CIA Annual Meeting LOOKING BACK…focused on the future

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Session Informal Presentation Moderator John Brierley Speakers John Brierley Lynne Patterson Session Informal Presentation Moderator John Brierley Speakers John Brierley Lynne Patterson

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Bank Economic Capital Concept A measure of the amount of capital required to underpin the business, based on the risks inherent in that business Measure risk specifically associated to the business, not a general industry perspective Banking is viewed on a short-term basis and the capital is measured over a one- year time horizon How far in the tail of the distribution depends on the bank target credit rating (AA = th percentile) Bank Economic Capital Concept A measure of the amount of capital required to underpin the business, based on the risks inherent in that business Measure risk specifically associated to the business, not a general industry perspective Banking is viewed on a short-term basis and the capital is measured over a one- year time horizon How far in the tail of the distribution depends on the bank target credit rating (AA = th percentile)

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Bank Economic Capital – Uses: Allocate economic capital by product and use for product pricing Fair and consistent way of allocating capital by platform and by product Return on economic capital the primary ROC measure used by analysts Effective way for management to compare profitability of different products and services within the financial institution

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Bank Economic Capital Components Credit Risk Operational Risk Business Risk Neutral Position Risk Interest Rate Risk Fixed Asset Risk Goodwill Other Bank Economic Capital Components Credit Risk Operational Risk Business Risk Neutral Position Risk Interest Rate Risk Fixed Asset Risk Goodwill Other

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Bank Economic Capital Components: Credit Risk Primary emphasis and largest component Stochastic model measuring credit migration Change in market value over the period Credit migration probabilities Default probabilities Loss in the event of default (LIED) Bank Economic Capital Components: Credit Risk Primary emphasis and largest component Stochastic model measuring credit migration Change in market value over the period Credit migration probabilities Default probabilities Loss in the event of default (LIED)

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Bank Economic Capital Components: Operational Risk Difficult to measure Build a database of loss events Experience expressed as an amount per transaction Evolving component of risk management

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Bank Economic Capital Components: Business Risk Very difficult to measure Small number of events Difficult to model Express as a percentage of revenue

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Bank Economic Capital Components: Neutral Position Risk Asset Liability mismatch Simplistic approach would look at 200 basis point parallel shifts (+ & -) in the yield curve Refined approach would use stochastically modeled interest rate scenarios Centrally calculated and allocated to each platform

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Bank Economic Capital Components: Interest Rate Risk Measures potential change in market value for capital assets Simplistic approach would look at 200 basis point parallel shifts (+ & -) in the yield curve Refined approach would use stochastically modeled interest rate scenarios Centrally calculated and allocated, except for insurance

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Bank Economic Capital Components: Fixed Asset Risk Non-invested assets Covers decrease in income from depreciation ROC requirement for pricing Goodwill Non-invested asset ROC requirement for pricing Other Insurance components

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Bank Economic Capital Components: Diversification Recognition given to risk diversification Between risks within a component Between components A correlation matrix is used Can only be accomplished if calculations are centralized

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Integrating with Bank Economic Capital: Credit Risk Component All insurance assets combined with other platform assets within the financial institution Combination of all assets is required in order to properly reflect diversification within the total asset portfolio Longer duration assets attract more capital (measure based on market value movement due to credit migration) Reinsurance ceded liability treated like any other asset - extremely long duration but low LIED Offset calculated amount with the Provision for Adverse Deviation embedded in the liabilities

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Integrating with Bank Economic Capital: Operational Risk Component A work in progress Risk areas identified Operational error database Reporting issues Expressed as a percentage of gross revenue, less claim payments (including change in policy liabilities)

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Integrating with Bank Economic Capital: Neutral Position Risk Component This is where asset liability mismatch risk (as measured by CALM) should go Since insurance capital managed separately from other platform capital management, the Insurance ALM provision is not added here Insurance is allocated a portion of the overall component – some double counting

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Integrating with Bank Economic Capital: Interest Rate Risk Component This is where asset liability mismatch risk is added (as measured by CALM using stochastically generated economic scenarios) “Total Balance Sheet” approach used Economic capital = rd percentile – liability Life Insurance measures the long-term interest rate risk, which is primarily a reinvestment risk Properly identifies capital for embedded options, such as Universal Life minimum interest rates Some offset from market movement of capital assets, since this risk is negatively correlated when liabilities increase with lower interest rates

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Integrating with Bank Economic Capital: Business, Fixed Asset and Goodwill Risk Components Centrally calculated factors (multiplied by Gross Revenue) applied consistently across all platforms Determined most appropriate definition for Insurance’s “Gross Revenue” to be consistent with bank definitions Centrally calculated diversification factors

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Integrating with Bank Economic Capital: Other Risks (Insurance Risks) Mortality Morbidity (incidence and termination) Lapse Home Auto Travel Property Catastrophe Reinsurance Auto loan buyback No explicit recognition of diversification within insurance risks

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Integrating with Bank Economic Capital: Other Risks (Insurance Risks) Monte Carlo simulations using actual inforce seriatim data where available (individual insurance, some group, some reinsurance) Binomial Distribution approximations used where actual inforce seriatim data is not available (some group insurance, home, auto, travel, some reinsurance) Annual modeling, generating factors to be applied for quarterly reporting

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Integrating with Bank Economic Capital: Other Risks (Insurance Risks) “Modified Balance Sheet Approach” used Economic capital = rd percentile of the distribution – mean of the distribution Do not offset economic capital by the Provision for Adverse Deviation PfAD measures misestimation and deterioration of the mean Economic capital measures volatility

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Integrating with Bank Economic Capital: Other Risks (Insurance Risks) Multi-year models used for multi-year guarantees (most individual insurance) Single year models used for short-term products (most P&C and group insurance) Multi-year model based on binomial distributions Mean and standard deviation obtained from projected inforce data (readily available from AXIS output) Randomly select a result from each future year binomial distribution and present value the result Repeat 100,000 times to obtain a multiple to apply to the single year model rd percentile amount

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Insurance Uses for Economic Capital: Consistent profit measurement with other platforms ROC reporting in published financial statements Pricing some products Property catastrophe reinsurance Embedded options within products, such as Universal Life account minimum interest rate guarantees Will expand use, especially for products where economic capital exceeds regulatory capital

CIA Annual Meeting Economic Capital Allocation LOOKING BACK…focused on the future Economic Capital vs. MCCSR: Both risk based, but EC more accurately reflects the risk specific to the company MCCSR grossed up for excluded components EC takes risk diversification into account, where MCCSR does not MCCSR significantly under-provides for interest rate risk, especially where embedded options (UL account guarantees) are present Before diversification EC > MCCSR After diversification EC < MCCSR Pricing with EC would result in charging more for interest rate risk and less for other insurance risks