various adverse scenarios on their statutory surplus and ultimately their FGD surplus. This allows the Group to quickly identify those drivers key to maintaining the target level of FGD surplus. Management has access to a heat map which allows continuous monitoring of the surplus position in our changing economic environment.
Long-Term Savings (LTS)
Our LTS businesses represent a significant part of the Group's earnings and capital (see the segmental disclosures in this report) and the aggregation of the primary risks to Old Mutual is naturally greatest within this segment. The most significant risks in LTS overall are business, market (equity and interest) and credit risk.
LTS has an inherent resilience against specific risks because its product and geographic diversity spread risk across its various businesses. The Group exposures within LTS break down as follows:
LTS business risk
Business risk is the risk that the LTS business performance will be below plan and therefore negatively impact on earnings and capital. The drivers that could result in this include negative variances in new business volumes, new business margins, lapse experience and expenses.
Lapse risk includes the risk that policyholders surrender their policies earlier than expected, resulting in capital strains. If large numbers of policies lapse, the business is exposed to losses on upfront commissions, and also to per-policy maintenance costs increasing above pricing assumptions, resulting in losses as policyholder charges fail to cover the ongoing costs of maintenance. Early surrender of policies can also crystallise unrealised losses for portfolios where market values are trading below book values or upfront commissions not fully earned by distributors cannot be recouped. Within the Group, we examine the impact on earnings and capital by stress testing both increased and decreased lapse rates in order to understand these impacts.
Lower than anticipated new business volumes can lead to acquisition expense overruns, resulting in reduced earnings and shareholder capital. By contrast, significantly higher than expected new business volumes can consume large amounts of capital and may risk capital strain. Within the Group, we examine the impact on earnings and capital by stress testing both increased and decreased new business volumes in order to understand these impacts.
Business risk is particularly significant as a proportion of total risk, in respect of the Group's unit-linked and asset management businesses, where there are few other significant risks relating to market, credit or insurance risk. Hence these risks comprise a large proportion of total risk in Wealth Management, Nordic and Retail Europe. While these risks are also important in US Life and South Africa & Emerging Markets, they represent a lower proportion of overall risk, given the market and credit related risks in US Life, and the market related risks in South Africa & Emerging Markets.
We have a number of mitigating actions in place to monitor and contain business risk.
During 2009 we took significant actions to reduce the cost base of all Group companies, particularly the Skandia UK and US Life businesses. This was also a major driver behind the recent Group restructuring as we aim to give scale to our Retail Europe businesses by combining them into a single unit. In addition, our ongoing platform strategy should ultimately result in cost savings. The changes in the US Life business were made in the first four months of 2009, and the risk reduction was quickly evident in the half-year economic capital calculations.
Within the US Life business we took significant steps to control the impact of lapses on the crystallisation of unrealised losses by building up significant cash holdings. These enabled us to withstand a temporary increase in terminations in the first half of the year without having to crystallise losses in the investment portfolio. A combination of a normalisation in terminations over the second half of the year and a reduction in corporate bond spreads reduced the risk and quantum of potential investment losses, which in turn allowed US Life to reduce its cash holdings. This is part of the ongoing monthly activity of the US Life Oversight Committee.
We also run a number of incentive programmes to encourage lower surrender levels in the business.
LTS market risk
The extent of the Group's discretion as to the allocation of investment return to policyholders varies according to the type of contract. Where contracts are related purely to longevity, mortality and morbidity risk, there is typically no sharing of better-than-expected or required investment returns. Under unit-linked and/or market linked contracts, policyholders receive the full investment return on the underlying assets, less any applicable fees, and the only residual market risk relates to the fluctuation in asset-based fees as a result of fluctuations in the underlying assets.
In most other classes of investment-related contracts, investment returns are attributed to, or shared with, policyholders, in the form of vesting and/or non-vesting bonuses. Non-vesting bonuses offer an option for management action, as they can be withheld in adverse circumstances.
Smooth bonus products constitute a significant proportion of South African business. We pay particular attention to declaring bonuses in a responsible manner, retaining sufficient reserves to meet our promise to clients that returns will be less volatile over time than purely market linked returns. Investment returns not distributed after deducting charges are credited to bonus-smoothing reserves, which are used to support subsequent bonus declarations.
For discretionary participating business underwritten in South Africa, there are well established management actions. Principles and Practices of Financial Management clearly set out how risks and surpluses are shared, how bonuses are declared, and how these classes of businesses are managed - including the management actions that will be taken in adverse conditions. These actions are sanctioned and signed-off by the OMLAC(SA) Board and are disclosed to the Financial Services Board of South Africa, OMLAC(SA)'s regulator.
In South Africa the stock selection and investment analysis process is supported by a well developed research function. For fixed annuities, we manage market risks where possible by investing in fixed interest securities with a duration closely corresponding to those liabilities. Market risk on policies that include specific guarantees and where shareholders carry the investment risk resides principally in the OMLAC(SA) guaranteed non-profit annuity book, which is closely matched with gilts, semi-gilts and high quality corporate bonds. Other non-profit policies are also suitably matched, based on comprehensive investment guidelines. Market risk on with-profit policies, where investment risk is shared with investors, is mitigated by appropriate bonus declaration practices.
In US Life's fixed annuities, policyholder option risk is managed by investing in fixed securities with durations within a half-year of the duration of the liabilities. Cash flows in any period are closely aligned to ensure any mismatch is not material. In addition, we carry out extensive interest rate scenario testing, as required by US regulatory authorities, to ensure that the amounts reserved are sufficient to meet the guarantee obligations. The guaranteed returns provided under equity-indexed annuities are hedged to ensure a close matching of option or futures pay-offs to the liability growth. Hedging is largely static with minimal trading. Variable annuities are no longer written and for those policies in force the guaranteed returns provided are dynamically hedged. Hedging positions are reviewed daily and readjusted as necessary. In our US businesses we include an assessment of our ability to hedge market movements and the effectiveness of these hedging programmes. Hedge ineffectiveness risk is the risk of underperformance of the hedge assets in comparison with the associated liabilities, in respect of the components that we hedge. This can arise from less than complete hedging, such as failure to hedge higher-order derivative measures and from non-hedgeable items such as basis risk.
Within OMLAC(SA) and US Life, reductions in interest rates can lead to an increase in the value of investment guarantees and options given to policyholders, causing a reduction in earnings and shareholder capital. We undertake regular and ongoing activity related to interest rate and equity hedging to mitigate this risk.
Real estate risk for the Group is low compared with other risk categories. It is noteworthy only in the OMLAC(SA) business where a portion of policyholder funds is invested in real estate to generate outperformance and diversify the asset portfolio and in Nedbank, where real estate assets are held as collateral backing mortgage loans on residential and commercial real estate.
LTS credit risk
The US Life business is exposed to credit risk by the substantial corporate bond holdings and asset backed securities within its investment portfolio. The risk relates not only to defaults or impairments but also to the possibility of widening credit spreads adversely impacting the market value of the investment portfolio. All these risks may create a liquidity need to bridge the gap between benefits payable on termination and realisable asset values.
We actively monitor and manage the US Life portfolio to mitigate credit risk. We appointed a new Chief Investment Officer in US Life, who has significant credit management experience. During 2009 we took action to rebalance the composition of the US Life investment portfolio. At the year end, the investment grade of the portfolio has improved although we continue to have an over-exposure to corporate bonds. There has been substantial improvement in unrealised losses on the portfolio, which as of 31 December stands at $497 million, down from $2,844 million in March 2009. We expect to see continued improvement in this area during 2010.
|
US Life: Composition of the investment portfolio |
||
|
$m |
31 December 2009 |
31 December 2008 |
|
Treasury/Agency |
505 |
351 |
|
CMBS/RMBS/ABS |
2,900 |
3,739 |
|
Corporate bonds |
11,947 |
9,682 |
|
Cash/shortterm |
839 |
1,218 |
|
Total investments & securities |
16,191 |
14,990 |
In other business units, shareholder credit-related exposure is predominantly relevant sovereign debts.
We are currently enhancing the process and systems infrastructure that support aggregation of credit exposures as part of the iCRaFT programme to ensure they are fully Solvency II compliant, with a target completion date of Q1 2010.
In line with Scandinavian market practice, SkandiaBanken (Skandia Nordic's banking arm) provides a full-range online retail banking service to customers in Sweden and Norway. Its lending portfolio has been built on sound lending practices and mostly (95%) comprises mortgages with excellent creditworthiness and low loan-to-value ratios (38% at December 2009); the residual exposure (5%) is comprised of unsecured loans. The bank has strong liquidity and was consequently only marginally affected by the market turbulence in 2009. Its credit loss ratio (credit losses as a percentage of the opening lending balance) remained low at only 0.14%.
Businesses outside Group risk appetite: US Life and Old Mutual Bermuda
Measured against the risk appetite limits set by the Group Executive Risk Committee and ratified by the Group Executive Committee, all the Group's businesses are within the Group's appetite except for US Life and Old Mutual Bermuda. It is worth noting that:
· Both these business units are managing their positions to reduce the risk in their business gradually, within their capabilities and minimising loss of value
· An Oversight Committee has been established for each business to monitor risk exposures, help to optimise risk-taking within the business and track progress monthly. The Committee members include the Group Risk and Actuarial Director, the Group Finance Director and relevant executives from the companies concerned
· Credit risk is actively managed in US Life, to improve the quality of the investment portfolio holdings while trying to avoid realising large losses by trading out of securities with significant unrealised losses at inopportune times; we have made significant progress in achieving this
· Asset/liability management has also been improved, with significant effort being spent on identifying the assets appropriate to different product lines and ensuring investment strategies match the profile of those liabilities
· The Oversight Committees have also been directly involved in making decisions relating to the closure of unprofitable product lines and those deemed to be excessively risky relative to the Group's risk appetite
· We monitor Old Mutual Bermuda's hedging and related risks daily, and the company has been closed to new business to prevent any increase in guarantee exposures brought on by growing the Variable Annuity book. Over time we expect exposures to reduce significantly as policies mature and roll off the book. We continue to monitor hedging activity closely on both an actual and notional basis
· In September 2009 the decision was taken to progressively and selectively remove the majority of the hedge positions on this business. This decision was taken in light of rising markets globally, which increased the liquidity risk inherent in our short futures strategy and reduced market risk and our improved capital position which allowed us to better absorb fluctuations in guarantee costs. It also helped us save on substantial hedging costs at a time of rising markets. We continue to monitor our "notional hedge" as rigorously as we would monitor any hedge which was actually in place, and therefore should markets begin to fall again we are in a position to replace protection rapidly. It is likely that we will maintain a dynamic approach towards hedging in this business, by varying the extent of hedges over time based on market conditions.
Banking
NEDBANK
Banking credit risk
As our primary banking business, Nedbank carries a substantial proportion of our credit risk through its lending and other financing activities (it should be noted that, due to the nature of its investment portfolio, US Life also retains a significant proportion of our credit risk).
Nedbank's financing activities contribute to its significant credit risk exposure. We expect impairment levels to remain stable or even start to reduce during 2010. This is due to a number of factors, including a slowdown in lending, the introduction of tighter lending criteria and the stabilisation of economic conditions.
Nedbank maintains a well diversified funding deposit base supporting a strong loan to deposit ratio. Nedbank has remained focused on attracting its share of the deposit base. The bank continues to pursue opportunities to lengthen and diversify its funding base, maintaining a strong regional presence with little reliance on foreign funding. The bank also has an immaterial reliance on securitised and interbank funding - facilitated by a strong retail and commercial deposit base.
Nedbank has cultivated and embedded a prudent and conservative risk appetite, primarily focused on the basics of banking in southern Africa. This is illustrated by a number of factors including conservative credit underwriting practices which have culminated in a high-quality, well collateralised wholesale book as well as further tightening of credit criteria in our retail book in anticipation of the economic downturn. This has resulted in Nedbank's reasonable credit concentration risk levels in relation to the South African market, with counterparty credit risk being restricted to non-complex, vanilla banking transaction.
Nedbank manages credit risk exposures through its credit risk management framework, which encompasses comprehensive credit policies, limits, governance structures and internal risk models that are fully Basel II compliant and in line with Group policies and practices. To address the changing conditions impacting on credit risk this year, Nedbank has:
· Closely monitored credit risk loss ratios and other key indicators through its credit risk monitoring committees
· Tightened credit granting criteria: for example on home loans it has tightened loan-to-value criteria, increased acceptance standards and where appropriate restructured credit risk agreements
· Tightened controls over large payments to and from global banks
· Increased staff to administer collections.
Banking market risk
The principal market risks in the Group's banking operations arise from:
· Trading risk in Nedbank Capital
· Banking book interest rate risk from repricing and/or maturity mismatches between on and off balance sheet components in all banking businesses.
We use a comprehensive market risk framework to ensure that market risks are understood and managed. Governance structures are in place to achieve effective independent monitoring and management of market risk.
Nedbank has a low level of assets and liabilities exposed to the volatility of IFRS fair value accounting; a small market trading risk in relation to total bank operations; relatively low banking book interest rate risk by international standards and low equity (investment) risk exposure, having successfully completed the non-core asset disposal strategy in 2007. Nedbank has low currency translation risk due to its strong regional focus and its relatively small offshore structure is deemed appropriate and optimal, given its current international strategy.
The Group's capital adequacy ratios increased significantly in 2009 and continued to be maintained above the group's target ratios. Ongoing focus will be given to increasing Core Tier 1 capital and the Tier 2 regulatory capital remains well diversified with no maturing subordinated debt until 2011.
Trading risk
We measure market risk exposures from trading activities at Nedbank Capital using value-at-risk (VaR), supplemented by sensitivity analysis and stress scenario analysis, and set limit structures accordingly.
The VaR measure estimates the potential loss in pre-tax profit over a given holding period for a specified confidence level. The methodology is a statistically defined, probability-based approach that takes into account market volatilities as well as risk diversification by recognising offsetting positions and correlations between products and markets. Risks can be measured consistently across all markets and products, and risk measures can be aggregated to arrive at a single risk number. The one-day 99% VaR number used by Nedbank represents the overnight loss that has less than 1% chance of occurring under normal market conditions. By its nature, VaR is only a single measure and cannot be relied upon as a means of measuring and managing risk on its own.
Banking book interest rate risk
This arises at Nedbank because:
· The bank writes a large quantum of prime-linked assets and raises fewer prime-linked deposits
· Funding is prudently raised across the curve at fixed-term deposit rates that reprice only on maturity
· Short-term demand-funding products reprice to different short-end base rates
· Certain ambiguous maturity accounts are non-rate-sensitive
· The bank has a mismatch in net non-rate-sensitive balances, including shareholders' funds, that do not reprice for interest rate changes
· Nedbank uses standard analytical techniques to measure interest rate sensitivity within its banking book. This includes static reprice gap analysis and point-in-time interest income stress testing for parallel interest rate moves over a forward-looking 12-month period.
Banking Business risk
Business risk is the risk of adverse outcomes resulting from a weak competitive position or from a poor choice of strategy, markets, products, activities or structures. Major potential sources of business risk include revenue volatility, owing to factors such as macroeconomic conditions, inflexible cost structures, uncompetitive products or pricing, and structural inefficiencies.
The South African economy has emerged from recession in the third quarter of 2009, posting only modest growth over the quarter, but the recovery gained some traction in the final quarter of 2009 as real GDP grew by 3.2%. The improved performance was mainly due to a rebound in manufacturing exports on the back of strong demand for commodities from China and a modest recovery in most major industrialised countries. However, some segments of the domestic economy are still under significant strain.
In the short term, the recovery is expected to continue to be hampered by high unemployment and high household debt levels resulting in a protracted recovery in retail banking. While wholesale banking, which has been resilient, even at the peak of the interest rate cycle, is showing increased signs of credit stress, the Group's own experience is still within expected and acceptable levels.
The fluctuations in earnings captured in business risk are those not attributable to the influence of other risk types. The major driver or input used in the earnings-at-risk methodology is a time series of historical profit and loss, cleansed of the effects of other risk types. The volatility of this time series of historical profits and losses becomes the basis for the measurement of business risk.
Nedbank's operational risk strategy and objectives are in line with the Basel II framework. Nedbank will apply for regulatory approval to transition its current operational risk management framework capabilities from the Standardised Approach to the Advanced Measurement Approach in 2010.
Nedbank Group actively manages business risk through the various management structures, as set out in the Enterprise Risk Management Framework, and an earnings-at-risk methodology similar to the Group's risk appetite metrics.
Mutual & Federal
For Mutual & Federal, the second-largest short-term insurer in South Africa, underwriting risk is the primary concern. Adverse weather patterns and large numbers of commercial fires impacted our underwriting profitability in the first half of the year, but the recovery in the second half reflected the fundamental soundness of our portfolios, our diligence in rate setting and our continuing adherence to responsible underwriting standards.
The potential sale of Mutual & Federal by the Old Mutual Group caused uncertainty in the business during 2009. This was coupled with the environmental challenges facing the industry and challenging internal projects, such as introduction of a single insurance administration system. The decision to make Mutual & Federal a wholly owned subsidiary of Old Mutual provided confidence to the local team. In 2010 management focus is on stabilising the operating platform and responding to changes within the market to continue to offer growth, profitability and value to clients.
US Asset Management
Since this is an asset management business, market volatility presents the greatest risk. We conduct our asset management activities in an agency capacity, hence clients take both the upside and downside risk in their portfolios. Our asset management affiliates are exposed to a second-order risk in respect of their asset-based management fees and performance-related fees. Over the year, we felt the impact of the financial crisis in a lower level of asset-based fees and substantially lower performance fees.
Old Mutual Bermuda (Legacy business)
In Old Mutual Bermuda, reductions in interest rates can cause more of the investment guarantees and options within its deferred annuity business to be in-the-money, reducing earnings and shareholder capital. We maintain regular interest rate hedging activity to mitigate this risk.
The guaranteed returns provided under equity-indexed annuities are hedged to ensure a close matching of option or futures payoffs to any liability growth. Hedging is largely static with minimal trading.
Variable annuities are no longer sold, and for in force policies, the guaranteed returns provided are dynamically hedged. We review hedging positions daily to readjust them as necessary. We include an assessment of our ability to hedge market movements and the effectiveness of these hedging programmes. Hedge ineffectiveness risk is the risk of hedge assets underperforming in comparison with the associated liabilities. This can arise from less than complete hedging, such as failure to hedge higher order derivative measures and from non-hedgeable items such as basis risk. The ongoing monitoring of hedge activity in Old Mutual Bermuda ensured that the effectiveness in respect of components hedged averaged 96% over 2009.
Old Mutual Bermuda remains outside our Group risk appetite and is being actively managed to mitigate losses.
Summary
Old Mutual has made considerable progress in 2009 in effectively managing risk and capital in order to create value. This is a particular achievement given the past year's volatility in financial markets. Our progress is due to the continued focus on group wide risk management through our Strategic priorities and iCRaFT programme. The risk environment will continue to evolve, and we embrace this journey. We are developing and implementing further tools to allow us to optimise business decisions and take a forward-looking view of integrated risk and capital management.
The Board believes that current capital and liquidity levels are adequate for a Group of our size and nature. It also confirms that the Group's internal systems of control, risk management and governance have operated as intended during 2009 and are therefore effective.
Statement of directors' responsibilities in respect of the Annual Report and the financial statements for the year ended 31 December 2009
The directors are responsible for preparing the Annual Report and the group and parent company financial statements in accordance with applicable law and regulations.
Company law requires the directors to prepare group and parent company financial statements for each financial year. Under that law they are required to prepare the group financial statements in accordance with IFRSs as adopted by the EU and applicable law and have elected to prepare the parent company financial statements on the same basis.
Under company law the directors must not approve the financial statements unless they are satisfied that they give a true and fair view of the state of affairs of the group and parent company and of their profit or loss for that period. In preparing each of the group and parent company financial statements, the directors are required to:
· select suitable accounting policies and then apply them consistently;
· make judgments and estimates that are reasonable and prudent;
· state whether they have been prepared in accordance with IFRSs as adopted by the EU; and
· prepare the financial statements on the going concern basis unless it is inappropriate to presume that the group and the parent company will continue in business.
The directors are responsible for keeping adequate accounting records that are sufficient to show and explain the parent company's transactions and disclose with reasonable accuracy at any time the financial position of the parent company and enable them to ensure that its financial statements comply with the Companies Act 2006. They have general responsibility for taking such steps as are reasonably open to them to safeguard the assets of the group and to prevent and detect fraud and other irregularities.
Under applicable law and regulations, the directors are also responsible for preparing a Directors' Report, Directors' Remuneration Report and Corporate Governance Statement that complies with that law and those regulations.
The directors are responsible for the maintenance and integrity of the corporate and financial information included on the company's website. Legislation in the UK governing the preparation and dissemination of financial statements may differ from legislation in other jurisdictions.
The directors confirm that to the best of their knowledge:
· The financial statements, prepared in accordance with the applicable set of accounting standards, give a true and fair view of the assets, liabilities, financial position and profit or loss of the company and the undertakings included in the consolidation taken as a whole; and
· The directors' report includes a fair review of the development and performance of the business and the position of Old Mutual plc and the undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties that they face.
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Julian Roberts |
Philip Broadley |
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Group Chief Executive |
Group Finance Director |
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11 March 2010
This information is provided by RNS
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