2nd Senior Actuary Investment & Risk Symposium

Managing Capital Volatility

Gaston Nossiter FIAA, MBA, CFA

Senior Vice President

Business Development

Global Financial Solutions

27 March 2012

Capital

What Capital?

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Capital Dimension

Regimes Comment

Statutory •Solvency I / II, U.S. stat., local solvency, etc.

•Slow convergence led by S.II

•Liquidity premium & discount rates

Economic •Company specific RBC model

•Used for decision making

•Most detailed RBC model

•May be used in statutory capital as internal model

Rating Agencies •S&P, Moody’s, AM Best, Fitch •The other RBC model…

Accounting •IFRS phase 1 / phase 2, US GAAP, local GAAP

•It’s broken – where to go from here? EV, EEV, MCEV, …

•P&L is important though

Market •Relative to local / global peers •Position in the cycle

•M&A currency

Volatility – VIX

3

What Volatility?

Chicago Board of Trade S&P500 Volatility Index

Interest Rates – USD 10 Year Treasury

4

Historical Low

Increasing HKD Capital Pressure

5

USD HKD Interest Rate Differential

VIF as a Source of Capital

6

Available Economic Capital => VIF

Source: Allianz Market Consistent Embedded Value Report 2008 & Allianz Market Consistent Embedded Value Report 2010

� Options to Manage VIF

� Full Monetisation

� Partial Monetisation

� Contingent Monetisation

Managing VIF Volatility

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Market Value of Assets

Best Best Best Best Estimate Estimate Estimate Estimate LiabilityLiabilityLiabilityLiability

Risk MarginRisk MarginRisk MarginRisk Margin

Solvency Solvency Solvency Solvency Capital Capital Capital Capital

RequirementRequirementRequirementRequirement(SCR)(SCR)(SCR)(SCR)

SurplusSurplusSurplusSurplus

� Monetization of expected future profits on the in-force portfolio with a release of some regulatory required capital

� Effectively selling the block of business for a fixed price

� Conceptually equity tranche

� Volatility of the VIF completely removed

� Maximize certainty, full future value realized today

Full Monetization

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Full Risk ReinsurancePolicyholder

Premium

Reinsurer

Upfront

payment

Premiums

Claims +

commissions

Insurer

Claims

payment

� Monetization of expected future profits on the in-force portfolio

� “Value in Force”

� Can be cashless or cash funded

� Allows release of some regulatory required capital

� Acts like debt, as excess profits get returned to the insurer.

� Creating a low risk (i.e. high probability of repayment) tranche allows access to debt-like cost funds

� Only available for a subset of the VIF

� Upside volatile but have locked in valuable floor

� Which can be recognized as regulatory capital

Partial Monetization

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Surplus Relief / VIF Financing

Policyholder

Premium

Reinsurer

Upfront

payment

Premiums

Claims +

commissions

Insurer

Claims

payment

Profit

share

� Provide Line of Credit / Capital Facility to meet future capital needs

� Flexible and efficient source of “just in time” capital

� Can be done well in advance of potential need

� Reinsurer analyses, prices and reinsures a small quota share of a larger block

� Reinsurer regularly reports current pricing terms and remaining capital / embedded value available in the block

� Terms and documentation already negotiated and in place

� Quota share can then be increased in future to raise additional levels of capital

� Can be done quickly and quietly, with minimal effort

� Provides certainty of financing size and cost in advance of need

� Monetises an otherwise intangible asset – the embedded value

Contingent Capital

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“Just in Time” Capital

� Solvency Margin management

� M&A financing

� Finance New Product Launch / Market Entry

� Finance other business initiatives

“Just in time” Capital

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Provides Line of Credit / Capital Facility that can be used for:

� HK reserving basis can create volatility even for a perfectly ALM matched portfolio

� Volatility is amplified when the portfolio is mismatched

� Statutory volatility impacts:� Amount of capital to be held

� Ability to pay dividends

� Ability to write new business

Economic vs Statutory Capital

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Hong Kong Statutory Basis

� “We are in a situation now in our society where the temptations to

provide “bad” financial reporting are probably greater than they used

to be. The need to get the stock price up, or to keep it up, is intense.”

Floyd Norris, Reporter

2001 Annual Report of the Financial Accounting Foundation

� “Reported earnings follow the rules and principles of accounting. The

results do not always create measures consistent with underlying

economics. However, corporate management’s performance is

generally measured by accounting income, not underlying

economics. Therefore, risk management strategies are directed at

accounting rather than economic performance”

Enron in-house risk management handbook

Economic vs. Statutory Capital

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Temptation to Manage to Non-Economic Measures

� Lobby regulator for change

� Raise additional capital

� Reinsure the liabilities

Managing Statutory Capital

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Options

Raise Additional Capital: A Comparison

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Benefit Reinsurance Debt Hybrid Debt Equity Securitization

R isk Transfer:

Cove rs losses above capital prov ided Yes No No No No

Comfortable with insurance risks Very No No Som ew hat Som ew hat

T arge te d at specific risks C an be No No No C an be

Acce ss to e xpe rtise Yes No No No Maybe

Financials:

Re duces require d RB C Yes No No No No

Re duces require d rating age ncy capital Yes (for full-risk) No Maybe No Maybe

T reated as T ie r 1 C apital Yes No Maybe Yes Maybe

Dilutiv e No No No Yes No

Financial lev e rage impact D ecrease Increase Increase Decrease D epends

Incre ase s total capital Yes Yes Yes Yes Yes

M ay cause a nee d to realize losses Yes No No No No

Incre ase s solv ency ratio Yes No Som ew hat Som ew hat D epends

S tructure:

Spe cial-purpose e ntity nee ded No No No No Yes

Cre dit enhance me nt / recourse nee ded Maybe No No No Maybe

Liquidity D epends Yes Yes Yes D epends

T ax e fficiency Partial to full Partial to full Partial to full None Full

Introduces counte rparty risk Yes No No No No

Cash or “cashle ss” Yes No No No Yes

V alue and C osts:

Fle xibility Yes Som e Som e No No

M aximum tenor Long Short-Medium Short-Medium Long Medium

M aximum size Medium to large Very large Very large Very large Very large

M inimum size Sm all to m edium Large Large Large Medium to large

M arke t status O pen O pen O pen O pen O pening

Rapid imple mentation O ften No No No No

Confide ntiality Yes (except Sch S) O nly if private No No No

Re strictions on manageme nt actions Maybe Maybe Maybe No Maybe

Administration and syste ms change s Maybe No No No Maybe

Low transaction costs Yes No No No No

O ve rall cost Low -Medium Low Medium High Low -Medium

Amount of legal documentation Low Medium Medium Medium High

� Raising additional capital provides a buffer but:

� Doesn’t address underlying cause of the volatility;

� Ties up capital that could be deployed elsewhere; and

� Depresses return on capital

� Coinsurance Funds Withheld� Allows insurer to:

� Convert the liability into an alternative basis;

� Retain control over the assets; and

� Redeploy excess capital

Reinsure the Liabilities

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One Idea: Coinsurance with Funds Withheld

Coinsurance Funds Withheld

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How does it work?

� Hong Kong Statutory reserve for the covered products would be coinsured to Reinsurer. That is, Insurer would pay the HK statutory reserves to Reinsurer on day one.

� Reinsurer would pay to Insurer two amounts:

� Funds Withheld (FWH) reserve equal to insurers GAAP reserves (which is

calculated on any basis); plus

� An initial ceding commission equal to the difference between the HK statutory

reserves and the FWH reserves is paid to Insurer

INSURER Reinsurer

HK Statutory Reserves

FWH = GAAP reserves

Initial Ceding Commission

Coinsurance Funds Withheld

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How does it work?

� On an on-going basis the following cashflows occur:

� Insurer would pay to Reinsurer:

� Gross premiums

� Investment Income on the FWH

� Any decrease in the FWH reserve

� Reinsurer would pay to Insurer:

� All benefits,

� An allowance to cover maintenance expenses,

� Any increase in the FWH reserve,

� Any experience refund

Coinsurance Funds Withheld

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Illustration

Year 2010 2011 2012 2013 2014

Before ReinsuranceINCOME STATEMENT

Total Net Premium Income 3,879,476 3,671,030 3,475,853 3,295,762

Investment Income 1,515,837 1,635,709 1,746,295 1,847,514

Total Income 5,395,313 5,306,740 5,222,147 5,143,276

Total Benefits 1,256,804 1,354,585 1,452,097 1,546,923

Total Increase in Reserves 2,474,410 2,297,851 2,104,892 1,923,256

Total Commission and Expenses 426,872 362,063 322,539 293,082

Reinsurance Cost 37,028 34,996 33,144 31,435

Cash Dividend 187,618 197,685 207,349 214,923

Total Benefits and Expenses 4,382,732 4,247,180 4,120,022 4,009,618

Income/(Loss) before Tax and Capital G/(L) 1,012,581 1,059,560 1,102,126 1,133,658

BALANCE SHEET

Investment Assets at End of Year 29,259,360 32,746,351 36,103,762 39,310,780 42,367,694

Reserves at End of Year 29,259,360 31,733,770 34,031,621 36,136,513 38,059,769

Surplus at End of Year - 1,012,581 2,072,141 3,174,266 4,307,925

Coinsurance Funds Withheld

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After ReinsuranceINCOME STATEMENT

Total Net Premium Income 3,879,476 3,671,030 3,475,853 3,295,762

Ceded Reinsurance Premium to RGA 29,259,360 3,879,476 3,671,030 3,475,853 3,295,762

Total Net Premium Income (29,259,360) 0 0 0 0

Investment Income 1,515,837 1,635,709 1,746,295 1,847,514

Interest Paid on Account Payable (FWH) 1,101,343 1,213,517 1,319,129 1,418,548

Total Benefits / Reinsurance Cost / Dividends 1,481,450 1,587,265 1,692,590 1,793,280

Reinsurance Recoveries 1,481,450 1,587,265 1,692,590 1,793,280

Total Net Benefits 0 0 0 0

Total Commission and Expenses 426,872 362,063 322,539 293,082

Reinsurance Allowance Received 8,222,285 426,872 362,063 322,539 293,082

Total Net Commission and Expenses (8,222,285) 0 0 0 0

Increase of Direct Reserve 2,474,410 2,297,851 2,104,892 1,923,256

Increase of Ceded Reserve 29,259,360 2,474,410 2,297,851 2,104,892 1,923,256

Total Increase of Reserve (29,259,360) 0 0 0 0

Experience Refund Received 0 3,072,497 2,935,219 2,779,852 2,627,948

Income/(Loss) before Tax and Capital G/(L) 8,222,285 3,486,991 3,357,411 3,207,018 3,056,914

BALANCE SHEET

Investment Assets at End of Year 29,259,360 32,746,351 36,103,762 39,310,780 42,367,694

Reserve at End of Year - - - - -

Gross Reserve at End of Year 29,259,360 31,733,770 34,031,621 36,136,513 38,059,769

Ceded Reserve at End of Year 29,259,360 31,733,770 34,031,621 36,136,513 38,059,769

Account Payable (FWH) at End of Year 21,037,075 21,037,075 21,037,075 21,037,075 21,037,075

Surplus 8,222,285 11,709,276 15,066,687 18,273,705 21,330,619

� Reduced Capital Volatility

� Insurer is holding the FWH (GAAP) reserve which tends to be more stable –

reducing volatility of Insurer’s Solvency Margin

� Counterparty Protection

� FWH structure means that the assets remain with Insurer. This provides Insurer

protection against Reinsurer’s default. It also allows Insurer to continue pursuing

preferred investment strategy, as assets do not need to be transferred and

Insurer can maintain its investment approach.

� Risk Transfer� RGA’s risk is that the FWH (GAAP) reserves held on behalf of RGA are

insufficient to meet future benefit payments

Coinsurance Funds Withheld

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Rationale

Conclusions

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Volatility Remains

Thank you for your attention.

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