Bruce Porteous Head of UK Risk Capital Development Standard Life UK Financial Services

1. How the Integration of Insurance and Banking Techniques and Thinking Can Add Real Commercial Value. Bruce Porteous Head of UK Risk Capital Development Standard Life UK Financial Services AGB Networking Evening

2. Agenda. • Action Group for Banking (Bruce Porteous). • Life Modelling Techniques in Banking (Harvey Chamberlain). • Lifetime Mortgage Products (John Young). • A Day in the Life of a Pension Fund Buy Out Actuary (David Collinson). • Funded Reinsurance Financing – the Warehouse Innovation (Greg Solomon). • A Lawyer’s Comparison of Banking and (Re)insurance Contracts (Ian Fagelson). • Actuaries in Alternative Investments including Hedge Funds (Keith Guthrie). • Economic Capital – A Unifying Approach (Pradip Tapadar). • A Tale of Two Institutions (Chris Hancorn, Patrick Kelliher). • Banker Response (Iain Allan).

3. AGB Goals. • The AGB “operates” in areas where the actuarial and banking worlds overlap. • Push: To demonstrate where actuarial thinking and skills have been applied in a banking or financial context to add real commercial value. • => create new career opportunities for the profession. • Pull: To narrow the knowledge gap on tools and skills available in banking and finance that not all actuaries might be aware of. • => draw new ideas and thinking into the profession.

4. AGB Membership and Activities. • Push: Actuaries working in; • Retail banking. • Bancassurance. • Academia. • Investment banking. • Pull: Actuaries working with non actuaries in; • Reinsurance. • Pensions buy out companies. • Consulting. • Hedge funds. • Investment banking. • Activities: • Articles and events showcasing push/pull themes.

5. Life Modelling Techniques in Banking Harvey Chamberlain Head of product profitability and pricing National Australia Bank AGB Networking Evening Complete article at: http://www.the-actuary.org.uk/pdfs/07_06_01.pdf

6. Financial Forecast Granularity for Performance Measurement • Granularity • Channel • Sub-product • Back & Front Book • Monthly steps • Extended time horizon • Financial Forecast • Volume • Income • Losses • Capital • Expenses

7. Process • Specify Output • Source bases & assumptions • Product • Financial & Economic • Customer • Capital & Accounting • Build & Test Excel prototypes • Build & Test PROPHET prototype

8. Financial Forecast Output

9. Related Uses • Pricing • Capital / Asset / Liability management • Scenario & sensitivity • Customer profitability • Capacity planning

10. Forecast Control Cycle Initial (Data, Basis, Assumptions) Revisions (Data, Basis, Assumptions) Model Interpretation Experience Monitored Forecast Performance

11. Lessons • Engagement • Product • Customer/Technology • Treasury • Risk • Finance • Data availability & limitations

12. Development of a House Price Inflation model to investigate pricing and risk for lifetime mortgage products John Young Head of product profitability RBS Retail Markets Finance AGB Networking Evening Complete article at http://www.the-actuary.org.uk/pdfs/07_06_10.pdf

13. What is a lifetime mortgage? • Customer borrows against equity in their home – while still living in the home • Two options available: • Lump Sum • Income • Loan accumulates until owner dies or enters care. • No Negative Equity Guarantee (NNEG).

14. What is different for a Lifetime mortgage? • Various risks taken on board. • Mortality risk • Interest rate risk • House Price Inflation (HPI) risk • Mismatch between income and costs

15. How does NNEG cost arise?

16. Why Stochastic Model? • Important when world is not linear • E.G. no cost if return exceeds a threshold • Simple case could be say 0%, 2% and 4% • If we used an average of say 2% then no cost • In real world the 0% outcome has a cost • Model with a stochastic model that gives probabilities to all outcomes – good and bad

17. How to model HPI? • Look at past data (limited data available) • To remove the distortion effect of volatile price inflation we looked at Real HPI • Two main features: “Twin peaks” for real returns Clumping of +ve and –ve returns HPI has clear peaks of positive and negative returns in distribution. HPI has clear runs of positive and negative returns. This shows boom & bust in UK HPI

18. 25% 75% 85% “Bust” “Boom” 15% Two state model for HPI • Log normal is simple approach but does not capture key features of “twin peaks” and clumping. • Use approach borrowed from Barrie and Hibbert to give fat tails for stock market modelling. • Sample from a two state Markov model to represent “Boom” and “Bust”. Draw from underlying boom and bust log normal distributions. “Boom” Lognormal: Example; Mean = 7% Std Dev = 9% “Bust” Lognormal: Example; Mean = -2% Std Dev = 7%

19. Results 1. • Two State stochastic approach gives a c40% higher expected cost of NNEG (versus single Lognormal model) and • Insight into additional behavioural risks: • Customers continue to drawdown maximum possible following “boom” in house prices. Reduces buffer to the lender in bad times. Could result in a c60% increase in expected cost • Early pre-payment rates would fall when NNEG close to biting. More people continue to hold property when NNEG bites. Could result in a c5% increase in expected cost

20. Products may be designed to have same expected costs • Lump sum product has thinner tail of very high excess costs • Mix of business sold could be very important if HPI falls Results 2. • This approach shows increased risk of expensive outcomes from the “income product”

21. Pension fund Buy out actuary David Collinson Head of liability acquisition Pension Insurance Corporation (PIC) AGB Networking Evening Complete article at http://www.the-actuary.org.uk/pdfs/07_07_10.pdf

22. Pension Security Insurance Corporation Pension Corporation Investments Pension Insurance Corporation • Fully FSA approved insurance company • Guernsey approved Reinsurer Corporate pension owner Pension Corporation Pension Corporation P I C H

23. Pension Corp -- Team Background • Private Equity • Insurance • Reinsurance • Capital Markets • Fund Management • Risk Management • M&A • Pensions

24. Role • Insurance pricing • Longevity pricing • Longevity risk transfer • Combined corporate/pension fund pricing • Capital efficiency • Financial versus operating company covenant calculations

25. Funded Reinsurance FinancingThe Warehouse Innovation Greg Solomon Director of Structured Life Reinsurance for Asia Swiss Re AGB Networking Evening Complete article at http://www.the-actuary.org.uk/pdfs/07_08_10.pdf

26. Action Group for Banking • Pushactuaries out to ‘alternative’ fields, like banking • Pullskills & tools from the banking world into the life industry • The “Warehouse” is a banking/treasury tool now being directly applied in the area of reinsurance financing for life companies

27. The Challenge for Life Companies • Life companies have a large economic asset on their balance sheet, their embedded value • For regulatory reporting, the insurer may often not take credit for this asset, as future profits “might not emerge” • At inception of a new policy there are significant outflows, covering commission, admin & other expenses, reserves, solvency capital, etc. • With no credit for future profits, this puts a strain on the company’s balance sheet – “new business strain”

28. Realistic Portfolio Projections

29. Conservatism Creates Capital Strain

30. Accelerating the Balance Sheet • Although the Regulator may not give the company credit for future profits, a reinsurer (or investors) might • The company then effectively gets a capital boost in their regulatory accounts, and repays this capital out of future surpluses, as they emerge • Effectively, a portion of the embedded value is provided up front, and is thus guaranteed to emerge

31. Acceleration eases Initial Strain

32. Variety of Solutions • Cashless Reinsurance Financing • many structures exist • e.g. rather than paying the money, the money is owed • but sometimes liquidity is required/desired • Securitisation of Embedded Value • investors pay money to buy a share of those future profits • transactions need to be very large (hundreds of millions) • Warehouse Financing • a cash facility which works for smaller deals too

33. The Warehouse Life Co. Capital Markets Swiss Re P&C Co. securitisation warehouse Life Co. Corporate securitisation Bigger Life Company

34. Advantages of the Warehouse • Cash is available for deals which would be too small for a full securitisation • The resulting pooled asset can be (but need not be) “repackaged” and securitised, depending on our need for additional capacity, market conditions, etc. • Liquidity can be sourced in any form of debt, allowing for flexibility in amount & duration • Diversification across transactions makes for a more “stable” and thus saleable repackaged asset

35. Global Market “Meltdown” • We have the choice of not securitising at the moment, leaving the Warehouse on our balance sheet until conditions settle down • We are not limited to conduit financing as a source of liquidity – so can continue to finance transactions

36. Insurance / Banking Contracts a lawyer’s perspectiveIan FagelsonPartner at Reed Smith Richards Butler LLP AGB Networking Evening Complete article at http://www.the-actuary.org.uk/pdfs/07_09_08.pdf

37. Insurance and Banking Contracts • Previously clear product distinctions now blurred • Unified regulatory structure • Legal and cultural differences continue to influence contract forms

38. Insurance and Banking Contracts • In England, justice must not only be done • It must be seen to be believed

39. Insurance and Banking Contracts • Insurable interest • Utmost good faith • Many a slip

40. English Insurance Contract Law • Is different from ordinary contract law • The differences: • stem primarily from the utmost good faith doctrine • are surprising to the uninitiated • are thought to be unfair to policyholders • are modified by regulators in consumer cases

41. Insurance Contract Law • Reform is proposed from time to time • The Law Commission proposed reform in 1980 – but nothing happened (at least not in this country) • The Law Commission is looking at the question again • Reform may be a real possibility this time • Reform likely to affect business and consumer insurance; life and non-life; direct insurance and reinsurance

42. Misrepresentation and Non-Disclosure • Description of the Current Law

43. Misrepresentation • Misrepresentation is: • an untrue statement; • of a material fact; • that induces the insurer to enter into the contract; • either at all • or on the particular terms

44. Non-Disclosure – the Duty of Utmost Good Faith • An applicant for (re)insurance is obliged to disclose facts:- • Which are material to the risk; • Which are within the knowledge of the applicant; • Which are not within the knowledge of the (re)insurer; and • Which induced the (re)insurer to enter into the contract at all or on its particular terms.

45. Consequencesof Misrepresentation and Non-Disclosure • The insurer may avoid the policy • This involves declining future claims and demanding refund of paid claims • Except in the case of fraud, the premium must be refunded

46. Warranties and Conditions • 'When I use a word,' Humpty Dumpty said, in a rather scornful tone,' it means just what I choose it to mean, neither more nor less.‘ • 'The question is,' said Alice, 'whether you can make words mean so many different things.' • 'The question is,' said Humpty Dumpty, 'which is to be master - that's all.'

47. Warranties • In ordinary contract law, a warranty is a contractual provision of relatively minor importance. Breach of a warranty entitles the innocent party to damages but does not entitle him to treat himself as discharged from the obligation to perform the contract. • In insurance law, a warranty is a provision of such fundamental importance that its breach automatically discharges the innocent party from any further obligations under the policy.

48. Conditions • In insurance law, a condition (unless it’s a condition precedent or subsequent) is a contractual provision of relatively minor importance. Breach of a condition normally entitles the innocent party to damages but does not entitle him to treat himself as discharged from the obligation to perform the contract. • In ordinary contract law, a condition (unless it’s a condition precedent or subsequent) is a provision of such fundamental importance that its breach entitles the innocent party to bring the contract to an end.

49. Inominate Term • A term which is neither a condition nor a warranty • Remedy for breach depends on the consequences of breach • Breach of a time limit for claims notification will rarely justify denial of claim

50. Law Commission Proposals for ReformConsultation Paper – 17 July 2007 Proposals include • Abolition of the duty of disclosure in consumer cases • Modifying the duty in business cases by changing the test of materiality • Restricting insurers’ ability to convert representations into warranties • Consumer life insurers likely to lose the right to avoid for non-fraudulent misrepresentation after five years? • Abolition of insurer’s remedy for innocent misrepresentation/non-disclosure • Proportionate remedy for negligent misrepresentation • New rules concerning notification of warranties • Softening insurers’ remedies for breach of warranty