Management of Asset Risk - I CM - 18 Risk & Capital Management Seminar - 9 July 2002 I N S U R A N C E A S S E T M A N A G E M E N T

2 Types of risk Do I have the correct strategy? –Model Risk –Strategic Allocation Can I implement the strategy? –Process Risk –Tactical Allocation

3 Agenda Definition of Risk Fixed Income Risk –Duration –Yield Curve –Credit/Sector –Security Selection Measuring and Controlling

4 What is Risk? Not necessarily volatility of returns Definitely not operational Ability to track benchmark Is this appropriate?

5 Risk Types Risk TypeInterest Rate Predictability Low Impact High Effectiveness Low Insurance Duration matching Risk TypeSector Predictability Medium Impact Medium Effectiveness Medium Insurance No Risk TypeCredit Predictability Low Impact High Effectiveness Low Insurance RBC, NAIC Risk TypeSecurity Predictability High Impact Medium Effectiveness High Insurance No

6 The Insurance Bias Typical Insurance Account Security Selection Credit Risk Yield Curve Duration Best Risk-Adjusted Returns - Lehman Brothers

7 Duration IF asset duration = liability duration, THEN, parallel changes in yield curve will not affect surplus Usefulness –Liabilities not discounted - not affected by yield curve movements –Yield curve movement not parallel –VFIC report Matching not necessarily better Accounting standards matter

8 Measuring Duration Rate Price with option without option PPP - + 0

9 Yield Curve Movements Guessing at the movement –Higher interest rates  shorter duration –Lower interest rates  longer duration –Steeper curve  barbell –Flatter curve  bullet Not very effective –Especially over longer horizons High up and downside potential

10 Credit Spreads U. S. Treasury Securities guaranteed by “full faith and credit” of the U.S. –No chance of default –Deep market –Caveat: yield curve movements All other securities contain credit risk Risk requires compensation

11 Credit Spreads Credit Spread - Difference in yield between debt and U.S. Treasury debt of same maturity Credit Component Liquidity Component

12 Credit Spreads Liquidity component fluctuates with market –Issue age & size –Not quality Rating agencies guide credit component S&P Ratings Investment Grade –AAA –AA –A –BBB Non Investment Grade –BB –B –C –D

13 Credit Spreads Spreads not static –Increase = “widening” –Decrease = “tightening” SpreadYieldPrice

14 Credit Spreads Ratings at end of year Ratings at beginning of year Source: Moody’s

15 Credit Problems Credit ratings not predictive –Quality is predictive Contradictory regulatory messages –High Yield highly correlated to Equity –RBC higher for Stock –High Yield not admitted in many states

16 Decomposing Credit Spreads

17 Security Selection Maturity Excess Return