R&I Rating Methodology by Sector

R&I Rating Methodology by Sector Life Insurance October 31, 2013 R&I applies its rating methodology for life insurance to life insurance companies that provide death benefits centered on mortality insurance and living benefits such as medical insurance and individual annuities, in Japan and abroad. For the leading overseas insurance groups, which frequently manage life and non-life insurance products, R&I performs a comprehensive evaluation after separately evaluating each business domain using its rating methodologies for life insurance and non-life insurance, among others. I. Evaluation of Industry Risk 1. View of industry risk Life insurance, which is defined in the Insurance Business Act as insurance where insurance premiums are received under contracts to pay a fixed amount of insurance claims in connection with the survival or death of individuals, is used mainly as one means to compensate households for an economic loss. In addition, life insurance companies frequently also handle insurance to pay a certain insurance benefit pertaining to personal injury or illness (so-called third sector insurance). Because of the nature of the product, life insurance is less subject to price competition, and given that insurers are characterized by low liquidity risk because funds are raised mainly through premiums that are paid under long-term policies, there is low industry risk. In fact, however, around 2000 there were successive insurance company failures in Japan involving life insurance companies that were holding excessive risk. The most recent insurer to close its doors was Yamato Mutual Life Insurance Co., which failed in 2008. These insurers generally suffered from weak risk management and limited awareness of ALM (asset and liability management), and had formed ill-balanced portfolios. One trait that can be said to have been shared by many of these insurers was the aggressive risk-taking pursued by top management, compounded by weak check and balance. Compared with the situation several years ago, life insurers risk management is greatly improved, but R&I must always pay careful attention to the management factors that pushed life insurers into bankruptcy despite the fact the industry 1/10

generally has low risk. (1) Market size, market growth potential and market volatility Worldwide, insurance premiums fundamentally continue to grow. Products in the annuity and medical care sectors in particular have become engines of growth, not only in Asia and other emerging markets where population growth is remarkable, but in advanced country markets as well, where demand is driven by factors such as aging, and there remains room for growth despite the market being mature. Japan s life insurance premium payments (including postal life insurance) exceed 30 trillion yen, making it the world s second largest market after the U.S. Assets have reached 300 trillion yen. Because growth of the living benefits sector can be anticipated as aging of the population and cutbacks in social security continue in Japan, the decline in the working age population will not necessarily lead directly to a contraction of the life insurance market. As a result, a sales focus continues to shift from death benefits to living benefits such as medical insurance that are highly profitable, and earnings from life insurance have not decreased very much. Although growth potential is low, R&I does not envisage the size of the life insurance market will contract significantly. The market for protection-type products such as mortality insurance and medical insurance is centered on long-term policies and is not sensitive to interest rates. Therefore market volatility is low. On the other hand, the market for annuities and other savings-based products is highly sensitive to interest rates, and compared with protection-type products, market volatility is greater as well. The market weighting of protection-type products and savings-based products differ by country and region, with protection-type products accounting for an especially high proportion of all insurance products in Japan. (2) Industry structure (competitive environment) Regulations in each country strongly influence the industry structure and competitive environment for life insurance. The influence of regulations pertaining to pricing, such as rules for premium rates and provisioning of policy reserves, in particular is substantial. In general, for life insurance, the components corresponding to safety loading and costs are incorporated into insurance premiums beforehand, providing a business structure that makes it easy to ensure earnings. In particular, safety loading for life insurance products in Japan is determined based on 2/10

standard premium rates that are set by law, making it difficult to engage in price competition. Life insurers accumulate policy reserves based on extremely conservative standard mortality rates provided by law (standard policy reserves), which also makes price competition difficult. Compared with Japan, price competition is more vigorous in Europe and the U.S., where insurance rates have been deregulated and traditional products have developed into commodity products. While Japan s life insurance market is served by about 40 companies, when viewed on the basis of premiums, the top-ranking insurance companies have achieved substantial oligopolization, and competitive conditions are not necessarily more severe than in Europe or the U.S. The overseas life insurance market is comprised of numerous players, and given the competitive environment is affected significantly by factors such as state regulations and regulations on market entry, R&I must evaluate each country and region separately. (3) Customer continuity and stability The customer base is comparatively stable. In addition to the long-term nature of insurance policies, this reflects the fact the life insurance industry offers numerous products with mechanisms such as surrender charges during the initial policy period. In markets such as Europe and the U.S., which have investment-type products and life insurance that have evolved into a commodity product, it is relatively easy to switch to another company. Compared with Europe and the U.S., the life insurance market in Japan is centered on long-term protection-type products, and therefore customer continuity and stability are high despite a certain level of surrenders during the initial policy period. (4) Protection, regulations and public aspects R&I s evaluation of protection and regulations differs depending on the regulatory framework and intentions and capabilities of the supervisory authorities charged with maintaining the system s soundness in a country or region. While review of insurance regulatory frameworks is progressing globally, including the introduction of Solvency II in Europe and the tightening of regulations on global systemically important insurers by the IAIS (International Association of Insurance Supervisors), R&I reflects this trend in its ratings by basing its evaluations on each country s thinking regarding bankruptcy procedures and its intention and capacity to support failed insurers. For insurance companies in Japan, regulations on management soundness that utilize the 3/10

solvency margin ratio as a basic indicator have been enacted, and bankruptcy procedures under the Insurance Business Act and the Act on Special Treatment of Corporate Reorganization Proceedings and Other Insolvency Proceedings of Financial Institutions are in place. The Life Insurance Policyholders Protection Corporation of Japan has been established as a mechanism to protect policyholders in the event of an insurer s bankruptcy. In comparison with the robust safety net for depositary financial institutions that is aimed at the stability of the financial system, however, the institution is weak. 2. View of Individual Firm Risk (1) Franchise 1) Position and competitiveness in the market The death coverage that has traditionally supported life insurers earnings, together with the high-growth, high-margin third sector, form the heart of R&I s evaluation of a life insurer s franchise. R&I judges the stability of the business by examining the value of the customer base and ability to sell new insurance policies. A life insurance company that can be highly assessed in terms of position and competitiveness in the market will be a company that has the following. A sizeable, stable customer base built over a long period (or through a merger or consolidation) A high market share in its core death coverage market A certain share of a third sector insurance product market with high growth and profitability Avoidance of price competition and maintenance of profitability on key products Attractive pricing aspects such as policyholder dividends Excellent brand power, etc. 2) Sales channels An insurer s sales channels play an extremely large role in enhancing its competitiveness and realizing the value of its franchise. In its rating evaluations, R&I takes into consideration each company s sales channel strategy and the productivity of its key sales channels, and focuses on whether these are contributing to the utilization of its customer base. Specifically, it is important for an insurer to have, for example, a highly productive dedicated sales channel and/or a successful multi-channel strategy. A highly productive dedicated sales channel employs a large high quality, highly stable sales team, rather than a structure that relies on mass hiring and a high rate of sales staff turnover. Such a channel 4/10

will have a high number of new policies and insurance premiums per sales agent, as well as a high policy retention rate. On the other hand, a multi-channel strategy, which has been adopted by the leading overseas insurance groups with few exceptions, is a strategy of maintaining several strong sales networks corresponding to customer attributes. With the presence of new sales channels including financial institutions, sales agencies, and insurance stores expanding in Japan as well, life insurers that intend to pursue a multi-channel strategy can also be expected to increase in the future. (2) Risk profile / risk appetite The risk profile, which highlights how an insurer is taking the main risks as it continues its operations, is a factor that will determine the future change in financial risk (risk resilience, earning capacity and liquidity as explained later). In its evaluation of risk appetite, R&I focuses primarily on an insurer s risk-taking policies toward various risks (insurance underwriting, market risk, and the risk from concentration of investments in major obligors or industries), and the complexity of the risks in conjunction with business and regional diversification. Verifying the risk profile/risk appetite stability based on an enterprise risk management (ERM) system is indispensable as well. Critical judgment parameters include whether the major risks are shared and recognized appropriately among the management team, whether the processes and methodologies for monitoring risks are reasonable, and whether insurance product pricing decisions and the strategies for ALM and asset investment are aligned with the risk appetite and risk profile. II. Evaluation of Financial Risk (1) Risk resilience 1) Buffer against risk When considering the risks facing life insurers, R&I will verify the adequacy of the buffer to absorb the risks. Buffer against risk = Risk buffer (net assets, various reserves, etc.) Total risk Under current insurance accounting, assets (securities, etc.) are marked to market, and 5/10

insurance obligations that represent the majority of liabilities are accounted for at acquisition cost (based on pricing assumptions at the time of policy conclusion). Consequently, life insurers equity capital on an accounting basis will diverge substantially from the value on an economic value (market-consistent evaluation) basis. Because premiums are recognized on a cash basis and costs are recognized on an accrual basis under insurance accounting, the time gap between revenue and expense is a problem as well. The acquisition of new policies temporarily puts pressure on life insurers solvency margin because costs mount when policies are obtained. On an economic value basis, the business activity is reflected directly in a company s value because in addition to new policy acquisition costs, the future profit contribution is recognized at the time new policies are acquired. Spurred by changes such as Europe s Solvency II regulation, the Financial Services Agency in Japan also is investigating the introduction of an economic value basis solvency regulation. When assessing the risk resilience of life insurance companies, R&I takes both accounting basis and economic value basis into consideration. However, at present an insurance company will not be bankrupt even if its capital on an economic value basis has become negative. Supervisory standards such as SMR that are designed to ensure soundness conform to current accounting practices, and capital on an accounting basis cannot be disregarded. For insurers with a low rating level in particular, R&I has to consider risk resilience on an accounting basis that is largely in line with the industry supervisory standards. *Risk resilience on an accounting basis R&I s computation methodology is outlined below. For the risk buffer value used as the numerator, R&I introduces asset and liability correction factors that it adds to net assets (excluding valuation difference), the reserve for price fluctuations and the contingency reserve. The main adjustments are for items such as unrealized gains or losses on assets (to conservatively evaluate asset prices, etc.) and the excess of the continued Zillmerized reserve. Although mutual companies foundation funds and subordinated loans basically are not evaluated, in the case of an insurer with a low rating, foundation funds are included to a certain extent as a supplemental buffer. Unrealized gains and losses on bonds are not included in the risk buffer. The reason is that life insurers guarantee the assumed interest rate to policyholders, and the negative spread will become burdensome in the future if the unrealized gains on bonds are used as the risk buffer. 6/10

For volume of risk, R&I basically utilizes the items used for calculation of the SMR with conservative adjustments for domestic and foreign regulation trends, while referring to the numerical values of each company s internal model. For risk measurement, R&I uses a 99.5% confidence interval as a yardstick for insurers rated in the BBB category. When evaluating risk resilience, R&I focuses on the risk buffer including unrealized gains and losses on equities. Risk resilience is susceptible to fluctuations in share prices when unrealized gains and losses on equities are counted, however. Therefore it is critical to also analyze capital quality, such as the weight of stock holdings in the risk buffer, and the results of stress tests. In this case, R&I makes its evaluation based on a review of the contents of contingency plans, risk management effectiveness, risk control policies, the results of each company s stress tests and other factors. *Risk resilience on an economic value basis R&I evaluates risk resilience on an economic value basis by taking into consideration regulatory trends in Japan and other countries and the condition of the insurance company s internal ERM and various risk measurements. Risk resilience on an economic value basis exhibits greater volatility than risk resilience on an accounting basis. Furthermore, when viewed for the entire industry there is considerable room for improving risk measurement methodologies. Therefore together with continually monitoring each company s progress in improving the precision and sophistication of its internal model, R&I incorporates into its ratings the extent to which a company will progress over the intermediate term with efforts to control changes in its risk resilience, while taking into consideration the company s risk-taking policies, risk mitigation program and the effectiveness of its ERM. 2) Risk/equity capital management structures As a means of supplementing the quantitative indicators discussed in 1) above, R&I qualitatively evaluates an insurance company s ability to maintain its risk resilience in the future. It does this by confirming how the insurer evaluates, recognizes and allocates its equity capital (and free surplus). The viewpoints taken during the equity capital evaluation process, including whether the insurer is able to comprehensively and correctly recognize risks, whether it is able to utilize knowledge it has obtained through its business activities to constantly verify business risks that 7/10

could have significant impacts on its operations, and whether its measures to cope with a situation when a risk is realized are appropriate, are an important element for evaluating the risk/equity capital situation. The degree to which management is aware of and focused on risk management, the positions of the Chief Risk Officer (CRO) and risk manager within the insurance company and their ability to speak out on and affect operations, are also important considerations. These points become even more significant for the evaluation of insurance groups that are moving forward with business diversification and regional spread. (2) Earning capacity 1) Three major sources of profit and loss relative to annualized premiums on in-force policies As discussed earlier, R&I emphasizes risk resilience on an economic value basis, and looks to earning capacity based on mortality margins, expense margins and investment margins, the three major sources of profit and loss, as a clue. The three major sources of profit and loss are simply part of the risk margin (in-force cash flows) and are expected to be absorbed in the evaluation of risk resilience on an economic value basis in the future. Specifically, R&I will seek to the extent possible to understand the structure of the assets and liabilities of each company from data such as the three sources of profit and loss, the average assumed interest rate, and duration (assets and liabilities). Among the three major sources of profit and loss, R&I will correct the investment margin to the domestic bond interest rate base because the investment margin frequently is inflated from investment sources such as foreign bond investments. R&I also deducts any group annuity investment margin and the amount required for interest payments. R&I looks at average earning capacity by using the profit margin for annualized insurance premiums on policies in force for personal insurance. 2) Quality and stability of earnings In recent years, more life insurance companies are increasing the weight of products that tend to experience rapid changes in sales and make a low profit contribution, such as variable annuity insurance and single premium whole life insurance. Therefore it is also important for R&I to evaluate the stability of profitability by looking at factors such as debt structure and profit contribution. Key points R&I will examine include (1) whether a company has achieved an asset and liability structure that is less susceptible to changes in the economy or the financial and capital markets and enables the company to ensure stable profits, (2) whether a company handles 8/10

traditional insurance products with a high profit contribution that enable it to stably report high insurance-related margins, (3) whether a company has achieved earnings diversification by region and business line, and (4) whether a company has been able to maintain and stably expand its highly profitable third sector business. Understanding the profitability of individual insurance products is essential as well. Because of the effect of improved mortality rates, traditional death benefits have generated a level of earnings that exceeds the earning (profit margin) that was initially assumed. On the other hand, while the profitability of the growing third sector insurance is high compared with death benefits, there is a concern that over the medium to long-term the payment rate (rate of incidence) will deteriorate as a result of price competition and advances in medical technology, and earnings will weaken. R&I will comprehend future earnings projections based on factors such as the status of divergence between the assumed payment rate and actual payouts, pricing review rules and their observance, and policies to address issues such as product revisions. (3) Liquidity Liquidity is one of the critical parameters that act as a trigger for the final bankruptcy of a financial institution. Japanese life insurance companies enjoy excellent liquidity risk resilience, with stable premium income prospects and ample negotiable assets. This point is a major factor supporting their ratings. 1) Highly liquid liabilities / highly liquid assets The risk of surrenders of group and individual annuities when interest rates are rising accounts for the major portion of liquidity risk for life insurers. R&I evaluates liquidity by examining the asset and liability structure and ALM policy of each company from viewpoints such as the extent to which the company can cover its policy reserves for group annuities and individual annuities, which may suffer from cash-outs during periods when interest rates rise, with highly liquid assets such as bonds. During Japan s prolonged period of low interest rates, however, actual data concerning the behavior of policyholders when interest rates increase has not been sufficiently accumulated, and there remains significant room for further elaboration of quantitative evaluations. 9/10

2) Liquidity risk management structures R&I evaluates an insurer s ability to maintain liquidity in future years. The main viewpoints in this regard are to what extent stable premium income can be anticipated and whether a company has prepared its management methodology, reporting methods and settlement procedures and been able to secure the necessary means of funding according to the severity of a cash crunch (normal periods, periods of heightened concern and crisis periods). III. Rating for Life Insurance Industry Issuer Rating / Insurance Claims Paying Ability Individual Firm Risk Financial Risk Importance Indicator Importance Franchise Position and competitiveness in the Risk resilience Buffer against risk market Risk/equity capital management structures Sales channels Earning capacity Three major sources of profit and loss relative to Risk profile / risk appetite annualized premiums on in-force policies Quality and stability of earnings Liquidity Highly liquid liabilities / highly liquid assets Liquidity risk management structures Industry Risk: Low Note) Importance is indicated by : extremely important, : important, or relatively important. * This report replaces all previous versions that have been released to date. The Rating Determination Policy and the Rating Methodologies R&I uses in connection with evaluation of creditworthiness (collectively, the "Rating Determination Policy and Methodologies") are R&I's opinions prepared based on R&I's own analysis and research, and R&I makes no representation or warranty, express or implied, as to the accuracy, timeliness, adequacy, completeness, merchantability, fitness for any particular purpose, or any other matter with respect to the Rating Determination Policy and Methodologies. Further, disclosure of the Rating Determination Policy and Methodologies by R&I does not constitute any form of advice regarding investment decisions or financial matters or comment on the suitability of any investment for any party. R&I is not liable in any way for any damage arising in respect of a user or other third party in relation to the content or the use of the Rating Determination Policy and Methodologies, regardless of the reason for the claim, and irrespective of negligence or fault of R&I. All rights and interests (including patent rights, copyrights, other intellectual property rights, and know-how) regarding the Rating Determination Policy and Methodologies belong to R&I. Use of the Rating Determination Policy and Methodologies, in whole or in part, for purposes beyond personal use (including reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), and storing the Rating Determination Policy and Methodologies for subsequent use, is prohibited without R&I's prior written permission. Japanese is the official language of this material and if there are any inconsistencies or discrepancies between the information written in Japanese and the information written in languages other than Japanese the information written in Japanese will take precedence. 10/10