Trends in VA Product Development and Hedging Strategy

Investment Symposium March 2009

F1–Trends in VA Product Development and Hedging Strategy

Niaz Haider Peter Sun Carl Mason Rajesh Bhandula

Moderator Ross Bowen

VA Risk Management ρ (rho) - a hedgeable risk

Rajesh Bhandula Director, Fixed Income Derivatives Marketing +1 212 841 3116

Rho – a hedgeable risk

Most VA products are short a put option on the underlying through the various embedded guarantees

Embedded put options have long expiries

GMDBs : option expiries easy to model from the life expectancies assumed in the VA portfolio

GLBs : Option expiries are shorter than GMDBs but more complicated to model

Long expiry makes the value of the put option very sensitive to the level of interest rates

Option value increasing with interest rates going lower and vice versa

Change in Rho due to change in the moneyness of the put option adds to the complexity of risk management

1 VA – Rate Risk (Rho) exposure

Black Scholes Put Option P = K*e-rT*(N-d1)-S*N(-d2) SPXt1=1500 Rho = δP/δr h Exposure Rho

SPXt0

SPXt1=500 30 year

Yield Curve 1 year

Regulatory rule changes require additional capital reserves held against GLBs. A portion of this capital calculation depends on the discounting effect of these long dated liabilities

VA – Correlation Cross-Gamma

The Rho position increases incrementally with the moneyness of the average short equity put strike Option intrinsic value Æ incrementally shorter rho Option vega Æ convexity of rho μ

SPX vega ρ

250 1750 Avg Policy Put Strikes

So as equities sell off, the liability MTM increases - thereby requiring more rho coverage Furthermore, this coverage is required at an increasing rate as the market approaches the underlying average equity strikes

2 Why Hedge Rho?

Change in the MTM of the VA liability attributed to change in rates can be very large ( especially in high volatility environment) Sensible if VA liabilities discounted with swap rate term structure

Mitigation of the “Japan syndrome”: Long periods of low rates/flat or inverted forwards associated with declining equity valuations Flatter / inverted curve for a given rate level means higher discount factors

Capital Relief under NAIC C-3 phase 2

Derivative Strategies to hedge Rho

3 Swap Strategies

Interest Rate Swaps

Hedger receives fixed interest rate to pay floating rate on a notional amount at pre-determined intervals ( e.g. every 3 months) for pre-determined term

Forward Starting Swaps

Hedger receives fixed on a swap with the start date in the future e.g. 2 years forward starting 10 year swap

Zero Coupon Swaps

Hedger receives one fixed interest payment at maturity of the swap to pay / receive one cashflow at maturity which is the future value of the compounded floating interest rate amounts during the life of the swap

Option Strategies

Receiver Swaptions A receiver swaption gives the owner of the swaption the right to enter into a swap to receive the fixed rate and pay the floating rate. Swaption is in the money when the market swap rate for the underlying swap is below the strike Example : 1y10y 3% RTR ( 1 year option on a 10 year swap that gives the buyer right to receive 3% fixed rate and pay LIBOR if the 10y swap rate is below 3% at expiry of the swaption

Interest Rate Floors Interest rate floor is a series of European put options or floorlets on a specified reference rate, usually LIBOR. The buyer of the floor receives money if on the maturity of any of the floorlets, the reference rate fixed is below the agreed strike rate of the floor Common Indices: CMS, Libor Forward starting ( 5X10, 5X15)

4 New products applicable as Rho hedges

Separation of curve risk from the level of rates

All other things equal, a flatter forward curve generates higher discount factors

Curve correlation products can hedge the shape of the forward curve Example: 5x15 Floor on (CMS30 –CMS5) struck at zero If purchased in a steeper yield curve environment, can be quite cheap Positively convex payoff in the event of either a bull or bear flattening or inversion Can cheapen further by conditioning floor payment contingent to CMS30 < 4%

5 Correlation products condition the hedge

GLB liability MTM a function of the joint probability of the underlying declining in a low rate environment

Correlation products can condition a rho hedge on the price of the underlying Example: 10y floor on 10CMS struck at 2.50% conditioned on S&P500 yoy D -10% 10y floor on 10CMS struck at 2.50% conditioned on S&P500 below 850

Correlation rho hedges presume underlying delta is hedged!

Variable Annuity Hedging – Effects

Beginning in spring of 2008, Rho hedgers began to receive fixed 10y to 30y swaps Peak coverage concentrated in the 20-30 year area of the swap curve

1500 5.5

1400 5

1300 4.5

1200 4

1100 S&P 3.5 30y 1000

3 30y Swap Rate Swap 30y

S&P index values S&P index 900

2.5 800

700 2

600 1.5 8 8 8 8 8 8 8 9 -0 -08 -08 -0 -0 -09 r n-0 g-0 p v c n-0 ay Jul-08 u e o e Feb-0 Mar-08 Ap M Ju A S Oct-0 N D Ja Feb Cause and effect – as equity prices fall in the 2nd half ’08 ÆVA hedgers delta hedge (sell SPX futures). SPX closer to short put strike position ÆShorter rho position Æ must continue to receive fixed Rates were lower when higher rho coverage was needed

6 Disclaimer

•The material in this document was produced BNP Paribas Securities Corp. (“BNPP”). •This document is only directed at institutional investors as defined by the National Association of Securities Dealers. Any investment or investment activity to which this document relates is available only to and will be engaged in only with relevant persons. This document is not intended for retail customers and should not be passed on to any such persons. Any person who is not a relevant person should not act or rely on this document or any of its contents. •The information and opinions contained in this presentation have been obtained from public sources believed to be reliable, but no representation or warranty, express or implied, is made that such information is accurate or complete and it should not be relied upon as such. Information and opinions contained in the report are published for the assistance of recipients, but are not to be relied upon as authoritative or taken in substitution for the exercise of judgement by any recipient, and are subject to change without notice. •This presentation is not, and should not be construed as, an offer document or an offer or solicitation to buy or sell any investments. No BNP Paribas Group Company accepts any liability whatsoever for any direct or consequential loss arising from any use of material contained in this presentation. This presentation is confidential and is submitted to selected recipients only. It may not be reproduced (in whole or in part) to any other person without the prior written consent of BNPP. A BNP Paribas Group Company and/or persons connected with it may effect or have effected a transaction for their own account in the investments referred to in the material contained in this report or any related investment before the material is published to any BNPP customers. On the date of this report, a BNP Paribas Group Company, persons connected with it and their respective directors and/or representatives and/or employees may have a long or short position in any of the investments mentioned in this presentation and may purchase and/or sell the investments at any time in the open market or otherwise, in each case either as principal or as agent. Additionally, a BNP Paribas Group Company within the previous twelve months may have acted as an investment banker or may have provided significant advice or investment services to the companies or in relation to the investment(s) mentioned in this presentation. •BNPP is a U.S. registered broker dealer and a FINRA and NYSE member. •By accepting this document you agree to be bound by the foregoing limitations.

7 The VA Hedging Environment

New Equity Derivative Tools Carl Mason Head of Equity Derivatives Strategy, Americas +1 212 841 2225

Insurance Flow Sales +1 212 841 3249

17 April 2009

Contents 1. Challenges for the VA Hedging Framework 2. Portfolio Hedging Outside the VA Sphere

17 April 2009 2 1. Challenges for the VA Hedging Framework

17 April 2009 3

The VA Hedging Framework VA Community Adoption 1. Delta The Underlying

2. Gamma Realized Volatility

3. Vega Implied Volatility

4. φ, η, ι, ϕ, κ, μ, ν, ξ or ψ ? Dividends Source: BNP Paribas

17 April 2009 4 Delta – Locking in the Roll Cost Delta Many VA hedgers are switching to selling total return swaps Mark-to-market P/L due to stock price change those doing so are selling swaps to LB guarantees make insurers long delta cover 60%-80% of their delta-hedge Historically sold index futures to hedge delta EAFE especially popular; also SPTR

Why? lock-in a price for the quarterly futures roll a total return instrument can hedge delta and dividend exposure of the VA liability cash flows can be timed to aid the liquidity of the liability + hedge portfolio

17 April 2009 5

Gamma – Attention Focused on the Short-Term Gamma Implied volatility is historically “rich”, even vs. recent realized volatility Change in delta due to a stock price change however short-dated options have LB guarantees make insurers short gamma been a fairly good buy through 2009 Without gamma hedging, an insurer’s delta hedge falls short, when stocks move VA hedgers continue to buy gamma buy 1-year OTM put options P/L the speed at which a delta- Stock growing interest in shorter maturities hedge fails when stocks move – liquidity less of an issue

1-Month S&P 500 Volatility 1-Week S&P 500 Absolute Return 100 20% 80 15% 60 10% 40 5% 20 0% 0 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 VIX 1-Month Realized Volatility (%) Realized Implied 17 April 2009 6 Source: BNP Paribas, Bloomberg Source: BNP Paribas Vega – Elevated Implied Volatility on Liquidity Squeeze Long-term implied volatility elevated Vega reflects a liquidity risk premium Mark-to-market P/L due to a change in market volatility expectations (implied volatility) we expect long-term implied vol to decline after vol term structure flattens The cost of future gamma hedging makes insurers short vega Vega hedgers buy long-term puts, var swaps or forward-starting var swaps S&P 500 Variance Swap Prices 60% some closed out existing positions some “selling tails” via variance swap 50% buy-writes, conditional variance swaps

40% Major Risk Prices Percentile on 10-Year Range 100%

80% 30% 60%

20% 40%

20%

10% 0% Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09

3M 12M 60M VIX USD 2Y Swap Spread CDX IG Source: BNP Paribas Source: BNP Paribas, Bloomberg 17 April 2009 7

Dividends – Learn From The Street 2003 S&P 500 Dividend Swap Prices Dividend declines brought structured 60 1800 product dealers’ attention to dividend risk

The Street is structurally long dividends 50 1600

40 1400 2004 – 2006 Dealers sought dividend lay-off partners 30 1200 Explosion of dividend swap trading

20 1000 Today Active two-way dividend swap market 10 800 Traditional investors can now express an active view on future dividends 0 600 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 You can trade futures on EuroSTOXX 50 dividends out to six years at Eurex Index 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Source: BNP Paribas 17 April 2009 8 Dividends – The Long Dividend Bias

VA providers are also long dividends S&P 500 Dividend Growth LB guarantees are based on stock 20% total returns, but many hedges pay 10% out based on stock price returns 0% -10% put options’ vega mark is based on -20% dividend assumptions -30% dividend expectations ↓ -40%

Ö forward price ↑ 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 Realized Growth Implied Growth Ö OTM put vega ↓ Source: BNP Paribas

Implied dividends typically grow slower Investors trade dividend swaps to than realized dividends 1. Target the timing of an earnings view partly due to equity risk premium stocks depend on fundamentals (E) partly due to excess supply of and long-term sentiment (P/E) dividends from end-users dividend swaps depend on E 2. Diversify an equity portfolio 3. Play dividend term-structure steepness

17 April 2009 9

Dividends – Sell Dividend Swaps to Manage Risk At maturity, the swap buyer and seller exchange cash flows

Dividend Amount

Buyer Seller Fixed Amount

Index dividend swaps give Sample Index Dividend Swap Termsheet Forward-starting -- a 2010 exposure to an index’s dividend swap pays 2010 dividends only stream -- equivalent to the Trade Date 26 August, 2008 dividends that index holders Start Date 31 December, 2009 receive, taking index changes Maturity Date 31 December, 2010 into account Index S&P 500 The fixed strike is the swap’s No. of Baskets 100,000 price -- the implied dividend Fixed Strike 28.00 Stock dividend swaps give exposure to a single stock’s Fixed Amount Number of Baskets x Fixed Strike dividends nit × dit Dividend Amount Number of Baskets x ∑∑ The dividend amount is ti Dt accumulated through the year to maturity Dividend swaps pay out based t each weekday from Start to Maturity on ordinary cash and stock i each share in the Index on t Gross dividends, before dividends, but exclude special d the dividend for share on t it i withholding and tax credits dividends nit number of sharesi in the index on t Dt index divisor on t

17 April 2009 10 2. Portfolio Hedging Outside the VA Sphere

17 April 2009 11

Portfolio Hedging Today – “Short Volatility” With implied volatility elevated, a put put-spread collar option’s price is historically high Benefit more immediate upside places a great drag on performance participation than put should stocks trade higher Cost limited downside protection ceiling on upside participation if stocks tumble, pay considerably “Short volatility” hedges are in vogue to roll protection to lower strikes buy a put-spread collar buy a vega-minus hedge vega-minus hedge embeds a series of overlapping short-dated put-spread collars, strikes fixed at future dates Elevated implied volatility helps the pricing of the put-spread collar and VMH Benefit may profit if stocks range-bound over year hedge a portfolio against stocks grinding lower if stocks rise through the year, hedged portfolio will likely impose only a small hurdle (if any) for participate, subject to a small drag portfolio profit on a stock gain Cost if stocks plummet one month but do not bounce back the next, hedge may be lacking at year end

17 April 2009 12 Portfolio Hedging Today – An Active Process The severe early-2009 market decline Current P/L of S&P 500 Put-Spread Collars Executed Earlier This Year illustrated a put-spread collar limitation 15% limited downside protection on 10% especially sharp market declines 5% 0%

-5% -10% The bear-market rally provides an -15% opportunity to roll down to lower strikes -20% -25% recently executed put-spread collars 31-Dec 14-Jan 28-Jan 11-Feb 25-Feb 11-Mar Date Collar Initially Traded face diminishing marginal gains should Source: BNP Paribas stocks retrace their 2009 lows soon Collar P/L Index return P/L at Expiry for Put-Spread Collared Portfolios by rolling the collar, gain protection at 20% index levels below where the current 10% put-spread collar can deliver 0%

-10%

-20% Alternatively, roll into a VMH, a strategy Keep Exisiting Collar on Portfolio

-30% where strike rolling is automatically Keep Collar on Portfolio, but Roll Down to Lower Strikes embedded -40% Unhedged Portfolio

-50% 17 April 2009 500 600 700 800 900 1000 1100 13 S&P 500 Source: BNP Paribas

Active Investors Crush Skew Recent rally is a manifestation of a high S&P 500 Volatility and 1-Month Returns volatility regime 80% 10000 60%

in high volatility regimes we see many y 40% 1000

switches from bear to bull and back 20% 100 again 0% S&P 500

Return / Volatilit -20% asymmetry between the ease in 10 maintaining long and short positions -40% -60% 1 promotes bear market squeezes '29 '39 '49 '59 '69 '79 '89 '99 '09 Min 1M Rtn Max 1M Rtn 12M Vol (1M "1/2-Life") S&P 500 Implied volatility skew steepness Source: BNP Paribas, Bloomberg “crushed” Skew Steepness (25-Delta-Put Vol - 25-Delta-Call Vol) / 50-Delta vol hedged investors rolling put-spreads 45% collared and unvested investors 40% chasing rallies, buying OTM calls 35% 30%

You might care because 25% less steep skew makes OTM puts less 20% expensive relative to OTM calls 15% Mar-99 Mar-01 Mar-03 Mar-05 Mar-07 Mar-09 3M 12M

Source: BNP Paribas, Optionmetrics 17 April 2009 14 Conclusions VA hedgers can do much to tighten up their delta-hedging consider roll costs consider dividends

VA hedgers face liquidity constraints in a challenging market implied volatility elevated hedges driven to the short term

Learn from the lessons of more nimble hedgers don’t buy tails if liquidity is limited consider short volatility hedges + be more active

17 April 2009 15

Disclaimer The risk of loss in trading securities and options can be substantial. Customers must consider all relevant risk factors including their own specific financial situation before trading. Options involve risk and are not suitable for all investors. See the Options Disclosure Document: Characteristics and Risks of Standardized Options.

This document is prepared for professional investors and is not intended for Private Customers and should not be passed on to any such persons. For the purpose of distribution in the United States this document is only intended for persons which can be defined as 'Major Institutional Investors' under U.S. regulations. Any U.S. person receiving this document and wishing to effect a transaction in any security discussed herein, must do so through a U.S. registered broker dealer. BNP Paribas Securities Corp. is a U.S. registered broker dealer.

The information and opinions contained in this document have been obtained from public sources believed to be reliable, but no representation or warranty, express or implied, is made that such information is accurate or complete, and it should not be relied upon as such. Information and opinions contained in the document are published for the assistance of recipients, but are not to be relied upon as authoritative or taken in substitution for the exercise of judgement by any recipient, and are subject to change without notice. This document is not, and should not be construed as, an offer document or an offer, recommendation or solicitation to buy or sell any investment(s) or to participate in any particular trading strategy. Any reference to past performance should not be taken as an indication of future performance. No BNP Paribas Group Company accepts any liability whatsoever for any direct or consequential loss arising from any use of material contained in this document. This document is confidential and is submitted to selected recipients only. It may not be reproduced (in whole or in part) for distribution to any other person. A BNP Paribas Group Company and/or persons connected with it may effect or have effected a transaction for their own account in the investment(s) referred to in this document or any related investment(s) before the material is published to any BNP Paribas Group Company's customers. On the date of this document a BNP Paribas Group Company, persons connected with it and their respective directors and/or representatives and/or employees may have a long or short position in any of the investment(s) mentioned in this document and may purchase and/or sell the investment(s) at any time in the open market or otherwise, in each case either as principal or as agent. Additionally, a BNP Paribas Group Company within the previous twelve months may have acted as an investment banker or may have provided significant advice or investment services to the companies or in relation to the investment(s) mentioned in this document.

17 April 2009 16 Prospering in the Financial Crisis

2009 Investment Actuary Symposium

Peter Sun, CFA, FSA, MAAA Milliman Financial Risk Management Practice

Ingredients for Success This is NOT a Traditional Actuarial Team

Cross-discipline talents are needed for a successful hedging program

Capital Markets Technology

Quantitative Development Actuarial

Basic Principles

Use technology & financial engineering for transformational improvement in the retirement security system Principles – Simplicity – Transparency – Reliability The impact of the current financial crisis

VA Continues to be a Critical Product

Insurance companies are in the asset accumulation business – Pure protection business is still important, but asset accumulation products are becoming increasing significant – VA is especially important – Innovations in guarantee features has fueled the recent VA growth

This trend is true in US, Asia and Europe VA Sales Are Sensitive to Market

There is $151 billion of VA sales in the US VA asset is $1.3 trillion, whereas the US GDP is $14 trillion

US VA Annual Sales

180 179

160 155 151 140 128 129 132 121 125 120 112 107 100 99 88 80

0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

We Expect Japan VA to Grow

Japan is likely to continue to experience the effect of savings transfer from low yielding deposits to VA with guarantees – More than 50% of Japanese assets are in cash and deposit

Low interest rate environment will help

Cash and Japan US Deposit Cash & Deposit 6,585 51% 5,602 17% Bond 282 2% 2,624 8% Equity 1,009 8% 10,747 32% Mutual Fund 541 4% 4,208 13% Life Insurance 1,971 15% 1,078 3% Pension 1,397 11% 6,032 18% Others 1,054 8% 2,930 9% VA Total 12,839 100% 33,220 100%

Billion US$, Japan data as of 3/2006, source Bank of Japan. US data as of 2005, source Board of Governors of the Federal Reserve The Recent Financial Crisis has been Severe

Failure of well known financial institutions – Lehman Brothers, Merrill Lynch, Bear Stern – Credit risk is brought to the fore

Worldwide decline in equity market

Rapid reduction of interest rates

Increased volatility

Worldwide Equity Market Decline Equity Market Turbulence Worldwide – S&P lost 47% Oct 2007 to Oct 2008 – In October 2008 alone: • S&P lost 17% • Japan: Topix dropped 21.3% • Europe: FTSE lost 11.7% STOXX lost 12.5%

S&P Movement from 11/1/2007 to 10/31/2008

1600

1500

1400

1300

1200

1100

1000

900

800 ay-08 ug-08 Nov-08 Feb-08 Nov-07 M A Rapid Reduction of Interest Rates

US Treasury price up and yield close to zero – Flight to safety FED cut rates Bond price tumbled and yield high – Credit spread widened

3 Month US Treasury Bond Yield (%)

4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 Jul-08 Oct-08 Jan-08 Nov-08 Feb-08 Apr-08 Jun-08 Nov-07 Dec-07 Sep-08 Mar-08 May-08 Aug-08

Significant Increase in Volatility

S&P Weekly Volatility from 11/1/2007 to 10/31/2008

35.0%

Both realized and implied volatility shot 30.0% up 25.0%

20.0%

15.0%

Realized vol tripled 10.0% Nov-07 Feb-08 May-08 Aug-08 Nov-08

Realized Vol Implied Vol Implied Vol at 40% by October 2008 VIX Close

90 80 Forced liquidation of hedge funds helped 70 amplify the market volatilities 60 50

0 Jul-08 Jul-07 Jul-06 Jul-05 Jul-04 Jan-09 Jan-08 Jan-07 Jan-06 Jan-05 Jan-04 VA Writers Incur Large Liabilities

Guarantees prove valuable to

Hybrid, 1.9% policyholders in financial crisis No Living – GLWB becoming the retirement Benefit, 19.1% vehicle of choice around the world

GM AB, 2.5% Most policies are becoming in-the- GLWB, 50.9% money GMIB, 21.2%

It is estimated that aggregate benefit GMWB, 4.3% value to exceed the aggregate account value by about $232 billion by October 31, 2008 – Larger than the GDP of over 130 countries

Hedging Programs Have Performed Well

It is estimated hedging has saved the insurance industry about $40 billion in September and October in 2008 – Save many companies from solvency issues

Hedging programs are on average 93% effective in recouping the capital market losses that hedging programs were designed to protect

Most hedging payoffs are due to movement in equity and exchange rates

Hedging is not fool-proof – In-depth understanding of risk management is required Illustrative Hedging Results Weekly Net P&L - Hedging vs. No hedging from 11/1/2007 to 10/31/2008 (million $)

0 P&L -10

-20

-30 Weekly Net P&L - Hedging vs. No hedging from 9/2008 to 10/2008 (million $) Jul-08

Jun-08 Oct-08 30 Jan-08 Apr-08 Nov-07 Mar-08 Nov-08 Feb-08 Aug-08 Dec-07 May-08 Sep-08

Hedged P&L Unhedged P&L 20

0 P&L

-10

-20

-30 Oct-08 Oct-08 Oct-08 Oct-08 Sep-08 Sep-08 Sep-08 Sep-08 Sep-08

Hedged Un-hedged

What Has Worked, What hasn’t What Has Worked

Insurance company hedging programs are designed to reduce the exposures to capital market risks – Do not take risks to make a profit

Use simple hedging instruments – Futures contracts – Plain vanilla options – Little counterparty risk

Be highly transparent – Open discussion of hedging methodologies – Reviewed and audited by multiple parties – Contained operational risks

Dynamic Hedging Best Practices

Development of Analytical Tools is essential – Liability valuation capabilities – Asset valuation and market monitoring tools – IT infrastructure and grid computing capabilities Strategy Development and Testing Dedicated staff for hedging activity – Capital markets professionals/traders – Actuarial modelers & students – Technology experts – Quantitative code developers Operational and trading controls Performance measurement and monitoring – Hedge effectiveness – Actuarial experience Make Risk Management an Integral Part of the Business Start early – Think through the implications of risk management from product conception – Can avoid unexpected results down the road

Start late – It is never too late to start hedging – Hedging will not recoup losses in the past, but can protect solvency in the future

Have an evolving process – All good hedging programs started simple – They evolve towards perfection through continuous refinements

Senior management support is the key

What Hasn’t Worked

Leave critical exposure unhedged

Follow accounting peculiarities blindly – US GAAP SOP03-1, Canadian GAAP are not fair valued – Following non-fair value accounting rules blindly hurt the economic fundamentals

Deviate from sound risk management principles – Under pricing – Unchecked fund allocation

Keep hedging practice as a secret – Leaving blind spots in hedging programs Companies’ Reactions to the Crisis

Companies’ Reactions

Tighten hedging programs – Basis mismatch containment – Policyholder anti-selection management – Enhanced operational control

Repricing – Pull back on benefit offering – Increase fees charge – Even for inforce business within contract limits

Commissions – Review of commission schedules to ensure DAC amortization Mergers and Acquisitions

We have seen dramatically increased interest in M&A activities

Companies with weak risk management results will be gobbled up by companies with strong risk management results

The difference between the weak and strong companies are not obvious during good economic times

Only the strong companies can survive this round of financial storm

Hedging best practice is the deciding factor

Regulators, Investors, Rating Agencies Regulators

More awareness of the need for risk management – Allowing more credit in statutory reporting if hedge effectiveness is proven

Company avoidance of unreasonable regulation – Example is to avoid standard scenario requirements through internal or external off-shore reinsurance

Regulators are experimenting too! – Regulators are leaving backdoors such as “permitted practices”

Investors Very focused on risk management practice – Hedging program performance is always asked about during conference calls

Clear and rapid reward and penalty for good and bad practices – Movement of company stock price is largely driven by the results of risk management practice for major VA writers

In need of a clear and transparent benchmark for the entire VA industry

Demand improved accounting standard that accurately reflects economic fundamentals Rating Agencies

Taking an economic fundamental view – See through corporate structure vairations

CTE approach – S&P ratings BBB, A, AA, AAA correspond to CTE(90), CTE(95), CTE(97), CTE(99)

Recognizing hedging programs

Hedging credit to increase as rating agencies get more comfortable with insurance companies’ ability to run hedging programs – S&P currently allows 50% credit

Case Studies Case Study 1: Successful Company

A major multinational VA writer

Company stock is least affected in peer group

Viewed positively by the market as the company with the best risk management practices

Is in a strong position to benefit from current financial crisis

How Did They do it?

Followed all sound risk management principles – Simple instruments – Transparent approach – Management focus

Hedged all major exposures

Implemented industry best practices over time

Worked with advisors from the inception Case Study 2: Not So Successful Company

A major multinational VA writer – Quickly losing market share

Company stock is down by over 80% in past year

Suffered downgrades from rating agencies and analysts

Company currently in a crisis mode

Left certain critical exposures unhedged – Was OK in normal times, but quickly blows up in crisis time

Program was not open so problems not identified early

In Summary

VA will continue to be a strong product

VA will evolve as a result of the recent financial crisis

Companies with strong risk management practices will come out ahead from this financial crisis

Risk management will be the key to differentiate the winners and losers Thank you

Milliman

Chicago 71 S. Wacker Drive, 31st Floor Chicago, IL T: +1 312 726 0677 E: [email protected]

Peter Sun, CFA, FSA, MAAA