Equity-Based Insurance Guarantees Conference November 12-13, 2012. Chicago, IL. Variable Annuity Risk Management Update

Equity-Based Insurance Guarantees Conference November 12-13, 2012 Chicago, IL Variable Annuity Risk Management Update Xiaohong Mo, FSA, MAAA, CFA

Variable Annuity Risk Management Update Equity-Based Insurance Guarantees Conference Chicago, IL November 12, 2012 (1030-1115 1115 Hours) Xiaohong Mo FSA, MAAA, CFA 1 1

Limitations and Disclosures This information is for investment professional use only. Not to be distributed to the public. The performance data shown throughout this document is for illustrative purposes only. Past performance is not an indication of future results. Recipients must make their own independent decisions regarding any strategies or securities or financial instruments mentioned herein. The products or services described or referenced herein may not be suitable or appropriate for the recipient. Many of the products and services described or referenced herein involve significant risks, and the recipient i should not make any decision i or enter into any transactionti unless the recipient i has fully understood all such risks and has independently determined that such decisions or transactions are appropriate for the recipient. Any discussion of risks contained herein with respect to any product or service should not be considered to be a disclosure of all risks or a complete discussion of the risks involved. The recipient should not construe any of the material contained herein as investment, hedging, trading, legal, regulatory, tax, accounting or other advice. The recipient should not act on any information in this document without consulting its investment, hedging, trading, legal, regulatory, tax, accounting and other advisors. 2012 Milliman Financial Risk Management LLC 2 2

Agenda Variable Annuity Product Update Risk Management Trends Protected Funds Variable Annuity Hedge Cost Index 3 3

Variable Annuity Product Update 4 4

A Historical Look at US VA Annual Sales Historical US VA Annual Sales 200 150 100 50 11/6/2012 5 $ Billions 0 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 12/31/2011 5 Source: Morningstar

Full year 2011 Variable Annuity Sales Results 12/31/11 Rank Full year 2011 VA Sales Top Ten Companies ($ in millions) 12/31/10 Rank Company 2010 Sales 2011 Sales % Chg. vs. 2010 Q4 11Mkt Share 1 2 MetLife $18,298.9 $28,439.1 55% 19.7% 2 1 Prudential 21,663.5 20,236.2-7% 12.0% 3 3 Jackson National 14,654.3 17,494.1 19% 10.2% 4 4 TIAA-CREF 14,164.8 13,543.0-4% 9.3% 5 5 Lincoln Financial 8,948.1 9,322.7 4% 5.9% 6 9 Nationwide 5,163.0 7,375.8 43% 5.6% 7 7 SunAmerica/VALIC 6,192.4 7,982.2 29% 5.5% 8 8 AXA Equitable 6,343.2 6,874.5 8% 4.7% 9 6 Ameriprise 6,208.5 6,399.9 3% 4.2% 10 10 AEGON/Trans-america 3,771.8 5,254.3 39% 3.7% Source: Morningstar 6 6

Trends: Product De-risking Competitive situation Companies have focused on moderating sales growth by de-risking of guarantees Lower benefits Increased fees Index funds and model portfolios Consolidation of distribution channels Risk-managed product design features Floating-rate withdrawals AXA : bonus linked to treasury rates Allianz and others : withdrawal rates linked to treasury rates Dynamic asset allocation / managed volatility Prudential, Metlife, Lincoln, AEGON, Ohio National, AIG 7 7

Trend: Product De-risking (Cont.) MetLife Prudential Jackson National Lincoln SunAmerica AXA Equitable GMIB Max drove sales in 2011 Volatility management and interest rate hedging inside the fund Reduced GMIB Max rollup rate to 5% and pulled back on VA sales Reduced HD benefits: lower roll-up and withdrawal %, higher fee 80%+ VA account value has dynamic asset allocation feature Companies followed lead by introducing protection within the fund Leader in product choices; maintains consistent pricing while scaling back benefits Closed the 8% roll-up on the LifeGuard Freedom Flex GLWB while increasing gp price and changing g funds Historical value proposition is to offer good value Launched managed volatility fund on $3Bil of inforce in 4Q2011 In April 2012, launched LVIP Protected Asset Allocation series of funds on VAs First to introduce a GLWB rider whose pricing linked to movements in volatility (VIX) Added SunAmerica Dynamic Allocation Portfolio, a volatility managed fund of funds, in 2012 Retirement CornerStone: GMIB rollup rate=min[8%, max(4%, 1% +10 year Treasury)], with dynamic fund transfer program Structured Capital Strategies: Structured Investment Option offers Segment Buffer. 8 8

Considerations behind Product Innovations Four premises behind recent innovations: Customers are more risk-averse US interest rates are at historical low Rising taxes might make VAs more attractive Inflation has become an important risk 9 9

Risk Management Trends 10 10

Industry Trends Market share consolidation Large players are increasing market share Several companies have exited the market Several have tried reducing sales Actuarial assumptions A couple companies announced reserve unlocking due to actuarial assumption updates Lapse GMIB utilization 11 11

Risk Management Trends Risk management strategies have tended to stabilize development of industry best practices Delta / Rho and opportunistic vega Reinsurance capacity is limited Use of structured solutions is minimal Hedge objectives moving towards economic basis GAAP reserving changes -> Non performance risk Financial crisis highlighted importance of statutory requirements 12 12

Risk Management Trends Economic basis : Risk-neutral valuation Swap curve or synthetic risk-free curve Historic long term volatility versus market based volatility Long term options are illiquid Pricing reflects large regulatory and capital costs Companies have reduced the amount of vega hedging, use of historic volatility aligns better with actual hedge strategy t Increased hedging of guarantees that are not fair valued GMDB Life-contingent portion of GLB 13 13

JP Morgan Hedging Losses Increased scrutiny around hedging, in particular Macro / Portfolio hedges in light of hedging losses from JP Morgan Objective Transaction Risks Introduced Reduce credit risk JPM corporate loans Increase exposure to credit risk Reduce exposure to credit risk Hedge JPM corporate loan risk CDS on High Yield Bond Sold CDS on 2017 Investment Grade Index. Substantially more exposure. Purchased CDS on 2012 Investment Grade Index. Basis risk Leverage Compounded basis risk. Liquidity risk Compounded basis risk, liquidity risk JP Morgan s hedging activity it was not risk-reducing i 14 14

Macro Hedging Best Practices Macro hedging used by many insurers to cover risks not covered by Core hedge program Best Practice Clearly defined objective Use of liquid and transparent hedge instruments Clearly defined risk-limits Financial / Accounting Considerations Operational controls and processes Consistent measurement and monitoring of performance and effectiveness Typical Company Practices Defined as reducing Economic or Statutory capital requiring Senior Management approval. Combination of equity, currency, interest futures and options Risk-limits Clear disclosures on accounting impact Tends to be a complex process requiring a range of models, often ad-hoc Given complexity, measurement and monitoring are in-frequent Overall, Macro hedging meets best practices. Operational processes and monitoring should be improved. 15 15

Industry Trends M&A Activities Active reviewing of existing blocks Old reinsurance blocks Discontinued blocks Mostly by private equity groups No confirmed transactions yet Complexity of guarantees Falling interest rates resulting in high h cost of hedging Many owners of existing VA blocks are willing to pay to exit the business Potential buyers are often off-shore reinsurers owned by private equity firms Focus on VA products Buyer and seller expect no future infusion of funds The off-shore reinsurance entity must be solvent based on the initial fund 16 16

M&A Valuation Trends Valuation Framework Risk Neutral valuation of all liability cash flows Explicit modeling of all future cash needs Ensures that t future calls on capital are sufficiently i remote Capital Framework Regulatory jurisdiction Appeal to rating agency Inclusion of all major risk factors, including un-hedgeable risks Profitability Measurement 17 IRR/PVDE Economic o c P&L Probability of ruin 17

Protected Funds 18 18

Protected Funds Target volatility funds have become an important tool for insurance companies to manage their GMxB risks. Diversification alone has proven to be a risk management tool with a lot to be desired through the financial crisis. The vulnerability of target volatility funds has prolonged slow market decline, such as the Japan scenario. Protected funds are enhancements to target volatility funds. 19 19

Protection Strategy Two sophisticated risk management techniques: Volatility Management Capital Protection ti Strategyt Reduces downside exposure and provides much greater certainty that investors can achieve funding objectives 20 20

Volatility Management Current Asset Allocation Targets a specific equity allocation (i.e. 60%) as a proxy for risk Maintains constant equity allocation regardless of market conditions Target Volatility Asset Allocation Targets a specific volatility level directly via a futures overlay Prevents portfolio volatility from dramatically increasing during crises 21 21

Capital Protection Strategy Capital Protection Strategy to reduce losses in adverse market environments The investor s portfolio is mapped to major market indices Use simple, liquid exchange-traded hedge instruments to replicate a 5-year rolling maturity put option Dynamic management of the Protection Strategy Ratchet protection level up to preserve gains Reset protection level down after extreme market declines to harvest hedge gains 22 22

Use of Derivatives Both components are implemented with exchange-traded futures contracts Futures are liquid, transparent and cash settle every day Alternatives (i.e. put options) have historically included a significant risk-margin which will tend to gradually deplete fund values over time Volatility management ensures that futures can be used to replicate a put option with a high degree of reliability Also includes counter-cyclical interest rate hedging If rates rise, hedges will be put in place to guard against future declines in interest rates The actual strategy can be tailored towards company s preference 23 23

Historical Backtesting Analysis Historical backtesting analysis shows the benefits of the Protection Strategy over the last decade for investors The following model portfolios were used in the backtesting analysis Asset Class Growth Balanced Moderate US Large Cap 34.3% 24.5% 19.6% US Mid Cap 8.8% 6.3% 5.0% US Small Cap 7.0% 5.0% 4.0% EAFE 20.0% 14.3% 11.4% BarCap Agg 30.0% 50.0% 60.0% 24 24

Historical Analysis Growth In our backtesting analysis, the Protection Strategy provided value to investors during the bear market from 2000-2002 and during the global financial crisis 25 The rates of return are hypothetical historical illustrations and do not represent the returns of any particular investment portfolio. There is no assurance that the investment process will consistently lead to successful investing. 25

Historical Analysis Balanced In our backtesting analysis, the Protection Strategy provided value to investors during the bear market from 2000-2002 and during the global financial crisis 26 The rates of return are hypothetical historical illustrations and do not represent the returns of any particular investment portfolio. There is no assurance that the investment process will consistently lead to successful investing. 26

Historical Analysis Moderate In our backtesting analysis, the Protection Strategy provided value to investors during the bear market from 2000-2002 and during the global financial crisis 27 The rates of return are hypothetical historical illustrations and do not represent the returns of any particular investment portfolio. There is no assurance that the investment process will consistently lead to successful investing. 27

The Protection Strategy Live Portfolios 30 Day Realized Volatility Protected Portfolios 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 7/22/2011 8/22/2011 9/22/2011 10/22/2011 11/22/2011 12/22/2011 1/22/2012 2/22/2012 Balanced Moderate Growth S&P 500 28 The rates of return are hypothetical historical illustrations and do not represent the returns of any particular investment portfolio. There is no assurance that the investment process will consistently lead to successful investing. 28

Annual Return Distribution Protected Growth Portfolio 29 29

VA Hedge Cost Index 30 30

VA Hedge Cost Index Estimated hedge cost for a hypothetical Lifetime GMWB block Generic product features and common benefit designs Typical actuarial and policy holder behavior features Industry benchmark of VA cost of hedging Widely used by participants in the VA marketplace as issuers or investors Closely tracked by equity analysts and risk managers Ongoing review and update on product features and assumptions 31 31

VA Hedge Cost Index (Cont.) Monthly update published on website. Source: Milliman website http://www.milliman.com/expertise/life-financial/products-tools/guarantee-index/ 32 32

VA Hedge Cost Index (Cont.) Also available in Bloomberg under ticker MLHCINEW Index <GO>. Source: Bloomberg 33 33

VA Hedge Cost Index Design Update Product features Target volatility of 10% Rider charge of 100 bps of GWB Age banded lifetime withdrawal rates Actuarial/policy holder modeling assumptions B-share base lapse rate assumptions based on industry survey Dynamic lapse reduces lapse when ITM GMWB utilization assumption more in line with industry pricing practice Ongoing review and update Impact analysis Methodology document update 34 34

Hedge Cost Index Update Impact Analysis The design update resulted in a 38 bps drop in expected hedge cost as of August 2012. Previous Design Current Design Change from Previous Design 1/30/2012 137 102 36 2/28/2012 134 99 35 3/29/2012 121 90 30 4/27/2012 129 96 33 5/30/2012 155 112 42 6/28/2012 155 114 42 7/30/2012 157 117 40 8/30/2012 148 110 38 Historical comparison shows that the difference between the new and old designs is in the range of 30 to 42 bps. 35 35

Expected Hedge Cost Attribution - Previous Design Previous hedge cost index was calculated based on the MGI volatility index and month-end swap interest t rates. Historical attribution analysis indicated that interest est rate is by far the major driver in the cost of guarantee. 36 36

Expected Hedge Cost Attribution - Current Design The monthly changes in the current Hedge Cost Index are driven by movements in the swap interest rates. Historical Swap Rates Year 1 5 10 20 30 1/30/2012 0.52% 1.03% 1.97% 2.56% 2.70% 2/28/2012 0.50% 1.10% 2.04% 2.64% 2.77% 3/29/2012 0.50% 1.24% 2.23% 2.84% 2.98% 4/27/2012 0.50% 1.12% 2.07% 2.70% 2.84% 5/30/2012 0.57% 1.03% 1.78% 2.32% 2.43% 6/28/2012 0.51% 0.94% 1.71% 2.29% 29% 2.43% 7/30/2012 0.40% 0.81% 1.62% 2.21% 2.35% 8/30/2012 0.40% 0.84% 1.73% 2.38% 2.54% 9/27/2012 0.37% 0.79% 1.71% 2.43% 2.61% 37 37

Summary US variable annuity market continues to consolidate. Sustainable product designs incorporate sound risk managements within the product and fund. Risk management best practices are developing. Protection Strategy is now a widely recognized solution with proven records. Tools are available for companies and analysts to closely monitor cost of VA guarantees. 38 38

Contact Details Xiaohong Mo xiaohong.mo@milliman.com Milliman Financial Risk Management, LLC 71 S. Wacker Drive, 31st Floor Chicago, IL 60606 Ph: +1 312.726.0677 Fx: +1 312 499.5700 www.milliman.com 39 39