Assessing Sources of Funding for Insurance Risk Based Capital

Assessing Sources of Funding for Insurance Risk Based Capital Louis Lee Session Number: (ex. MBR4)

AGENDA for Today 1. Motivations of Capital Needs 2. Practical Risk Based Capital Funding Options 3. Types of Reinsurance Solutions 4. Worked Example

AGENDA 1. Motivations of Capital Needs 2. Practical Risk Based Capital Funding Options 3. Types of Reinsurance Solutions 4. Worked Example

MOTIVATIONS OF CAPITAL NEEDS Strain from New Business growth Efficient use of Existing Capital Short-term Volatility in Asset Returns Earnings volatility, volatility from catastrophic events Rating Agency requirement Changes in Regulatory Capital requirements and Accounting standards

Premiums (USD billions) INSURANCE GROWTH IN ASIA Strain from New Business growth 800 2010 Life Insurance Premiums 700 600 Weak Growth Outlook 500 400 300 Strong Growth Outlook 200 100 0 China Rest of World Latin America, Carribean Asia ex Japan, China Europe ex UK North America Japan UK Source: Swiss Re Sigma

ASSET RETURN VOLATILITY SINCE JUNE 2011 Short-term Volatility in Asset Returns 10% 5% Equity Index Movments since June 2011 0% -5% -10% -15% -20% Most Asian markets not fully recovered -25% Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 US UK Hong Kong Korea Taiwan Japan China Source: Yahoo! Finance

REGULATORY CONDITIONS IN ASIA Current Solvency standard Commentary Appetite for Solvency II China Solvency I framework Conservative reserving requirements and capital factors for solvency calculations relative to market conditions Discussions of Solvency II Restrictions of sub-ordinated debt funding Limitation on foreign JV s ownership at <50% Japan RBC framework Tightening of risk factors in 2012^ Expected drop in solvency ratios for 400-500% Korea RBC framework RBC framework in 2011 had increased emphasis on ALM and duration matching In 2012, Insurance risk factors split into subproducts Hong Kong Solvency I framework Impact of low interest rates on reserves, impacting solvency Pursuing Solvency II or equivalent Monitoring Solvency II Not focused ^ Restricted use and inclusion of statutory reserves; sub-ordinated debt; deferred tax assets; and future earnings in solvency margin. Tightening of risk measurements; changes to interest rate and asset management risk factors; risk coefficients based on market data and raising confidence level from 90% to 95%

REGULATORY CONDITIONS IN ASIA Current Solvency standard Commentary Appetite for Solvency II India Solvency I framework Limitation on foreign JV s ownership at 26% IPO s still delayed No keen interest to implement Solvency II Taiwan RBC framework (since 2003) Recent developments include: Relaxation of marked-to-market assets value Restriction of launching new products if solvency <200% Monitoring European implementatio n Singapore RBC framework (since 2005) Monitoring Solvency II Malaysia RBC framework (since 2009) RBC guidelines for Takaful operators Monitoring Solvency II Thailand RBC framework (implemented 2011) Increase minimum solvency ratio from 125% to 140% in 2013 Not focused Indonesia RBC framework (since 2005) Not focused

CAPITAL FUNDING OPTIONS Equity Raising Injection of Capital from Parent Company Debt Issuance (including Sub-ordinated Debt) Reinsurance

CAPITAL FUNDING OPTIONS Equity Debt Reinsurance Relative cost High Medium Low to High Sensitivity to market conditions High High Medium Limits on RBC Credit None Capped Varies Tax deductible? No Yes Yes Fast to arrange No No Yes

RECENT and PENDING EQUITY ISSUANCE IN ASIA Company Listed in IPO Size (USD) IPO Date New China Life China/Hong Kong $2bn Dec 2011 AIA Hong Kong $20.5bn Oct 2010 Samsung Life Korea $4.4bn May 2010 Dai-ichi Life Japan $11.2bn Apr 2010 Korea Life Korea $1.5bn Mar 2010 PICC China $0.8bn Pending 2012 Mirae Asset Life Korea $0.5bn Pending 2012 Taikang Life China $3-4bn Pending soon

SUB-ORDINATED DEBT Sub-Ordinated Debt Constraint in China (as of Oct 2011): Subject to CIRC Guidelines Maximum funding of 50% of prior year Net Asset Value level (down from 100%) Three year operating track record required Required solvency margin coverage above 100% to issue and insufficient capacity in domestic corporate bond market CIRC committed to supporting Yuan issuance from HK but still affordable at 5.5% to 5.8% yields achieved for 2011 issuance Global BBB and CDS spreads May 2007 to Mar 2012 Source: Barclays

EUROZONE INSURANCE STRESS Volatile Sovereign Debt Impact of volatile sovereign spreads within Eurozone has a mixed impact within the sector depending on degree of asset leverage and policyholder participation 8.0 6.0 Eurozone Market Yields (5 yr govt bonds) 4.0 2.0 0.0 Germany France Belgium Spain Italy 30-Jun 28-Nov 3-Apr Source: Wall Street Journal

REINSURANCE FUNDING DYNAMICS Global Reinsurers are cost effective sources of RBC because: Global reinsurers typically price and assess risk according to an internal economic capital approach that aims for consistent risk decisions across markets, products and reinsurance structures, while also taking account of rating agency capital model implications and statutory capital implications. As market participants, reinsurers are very familiar with insurance product risk/reward trade-offs. RBC funded through a reinsurance program can be highly cost effective as reinsurers can quickly analyze and understand the detailed insurance risks arising. Global reinsurers are generally well capitalized and have a cost of capital that benefits from high diversification (lower volatility of results) and generally less exposure to interest rate risk than their clients. But most global reinsurers are composites and exposed to additional volatility from extreme P&C events. This is mitigated by strong control of the accumulation of exposures accepted and securing protection from retrocession partners and the capital markets. Execution costs of implementing a reinsurance program are typically not material.

CRITICAL FACTORS IN IMPLEMENTING A CUSTOMISED REINSURANCE PROGRAM RBC funding projects often have competing objectives understand the key objectives to be delivered on and then run a process that takes account of likely trade-offs factored in from the beginning Some typical competing objectives to work through Cost effective source of RBC funding Run a broadbased auction process with multiple phases of negotiation Favor innovation and high levels of customization Start the process well before the funding deadline Ensure relevant high quality data that is well organized is available to reinsurer Rapid implementation deadline Run a focused process with a shortlist of qualified vendors Avoid innovation, only adopt safe harbor structures with known precedents

CRITICAL FACTORS IN IMPLEMENTING A CUSTOMISED REINSURANCE PROGRAM Ensure compliance with regulator requirements Limit the level of innovation attempted Follow the rules Flexible structure to adapt to changing circumstances => Ensure structure has optionality even if pricetag is higher (eg having variable early termination rights, right to include future new business, event triggers for termination etc) Limited team resources available Be decisive on vendor selection, shortlisting of acceptable program structures, clear internal Go/No Go decision points Ensure C suite buy in across Finance, Actuarial, Tax, Risk Management, Compliance, Operations

TYPES OF REINSURANCE TRANSACTIONS Quota share of block of business (inforce and/or new business) Monetize Embedded Value Upfront financing solutions Modified Coinsurance

Quota Share Reinsurance Premiums Reinsurance Admin Fee Insurance Company % Quota Share Agreement Reinsurer Ins Risk Capital Reinsurance Commissions Reinsurance Claims Profit Commission Can be achieved by reinsuring YRT risk premiums Optimal relief by reinsuring statutory capital intensive products Level of risk transfer is flexible depending on structure

Monetize Embedded Value Cashflows before reinsurance 120 100 80 60 40 20 0 Transfer Reinsurer Statutory required capital for this block goes to zero Payment of Embedded Value Accelerate profits for the block of business Immediate release of free surplus and insurance risk capital, for the life of the portfolio Maximum risk transfer

Financing Solutions Before Reinsurance 100 80 60 40 20 0-20 -40-60 After Reinsurance 100 80 60 40 20 0-20 -40-60 Available Capital Required Capital Provides liquidity for new business strain Optimize earnings position of the block of business Achieves capital relief from increased cash position and reduction in insurance risk required capital

Modified Coinsurance Reserves 50% Reserves Transfer Reinsurer Statutory Capital Released 50% Deposited back to Insurer Optional ceding commission Achieves reserves relief without the need to transfer reserves Statutory capital (in most jurisdictions, % of reserves and NAR) released Optional initial ceding commission as additional funding

Modified Coinsurance Portfolio Assumptions Company ABC sells UL-type product Single premium (plan to sell 1,000 M next year) Death benefit = 10 times single premium payment + fund value; Surrender (lapse) benefit = Fund value Product charges and best estimate assumptions Fund charges = 5% per year, no surrender charge; Mortality rate = 5, no lapse, Investment income = 10% Company ABC key information Raised 100M through IPO, no debt, no intangible asset; Field force commission = 10%, payable in first year; Administrative expenses = 0.5% per year. Reinsurer XYZ key information Has 100M of available capital; No expense. Regulatory environment No tax Required capital = C2 (0.1 x NAR) + C3 (3% x Reserves)

Before Reinsurance P & L ABC company XYZ Reinsurer Revenues Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 Premiums 1,000 0 0 0 0 0 Investment income 10 101 110 10 11 12 Allowance + ModCo adj. 0 0 0 0 0 0 Total 1,010 101 110 10 11 12 Benefits Claims 0-5 -5 0 0 0 Reserves -1,000-50 -53 0 0 0 ModCo adjustment 0 0 0 0 0 0 Expenses/Commissions -100-5 -5 0 0 0 Total -1,100-60 -63 0 0 0 Total P&L -90 41 47 10 11 12 * Sums may be off +/- 1 because of roundings. Note: figures for illustrations purposes only. Accounting treatment of modco transactions vary by jurisdiction.

Before Reinsurance Assets Balance sheet ABC company XYZ Reinsurer Year 0 Year 1 Year 2 Year 3 Year 0 Year 1 Year 2 Year 3 Bonds 100 1,010 1,101 1,201 100 110 121 133 Account receivable 0 0 0 0 0 0 0 0 Total 100 1,010 1,101 1,201 100 110 121 133 Liabilities & Capital Reserves 0 1,000 1,050 1,103 0 0 0 0 Account payable 0 0 0 0 0 0 0 0 Surplus 100 10 51 98 100 110 121 133 Total 100 1,010 1,101 1,201 100 110 121 133 Solvency position Required capital 0 31 33 34 0 0 0 0 Solvency ratio n/a 32% 157% 289% n/a n/a n/a n/a * Sums may be off +/- 1 because of roundings. Note: figures for illustrations purposes only. Accounting treatment of modco transactions vary by jurisdiction.

Before Reinsurance Cash flow statement ABC company XYZ Reinsurer Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 Cash (beginning of year) 100 1,010 1,101 100 110 121 + Premiums 1,000 0 0 0 0 0 + Investment income 10 101 110 10 11 12 - Claims 0-5 -5 0 0 0 - Expenses/Commissions -100-5 -5 0 0 0 + TRANSFER 0 0 0 0 0 0 Cash (beginning of year) 1,010 1,101 1,201 110 121 133 * Sums may be off +/- 1 because of roundings. Note: figures for illustrations purposes only. Accounting treatment of modco transactions vary by jurisdiction.

Modified Coinsurance Structure 50% Modified Coinsurance Risks are shared 50%/50% Reinsurance allowance = ½ Cedant expenses Assets/Reserves are not transferred to Reinsurer ModCo adjustment = Ending reserves Beginning reserves * (1+ModCo interest) ModCo interest = Investment income on assets backing reserves

After Reinsurance (with Modified Coinsurance) Revenues P & L ABC company XYZ Reinsurer Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 Premiums 500 0 0 500 0 0 Investment income 10 106 114 10 6 9 Allowance + ModCo adj. 550-23 -24 0 0 0 Total 1,060 84 90 510 6 9 Benefits Claims 0-3 -3 0-3 -3 Reserve Increase -1,000-50 -53 0 0 0 ModCo adjustment 0 0 0-500 25 26 Expenses/Commissions -100-5 -5-50 -3-3 Total -1,100-58 -60-550 20 21 Total P&L -40 26 30-40 26 30 * Sums may be off +/- 1 because of roundings. Note: figures for illustrations purposes only. Accounting treatment of modco transactions vary by jurisdiction. Modco adj = 50% of (Reserve increase + Expenses + Inv Income on prior year reserves)

After Reinsurance (with Modified Coinsurance) Balance sheet ABC company XYZ Reinsurer Assets Year 0 Year 1 Year 2 Year 3 Year 0 Year 1 Year 2 Year 3 Bonds 100 1,060 1,136 1,218 100 60 86 116 Account receivable 0 0 0 0 0 0 0 0 Total 100 1,060 1,136 1,218 100 60 86 116 Liabilities & Capital Reserves 0 1,000 1,050 1,103 0 0 0 0 Account payable 0 0 0 0 0 0 0 0 Surplus 100 60 86 116 100 60 86 116 Total 100 1,060 1,136 1,218 100 60 86 116 Solvency position Required capital 0 16 16 17 0 16 16 17 Solvency ratio n/a 387% 529% 679% n/a 387% 529% 679% * Sums may be off +/- 1 because of roundings. Note: figures for illustrations purposes only. Accounting treatment of modco transactions vary by jurisdiction.

After Reinsurance (with Modified Coinsurance) Cash flow statement ABC company XYZ Reinsurer * Sums may be off +/- 1 because of roundings. Year 1 Year 2 Year 3 Year 1 Year 2 Year 3 Cash (beginning of year) 100 1,060 1,136 100 60 86 + Premiums 1,000 0 0 0 0 0 + Investment income 10 106 114 10 6 9 - Claims 0-5 -5 0 0 0 - Expenses/Commissions -100-5 -5 0 0 0 + TRANSFER 50-20 -21-50 20 21 Cash (beginning of year) 1,060 1,136 1,218 60 86 116 Note: figures for illustrations purposes only. Accounting treatment of modco transactions vary by jurisdiction.

THANK YOU Contact Details: Louis Lee +852 2588 7138 llee@scor.com