Strategic Insurance Asset Management Seminar | Risk & Capital Management

1. I N S U R A N C E A S S E T M A N A G E M E N T Management of Asset Risk - I CM - 18 Risk & Capital Management Seminar - 9 July 2002

2. Types of risk • Do I have the correct strategy? • Model Risk • Strategic Allocation • Can I implement the strategy? • Process Risk • Tactical Allocation

3. Agenda • Definition of Risk • Fixed Income Risk • Duration • Yield Curve • Credit/Sector • Security Selection • Measuring and Controlling

4. What is Risk? • Not necessarily volatility of returns • Definitely not operational • Ability to track benchmark • Is this appropriate?

5. Risk Type Interest Rate Risk Type Sector Predictability Predictability Low Medium Impact Impact High Medium Effectiveness Effectiveness Low Medium Insurance Insurance Duration matching No Risk Type Credit Risk Type Security Predictability Predictability Low High Impact Impact High Medium Effectiveness Effectiveness Low High Insurance Insurance RBC, NAIC No Risk Types

6. The Insurance Bias Security Selection Best Risk-Adjusted Returns - Lehman Brothers Credit Risk Duration Typical Insurance Account Yield Curve

7. Duration • IF asset duration = liability duration, THEN, parallel changes in yield curve will not affect surplus • Usefulness • Liabilities not discounted - not affected by yield curve movements • Yield curve movement not parallel • VFIC report • Matching not necessarily better • Accounting standards matter

8. Measuring Duration without option with option Price - + 0 P P P Rate

9. Yield Curve Movements • Guessing at the movement • Higher interest rates  shorter duration • Lower interest rates  longer duration • Steeper curve  barbell • Flatter curve  bullet • Not very effective • Especially over longer horizons • High up and downside potential

10. Credit Spreads • U. S. Treasury Securities guaranteed by “full faith and credit” of the U.S. • No chance of default • Deep market • Caveat: yield curve movements • All other securities contain credit risk • Risk requires compensation

11. Credit Spreads • Credit Spread - Difference in yield between debt and U.S. Treasury debt of same maturity • Credit Component • Liquidity Component

12. Liquidity component fluctuates with market Issue age & size Not quality Rating agencies guide credit component S&P Ratings Investment Grade AAA AA A BBB Non Investment Grade BB B C D Credit Spreads

13. Credit Spreads • Spreads not static • Increase = “widening” • Decrease = “tightening” Spread Yield Price

14. Credit Spreads Ratings at end of year Ratings at beginning of year Source: Moody’s

15. Credit Problems • Credit ratings not predictive • Quality is predictive • Contradictory regulatory messages • High Yield highly correlated to Equity • RBC higher for Stock • High Yield not admitted in many states

16. Decomposing Credit Spreads

17. Security Selection Excess Return Maturity