Goldman Sachs Financials Conference„Surviving in a low interest rate environment“

Prof. Dr. Michael Koller, CRO and Group Chief Acturay

Rome, 18 June 2003

Management Summary

Understanding EconomicPrinciples?

Economically Bancrupt ?

No

No

Yes

Yes

2

Are you gambling ?

Are able to take risk ?

No

No

No

Yes

Yes

Contents

� Understanding economic principles

� Fair values et al

� Risk Taking

� Pricing New Business

� Summary

3

� Summary

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

• The traditional methods for valuation of life

contracts are

insufficient

4

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

• Aim of the Fair Value /

Valuation Portfolio

Method is to give a consistent framework

for answering / solving

these issues

Economic

Is your company run by accounting or economically?

Statutory

Fixed

Equity Securities

Real estate

Liabilities (long-term)

Liabilities (long-term)

IAS

Real estate

Equity Securities

Liabilities (long-term)

Real estate

Equity Securities

Interest rate rise

5

Fixedmaturities

(mid-term)

Fixed

maturities

(mid-term) Statutory

Equity

Equity increases

IAS Equity

Equity decreases

Fixed

maturities

(mid-term) Economic

Equity

No impact

Are your actuaries understanding economic

valuation?

Yie ld Curve

Base Y ear 2003

Stat Interes t 3.50%

Scenario 1 2 3 4 5 6 7 8 9 10 11

30.11.2002 0.95% 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 98 1.71% 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 tica l S 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 14'638'049 1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

30.11 .2002

-25BP

-50BP

01. Jan 98

25BP

Calc Forward Rates

6

-50BP 587'755'665 14'638'049

1. Januar 1998 550'684'111 -22'433'505

25B P 565'553'755 -7'563'861

Effe ctive Group Life : Annuitie s in Pa ym e nt

0.00%

0.50%

1.00%

1 4 7 10 13 16 19 22 25 28

25BP

530'000'000

540'000'000

550'000'000

560'000'000

570'000'000

580'000'000

590'000'000

600'000'000

Statutor ial Market

V alue

-25BP -50BP 1. Januar

1998

25BP

Overview of the actuarial process

Pricing policies

� Profitability oriented� Margin protection

� Profit testing

� Computer aided pricing

Underwriting policies� Strict result control

Actuarial competence is a major strength of Swiss Life

Prudent reserving� Regular update of tables used

7

� Strict result control

� No compromise for volume� No antiselection

Maintain and build up

further financial strength

Reinsurance policies� Add-on

� Treaties with top quality reinsurer

� Regular update of tables used

� Anticipation of future trends� Prudent choice of interest rates

Result control� Controlling

� Profit analysis

� ALM

� Embedded value

Contents

� Understanding economic principles

� Fair values et al

� Risk Taking

� Pricing New Business

� Summary

8

� Summary

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)

9

� 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

Mark to market B/S: Available capital

Expected Cash Flows for a contract

-400'000

-300'000

-200'000

-100'000

0

100'000

200'000

Ca

sh

Flo

w

Premium (BoY)

Expense (BoY)

Surrender (EoY)

CF- Pattern Yield curve (ZCB)

10

-700'000

-600'000

-500'000

40 41 42 43 44 45 46 47 48 49

Age of Policyholder

Surrender (EoY)

Claims (EoY)

i_tCF_t

MV_Lia = MV(ins) - MV(outs)

Free_Capital = MV_Assets - MV_Lia

(Available Capital)

Liabilities

11

Contents

� Understanding economic principles

� Fair values et al

� Risk Taking

� Pricing New Business

� Summary

12

� Summary

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

13

• 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

Risk management landscape

Financial Risk

Market Risks

Structural CFMismatch /

Liquidity Risk

Credit Risk

� Interest Rate� Equity� FX� Real Estate� Alternative Investments� Diversification

� Default� Rating Migration Activites� Counterparty / Issuer

Liquidity Risks � Trading

� Funding� Withdrawals

ALM MismatchRisk

14

Swiss Life RiskLandscape

Operational Risk

UnderwritingRisk

Failure Risk

External Risk

� People� Process and Control� Technology

� Business� External Disruption� Regulatory / tax

� Longevity� Disability� Death� Adverse Selection� Catastrophe� Frequency and Severity

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

10000

20000

30000

40000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

15

� 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

-40000

-30000

-20000

-10000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Income Credit P/L

ALM

Investment Management

• Historical focus: total return• Responsible: CIO

ALM Management

• Focus: Economic Contribution• Responsible: all

CFO

16

Product Economics

• Historical focus: Economic Margin• Responsible: CRO

Commercial Aspects

• Historical focus: Volume • Responsible: CMO

CIO

CRO

CMO

CFO

EC/FV(1)

FV: Fair value (1) EC: Economic Risk Capital

Contents

� Understanding economic principles

� Fair values et al

� Risk Taking

� Pricing New Business

� Summary

17

� Summary

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

• Highly professional tariff rating

• Focus on profitability

• Integrated controlling

cycles

18

• 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

• For new tariffs/products profit testing methods are

applied. Old portfolio monitored on regular basis

cycles

• No dumping

• Regular monitoring of

experience

Mixed Endowment (Pricing)

0.6

0.8

1

1.2

19

0

0.2

0.4

0.6

20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64

Interest 2.75% Interest 2% Interest 3.5% Yield 30.11.2002

Product Management: Reporting Example

20

Contents

� Understanding economic principles

� Fair values et al

� Risk Taking

� Pricing New Business

� Summary

21

� Summary

Scylla and Charybdis

22

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

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)

� Application of AFP and RoRAC leads to a competitive advantage

� Traditional Business-model needs

23

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 know-

how!

� Traditional Business-model needs

to be changed

� Risk Management and actuarial

competence become key topics

Discussion

24

Discussion