A Rating Agency Perspective On Life Insurer Risk Management

1. A Rating Agency Perspective OnLife Insurer Risk Management Presented by: Joel LevineVice President & Senior AnalystLife Insurance Group April 26, 2004

2. Presentation Outline • Usefulness of available risk management information - rating agency focus versus management information and regulatory reporting • What rating agencies worry about • Lessons from past failures • Growing complexity of business – GMDB and UL no lapse guarantees • Secondary market for insurance contracts • Hedging VA guaranteed living benefits • Conclusions

3. A Lot Of Data,Not Enough Information

4. Rating Agency Focus • Credit analysis focuses on operating entity and enterprise level (holding co.) financial condition • Analyzes the organization’s ability to withstand stress from multiple sources of risk • Comprehensive in scope: liquidity, asset default, concentration, interest rate, market, inflation, actuarial, competitive, reputation, regulatory, litigation, merger/business integration, etc. • Ongoing concern point of view, except for liquidity • Compound interaction among risk factors, not just one at a time • Medium term horizon

5. Issuer Management Reporting Focus • Many issuers are managed as decentralized business segments with fragmented reporting • Separately managed investment portfolios with tailored ALM requirements • Management reports (e.g., scenario projections) are produced on an independent, business segment basis • Surplus assets are generally ignored • Corporate (holding co) balance sheet and income components are ignored • Affiliated entities are excluded • Scenario analysis on a run-off basis

6. Regulatory Reporting Focus • Cash flow testing provides useful information, but has its limitations • Reserve adequacy focus as opposed to company performance (e.g., capitalization level over time) • Not all businesses/products are included • Performed on a run-off basis • Surplus assets are ignored • Corporate (holding co) balance sheet and income components are ignored • Affiliated entities are excluded • Primarily focused on interest rate risk (except for NAIC C-3 Phase II) • SAP only, no GAAP information

7. Desirable Supplementary Risk Mgt Reporting • Goal is to achieve a clearer understanding of the drivers of performance and the potential for significant losses – tail risk • Break-even scenario analysis - what it would take to impair the organization over a given time horizon • Stress economic scenario analysis • VaR/EaR analysis – a more comprehensive analysis of risk that would reflect compound interaction of various risk factors • Fair value accounting • Embedded value – sensitivity analysis

8. What Do Rating Agency Analysts Worry About?

9. Lessons From Past Failures • General American (1999) – liquidity risk of 7-day putable funding agreements, reinsurance with a weak company, loss of confidence by institutional investors • Confederation Life (1994) – heavy investment portfolio losses in real estate and commercial mortgages, unsuccessful acquisition strategy • First Capital Holding (1991) and First Executive (1991) – losses on high yield bonds, increase in policy surrenders impairing company liquidity

10. The Business Is Getting More Complex and Risky • Increasingly, new products are being created with a focus on guarantee elements • Equity market uncertainty has made investors more receptive to floors on returns • Guarantees have become huge drivers of annuity sales (GMWB, GMIB) • Guarantees have crept into life insurance products - e.g., UL no lapse guarantees (AXXX) • New embedded risks are extremely complex and require sophisticated modeling in order to understand and hedge them • Some companies are developing me-too designs without having a full appreciation of the risk

11. What Keeps A Rating Agency Analyst Up At Night? • Issuers that engage in products/activities that require undemonstrated competencies and/or that lack a cohesive process to manage them • Does the issuer recognize the risks it has assumed – e.g., dollar for dollar partial withdrawals? • VA secondary guarantees – when did life insurers become expert managers/traders of market risk? • Does the issuer currently have or can it acquire sufficient resources to manage the risks? • Is senior management committed? • Who’s accountable for the process – nobody/everybody, multiple committees, CRO?

12. Lesson Learned – GMDB Is More Than Actuarial Risk • Historically, life insurers accumulated actuarial risks and managed them using risk selection, diversification, and reinsurance • GMDB reinsurers tried to “diversify” by writing new business at different points in time (over a market cycle) – benefit payment on death only would provide “diversification” by exercise date • Back-testing using historical equity market prices validated the “insignificant” economic risk of GMDB; risk neutral valuation not well understood • Ignored the systematic nature of market risk and the “temporary” impacts on statutory surplus

13. A Case Study – UL No Lapse Guarantee • UL no-lapse guarantees expose issuers to potentially significant and systematic risks • Simultaneous occurrence of low lapse rates and low interest rates may produce very large losses; moderate adverse deviations can create material losses • Moody’s is concerned that issuers’ pricing lapse assumptions may be too high and rely upon naive/irrational policyholder behavior • Pattern of statutory earnings under adverse lapse scenario is for losses to emerge in later policy durations; masking of the problem in the early years

14. A Case Study – UL No Lapse Guarantee (Cont’d)

15. A Case Study – UL No Lapse Guarantee (Cont’d)

16. How Will Middle-Tier Issuers Cope? • VA secondary guarantee hedging requires a significant and expensive commitment of resources • Systems development to integrate policy admin system with new actuarial modeling systems • Hardware – massive amount of policy records and many thousands of stochastic simulations • Accounting support and internal controls • Experienced traders • Outsource it? – can I afford it? - actuarial consulting firm, derivatives dealer with a turnkey program, emerging reinsurance programs • Can a middle-tier issuer remain competitive?

17. Secondary Market For Insurance Contracts • Firms are being formed to facilitate a secondary market for annuity contracts and life insurance policies – and arbitrage the “irrational” policyholder behavior pricing assumptions • IBuyAnnuities.com • CoventryFirst.com • Wall Street capital has not been deployed in a significant way to-date, but that could change • Potentially dire implications for some issuers • Lapse assumptions for in-the-money GMDB, GMWB/GMIB, $ for $ partial withdrawals • Mortality assumptions for life insurance policies

18. Analyze This – What’s The “Right” Objective For A Hedging Strategy?

19. VA Secondary Guarantee Hedging Objectives • Reduce the tail risk – potential for large economic (pv of net cash flows) losses • But, subject to external constraints: NAIC RBC, rating agency capital requirements, preserve company shareholder dividend capacity, maximum tolerable GAAP income loss, etc. • Competing constraints make it difficult to resolve analytically (e.g., with an optimizer) • For a rating agency, reported GAAP net income is not necessarily controlling; economics are the primary concern

20. Secondary Guarantees Subject To FAS 133 • Both assets and liabilities are marked-to-market, so GAAP results are reasonably predictable with one major exception • Popular dynamic hedging practice is to match the liability “greeks” – delta, rho, gamma, vega, cross-sensitivities; trade-off between effectiveness and cost • Arguments made that implied volatility for long-term derivatives fluctuates and tends to be mean-reverting: makes it difficult to match the liabilities’ sensitivity to changes in volatility (vega)

21. Secondary Guarantees Subject To FAS 133 (Cont’d)

22. Secondary Guarantees Subject To FAS 133 (Cont’d) • If long-term implied volatility is “noise”, can it be safely ignored – and could one hedge with futures only? • Maybe, but one shouldn’t ignore the risk that delta may change significantly with large market moves (gamma) – therefore, may need some option exposure • Under NAIC C3 Phase II, stochastic simulations will be used to determine SAP reserve and RBC levels

23. Secondary Guarantees Subject To FAS 133 (Cont’d) • NAIC C3 Phase II methodology ignores spot market parameters such as implied volatility • Hedging vega will not necessarily produce a more stable SAP financial result • Responses of the hedge assets to changes in implied volatility will not be offset by corresponding changes in the values of the SAP liabilities

24. Emerging Direction Of Hedging VA Secondary Guarantees • Index hedge – long-term options covering well defined risks, while the insurer retains the uncertain, unhedgeable risks • Hedge payoff based upon an assumed basket of indices, with provision for basket changes over time, and pricing that varies accordingly • Insurer retains the basis risk – basket vs actual fund performance • Long-tenor hedge whose payoff approximates the payoff pattern of the particular GLB design; issuer would assume the basis risk between the actual VA GLB payoff and the approximation • Contractholder exercise efficiency would be another source of error

25. Future Direction Of Hedging VA Secondary Guarantees • Index hedge (cont’d) • Rating implications would depend upon the effectiveness of the hedge • Insurer would need to demonstrate effectiveness through stochastic modeling that the basis risk would be manageable – i.e., the tail risk (economic perspective) would not be excessive • SAP impact would need to be considered – how would statutory surplus be impacted using such a hedge under various scenarios? • SAP surplus impact might be mitigated by using a combination reinsurance/derivatives structure

26. Conclusions

27. Conclusions • Life insurers are rapidly expanding into new types of less familiar risks – e.g., trading market volatility • Management and regulatory reporting needs to catch up with the complexity of these new risks – rapid strides are being made • Risk management processes have been developed and are evolving - but are untested under extreme market conditions • Basis risk and modeling risk inherent in hedging are difficult to quantify • Insurance business has become more risky - assessment of risk management skills has become more challenging and critical to the credit ratings process