A Rating Agency Perspective On Life Insurer Risk Management

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A Rating Agency Perspective OnLife Insurer Risk
Management

• Presented by
• Joel LevineVice President Senior AnalystLife
  Insurance Group

April 26, 2004
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Presentation Outline

• Usefulness of available risk management
  information - rating agency focus versus
  management information and regulatory reporting
• What rating agencies worry about
• Lessons from past failures
• Growing complexity of business GMDB and UL no
  lapse guarantees
• Secondary market for insurance contracts
• Hedging VA guaranteed living benefits
• Conclusions

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A Lot Of Data,Not Enough Information
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Rating Agency Focus

• Credit analysis focuses on operating entity and
  enterprise level (holding co.) financial
  condition
• Analyzes the organizations ability to withstand
  stress from multiple sources of risk
• Comprehensive in scope liquidity, asset default,
  concentration, interest rate, market, inflation,
  actuarial, competitive, reputation, regulatory,
  litigation, merger/business integration, etc.
• Ongoing concern point of view, except for
  liquidity
• Compound interaction among risk factors, not just
  one at a time
• Medium term horizon

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Issuer Management Reporting Focus

• Many issuers are managed as decentralized
  business segments with fragmented reporting
• Separately managed investment portfolios with
  tailored ALM requirements
• Management reports (e.g., scenario projections)
  are produced on an independent, business segment
  basis
• Surplus assets are generally ignored
• Corporate (holding co) balance sheet and income
  components are ignored
• Affiliated entities are excluded
• Scenario analysis on a run-off basis

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Regulatory Reporting Focus

• Cash flow testing provides useful information,
  but has its limitations
• Reserve adequacy focus as opposed to company
  performance (e.g., capitalization level over
  time)
• Not all businesses/products are included
• Performed on a run-off basis
• Surplus assets are ignored
• Corporate (holding co) balance sheet and income
  components are ignored
• Affiliated entities are excluded
• Primarily focused on interest rate risk (except
  for NAIC C-3 Phase II)
• SAP only, no GAAP information

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Desirable Supplementary Risk Mgt Reporting

• Goal is to achieve a clearer understanding of the
  drivers of performance and the potential for
  significant losses tail risk
• Break-even scenario analysis - what it would take
  to impair the organization over a given time
  horizon
• Stress economic scenario analysis
• VaR/EaR analysis a more comprehensive analysis
  of risk that would reflect compound interaction
  of various risk factors
• Fair value accounting
• Embedded value sensitivity analysis

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What Do Rating Agency Analysts Worry About?
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Lessons From Past Failures

• General American (1999) liquidity risk of 7-day
  putable funding agreements, reinsurance with a
  weak company, loss of confidence by institutional
  investors
• Confederation Life (1994) heavy investment
  portfolio losses in real estate and commercial
  mortgages, unsuccessful acquisition strategy
• First Capital Holding (1991) and First Executive
  (1991) losses on high yield bonds, increase in
  policy surrenders impairing company liquidity

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The Business Is Getting More Complex and Risky

• Increasingly, new products are being created with
  a focus on guarantee elements
• Equity market uncertainty has made investors more
  receptive to floors on returns
• Guarantees have become huge drivers of annuity
  sales (GMWB, GMIB)
• Guarantees have crept into life insurance
  products - e.g., UL no lapse guarantees (AXXX)
• New embedded risks are extremely complex and
  require sophisticated modeling in order to
  understand and hedge them
• Some companies are developing me-too designs
  without having a full appreciation of the risk

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What Keeps A Rating Agency Analyst Up At Night?

• Issuers that engage in products/activities that
  require undemonstrated competencies and/or that
  lack a cohesive process to manage them
• Does the issuer recognize the risks it has
  assumed e.g., dollar for dollar partial
  withdrawals?
• VA secondary guarantees when did life insurers
  become expert managers/traders of market risk?
• Does the issuer currently have or can it acquire
  sufficient resources to manage the risks?
• Is senior management committed?
• Whos accountable for the process
  nobody/everybody, multiple committees, CRO?

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Lesson Learned GMDB Is More Than Actuarial Risk

• Historically, life insurers accumulated actuarial
  risks and managed them using risk selection,
  diversification, and reinsurance
• GMDB reinsurers tried to diversify by writing
  new business at different points in time (over a
  market cycle) benefit payment on death only
  would provide diversification by exercise date
• Back-testing using historical equity market
  prices validated the insignificant economic
  risk of GMDB risk neutral valuation not well
  understood
• Ignored the systematic nature of market risk and
  the temporary impacts on statutory surplus

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A Case Study UL No Lapse Guarantee

• UL no-lapse guarantees expose issuers to
  potentially significant and systematic risks
• Simultaneous occurrence of low lapse rates and
  low interest rates may produce very large losses
  moderate adverse deviations can create material
  losses
• Moodys is concerned that issuers pricing lapse
  assumptions may be too high and rely upon
  naive/irrational policyholder behavior
• Pattern of statutory earnings under adverse lapse
  scenario is for losses to emerge in later policy
  durations masking of the problem in the early
  years

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A Case Study UL No Lapse Guarantee (Contd)
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A Case Study UL No Lapse Guarantee (Contd)
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How Will Middle-Tier Issuers Cope?

• VA secondary guarantee hedging requires a
  significant and expensive commitment of resources
• Systems development to integrate policy admin
  system with new actuarial modeling systems
• Hardware massive amount of policy records and
  many thousands of stochastic simulations
• Accounting support and internal controls
• Experienced traders
• Outsource it? can I afford it? - actuarial
  consulting firm, derivatives dealer with a
  turnkey program, emerging reinsurance programs
• Can a middle-tier issuer remain competitive?

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Secondary Market For Insurance Contracts

• Firms are being formed to facilitate a secondary
  market for annuity contracts and life insurance
  policies and arbitrage the irrational
  policyholder behavior pricing assumptions
• IBuyAnnuities.com
• CoventryFirst.com
• Wall Street capital has not been deployed in a
  significant way to-date, but that could change
• Potentially dire implications for some issuers
• Lapse assumptions for in-the-money GMDB,
  GMWB/GMIB, for partial withdrawals
• Mortality assumptions for life insurance policies

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Analyze This Whats The Right Objective For A
Hedging Strategy?
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VA Secondary Guarantee Hedging Objectives

• Reduce the tail risk potential for large
  economic (pv of net cash flows) losses
• But, subject to external constraints NAIC RBC,
  rating agency capital requirements, preserve
  company shareholder dividend capacity, maximum
  tolerable GAAP income loss, etc.
• Competing constraints make it difficult to
  resolve analytically (e.g., with an optimizer)
• For a rating agency, reported GAAP net income is
  not necessarily controlling economics are the
  primary concern

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Secondary Guarantees Subject To FAS 133

• Both assets and liabilities are marked-to-market,
  so GAAP results are reasonably predictable with
  one major exception
• Popular dynamic hedging practice is to match the
  liability greeks delta, rho, gamma, vega,
  cross-sensitivities trade-off between
  effectiveness and cost
• Arguments made that implied volatility for
  long-term derivatives fluctuates and tends to be
  mean-reverting makes it difficult to match the
  liabilities sensitivity to changes in volatility
  (vega)

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Secondary Guarantees Subject To FAS 133 (Contd)
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Secondary Guarantees Subject To FAS 133 (Contd)

• If long-term implied volatility is noise, can
  it be safely ignored and could one hedge with
  futures only?
• Maybe, but one shouldnt ignore the risk that
  delta may change significantly with large market
  moves (gamma) therefore, may need some option
  exposure
• Under NAIC C3 Phase II, stochastic simulations
  will be used to determine SAP reserve and RBC
  levels

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Secondary Guarantees Subject To FAS 133 (Contd)

• NAIC C3 Phase II methodology ignores spot market
  parameters such as implied volatility
• Hedging vega will not necessarily produce a more
  stable SAP financial result
• Responses of the hedge assets to changes in
  implied volatility will not be offset by
  corresponding changes in the values of the SAP
  liabilities

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Emerging Direction Of Hedging VA Secondary
Guarantees

• Index hedge long-term options covering well
  defined risks, while the insurer retains the
  uncertain, unhedgeable risks
• Hedge payoff based upon an assumed basket of
  indices, with provision for basket changes over
  time, and pricing that varies accordingly
• Insurer retains the basis risk basket vs actual
  fund performance
• Long-tenor hedge whose payoff approximates the
  payoff pattern of the particular GLB design
  issuer would assume the basis risk between the
  actual VA GLB payoff and the approximation
• Contractholder exercise efficiency would be
  another source of error

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Future Direction Of Hedging VA Secondary
Guarantees

• Index hedge (contd)
• Rating implications would depend upon the
  effectiveness of the hedge
• Insurer would need to demonstrate effectiveness
  through stochastic modeling that the basis risk
  would be manageable i.e., the tail risk
  (economic perspective) would not be excessive
• SAP impact would need to be considered how
  would statutory surplus be impacted using such a
  hedge under various scenarios?
• SAP surplus impact might be mitigated by using a
  combination reinsurance/derivatives structure

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Conclusions
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Conclusions

• Life insurers are rapidly expanding into new
  types of less familiar risks e.g., trading
  market volatility
• Management and regulatory reporting needs to
  catch up with the complexity of these new risks
  rapid strides are being made
• Risk management processes have been developed and
  are evolving - but are untested under extreme
  market conditions
• Basis risk and modeling risk inherent in hedging
  are difficult to quantify
• Insurance business has become more risky -
  assessment of risk management skills has become
  more challenging and critical to the credit
  ratings process