Dr. Etti G. Baranoff Virginia Commonwealth University

1. Mortgage Backed Securities and Capital of Life Insurers:Was the Industry prepared for the Credit Crunch of 2007-2008? Dr. Etti G. BaranoffVirginia Commonwealth University Thomas W. SagerThe University of Texas at Austin

2. Objectives U.S. life insurance industry: • What was the exposure to MBS? • Were the risks of MBS anticipated? • What capital adjustments would accommodate the risks of MBS? Benchmarking tool for individual insurers

3. Exposure to MBS

4. Exposure to MBS

5. Risk Recategorization of MBS • Risk assessment measure • RAR (Regulatory Asset Risk) • Based on C-1 component of life insurer Risk-Based Capital • “Penalty” weights for risky assets • Bond 1 = 0.3% - Bond 4 = 9% • Bond 2 = 1% - Bond 5 = 20% • Bond 3 = 4% - Bond 6 = 30%------------------------------------------------ • Stocks = 30%, etc.

6. Recategorization Scenarios • RAR1 = 25% of MBS from 1 to 5,6 equally • RAR2 = RAR1 + 12.5% of MBS from 2 to 5,6 equally • RAR3 = RAR1 + 25% of MBS from 2 to 5,6 equally • RAR4 = 50% of MBS from 1 + 25% from 2 to 5,6 equally • RAR5 = 75% of MBS from 1 + 25% from 2 to 6

7. Effect of Recategorizations on Asset Risk (2006)

8. Were MBS Risks Anticipated? • Capital structure model • Log Capital = a + b0 log RAR0 + bi (log RARi – logRAR0) + ERM control variables • bi > 0 implies prudent anticipation • bi < 0 implies “irrational exuberance” • <Model applied for Residential MBS only>

9. ERM Control Variables • Product risk – life, health, annuities writings • Regulation – RBC ratio • Operations – ROC, use of derivatives • Structure – stock vs mutual, affiliated group member • Size – total assets, writings, liabilities---------------------------------------------------Dropped insignificant control vars

10. Capital Model for 2006(Table 4 Summary – Residential MBS only)

11. Adaptations to MBS Risks • Capital structure model • Log Capital = a + b log RAR0 + ERM control variables • Capital adjustment controlled by b and change in RAR risk • Adjustment ratio = (new RAR / old RAR)b • <Model applied for Residential MBS only>

12. Adaptations to MBS Risk(2006 – Residential MBS only) • For 2006, b = 0.10967 (p-value < 0.0001) ------------------------------------------------------------ • Ex: Insurer A has RAR = 1.14% of invested assets; recategorizes MBS risk per scenario 1 => new RAR = 1.79%.Cap adjustment ratio = (1.79/1.14)0.10967 = 1.0507 – a 5% increase in total capital.------------------------------------------------------------ • Ex: Insurer B has RAR = 1.14% of invested assets; recategorizes MBS risk per scenario 4 => new RAR = 2.83%.Cap adjustment ratio = (2.83/1.14)0.10967 = 1.10486 – a 10.5% increase in total capital.

13. Benchmarking

14. Benchmarking • Ex: Insurer A has (Residential) MBS = 20% of bond portfolio in 2006, scenario 1 cap adjustment of 1.3% vs. adjustment of 9% for its peer group • Ex: Insurer B has (Residential) MBS = 20.4% of bond portfolio in 2006, scenario 1 cap adjustment of 19.4% vs. adjustment of 9% for its peer group