1. INSURANCE ERM SWEEPSTAKES: WHO’S WINNING: RISK MANAGEMENT OR THE RISKS? NEIL T. STRAUSSSOA ERM APRIL 20 2012

2. 2 It’s Been Quite Risky Recently  Eurozone  U.S. Budget Stand-off  Equity Market Volatility  Interest Rates to Unprecedented Low Rates  Financial Crisis Recovery ? / Bumpiness  Regulatory Debate related to Financial Companies  MF Global  … And much, much more

3. 3 Life Insurance Sector: The Good, The Bad, The Mixed?  The Good – Investments – Bond and Mortgage Risk Management  The Bad – Interest Rate Risk Management  The Mixed – Product Risk: Variable Annuities

4. 4 The Good: Investment Risk – Risk Management Wins!

5. 5 Investment Losses Normalizing; 2011: Down, but Above-Avg ACLI CML Delinquency Rate CML Losses* : Moody’s Universe Bond / Pfd Stock Credit Losses* : Moody’s Universe *Data source: Highline Data  RMBS, CMBS remain elevated  CML: ~ 60bp remaining next couple yrs  Bonds/Pfd stock: ~ 25-40 bp annualized  Peripheral Eurozone sov/bank exposure minimal 2011 Credit Loss Expectations 2Q11: 12 bp

6. 6 The Bad: Interest Rate Risk – Risk Management Loses!

7. 7 Interest Rates: Risk from Flat/Down or Spike Up Flat/Down:  Next 3-5 years: modest, growing earnings drag  Longer-term: material earnings/capital impact  At risk: long-tail liabilities and unhedged VA “rho”  Risk management: do nothing, limited hedges, or wait for a higher-rate entry point Spike Up:  Disintermediation risk  Fixed income investments underwater  Significant block written at low rates  Risk management: caps and market value adjustment feature Best scenario for industry: gradually rising interest rates – likely?

8. 8 Interest Rates: Risk from Flat/Down  Few insurers have bought protection against lower interest rates, either because of the high cost of doing so or because they deem the risk to be remote (editor’s addition: Risk management using the old technique of ‘crossing one’s fingers’ Humans will be humans – the biggest risk of all). Exceptions are the minority of companies that have bought interest rate floors, insurers with interest rate hedging programs for variable annuity lifetime income guarantees, and companies that have locked in interest rates on the investment of future premiums for products such as no-lapse universal life and long-term care.  Moody’s Investors Service, August 19, 2011 (excluding insert)

9. 9 The Mixed: Product Risk (Tie: Risk/Risk Management)

10. 10 Life Insurer Product Risk: Variable Annuity (VA)?  What is a variable annuity?  Insurance product allowing customer to invest deposits in a range of investment options  Insurer agrees to make future periodic payments to the customer  Includes a death benefit  Funds accumulate tax-deferred  Investment Risk is the policyholder’s, not the insurance companies  … that is until the Advent of guaranteed living benefits  Insurance company takes investment risk in certain scenarios 10

11. 11 Variable Annuity Risk Management Evolution  First RM for VA’s - “Head in the sand” – i.e., no risk management  Actuarial analysis – 1999 - 2000  Borrowed techniques used for more traditional products  Goals – simplicity; limiting reserves required  Hampered by lack of robust technology  Could not get actuaries and investment people in the same room – “you just don’t understand”  Stochastic modeling – beginning mid-2000’s  Availability of computer power  Development of modeling techniques  Regulatory pressure  VA Guarantee Arms Race repeated itself: 2002/3 and then 2008/9\  Conclusion – it takes > a near-death experience to change – need a death experience!  Even in 2011, the risk/growth equation hard to navigate – current market 11

12. 12 VA’s Add Earnings/Capital Volatility  Hedging-related issues  Competing hedge goals: economics, GAAP and Stat  Limited rho hedging  Liquidity risk from collateral posting  Earnings and capital volatility from VA book  Captive reinsurance masks capital shortfalls Includes 28 rated companies; operating income = net income – net realized cap gains ex derivatives GAAP Income Volatility

13. 13 Some Key VA Issues  How de-risked are the new products?  Tail risk improving  More equity and interest rate risk passed back to customers  Low vol funds, automatic equity reallocation, interest rate-dependent withdrawal rates, etc.  Which companies’ VA business have better credit profiles?  Sound product design  Comprehensive (including static) hedging of economics  Transparency  How does Moody’s evaluate VA risk?  Examine capital post-stress event (30% drop in equities)  Compare results with Moody’s view of required capital  Incorporate transfer of risk and capital to reinsurance captive  Review greeks hedged versus exposure (including f/x, interest rate, etc.)

14. 14 Assessing Risk Management  It starts with assessing risk tolerance  It only then moves onto analyzing risk management  Board of Directors – oversight  Executive Management – top down management of risks  Business Line Management – bottom up management of risks  What is the right breakdown?

15. 15 Shampoo: The endless loop of rinse, repeat  Risk identification  Risk measurement  Risk Mitigation  Risk Prioritization  Risk Monitor – Repeat

16. 16 Everybody’s a risk manager, the only way? »

17. 17 Risk Management Quotable Quotes  “What’s a Chief Risk Officer?”  Heard at one of the first financial companies to implode in 2008, 3 months prior  “Everybody’s sub-optimizing in the enterprise for their business/function except for the CEO, CFO and CRO who are optimizing for the whole”  Heard from one of the first CROs in the insurance industry (paraphrased)  “If money isn’t loosened up, this sucker could go down”  George Bush, October 2008

18. 18 Risk Management Quotable Quotes  Is this ERM enough for the financial sector?: Can regulation/government ever catch up to the private sector: Imagine the police without the ability to speed or carry weapons?  Anonymous  “There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know.”  Donald Rumsfeld

19. 19 Background – Neil Strauss  Vice President - Senior Credit Officer in Financial Institutions Group of Moody’s Investors Service – responsible for a portfolio of U.S. ratings within the Life Insurance Group.  Prior, worked for about 30 years in a variety of roles both in the insurance industry and as a senior credit rating agency insurance and reinsurance sector analyst.  Held actuarial, risk management, and credit roles at New York Life, AXA-Equitable and AIG, respectively. Consulted for Promontory Financial Group and Neil T. Strauss Associates, LLC. on insurance, risk management and rating agency related engagements.  Adjunct professor in the Graduate Division of New York University’s School of Professional and Continuing Studies. Currently teaches a course that he developed on Enterprise Risk Management for the Insurance Sector, both online and onsite.  A graduate of Johns Hopkins University.  Professional designations as an actuary and as a chartered enterprise risk analyst, both from the Society of Actuaries.

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