The Dynamics of Annuity Pricing, Credit, Mortality Risk & Capital Management for UK Life Offices John Hibbert 23 rd June 3 Finance & Investment Conference 2 Overview Some background on the annuity market. What policy questions do we want to answer? A stochastic model of annuity business: Interest rates Credit behaviour & credit spreads Mortality uncertainty A basic case study.
UK Annuity Rates Analysis at March 2 3 Scottish Widows Prudential Legal & General Friends Provident Canada Life AMP NPI Sun Life Standard Life Norwich Union GE Life Annuity Based on Gilt Rate Annuity Based on Swap Rate Approx 2 basis Approx 65 basis.9.8.7.6.5.4.3.2. 7 7 72 73 74 7 76 77 78 79 8 8 82 83 84 8 Annuity Rate Per, (Male Age 65) Source: Annuity Direct, Man aged 65, Single Life, No guarantee, level annuity. Assumes 5% expense loading, and 9% PxA92 with CMI 7 improvements. UK Annuity Rates Analysis at May 3 4 AMP NPI Friends Provident Prudential Canada Life Scottish Widows Standard Life Clerical Medical Legal & General Norwich Union AXA Sun Life Annuity Based on Gilt Rate Annuity Based on Swap Rate Approx 2 basis.9.8.7.6.5.4.3.2. 64 6 66 67 68 69 7 7 72 73 74 7 Annuity Rate Per, (Male Age 65) Source: Annuity Direct, Man aged 65, Single Life, No guarantee, level annuity. Assumes 5% expense loading, and 8% PxA92 with CMI 7 improvements.
Implied rates of return vs Mortality assumption 5 5.% Internal Rate of Return 4.5% 4.% 3.5% AMP NPI Prudential Swap rate Gilt yield Scottish Widows 3.% 7% 75% 8% 85% 9% 95% % 5% % 5% 2% % of PMA92 (with CMI imps.) Source: Annuity Direct, Man aged 65, Single Life, No guarantee, level annuity. Assumes 5% expense loading, Annuity rates at 25 th May 3. 6 Background Highly competitive annuity market. Increasing exposure among issuers to credit-risky bonds. Heightened awareness of mortality risk due to past errors in forecasting. Scarcity of capital. Regulator s focus on risk management.
7 Policy Issues # How much capital is required to support annuity business? Statutory basis? Economic basis ~ Probability of capital exhaustion limited below some threshold level. What ROC is achieved? How do credit risk & mortality risk fit together? How can credit & mortality hedges be evaluated? How much of the bond spread is lost through (expected) default? 8 Policy Issues #2 Portfolio management: How much diversification is required within the bond portfolio? Is it appropriate to re-balance to maintain a minimum rating level in the bond portfolio? How likely are we to experience default rates above a specified level?
9 A Model For Annuity Business Aim to combine models for: Liabilities (& Mortality uncertainty) Asset model Term structure behaviour Credit behaviour (issuer credit states & credit spreads) Valuation rules Model choice What sort of model? Closed-form? Historic simulation? Monte-Carlo Simulation? There is an array of choices for each component of the model Parsimony Transparency Evolution
Model Components: Liabilities Analysis of 4 cohorts : Cohort # Age Sex (=Male, =Female) Annuity Payment Per Life Start Date (Deferral) Guarantee Period Type Smoker Non- Smoker Number of Lives in Cohort FALSE 2 55 6 FALSE 3 65 75 FALSE 4 75 FALSE Model Components: Liabilities 2 8,, Outflow ( ) 7,, 6,, 5,, 4,, 3,, Age= Age=55 Age=65 Age=75 2,,,, 2 3 4 6 Term (Years)
Model Components: Liabilities 3 25,, Outflow ( ) 2,, 5,,,, Age=75 Age=65 Age=55 Age= 5,, 5 9 3 7 2 25 29 33 37 4 45 Time (Years) 49 53 57 6 65 69 Model Components: Default-Free Term Structure Model 4 Spot Rate, R(t,T) 8% 6% 4% 2% % 8% 6% 4% 2% % 5 5 2 25 3 Term (Years) Note: α =.2, α 2 =.75, σ =., σ 2 =.2, µ=.96, g=-.5
Model Components: Credit Behaviour & Credit Spreads We have used a modified version of the (CreditMetrics-style) framework of Jarrow-Lando-Turnbull. Provides a method to describe rating changes and defaults. Provides a potential method for modelling the behaviour of credit spreads. 5 A sample -year credit transition matrix 6 -Year Credit & Default Transition Matrix Rating at End of Period AAA AA A BBB BB B CCC Default AAA 88.%.6%.9%.2%.3% - - - 2 AA 3.9% 88.% 6.7%.9%.3%.3% - - 3 A.2% 5.4% 87.8% 5.3%.8%.4% -.% 4 BBB.%.6% 9.6% 82.5% 5.3%.3%.2%.4% 5 BB.%.3%.% 9.7% 79.2% 7.2%.9%.7% 6 B -.2%.4%.8% 6.3% 85.4% 2.7% 4.2% 7 CCC - -.5%.5% 2.6% 9.6% 7.4% 4.5% Default - - - - - - -.% Rating at Start of Period
7 Implied default rates Cum Probability of Default (%) % 9% 8% 7% 6% % 4% 3% 2% % % 5 5 2 25 3 Time (Years) AAA AA A BBB BB B CCC Bond Yields Analysis at st March 2 8 Government Bond Swap Contract AA-rated Bond Prudential Annuity () Scottish Widows () A-rated Bond BBB-rated Bond BB-rated Bond B-rated Bond Default-Free Yield Risk / Liquidity Premium Expected Credit Loss Implied Spread Over Gilt 4 6 7 8 Basis Points 9
9 Sample credit spot spreads Spot Spread Over Risk-Free Rate 5% 4% 3% 2% % % AAA AA A BBB BB B CCC 2 4 6 8 2 4 6 8 2 22 24 26 28 3 M aturity (Years) Note: B&H best estimate transition matrix,δ=.333, π=3 2 Variation in US Credit Spreads Spread over Government Bond (%) 8 7 6 5 4 3 2 BBB minus Govt. AAA minus Govt. 92 93 94 9 96 97 98 99
Model Components: Mortality Model CMI Tables estimate Stochastic Mortality Model Generates random fluctuations around this central estimate. q x (t) = q x (,t)exp[ Y t - σ Y2 /2 - tσ X2 /2 ] 2 Y t = X t +σ Y Z Yt X t = X t- +σ X Z Xt Stochastic Mortality The Basic Idea 22 6 Number of deaths per 4 2 8 6 4 2 84 8 86 87 88 89 9 9 92 93 94 Year 9 96 97 98 99 2 22 Note : Historical & predicted female population death rates in England & Wales (75 84 yr olds)
Stochastic Mortality Calibration A / 7-year-old Male 23.25.2 q 7.5..5 2 4 6 8 2 Year 22 24 26 28 22 Note: σ X = 4% and σ Y = % Projected Payments Under Stochastic Mortality 24 2,, 9,, 8,, Total Outflow 7,, 6,, 5,, 4,, 3,, 2,,,,,, 3 5 7 9 3 5 7 9 Time (Years) Barrie & Hibbert Note:Cohort size =, lives
Model Components: Valuation Rules Economic analysis Value assets and liabilities at their market values What is the MV of the liabilities? We assume here that they are defaultfree, i.e. discount at gilt yields. 25 Model Components: Valuation Rules Statutory basis Different practice among UK life offices Typical approach: Calc IRR on bond portfolio cash flows (promised cashflows) Make deduction for prudent default loss (typically -25 bp) Apply 97.5% haircut Generally results in statutory yield > gilt yield Does this reflect liquidity or is default allowance inadequate? Also results in statutory solvency position less volatile than economic one Credit spread volatility feeds through to liabilities 26
Model Components: Performance Criteria 27 Monte Carlo simulation exercises generate a vast amount of data. What criteria do we want to use to compare different management strategies? Probability of insolvency Statutory Economic Fix insolvency probability & estimate required capital support 28 Case # Expected cash outflows matched with default-free discount (zero-coupon) bonds. Single issue per year of annuity outflow. Mortality is known and deterministic according to the CMI tables. (Stochastic mortality model is switched OFF) All cash flows should be perfectly matched.
Case # Matched Govt Bonds; SMM=off 29 Economic Liability Value ( M) 2 Year 5 Portfolio Market Value ( M) 2 3 Case #2 Portfolio invested in (notional) credit-risky (AAA-rated) bonds. Same portfolio value as for case #. Diversified (notional) portfolio of issuers. Mortality is known and deterministic according to the CMI tables. (Stochastic mortality model is switched OFF) Potential mis-matching due to credit risks.
Case #2 AAA-rated Bonds; SMM=off 3 Economic Liability Value ( M) 2 Year 5 Portfolio Market Value ( M) 2 Simulated default experience ( AAA-rated issuers) 32 Cumulative Number of Defaults 9 8 7 6 4 3 2 2 3 Time (Years) 4 5
Distribution of year-by-year portfolio delivered cash flows 33 2,, Portfolio Principal Payout 5,,,, 5,, 5 9 3 7 2 25 29 33 37 4 45 49 53 57 AAA-rated issues. Buy & hold. Time (Years) Case #8 Year 5; A-rated Bonds; SMM=on; No Rebalance 34 Economic Liability Value ( M) 2 Year 5 Portfolio Market Value ( M) 2
35 Case #8 Year 5; A-rated Bonds; SMM=on; No Rebalance 999 998 997 996 995 994 993 992 99 99 989 988 987 986 985 984 983 982 98 98 979 978 977 976 975 974 973 972 97 97 969 968 967 966 965 964 963 962 96 96 959 958 957 956 955 954 953 952 95 9 949 948 947 946 945 944 943 942 94 94 939 938 937 936 935 934 933 932 93 93 929 928 927 926 925 924 923 922 92 92 99 98 97 96 95 94 93 92 9 9 99 98 97 96 95 94 93 92 9 9 899 898 897 896 895 894 893 892 89 89 889 888 887 886 885 884 883 882 88 88 879 878 877 876 875 874 873 872 87 87 869 868 867 866 865 864 863 862 86 86 859 858 857 856 855 854 853 852 85 8 849 848 846 847 845 844 843 842 84 84 839 838 837 836 835 834 833 832 83 83 829 828 827 826 825 824 822 82 823 82 89 88 87 86 85 84 83 82 8 8 89 88 87 86 85 84 83 82 8 8 799 798 797 796 795 794 793 792 79 79 789 788 787 786 785 784 783 782 78 78 779 778 777 776 775 774 773 772 77 77 769 768 767 766 765 764 763 762 76 76 759 758 757 756 755 754 753 752 75 7 749 748 747 746 745 744 743 742 74 74 739 738 737 736 735 734 733 732 73 73 729 728 727 726 725 724 723 722 72 72 79 78 77 76 75 74 73 72 7 7 79 78 77 76 75 74 73 72 7 7 699 698 697 696 695 694 693 692 69 69689 688 687 686 685 684 683 682 68 68 679 678 677 676 675 674 673 672 67 67 669 668 667 666 665 664 663 662 66 66 659 658 657 656 655 654 653 652 65 6 649 648 647 646 645 644 643 642 64 64 639 638 637 636 635 634 633 632 63 63 629 628 627 626 625 624 623 622 62 62 69 68 67 66 65 64 63 62 6 6 69 68 67 66 65 64 63 62 6 6 599 598 597 596 595 594 593 592 59 59 589 588587 586 585 584 583 582 58 58 579 578 577 576 575 574 573 572 57 57 569 568 567 566 565 564 563 562 56 56 559 558 557 556 555 554 553 552 55 5 549 548 547 546 545 544 543 542 54 54 539 538 537 536 535 534 533 532 53 53 529 528 527 526 525 524 523 522 52 52 59 58 57 56 55 54 53 52 5 5 9 8 7 6 5 4 3 2 499 498 497 496 495 494 493 492 49 49 489 488 487 486 485 484 483 482 48 48 479 478 477 476 475 474 473 472 47 47 469 468 467 466 465 464 463 462 46 46 459 458 457 456 455 454 453 452 45 4 449 448 447 446 445 444 443 442 44 44 439 438 437 436 435 434 433 432 43 43 429 428 427 426 425 424 423 422 42 42 49 48 47 46 45 44 43 42 4 4 49 48 47 46 45 44 43 42 4 4 399 398 397 396 395 394 393 392 39 39 389 388 387 386 385 384 383 382 38 38 379 378 377 376 375 374 373 372 3737 369 368 367 366 365 364 363 362 36 36 359 358 357 356 355 354 353 352 35 3 349 348 347 346 345 344 343 342 34 34 339 338 337 336 335 334 333 332 33 33 329 328 327 326 325 324 323 322 32 32 39 38 37 36 35 34 33 32 3 3 39 38 37 36 35 34 33 32 3 299 298 297 296 295 294 293 292 29 29 289 288 287 286 285 284 283 282 28 28 279 278 277 276 275 274 273 272 27 27 269 268 267 266 265 264 263 262 26 26 259 258 257 256 255 254 253 252 25 2 249 248 247 246 245 244 243 242 24 24 239 238 237 236 235 234 233 232 23 23 229 228 227 226 225 224 223 222 22 22 29 28 27 26 25 24 23 22 2 2 29 28 27 26 25 24 23 22 2 99 98 97 96 95 94 93 92 9 9 89 88 87 86 85 84 83 82 8 8 79 78 77 76 75 74 73 72 7 7 69 68 67 66 65 64 63 62 6 6 59 58 57 56 55 54 53 52 5 49 48 47 46 45 44 43 42 4 4 39 38 37 36 35 34 33 32 3 3 29 28 27 26 25 24 23 22 2 2 9 8 7 6 5 4 3 2 9 8 7 6 5 4 3 2 99 98 97 96 95 94 93 92 9 9 2 3 4 5 6 7 8 9 2 3 4 5 6 7 8 9 2 2 22 23 24 25 26 27 28 29 3 3 32 33 34 35 36 37 38 39 4 4 42 43 44 45 46 47 48 49 5 52 53 54 55 56 57 58 59 6 6 62 63 64 65 66 67 68 69 7 7 72 73 74 75 76 77 78 79 8 8 82 83 84 85 86 87 88 89 2 2 Portfolio Market Value ( M) Economic Liability Value ( M) Year 5 36 Case #8 Year 5; A-rated Bonds; SMM=on; No Rebalance 999 998 997 996 995 994 993 992 99 99 989 988 987 986 985 984 983 982 98 98 979 978 977 976 975 974 973 972 97 97 969 968 967 966 965 964 963 962 96 96 959 958 957 956 955 954 953 952 95 9 949 948 947 946 945 944 943 942 94 94 939 938 937 936 935 934 933 932 93 93 929 928 927 926 925 924 923 922 92 92 99 98 97 96 95 94 93 92 9 9 99 98 97 96 95 94 93 92 9 9 899 898 897 896 895 894 893 892 89 89 889 888 887 886 885 884 883 882 88 88 879 878 877 876 875 874 873 872 87 87 869 868 867 866 865 864 863 862 86 86 859 858 857 856 855 854 853 852 85 8 849 848 847 846 845 844 843 842 84 84 839 838 837 836 835 834 833 832 83 83 829 828 827 826 825 824 823 822 82 82 89 88 87 86 85 84 83 82 8 8 89 88 87 86 85 84 83 82 8 8 799 798 797 796 795 794 793 792 79 79 789 788 787 786 785 784 783 782 78 78 779 778 777 776 775 774 773 772 77 77 769 768 767 766 765 764 763 762 76 76 759 758 757 756 755 754 753 752 75 7 749 748 747 746 745 744 743 742 74 74 739 738 737 736 735 734 733 732 73 73 729 728 727 726 725 724 723 722 72 72 79 78 77 76 75 74 73 72 7 7 79 78 77 76 75 74 73 72 7 7 699 698 697 696 695 694 693 692 69 69 689 688 687 686 685 684 683 682 68 68 679 678 677 676 675 674 673 672 67 67 669 668 667 666 665 664 663 662 66 659 66 658 657 656 655 654 653 652 65 6 649 648 647 646 645 644 643 642 64 64 639 638 637 636 635 634 633 632 63 63 629 628 627 626 625 624 623 622 62 62 69 68 67 66 65 64 63 62 6 6 69 68 67 66 65 64 63 62 6 6 599 598 597 596 595 594 593 592 59 59 589 588 587 586 585 584 583 582 58 58 579 578 577 576 575 574 573 572 57 57 569 568 567 566 565 564 563 562 56 56 559 558 557 556 555 554 553 552 55 5 549 548 547 546 545 544 543 542 54 54 539 538 537 536 535 534 533 532 53 53 529 528 527 526 525 524 523 522 52 52 59 58 57 56 55 54 53 52 5 5 9 8 7 6 5 4 3 2 499 498 497 496 495 494 493 492 49 49 489 488 487 486 485 484 483 482 48 48 479 478 477 476 475 474 473 472 47 47 469 468 467 466 465 464 463 462 46 46 459 458 457 456 455 454 453 452 45 4 449 448 447 446 445 444 443 442 44 44 439 438 437 436 435 434 433 432 43 43 429 428 427 426 425 424 423 422 42 42 49 48 47 46 45 44 43 42 4 4 49 48 47 46 45 44 43 42 4 4 399 398 397 396 395 394 393 392 39 39 389 388 387 386 385 384 383 382 38 38 379 378 377376 375 374 373 372 37 37 369 368 367 366 365 364 363 362 36 36 359 358 357 356 355 354 353 352 35 3 349 348 347 346 345 344 343 342 34 34 339 338 337 336 335 334 333 332 33 33 329 328 327 326 325 324 323 322 32 32 39 38 37 36 35 34 33 32 3 3 39 38 37 36 35 34 33 32 3 299 298 297 296 295 294 293 292 29 29 289 288 287 286 285 284 283 282 28 28 279 278 277 276 275 274 273 272 27 27 269 268 267 266 265 264 263 262 26 26 259 258 257 256 255 254 253 252 25 2 249 248 247 246 245 244 243 242 24 24 239 238 237 236 235 234 233 232 23 23 229 228 227 226 225 224 223 222 22 22 29 28 27 26 25 24 23 22 2 2 29 28 27 26 25 24 23 22 2 99 98 97 96 95 94 93 92 9 9 89 88 87 86 85 84 83 82 8 8 79 78 77 76 75 74 73 72 7 7 69 68 67 66 65 64 63 62 6 6 59 58 57 56 55 54 53 52 5 49 48 47 46 45 44 43 42 4 4 39 38 37 36 35 34 33 32 3 3 29 28 27 26 25 24 23 22 2 2 9 8 7 6 5 4 3 2 9 8 7 6 5 4 3 2 99 98 97 96 95 94 93 92 9 9 2 4 3 5 6 7 8 9 2 3 4 5 6 7 8 9 2 2 22 23 24 25 26 27 28 29 3 3 32 33 34 35 36 37 38 39 4 4 42 43 44 45 46 47 48 49 5 52 53 54 55 56 57 58 59 6 6 62 63 64 65 66 67 68 69 7 7 72 73 74 75 76 77 78 79 8 8 82 83 84 85 86 87 88 89.5.6.7.8.9...2.3.4.5.5.6.7.8.9...2.3.4.5.6.7.8.9 Solvency Ratio Stochastic Mortality Factor Year 5
37 Case #8 Year 5; A-rated Bonds; SMM=on; No Rebalance 999 998 997 996 995 994 993 992 99 99 989 988 987 986 985984 983 982 98 98 979 978 977 976 975 974 973 972 97 97 969 968 967 966 965 964 963 962 96 96 959 958 957 956 955 954 953 952 95 9 949 948 947 946 945 944 943 942 94 94 939 938 937 936 935 934 933 932 93 93 929 928 927 926 925 924 923 922 92 92 99 98 97 96 95 94 93 92 9 9 99 98 97 96 95 94 93 92 9 9 899 898 897 896 895 894 893 892 89 89 889 888 887 886 885 884 883 882 88 88 879 878 877 876 875 874 873 872 87 87 869 868 867 866 865 864 863 862 86 86 859 858 857 856 855 854 853 852 85 8 849 848 847 846 845 844 843 842 84 84 839 838 837 836 835 834 833 832 83 83 829 828 827 826 825 824 823 822 82 82 89 88 87 86 85 84 83 82 8 8 89 88 87 86 85 84 83 82 8 8 799 798 797 796 795 794 793 792 79 79 789 788 787 786 785 784 783 782 78 78 779 778 777 776 775 774 773 772 77 77 769 768 767 766 765 764 763 762 76 76 759 758 757 756 755 754 753 752 75 7 749 748 747 746 745 744 743 742 74 74 739 738 737 736 735 734 733 732 73 73 729 728 727 726 725 724 723 722 72 72 79 78 77 76 75 74 73 72 7 7 79 78 77 76 75 74 73 72 7 7 699 698 697 696 695 694 693 692 69 69 689 688 687 686 685 684 683 682 68 68 679 678 677 676 675 674 673 672 67 67 669 668 667 666 665 664 663 662 66 66 659 658 657 656 655 654 653 652 65 6 649 648 647 646 645 644 643 642 64 64 639 638 637 636 635 634 633 632 63 63 629 628 627 626 625 624 623 622 62 62 69 68 67 66 65 64 63 62 6 6 69 68 67 66 65 64 63 62 6 6 599 598 597 596 595 594 593 592 59 59 589 588 587 586 585 584 583 582 58 58 579 577 578 576 575 574 573 572 57 57 569 568 567 566 565 564 563 562 56 56 559 558 557 556 555 554 553 552 55 5 549 548 547 546 545 544 543 542 54 54 539 538 537 536 535 534 533 532 53 53 529 528 527 526 525 524 523 522 52 52 59 58 57 56 55 54 53 52 5 5 9 8 7 6 5 4 3 2 499 498 497 496 495 494 493 492 49 49 489 488 487486 485 484 483 482 48 48 479 478 477 476 475 474 473 472 47 47 469 468 467 466 465 464 463 462 46 46 459 458 457 456 455 454 453 452 45 4 449 448 447 446 445 444 443 442 44 44 439 438 437 436 435 434 433 432 43 43 429 428 427 426 425 424 423 422 42 42 49 48 47 46 45 44 43 42 4 4 49 48 47 46 45 44 43 42 4 4 399 398 397 396 395 394 393 392 39 39 389 388 387 386 385 384 383 382 38 38 379 378 377376 375 374 373 372 37 37 369 368 367 366 365 364 363 362 36 36 359 358 357 356 355 354 353 352 35 3 349 348 347 346 345 344 343 342 34 34 339 338 337 336 335 334 333 332 33 33 329 328 327 326 325 324 323 322 32 32 39 38 37 36 35 34 33 32 3 3 39 38 37 36 35 34 33 32 3 299 298 297 296 295 294 293 292 29 29 289 288 287 286 285 284 283 282 28 28 279 278 277 276 275 274 273 272 27 27 269 268 267 266 265 264 263 262 26 26 259 258 257 256 255 254 253 252 25 2 249 248 247 246 245 244 243 242 24 24 239 238 237 236 235 234 233 232 23 23 229 228 227 226 225 224 223 222 22 22 29 28 27 26 25 24 23 22 2 2 29 28 27 26 25 24 23 22 2 99 98 97 96 95 94 93 92 9 9 89 88 87 86 85 84 83 82 8 8 79 78 77 76 75 74 73 72 7 7 69 68 67 66 65 64 63 62 6 6 59 58 57 56 55 54 53 52 5 49 48 47 46 45 44 43 42 4 4 39 38 37 36 35 34 33 32 3 3 29 28 27 26 25 24 23 22 2 2 9 8 7 6 5 4 3 2 9 8 7 6 5 4 3 2 99 98 97 96 95 94 93 92 9 9 2 3 4 5 6 7 8 9 2 3 4 5 6 7 8 9 2 2 22 23 24 25 26 27 28 29 3 3 32 33 34 35 36 37 38 39 4 4 42 43 44 45 46 47 48 49 5 52 53 54 55 56 57 58 59 6 6 62 63 64 65 66 67 68 69 7 7 72 73 74 75 76 77 78 79 8 8 82 83 84 85 86 87 88 89 2. 2. 3. 3. 4. 4. 5..5.6.7.8.9...2.3.4.5.6.7.8.9 Solvency Ratio Average Credit Status Year 5 38 Case #8 Year 5; A-rated Bonds; SMM=on; No Rebalance 89 88 87 86 85 84 83 82 8 8 79 78 77 76 75 74 73 72 7 7 69 68 67 66 65 64 63 62 6 6 59 58 57 56 55 54 53 52 5 49 48 47 46 45 44 43 42 4 4 39 38 37 36 35 34 33 32 3 3 29 28 27 26 25 24 23 22 2 2 9 8 7 6 5 4 3 2 9 8 7 6 5 43 2 9 9 92 93 94 95 96 97 98 99 2 3 4 5 6 7 8 9 2 3 4 5 6 7 8 9 2 2 22 23 24 25 26 27 28 29 3 3 32 33 34 35 36 37 38 39 4 4 42 43 44 45 46 47 48 49 5 52 53 54 55 56 57 58 59 6 6 62 63 6465 66 67 68 69 7 7 72 73 74 75 76 77 78 79 8 8 82 83 84 85 86 87 88 89 9 9 92 93 94 95 96 97 98 99 2 22 23 24 25 26 27 28 29 2 2 22 23 24 25 26 27 28 29 22 22 222 223 224 225 226 227 228 229 23 23 232 233 234 235 236 237 238 239 24 24 242 243 244 245 246 247 248 249 2 25 252 253 254 255 256 257 258 259 26 26 262 263 264 265 266 267 268 269 27 27 272 273 274 275 276 277 278 279 28 28 282 283 284 285 286 287 288 289 29 29 292 293 294 295 296 297 298 299 3 32 33 34 35 36 37 38 39 3 3 32 33 34 35 36 37 38 39 32 32 322 323 324 325 326 327 328 329 33 33 332 333 334 335 336 337 338 339 34 34 342 343 344345 346 347 348 349 3 35 352 353 354 355 356 357 358 359 36 36 362 363 364 365 366 367 368 369 37 37 372 373 374 375 376 377 378 379 38 38 382 383 384 385 386 387 388 389 39 39 392 393 394 395 396 397 398 399 4 4 42 43 44 45 46 47 48 4494 42 43 44 45 46 47 48 49 42 42 422 423 424 425 426 427 428 429 43 43 432 433 434 435 436 437 438 439 44 44 442 443 444 445 446 447 448 449 4 45 452 453 454 455 456 457 458 459 46 46 462 463 464 465 466 467 468 469 47 47 472 473 474 475 476 477 478 479 48 48 482 483 484 485 487486 488 489 49 49 492 493 494 495 496 497 498 499 2 3 4 5 6 7 8 9 5 5 52 53 54 55 56 57 58 59 52 52 522 523 524 525 526 527 528 529 53 53 532 533 534 535 536 537 538 539 54 54 542 543 544 545 546 547 548 549 5 55 552 553 554 555 556 557 558 559 56 56 562 563 564 565 566 567 568 569 57 57 572 573 574 575 576 577 578 579 58 58 582 583 584 585 586 587 588 589 59 59 592 593 594 595 596 597 598 599 6 6 62 63 64 65 66 67 68 69 6 6 62 63 64 65 66 67 68 69 62 62 622 623 624 625 626 627 628 629 63 63 632 633 634 635 636 637 638 639 64 64 642 643 644 645 646 647 648 649 6 65 652 653 654 655 656 657 658 659 66 66662 663 664 665 666 667 668 669 67 67 672 673 674 675 676 677 678 679 68 68 682 683 684 685 686 687 688 689 69 69 692 693 694 695 696 697 698 699 7 7 72 73 74 75 76 77 78 7 79 7 72 73 74 75 76 77 78 79 72 72 722 723 724 725 726 727 728 729 73 73 732 733 735 734 736 737 738 739 74 74 742 743 744 745 746 747 748 749 7 75 752 753 754 755 756 757 758 759 76 76 762 763 764 765 766 767 768 769 77 77 772 773 774 775 776 777 778 779 78 78 782 783784 785 786 787 788 789 79 79 792 793 794 795 796 797 798 799 8 8 82 83 84 85 86 87 88 89 8 8 82 83 84 85 86 87 88 89 82 82 822 823 824 825 826 827 828 829 83 83 832 833 834 835 836 837 838 839 84 84 842 843 844 845 846 847 848 849 8 85 852 853 854 855 856 857 858 859 86 86 862 863 864 865 866 867 868 869 87 87 872 873 874 875 876 877 878 879 88 88 882 883 884 885 886 887 888 889 89 89 892 893 894 895 896 897 898 899 9 9 92 93 94 95 96 97 98 99 9 9 92 93 94 95 96 97 98 99 92 92 922 923 924 925 926 927 928 929 93 93 932 933 934 935 936 937 938 939 94 94 942 943 944 945 946 947 948 949 9 95 952 953 954 955 956 957 958 959 96 96 962 963 964 965 966 967 968 969 97 97 972 973 974 975 976 977 978 979 98 98 982 983 984 985 986 987988 989 99 99 992 993 994 995 996 997 998 999 2.5.6.7.8.9...2.3.4.5.6.7.8.9 Solvency Ratio Cumulative Number of Defaults Year 5
39 Assessing risk-based capital What do we mean by risk-based capital? The capital required to fund the liabilities with a given level of confidence. Two components: Fair/realistic value Mis-match reserve Two approaches: run-off approach VAR-style percentile calculation Capital requirements to support various credit strategies 4 5% Fixed mortality Capital requirement (% realistic valuation) % 5% Stochastic mortality % GOVT AAA AA A Credit rating of bond portfolio
4 Summary Annuity providers are operating in an environment of intense competition. Liabilities are increasingly supported by credit-risky asset portfolios. Profitability hinges on a number of uncertain factors: The future realised credit experience The future realised mortality experience The level of anticipated cash flow matching Interest rate variability Stochastic models enable providers to investigate & quantify these factors providing a path towards: A better understanding of total portfolio exposure Better risk management & capital allocation 42 Copyright 3 Barrie & Hibbert Limited Barrie & Hibbert Limited is regulated by the Financial Services Authority The information in this report is believed to be correct but cannot be guaranteed. All opinions and estimates included in this report constitute our judgement as of the date indicated and are subject to change without notice. This report is intended for information purposes only and is not intended as an offer to buy or sell securities. 23 rd June 3