1. Use of Reinsurance in Pension Risk Management April 16 th, 2007 Presented By Jean-François Lemay

2. 2 Use of Reinsurance Overview Pension Buy-outs in the UK Longevity Bonds Use of reinsurance in Canada Pricing and asset management from a reinsurer’s perspective

3. 3 Pension Buy-outs in the UK Changes in regulation and accounting standards mean that the deficit of approx. £50 billion on £500 billion UK pensions liabilities have become a serious issue for many companies Combining this phenomenon with some high profile corporate bankruptcies and restructuring, e.g. Marconi, so the UK became a major market opportunity both in buying pension liabilities and in buying distressed companies with even more distressed pension schemes Initially, in the UK there are two significant players in the bulk annuities/pensions buy-out market: The Prudential and Legal & General. We now have many players, some are specialized in the area (Paternoster), some are just private equity players looking for an asset-intensive play (Cerberus). UK has a much greater prevalence of payout annuities, hence the longevity risk has taken a much more prevalent place.

4. 4 Pension Buy-outs in the UK Two main strategies to accomplish buy-out in the UK using offshore entities: ► Life Insurance Buy-Out ► Shell Company Spin-Off

5. 5 Life Insurance Buy-Out Offshore Reinsurer ABC Life (Rated onshore life insurance Co.) Collateral for Counterparty risk Pension Plan Insurance Contract Reinsurance Company/Sponsor

6. 6 Shell Company Spin-Off Offshore Insurer Collateral for Counterparty risk Pension Plan Buy-out Insurance Company/Sponsor Pension Plan Shell company

7. 7 Pension Buy-outs in the UK Under both UK strategies an offshore entity ends up with the risk. Offshore entities can offer a more competitive price because of lower capital costs and taxes. Both strategies call for the simple and full transfer of liabilities to an insurer/reinsurer Reinsurance is an effective way of transferring the longevity risk and the investment risk. Reinsurance would be tailored exactly to the pension plan’s mortality experience, so no volatility would be left on the reinsured lives. Reinsurance would reduce volatility of both the accounting liabilities and valuation liabilities. Reinsurance would eliminate the volatility of the portion of the risk reinsured. Accounting liabilities are going to be much more important with the new rules requiring that pension liabilities be shown on the balance sheet and not only as a footnote

8. 8 Longevity Bonds A relatively new twist The structure is likely to evolve probably all will have different twists The European Investment Bank / BNP Longevity bond issued in 2004 is a good example: Payments are linked to a survivor index The interest paid is X$ times the proportion of survivors from a group aged 65 at issue Survivorship using UK government statistics Issuer is the European Investment Bank (AAA rated) Structurer and manager is BNP Paribas Partner Re is the reinsurer

9. 9 Longevity Bond Bond Holder (Pension Plan) Issuer Issue Price Reinsurer Reinsurance Floating rate tied to longevity

10. 10 Longevity Bonds Same net effect: a reinsurer gets the mortality risk The difference is that it is transferred to the pension plan through a rated asset This fact may make it easier to enter into More liquid than pure reinsurance However the longevity bond is based on an index, not on the actual mortality experience of the plans, hence a basis risk left for the pension plan The plan may not be able to increase surplus / reduce deficit even if the price of the longevity bond is more attractive than the reserve calculation This may or may not be a more efficient structure from a tax or capital perspective

11. 11 Use of Reinsurance in Canada Reinsurance in Canada could take a similar form to the UK reinsurance structure. Assets need to stay in Canada in an OSFI-regulated trust in order for the ceding insurance company to get reserve relief So this is not just for counter-party risk, but is mandated for reserve and capital relief The reinsurance would likely be done on a funds withheld basis, meaning that the initial premium is never transferred from the insurer to the reinsurer, it is withheld and will appear as a payable on the insurers book. This would be a more efficient way from a capital perspective than putting all the assets in the trust. Assets in trust need to be 110% of Stat reserves, but you only need 100% of stat reserve on funds withheld.

12. 12 Use of Reinsurance in Canada Offshore Reinsurer ABC Life (Rated onshore life insurance Co.) Collateral for Reserve Relief Pension Plan Insurance Contract Reinsurance (funds withheld basis) Company/Sponsor

13. 13 Use of Reinsurance in Canada The devil is in the details. While the general structure for each transaction may be similar, there will always be customizations: What are the provisions if the assets in trusts are not sufficient? Who manages the business (pay pensions, keep records)? What are the rules relative to the assets in the trust? Any Letters of credit? What happens if the reinsurer gets downgraded? Any rights to recapture the business? In short, this is a mini M&A exercise

14. 14 Use of Reinsurance in Canada Not aware of any similar transactions being done in Canada Currently, the large insurers in Canada are the only source of annuities But if you have a large plan, you may not be able to get a quote for your whole block About $1B in annuities done in Canada in a year. Some blocks are much larger than that. So basically we are at the stage where the UK was prior to the entry of the new players and offshore reinsurers.

15. 15 Use of Reinsurance in Canada The costs of doing one of those transactions for one of these offshore player is large: They many not have the life insurance company setup yet, so they need to buy/borrow/build one. They may not have any mortality expertise in Canada – so a lot of consulting costs to price the deal It may be easier for a very large plan to get a quote than for a medium-sized plan, since the large plan will attract more bidders willing to absorb the cost of setting up a structure in Canada.

16. 16 Pricing Reinsurance The cost of reinsurance will be driven mainly by the yield available in the markets, mortality, taxes and the cost of the capital needed to support the business. The cost of reinsurance may be different than the solvency liability, depending on : The interest rate used for the calculation of the liabilities relative to the current rates The assumptions used (mortality being the main one) in the calculation of the liabilities vs. the best estimate mortality used in the reinsurance The relationship between the liabilities booked and the cost of reinsurance may also change depending on which piece of the liabilities is reinsured Reinsurance may target only the pieces where the price is than the liabilities There could be other accounting issues, such as realization of deferred gains/losses, etc.

17. 17 Pricing Reinsurance Following is an example of the three main factors in the reinsurance price would be estimated be the reinsurer: Mortality Return on assets Cost of capital

18. 18 Pricing Reinsurance Mortality Experience data would be the first thing a reinsurer would look at. Only large plans would have credible data, but anything would help Refinements could be made by looking at the occupation, amounts, geographic distribution History of the plan will also be important, the reinsurer may look at if there was anti-selection at any given point in time – was there an offer of lump sums or any other conversions? The reinsurer will have to use mortality improvement factors, for example, 1% improvement per year from the starting experience.

19. 19 Pricing Reinsurance Return on assets Reinsurer will look at what is the yield on a portfolio that he could purchase today that matches the liability cash flows Will use a set of investment guidelines to have a realistic mix of provincial, Canada and corporate bonds, as well as a credit quality mix. To that yield, the reinsurer will subtract an expected default rate, to take credit risk into account. Some would use an optimizer to generate the portfolio used for pricing, and for managing the assets. Often this net return on asset is converted to a spread over treasuries or a spread over the swap curve, for example, treasuries + 90bps.

20. 20 Pricing Reinsurance A linear optimizer can be used to make the most optimal fixed income portfolio selection The optimizer would select from a list of available bonds the portfolio that best matches the liability portfolio with the highest yield, ensuring that: Mismatch risk, determined through interest rate scenario testing is within risk tolerance and The portfolio fits all constraints, such as: Overall credit quality Exposure per issuer, per sector, per type, per rating (duration-weighted) Any other risk metric, such as maximum negative cash flows in any given year The universe of bonds used as input to the optimizer would be price as of the time of the optimization, and would include the full bid-offer spread. The universe would also have been screened by the asset manager to eliminate any undesirable names and ratings used by the optimizer may be adjusted by the asset manager to reflect any view the manager has on that particular issue.

21. 21 Pricing Reinsurance Cost of capital Reinsurer will come up with the capital it needs to support the business. Offshore reinsurers may not have statutory capital requirements as such (Bermuda minimum capital is $250k!), so reinsurer will calculate an economic capital, i.e. an amount set aside that is a measure of the risk of the business Economic capital will depend on the certainty around the assumptions as well as the risk of the asset portfolio Then a cost of capital is calculated so that the reinsurer obtains it’s target return on capital. Often expressed as a reduction in the discount rate used, for example 30bps. So in our example, if we earn treasuries + 90 bps, and need 30 bps for the cost of capital, then the price offered will be discounting the liability cash flows (calculated using the reinsurer’s mortality assumption) at the treasury curve + 60bps.

22. 22 Summary UK market may be an indicator of what lies ahead Reinsurance is a flexible tool and may ultimately be the only outlet for large amounts of longevity risks New accounting rules in the US may speed up evolution there