Capital Management Key Learnings from Current Market Turmoil/Volatility

1. Capital ManagementKey Learnings from Current Market Turmoil/Volatility Simon Curtis Executive Vice President & Chief Actuary June 25th, 2009 Halifax

2. Economic Turmoil Has Highlighted Need To Re-think Capital Management In Several Areas • Increasing Capital Adequacy MIS • Pro-cyclicality of Regulatory Capital Regime • Importance and Role of Stress Testing • Role of Regulatory vs. Internal Capital Models • Volatility of Capital Models • Risk Diversification and Risk Mitigation • Increasing the Focus on Downstream Silo Capital • IFRS Phase 2 Implications

3. Increasing Capital Adequacy MIS • MIS needs to support regulatory capital management have increased significantly Company Example

4. Pro-Cyclicality of Regulatory Capital Regime • External environment (regulators, analysts, rating agencies, etc.) are demanding higher capital ratios after severe shock than before the shock • effectively requiring immediate capitalization for second shock • requiring significant capital raises at time in cycle when capital is scarce/expensive • Regulatory formulas, particularly stochastic or model based components, are significantly increasing underlying requirements based on point in time risk measurement • Result is that regulatory capital requirements are increasing significantly at time balance sheets are stressed • Go forward implications • companies should modify practices to systematically operate at capital ratios above long term “target” in good times to provide internal flexibility for bad times • regulatory formulas that avoid or dampen pro-cyclicality would be desirable • OSFI action of segregated fund CTE levels is a good example • introducing explicit ops risk and other components and eliminating arbitrary MCCSR scale up requirements would be beneficial

5. Importance and Role of Stress Testing • Recent economic turmoil appears to be highlighting a fundamental difference between professional requirements of stress testing (e.g. DCAT) and regulatory/management focus

6. Role of Regulatory vs. Internal Capital Models • In recent years, companies (with regulator encouragement) have spent considerable time and resources on developing economic capital models with decreased focus on regulatory models • many companies believed they were significantly over-capitalized based on economic models • In current turmoil, all regulatory and external focus (including rating agencies) has been on regulatory capital ratios and adequacy with economic capital largely ignored • companies have been raising capital to support regulatory requirements • Economic capital models typically have components fundamentally inconsistent with regulatory framework • full diversification credits • full risk mitigation credits • lower scale ups for ops risk/other non-inventoried risks • more model reliance and volatility • focus on single catastrophe (not being capitalized to have strong ratios after first catastrophe) • Is the role of economic models to establish risk appetite and risk adjusted return requirements rather than level of capitalization required?

7. Volatility of Capital Models • Current equity market meltdown is shown inherent volatility of advanced stochastic models • current models and literature do not calibrate models to where you are in the economic cycle • catastrophic scenario imposed on top of catastrophic scenario • Outcome is that model based requirements immediately release significant amounts of capital in good cycles and force immediate accrual of need for significant additional resources in poor cycles • this creates rather than mitigates stability and solvency risk in the system

8. Volatility of Capital Models [cont’d] • There are several potential solutions • introduce reversion to mean assumptions in the models (counter cyclicality) • create more dynamic capital targets and minimums • Are stochastic models the right approach to setting capital? • clearly the best approach to understand risk profiles and potential ranges of outcomes, including catastrophic exposures • unclear if they are appropriate when imposed on a specific point of time environment given nature of how assumptions are developed • long term “average” market conditions (real world) OR • sentiment based liquidation perspective (risk neutral)

9. Risk Diversification & Risk Mitigation • Regulators have resisted calls for risk diversification credit in capital formulas – are they correct? • current crisis is example that there may be limited diversification within investment risks (credit/market) in a true “tail” event • diversification between investment risks and other risks (ops risks, insurance risks, policyholder behaviour risks) has been robust in current crisis, but would this be true in pandemic • Regulators have also resisted calls for risk mitigation credits for dynamic strategies (e.g. dynamic hedging of equity guarantees) • Ultimately, risk mitigation and risk diversification are important, and some incentive to encourage this in regulatory capital framework is desirable

10. Increasing the Focus on Downstream Silo Capital • In benign market conditions, managing interactions of multiple levels of regulatory requirements (consolidated versus local regulatory solvency versus rating agency) is a relatively stable exercise • However, in a volatile/stressed environment the multiple levels of constraints: • introduce complexity issues in accurately modeling complex interactions • create pockets of trapped capital/unexpected capital calls that can make consolidated capital requirements higher than may be perceived by looking to p-down • create real issues in moving capital around the organization • Key learning is that models/tools focus on downstream needs and fungability not just top down requirements

11. IFRS Phase 2 Implications • If stress tested against economic conditions of last 6 months the IAIS direction on solvency would likely have led to widespread statutory insolvency, internationally and in Canada • risk neutral rates went down considerably leading to shock increase in liability values • extreme spread widening caused significant shock decrease in fixed interest asset values (compounding equity shocks) The Phase 2 model does not survive a real event stress test