Goldman Sachs Financials Conference Surviving in a low interest rate environment

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1 Goldman Sachs Financials Conference Surviving in a low interest rate environment Prof. Dr. Michael Koller, CRO and Group Chief Acturay Rome, 18 June 2003

2 Management Summary Understanding Economic Principles? No Yes Economically Bancrupt? No Yes Are you gambling? No Yes Are able to take risk? Yes No 2

3 Contents Understanding economic principles Fair values et al Risk Taking Pricing New Business Summary 3

4 Current Problems Underestimated risk in asset allocations of life insurers lead to huge losses Low interest environment leads to the question whether statutory reserves are sufficient IASC and FASB want to introduce the concept of Fair Value which needs to be detailed Embedded Value as a tool for the valuation of life insurance companies seems to be insufficient Changed business strategies require an adequate pricing based on economic principles The traditional methods for valuation of life contracts are insufficient Aim of the Fair Value / Valuation Portfolio Method is to give a consistent framework for answering / solving these issues 4

5 Is your company run by accounting or economically? Interest rate rise Statutory IAS Economic Equity Securities Liabilities (long-term) Equity Securities Liabilities (long-term) Equity Securities Liabilities (long-term) Real estate Real estate Real estate Fixed maturities (mid-term) Statutory Fixed maturities (mid-term) IAS Equity Fixed maturities (mid-term) Economic Equity Equity No impact Equity decreases Equity increases 5

6 Are your actuaries understanding economic valuation? Yie ld Curve Base Year 2003 Calc Forward Rates Stat Interest 3.50% Scenario % 1.02% 1.25% 1.62% 1.89% 2.03% 2.18% 2.35% 2.53% 2.62% 2.71% -25BP 0.70% 0.77% 1.00% 1.37% 1.64% 1.78% 1.93% 2.10% 2.28% 2.37% 2.46% -50BP 0.45% 0.52% 0.75% 1.12% 1.39% 1.53% 1.68% 1.85% 2.03% 2.12% 2.21% 01. Jan % 1.48% 1.66% 1.76% 1.87% 2.04% 2.04% 2.20% 2.34% 2.36% 2.50% 25B P 1.46% 1.23% 1.41% 1.51% 1.62% 1.79% 1.79% 1.95% 2.09% 2.11% 2.25% Results Sum of Annuities 38'964'389 [E 1996/2000] Difference M a the m a ticasl tatutorial 573'117'616 Re se rve M arket Value 556'879'280-16'238'336-25BP 571'956'500-1'161'116-50BP 587'755'665 14'638' Januar '684'111-22'433'505 25B P 565'553'755-7'563' % 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% BP -50BP 01. Jan 98 25BP Effe ctive Group Life : Annuitie s in Pa ym e nt 600'000' '000' '000' '000' '000' '000' '000' '000'000 Statutorial Market V alue -25BP -50BP 1. Januar BP 6

7 Overview of the actuarial process Actuarial competence is a major strength of Swiss Life Pricing policies Profitability oriented Margin protection Profit testing Computer aided pricing Underwriting policies Strict result control No compromise for volume No antiselection Maintain and build up further financial strength Prudent reserving Regular update of tables used Anticipation of future trends Prudent choice of interest rates Reinsurance policies Add-on Treaties with top quality reinsurer Result control Controlling Profit analysis ALM Embedded value 7

8 Contents Understanding economic principles Fair values et al Risk Taking Pricing New Business Summary 8

9 Why Fair Values (FV) Traditional valuation methods focus on value creation and do not take into account the corresponding risks This effects become apparent in particular for Interest guarantees Implicit policyholder options (e.g. taking capital or annuity) Surrender values Different strategic asset allocations FV serve as a benchmark for additional reserves for liabilities FV is in line with AFP and therefore consistent with capital markets The application of FV in insurance leads to a competitive advantage 9

10 Mark to market B/S: Available capital CF- Pattern Yield curve (ZCB) Expected Cash Flows for a contract 200' ' '000 Cash Flow -200' ' ' ' '000 Premium (BoY) Expense (BoY) Surrender (EoY) Claims (EoY) -700' Age of Policyholder CF_t i_t MV_Lia = MV(ins) - MV(outs) Free_Capital = MV_Assets - MV_Lia (Available Capital) 10

11 Liabilities 11

12 Contents Understanding economic principles Fair values et al Risk Taking Pricing New Business Summary 12

13 Required Capital: How to determine The following steps are required for the definition of the required risk capital Definition of the risk map Model for the different risks Calculation of the probability distribution and the required risk capital In order to measure market risk capital Swiss Life uses a standard methodology adjusted for insurance liabilities Market Risk: Risk Metrics (TM) For insurance liabilities some adjustments were required 13

14 Risk management landscape Market Risks Interest Rate Equity FX Real Estate Alternative Investments Diversification Financial Risk Liquidity Risks Trading Credit Risk Default Rating Migration Activites Counterparty / Issuer ALM Mismatch Risk Structural CF Mismatch / Liquidity Risk Funding Withdrawals Swiss Life Risk Landscape Underwriting Risk Longevity Disability Death Adverse Selection Catastrophe Frequency and Severity Failure Risk People Process and Control Technology Operational Risk External Risk Business External Disruption Regulatory / tax 14

15 Duration mismatch properly understood Most life insurers have a duration mismatch Example Duration Assets 6 yrs, liabilities 10 yrs Falling interest rates are a real danger (Japanese situation) 0 Effects will be seen in the future if interest rates do not move upward Losses will be seen in the future even if today the insurer is not economically bankrupt! ALM and Duration management is needed in order to survive such conditions Income Credit P/L 15

16 ALM Investment Management Historical focus: total return Responsible: CIO ALM Management Focus: Economic Contribution Responsible: all CFO CIO EC/FV (1) CRO CMO Product Economics Historical focus: Economic Margin Responsible: CRO Commercial Aspects Historical focus: Volume Responsible: CMO FV: Fair value (1) EC: Economic Risk Capital 16

17 Contents Understanding economic principles Fair values et al Risk Taking Pricing New Business Summary 17

18 Pricing policies ensure long term profitability and adequate reserving Tariff/premium rate allow Setting up sufficient technical reserves Increase of equity Financing of solvency No cross subsidies between different branches, product lines or product generations In general, the same technical base used for pricing and for reserving (exceptions for annuities) For coverage with no tariff guarantee (e.g. health) review of the level of tariff rate at each renewal date: no compromises if customer does not accept proposed tariff increase Highly professional tariff rating Focus on profitability Integrated controlling cycles No dumping Regular monitoring of experience For new tariffs/products profit testing methods are applied. Old portfolio monitored on regular basis 18

19 Mixed Endowment (Pricing) Interest 2.75% Interest 2% Interest 3.5% Yield

20 Product Management: Reporting Example 20

21 Contents Understanding economic principles Fair values et al Risk Taking Pricing New Business Summary 21

22 Scylla and Charybdis 1) Valuation needs to seek a way between Scylla and Charybdis! 2) In order to do this one needs to properly understand the Methods 3) There is not only one method which can answer each question 4) A lot of pragmatism is required 22

23 Learning's from Arbitrage Free Pricing The consequent application of AFP and RoRAC within an insurance entity enhances the insights into the business considerably This is in particular useful for identifying the cost of guarantees (interest, surrender, etc) All newly priced products need to analysed as well with this measure The implementation of AFP and RoRAC needs well defined processes and adequate models and a lot of knowhow! Application of AFP and RoRAC leads to a competitive advantage Traditional Business-model needs to be changed Risk Management and actuarial competence become key topics 23

24 Discussion 24

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